Roth IRAs: A Bad Idea?

I have a feeling this may turn out to be one of the most useful things I EVER post.David Collum is a professor at Cornell University and a wickedly funny financial pundit and sometime blogger. Perhaps more consistent and better than I on that count. ;) Each year since 2009 he has written an annual review of what he has found most important to him and his investing thesis. It's a great read. Google it.

Last year his think piece contained a discussion of Roth IRAs. He has an interesting take. In short, he believes they are a scam. I could re-characterize what he said but I found the whole argument so worthwhile that I am going to simply CUT AND PASTE IT and let you hear David and what he has to say, because by comparison to David I am a very poor writer. I did omit the numerous embedded citations though. Enjoy!

Roth IRA: A Bad Idea

Before leaving the world of pensions I’m gonna pick a fight with Roth IRAs. When the Roth IRA was first announced I had a unique—as in only-guy-on-the-planet unique—visceral response. The original IRA was very farsighted: Savers were allowed to compound wealth unfettered by taxes while the government deferred tax revenues to future generations. By contrast, the Roth IRA pulled tax revenues forward, leaving future generations to take a hike. Imagine the truly awesome demographic problems we would have if the Roth had been introduced in the 60s and the entire baby boom generation became entirely tax exempt. Was this an oversight? I don’t think so. The introduction of the Roth and the substantial revenues from regular-to-Roth rollovers coincided with the Clinton administration’s efforts to balance the on-balance-sheet Federal budget for the first time in decades. That is my minor gripe. To set up my really big gripe we must first dispel a widely held misconception and a common oversight.  In a regular IRA, the money is taxed at the end, whereas in a Roth IRA taxes are levied up front. If the two are taxed at the same rate—this is a critical provision—the outcome is identical. They are not just similar, it’s an identity. Break out your calculator if you must. There is no differential advantage offered by compounding in the Roth over the regular IRA. Simply put: Any advantage of the Roth IRA relative to a regular IRA necessarily stems from a lower tax rate while working than in retirement. Period/full stop.  The tax rates of the Roth and regular IRAs are fundamentally different: Roth IRA: Front-end loaded taxes paid at the marginal tax rate (highest tax bracket). Regular IRA: Back-end loaded taxes paid at the effective tax rate (integrated over all tax brackets). The distinction of marginal versus effective tax rate is critical and seems to be lacking from most analyses. One can calculate marginal and effective rates for any income online.  Let’s return to the top-5-percentile family—the 5 percenter. If they had used a regular IRA, they would be paying a 7% effective tax rate incurred on their $48,000 per year withdrawal in retirement. They paid an approximate 32% marginal tax rate—the tax rate at the top bracket—to shelter a few thousand per year in a Roth IRA. The numbers simply do not work. It is worse than that. Let us consider the lucky soul family—the extraordinarily rare couple—who actually accrued 25 annual salaries in their retirement account. For this family a 4% annual withdrawal will be equal to an annual salary while working, placing them in the same tax bracket (ignoring unknowable tax law changes). Even so, they paid 32% marginal tax on the Roth to avoid a 22% effective tax rate incurred by the regular IRA. The numbers still don’t work. I do not understand why the Roth is being sold so enthusiastically to the public. Now ponder all those folks who rolled over a lump sum from a regular to a Roth IRA. They not only paid the marginal tax rate on the rollover but caused the marginal rate to spike to a higher level! It’s hard to imagine that will prove to be a smart move. Congress is considering moving all pension funds to what is effectively Roth IRA rules as part of their Fiscal Cliff negotiations. You young guys are about to get hosed.

It didn't happen but Congress WAS entertaining that last idea. Is it coming? I don't know but it's a huge watch out. Anyway, a great take on Roth IRAs and a valuable counterpoint to all the financial planners and brokers who eagerly pushed their clients into the Roth orbit in The Great Roth Asset Collection of 2011/2012 that we discussed before.

No Social Security Benefit Increase. Sorry!

The Bureau of Labor and Statistics reported yesterday morning that the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) was at 213.898 in July. What does this mean? Likely there will be no change to Social Security Benefits and the Maximum Contribution Base this year. (Hey it's Friday the 13th! You expected good news?)

There wasn't one last year either. Luckily they can't reduce the benefit should CPI start falling on a sustained basis. 0.25% on your savings (money market) and reduced SS benefits. That would really hurt retirees.

Annuities in 401k Plans?

Insurers and mutual-fund companies are have become aware that the decade's poor stock market performance and low fixed income yields means there's an acute danger that Americans will outlive their savings.They've responded by selling annuities as holdings for 401k plans.What's an anuuity you say? Rather than go into the details of straight annuities ad all their permutations I will point you to the explanation given by Investopedia:

Annuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the benefits of strong returns from their fund's investments.

That's an annuity. Picking up the story, written by Bloomberg's reporter Martha Collins:

The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs. President Barack Obama on Feb. 1 called for a change in government rules to allow adding annuities to 401(k) retirement plans. While the annuities offer a steady stream of income in exchange for upfront payments, the price for peace of mind may be higher fees and less access to cash.

“You’re paying for a benefit that you may or may not use,” said Glenn Daily, a fee-only insurance consultant, referring to annuities. “These things are so complicated I doubt many people will understand what they’re buying.”

MetLife Inc. and Prudential Financial Inc., the two largest U.S. life insurers, are aiming to tap into what may become a $1 trillion market by blending annuities with target-date 401(k) funds, which shift to more conservative assets such as bonds as an investor nears retirement. The funds were used as the default investment by 87 percent of retirement plans in 2008 with automatic enrollment, according to Vanguard Group Inc.

Insurers are working with mutual-fund companies to build the guarantees into 401(k) funds because state laws require an insurance charter to sell annuities.

The income guarantee that insurers and mutual-fund companies are developing lets workers pay for an annuity in installments using their regular contributions to retirement accounts, said Garth Bernard, chief executive officer of the Boston-based Sharper Financial Group, which specializes in retirement income solutions for financial companies.

Fund Scrutiny

Legislators have scrutinized target-date funds because some lost as much as 41 percent in 2008. The funds attracted $45 billion last year, up from $28.7 billion in 2006, according to Chicago-based Morningstar Inc.

“It’s a huge market,” said Tom Johnson, senior vice president in New York Life Insurance Co.’s retirement income security business, of the potential for annuity/retirement accounts. Americans held $6.8 trillion in 401(k) plans and IRAs as of September 2009, according to the Investment Company Institute, a Washington-based mutual fund trade group. If 15 percent of those assets went to guarantees, it could mean more than $1 trillion for insurers, Johnson said.

“We believe guaranteed income is important because it locks in a level of retirement income,” said Jamie Kalamarides, senior vice president of retirement solutions for Prudential, based in Newark, New Jersey. “Most Americans aren’t saving enough.”

Prudential, MetLife

Prudential and MetLife have already introduced income guarantees designed for target-date funds. Investment-management firm BlackRock Inc. is offering to employers a target-date fund with a MetLife annuity as the fixed-income component, said Kristi Mitchem, head of New York-based BlackRock’s U.S. defined contribution.

Asset manager AllianceBernstein Holding LP is working on a similar product with multiple insurers including Axa SA, while Putnam Investments LLC expects to announce a lifetime income benefit for its 401(k) funds this year, the companies said.

Fidelity Investments, the largest target-date fund provider, offers employers a 401(k) fund with an annuity through insurer Genworth Financial Inc., said Michael Doshier, vice president of the Boston-based company’s workplace investing group. Vanguard is also exploring income stream options within its retirement plans, said spokeswoman Linda Wolohan.

Two Forms

The types of guarantees being developed vary and have trade-offs, said Bernard of Sharper Financial. One type has relatively high fees and another prevents retirees from liquidating their savings once they start receiving monthly income, he said.

Annuities and guaranteed income benefits in retirement plans can be an important safeguard against outliving savings as more Americans fund their own retirement, said Moshe Milevsky, a finance professor at York University in Toronto. Combining them with target-date funds is a concern, he said.

“Let’s not get carried away,” said Milevsky, who specializes in insurance. “To say that we are going to lever these guarantees on top of target-date funds that have not been fully tested yet, I’d be wary.” The Department of Labor endorsed target-date funds as a default investment option for employers in 2007.

The Treasury and Labor departments started reviewing public comments this month on how to make it easier to convert savings into lifetime income streams.

Government Guidance

“Many plan sponsors would like explicit guidance from regulators,” said Tom Idzorek, chief investment officer at Ibbotson Associates, a unit of Morningstar. A government endorsement would create “a rush of sponsors trying to add these to plans,” he said.

Last year, 4 percent of employers offered a plan that allowed participants to allocate a portion of contributions to an income guarantee, according to Callan Associates Inc., which surveyed 90 plan sponsors with more than $100 million in assets. The previous year, the total was 3 percent. Employers are concerned about cost, portability and how to pick an insurance provider, said Lori Lucas, defined contribution practice leader for the San Francisco-based investment-consulting firm.

Annual fees for guarantees in 401(k)s can be 95 basis points or more above the retirement plan’s investment-management fees, she said. A basis point is 0.01 percentage point.

“Those fees may reduce account values by 7 percent to 9 percent over 10 years,” said Drew Denning, vice president of retirement and investor services at Principal Financial Group Inc. The Des Moines-based firm, the fourth-largest provider of target-date funds, recommends investors wait until retirement, when they know their financial circumstances, before deciding to shift a portion of their savings to an annuity, Denning said.

Switching Insurers

Employers also are concerned that guarantees will prevent employees from exiting their retirement plans if they transfer jobs, said John Carl, president of the New York-based Retirement Learning Center, which consults plan sponsors.

“The portability of these contracts at this juncture is minimal between insurers,” Carl said. “You’re essentially locked into the program you choose -- or are defaulted into.”

That’s because an insurer calculates its annuity payments based in part on the life expectancy of a pool of individuals holding such contracts, which makes it harder to switch from one insurer to another, Carl said.

Solvency of the offering company is another impediment, said Robert Toth, an attorney who specializes in retirement plan products and services.

“How do you make a decision that the insurance company will still be here 30 years from now?” said Toth, who is based in Fort Wayne, Indiana. “Employers fear making that choice and being responsible.”

Longevity Insurance

Longevity insurance, another type of income guarantee, may be a better, cheaper option for protecting against outliving savings, said Daily, the New York-based insurance consultant. Longevity insurance guarantees future monthly income typically around age 80 and may be less expensive because “you’re only buying the tail end” of the benefit, Daily said.

“Why should you take the plunge now instead of waiting?” said Daily. “Some of these guarantees are so hard to value that you have to be an economist to figure it out.”

That's a balanced article and I compliment Ms. Collins for presenting it that way.

Roth Conversion Strategies

2010 is The Year of the Roth. This has been a constant theme of mine in this blog as I attempt to highlight the opportunity and point out some of its dangers and pitfalls.

As with most strategies there is an "offensive" way to play it as well as a "defensive" way. The following article is definitely an offensive-minded strategy, involving account-splitting and characterization reversals. I hadn't thought of this. Here's what was written:

U.S. investors who convert a traditional Individual Retirement Account into two or more Roth accounts to make a bet on the market rising can save on taxes if it doesn’t.

The multiple Roth IRAs should be split among different investments, according to Joseph Spada, managing director of Summit Financial Resources in Parsippany, New Jersey, whose average client has $25 million in net worth. A conversion can be reversed if some of the assets lose value, saving $140,000 in income taxes, for example, on an account worth $1.2 million.

“The IRS is giving you a bucket of mulligans with your IRA,” said John Bledsoe, a Dallas-based estate planner, referring to the term used in golf for a do-over. Investors who convert to a Roth IRA have until Oct. 17, 2011, to undo their decisions and recoup taxes paid, said Bledsoe, author of “The Gospel of Roth,” whose average client has $100 million or more in assets.

The Internal Revenue Service lifted income restrictions this year on converting a traditional IRA to a Roth IRA, meaning U.S. taxpayers making more than $100,000 a year in adjusted income can make the transfer. There’s no limit on conversions if an investor has multiple IRAs or a cap on the amount that can be converted.

Those who switch from a traditional IRA, where taxes are paid only on withdrawals, to a Roth IRA, must pay income taxes upfront in exchange for tax-free withdrawals during retirement. A taxpayer in the top income bracket with an IRA worth $1.2 million would pay 35 percent or $420,000 in federal taxes when converting the account into a Roth IRA this year.

Three-Way Divide

A $1.2 million account could be divided into three Roth IRAs worth $400,000 each, Spada said. The first account may be invested in fixed income, the second in equities and the third in high-yield bonds. If one fund lost value, the investor would save the 35 percent tax paid on the $400,000 account, or $140,000, by recharacterizing that Roth IRA into a traditional one, Spada said.

“You don’t want to pay the tax on an account that actually went down in value,” Spada said. Undoing the conversion doesn’t change the fact you lost money on your investments, which is why investors shouldn’t take more risk than they normally would when converting to multiple Roth IRAs, he said.

Free Look

Theodore Lustig converted his family’s IRA into three Roth accounts with different asset types on Jan. 4. The 55-year-old attorney put the first account in fixed income, the second in oil stocks and the third in U.S. bank stocks.

“You have a free look,” said Lustig, who’s based in Dallas. “You have until October 2011 to see how your investments have performed.”

Lustig said he could reverse the conversion on accounts that decline or, “if everything works out,” pay a lower tax on income from accounts converted in January that rise in value.

“Even if it turns out that I will save taxes by converting, the conversion may still be undone if I just get cold feet or have unforeseen expenses and no longer want to pay the taxes on the income,” he said.

Wow. Combine a complicated law with a monetary incentive and all sorts of things can happen. Sort of like derivatives. Or securitization.

I don't have an opinion on these strategies. They purport to give a free lunch, something I don't believe exists in this world. I guess I would want to have a LONG conversation about them before I even considered them. As every tax attorney can tell you, "recharacterization"-- when used by the IRS-- is painful. So can be updated guidance, revenue rulings and tax cases. As with everything on this blog, do your own due diligence.

Income Replacement Rate Fallacy

"Rules of thumb are, quite simply, rules of dumb."--

Larry Kotlikoff, BU Professor and co-author of "The Coming Generational Storm" and "Spend Til the End"

When we use "rules of thumb" we are making an approximation instead of a precise measurement. That's what rules of thumb mean, literally, using your thumb as a measuring stick or ruler. Then why are we surprised when those measurements don't add up?

Robert Powell has written an article about a new study by two University of Wisconsin-Madison professors showing just how badly use of a common rule of thumb regarding income replacement rates in retirement turned out to be. Their findings were about what you would expect:

The rule of thumb is that you'll need to replace 70% of your pre-retirement income on average once you retire, but evidence continues to mount that this assumption by many professionals and retirement savers is way off base.

Now, a new study by two professors casts further doubt on the idea that the widely used replacement-rate figure is a sound basis for building a retirement plan.

"The rule of thumb that replacement rates should be above 70% to maintain living standards in retirement is conceptually flawed," wrote John Karl Scholz and Ananth Seshadri, two University of Wisconsin-Madison professors, in their paper "What Replace Rates Should Households Use?"

In fact, no more than 15% of the population Scholz and Seshadri studied need to replace 65% to 90% of their pre-retirement income. And almost 50% of the population needed to replace less than 65% of their pre-retirement income.

In short, the authors said: More refined guidance is needed to serve households well.
Target replacement rates are less than 100% for three main reasons, according to the study published by the Michigan Retirement Research Center.

"First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement."

Still, that ignores a whole host of issues related to coming up with the right replacement rate.

For instance, consider what effect children likely have on your expenses prior to and in retirement, the authors wrote. Most calculators use the same replacement rate regardless of the number of children in a household, the authors said. But the number of children you have matters when it comes to calculating your replacement rate. In fact, all things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working. (Of course, the kids' ages at the time of retirement will affect that calculation.)

What is needed for your real number is not back-of-the-napkin calculations but something the authors refer to as the life-cycle model. To be fair, the author's study did note that replacement rates -- even when using the life-cycle model -- did confirm some commonly held beliefs. Specifically, "replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families."

But even then you still need to take into account the effect of federal taxes, medical expenses, education, and what the authors call earnings shocks or -- in laymen's terms -- layoffs and big salary increases.

When all is said and done, the authors suggest that optimal replacement rates could range anywhere from 23% (for single parents with several children and a negative late-in-career earnings shock) to 240% (for low-income, married households with a few children and a substantial positive late-in-career earnings shock).

In other words, "conventional advice may overstate optimal targets by a factor of two, or understate retirement consumption needs by a factor of three depending on the idiosyncratic experiences of households," Scholz and Seshadri said in their study. See the study (PDF).

That's especially the case when it comes to online calculators, the authors said. With the life-cycle model, the replacement rate depends on factors often ignored by online calculators. "The savings requirements of two households with the same earnings profile, retirement age and life expectancy would be given an equivalent target by the online planning tools regardless of whether one household raised five children and other had none," the authors said. They said the optimal replacement rate for married couples is 75%, but just 55% for singles.

Put another way, if you're using an online calculator to plan your retirement, you might be under-saving or over-saving by a wide margin, though the consequence of over-saving might not be as bad as under-saving.
'Rules of dumb'

Experts, meanwhile, seemed to agree with the conclusions reached by Scholz and Seshadri.

"The use of replacement rates to form financial plans does not meet a reasonable fiduciary standard," said Larry Kotlikoff, a Boston University professor.

"Rules of thumb are, quite simply, rules of dumb," he said. "Their use violates the financial planner's Hippocratic oath: First do no harm."

Kotlikoff also said the model used in Scholz and Seshadri's study is not without its warts. "But it's fine for its purpose, which is comparing conventional financial planning with economics-based planning."

Rick Miller, a certified financial planner with Sensible Financial Planning, cautioned against using any rules of thumb. "Using rules of thumb can be very dangerous, if they significantly understate the requirement, or can risk significant regret, if they overstate the requirement."

The summary for this article (and indeed the whole study) is simple: When you need to determine numbers regarding things far out in the future you can't use rules of thumb! You actually have to crunch the numbers!

See your trusted tax advisor or financial planning professional for advice in this area.

The Skinny on Roth IRA Conversions

I have been highlighting the opportunity that is coming up for CERTAIN investors to take advantage of new provisions allowing conversion of regular IRAs to Roth IRAs. It's not for everyone, but for those for whom it IS appropriate, I believe the savings will be substantial.

As a reminder, here are some Roth IRA basics:

* Contributions to a Roth still carry
income limits ($176,000 for married;
$120,000 if you’re single in 2009).
It’s just conversions that have no
income restrictions.
* Until the end of 2009, conversions
from an IRA to a Roth are limited to
anyone with income of less than
$100,000.
* Contributions to a Roth IRA are
made with after-tax money. In other
words, the contribution is not
deductible. That’s why investors
owe income tax when converting
deductible contributions made to a
traditional IRA to a Roth IRA.
* Contributions can be withdrawn any
time without tax or penalty – this
includes any amount converted.
* Once your money is in a Roth -
whether from annual contributions or
a larger converted amount - it grows
tax-free.
* All profits can be withdrawn tax-free
provided the account holder is at least
59 ½ and the account has been open
at least five years.

Fidelity Investments, as part of its improved "investor-friendly" interface, has a nice article complete with examples,entitled "Conversion Confusion" demonstrating the opportunity. You can find it here.

Pay now or pay later? That is the question if you're weighing the pros and cons of converting your traditional individual retirement accounts to a Roth. The benefit of a Roth is simple: Once you're in, you don't have to worry about paying taxes on that account, ever. Tax-free income down the road, though, comes with a price. And that price can be hefty: In the eyes of Uncle Sam, what you convert is taxed as ordinary income.


A bigger tax bill is probably the last thing you need right now. But ironically, this tough economic environment may make it an ideal time to convert to a Roth. Those smaller IRA balances means you’ll owe less tax. (Talk about a silver lining.) Think your income disqualifies you? As of 2010 the $100,000 adjusted-gross-income cap on Roth conversions will disappear. And, next year — and next year only — investors will have the option of spreading their tax liability over two years.

Despite all of the excitement surrounding the Roth, converting doesn't make sense for everyone. At a minimum, says Chris McDermott, a certified financial planner and senior vice president of investor education at Fidelity Investments, investors should be able to answer “yes” to three key questions: Do you expect to pay a higher tax rate when you retire? Do you plan to hold the account for at least 10 years? Can you pay the taxes owed without tapping a tax-sheltered account?

Even if you do answer yes to all three, there are other considerations, notes Barbara Steinmetz, a certified financial planner in San Mateo, Calif. Among them, how will the conversion affect your overall tax situation? “Just a small amount could make the difference to bump you from one bracket to another,” she says. “My advice is to always run the numbers.”

The Fidelity conversion analysis tool appears to be for subscriber-investors only. Here's one that Wells Fargo makes available to all. I haven't vetted it but these tools should only be used to initially evaluate whether conversion MAY make sense for you. Then, as always, you should discuss your options with your trusted financial advisor or tax professional.

Boomers in Denial

Two things are infinite: the universe and human stupidity; and I'm not sure about the universe.

- Albert Einstein

Think that the savings rate isn't set to increase in the next few years? It will. Why? It HAS TO or an entire generation is going to badly underfund their retirement. Why do I say that? Well, Wells Fargo just released their Retirement Fitness Survey, and had a few pointed things to say about the investment habits of pre-retirees ages 50 to 59.:

“There is a sense of denial among the pre-retirees,” said Lynne Ford, head of Wells Fargo Retail Retirement.

Even after suffering significant losses last year, many remain overly optimistic about their investment returns and the ability of their savings to fund their expenses after they stop working.

Only 23 percent of pre-retirees are saving more for their retirement than they were a year ago, the survey found. Most, some 57 percent, are saving the same amount, and 20 percent are saving less.

Perhaps even more startling is the extent to which their savings are falling short of their goals. On average, these pre-retirees expected they would need $800,000 to fund their retirement. However, most had only saved about $300,000.

Despite their inadequate savings, nearly two-thirds of the group lack any formal plans for retirement savings or spending strategies.

Of the 35 percent of those who had a written plan for retirement, only slightly more than half — about 52% percent — say they had updated it in the past year during the market downturn.

Okay folks, this is just plain silly. If you have a car crash, don't you think it might be wise to step out of the vehicle and assess the damage? You don't just blithely drive on! There's more:

Among the biggest mistakes people are making is over-estimating their investment returns and the amount of money that can safely be withdrawn each year in retirement.

In the survey, both those who were about to retire and those who already had said they expected their savings to grow by 8.7 percent each year, on average. However, the compound annual growth rate of the S&P 500 from 1958 through 2008 was only 6.6 percent.

People also under-estimate how long they will live in retirement, she said. A healthy person in their mid-sixties can easily expect to live into their eighties or even nineties. However, few people are prepared to support themselves in retirement for more than twenty years.

Okay, Mark here. Now we are turning a negligent activity into the criminal. It's not just denial any longer, it's willful ignorance. This continues our theme of people being their own worst enemies when it comes to investing. See this post. We continue our foibles while strolling through the land of planning as well, it seems.

Like Wile E. Coyote, we stepped over the cliff last year. Shouldn't we have said to ourselves that cliff and no parachute are a bad combination? But, according to Wells Fargo, it seems we just dusted ourselves off and continue to chase Roadrunner for the next episode.

The "Stretch" IRA

In your late night studies on retirement investing vehicles, you may have come across the term 'stretch IRA'. This is actually not a category of IRA, such as a Traditional, Roth, SEP or SIMPLE IRA. It is more like a financial-planning or wealth-management strategy imbedded in the product (IRA) provisions.

The "stretch" provision is one you might be interested in if you are using your IRA primarily to provide for your beneficiaries. That is, if your retirement needs will be funded by other assets (lucky you!. Then, you may want to take advantage of this provision in order to structure flows to persons other than yourself.

Identifying the Concept

Does your IRA allows the beneficiary to distribute the assets over a life-expectancy period and also allow him or her to designate a second-generation beneficiary of the inherited IRA? If so, it is this provision that allows a beneficiary to designate a second-generation beneficiary (and even a third, fourth and so on)that determines whether the IRA has the "stretch" provision. It allows the IRA to be passed on from generation to generation, thereby stretching the life of the vehicle.

How It Works

The beneficiary must follow certain rules to ensure he or she doesn't owe the IRS excess-accumulation penalties, which are caused by failing to withdraw the minimum amount each year. How so?

Let's use an example:

Huey's designated beneficiary is his son Dewey. Huey dies in 2008, when he is age 70 and Dewey is age 40. Dewey's life expectancy is 42.7 (determined in the year following the year Huey died, when DDewey is age 41). This means that Dewey is able to stretch distributions over a period of 42.7 years. Dewey elects to stretch distributions over his life expectancy, and he must take his first distribution by Dec 31, 2009, the year-end following the year Tom died.

To determine the minimum amount that must be distributed, Dewey must divide the balance on Dec 31, 2008, by 42.7. If Dewey withdraws less than the minimum amount, the shortfall will be subject to the excess-accumulation penalty. To determine the minimum amount he must distribute for each subsequent year, Dewey must subtract 1 from his life expectancy of the previous year. He must then use that new life-expectancy factor as a divisor of the previous year-end balance.

Now, remember our assumptions. The IRA plan document allowed Dewey to designate a second-generation beneficiary, and he designated his son Louie. If Dewey were to die in 2013, when his remaining life expectancy is 38.7 (42.7 - 4), Louie could continue distributions for Dewey's remaining life expectancy. It is important to note that only the first-generation beneficiary's life expectancy is factored into the distribution equation; therefore, Louie's age is not relevant.

In this example, Huey could have chosen to designate Louie as his own beneficiary, resulting in a longer stretch period. In such a case, Louie would be the first-generation beneficiary, and his life expectancy instead of Dewey's would be factored into the equation.

Primary Benefits of the Stretch Concept

Tax Deferral

The primary benefit of the stretch provision is that it allows the beneficiaries to defer paying taxes on the account balance and to continue enjoying tax-deferred and/or tax-free growth as long as possible. Without the stretch provision, beneficiaries may be required to distribute the full account balance in a period much shorter than the beneficiary's life expectancy, possibly causing them to be in a higher tax bracket and/or resulting in significant taxes on the withdrawn amount.

Flexibility

Usually, the stretch option is not a binding provision, which means the beneficiary may choose to discontinue it at anytime by distributing the entire balance of the inherited IRA. This allows the beneficiary some flexibility should he or she need to distribute more than the minimum required amount, say in the case of a financial emergency.

Benefits for Spouses

Remember, a spouse beneficiary is allowed to treat an inherited IRA as his or her own. When the spouse elects to do this, the spouse beneficiary is given the same status and options as the original IRA owner and the stretch concept is not even in play. However, should the spouse choose to treat the IRA as an inherited IRA, then the stretch rule may apply.

Conclusion

Consult your current IRA provider or financial institution if this concept is of interest to you. IRAs can be transferred if this provision is not present in your provider's IRA plan documents. Finally, be sure to consult with your tax and financial professional for assistance. This concept must mesh with your financial profile and your wealth-management goals.

The Roth IRA Conversion Opportunity

In addition to providing information regarding planning topics, it is our mission to make it ACTIONABLE. That is why this next article may be one of the most important we pen this year. (We think our other may have been regarding the timing opportunity for 529 plans.) What is up, you say? Well, under the Tax Increase Prevention and Reconciliation Act of 2005, all taxpayers will be able to convert all or some of their traditional IRAs into a Roth IRA, REGARDLESS OF INCOME.

Now, instead of being faced with an "unhelpful" income cap on who could avail themselves of the chance to pay taxes now as a way to avoid paying more taxes later, anyone can do so, and that is big, big news. So much so that the entire financial planning industry is gearing up for this opportunity. For you out there with significant IRA assets, and a connection to a financial advisor or planner, steel yourself to the fact that many phone calls and letters will be coming to advise you of the opportunity and how it relates to your savings and retirement goals as well as legacy planning. Just watch.

Do we think the information deluge to come is misplaced? Absolutely not! As we said, we think this will be one of the most important pieces we write this year. But we also think you'd be well served with answers to some of the most frequently asked questions about Roth IRA conversions before the storm hits. Just imagine this as a pre-emptive strikeof sorts.

Prior to 2010, the amount converted would be reported as income on that year's tax return. Under TIPRA, however, conversions done in 2010 don't have to be reported on your 2010 tax return. Instead, you get to report the income on your 2011 and 2012 tax returns.

Thus, if you converted a $100,000 IRA in 2010, you would report $50,000 in ordinary income in 2011 and $50,000 in 2012, i.e. you get to split your income, thereby potentially reducing your tax burden.

If you do a Roth IRA conversion in 2011 or in a later year, you don't get to spread the income or tax bill over two years. So for one year, your phone will ring off the hook and your mailbox will be stuffed to bursting. Just kidding.


You don't HAVE to split the income however. You and your advisor should engage in "tax planning". If you think splitting the income will create a larger overall tax bill, you can opt out of splitting the income over two years. But the election is all-or-nothing. No piecemeal splits.


Enquiring minds might want to know, given present market dynamics, what happens if you convert to a Roth IRA when there is basis (the original amount invested) in the traditional IRA but it's worth less now than the original contribution(s)? Alas, there's no guidance on that issue. Perhaps a loss can be recognized or perhaps the basis will fully carry over. No one knows yet.

More in our next article. Stay tuned!

Insecurity Grows Among Retirees

In an article carried in the Retirement Income Journal (whose subtag is "The information journal of the decumulation industry"!)we find some alarming data:

The number of retirees who say they are worried about financial security has more than doubled in the past year, and many are tightening budgets or seeking professional financial advice. Forty-nine percent of retirees said they felt less secure than when they first entered retirement, compared with 20% who said so last year.

The findings come from a survey of retirees aged 56 to 77 with $100,000 or more in investable household assets.

The survey also found a significant decline in the number of retirees who feel very confident they have saved enough money to live comfortably throughout their retirement. Today, only one in four of the retirees are extremely confident they have saved enough, a 12 percentage-point drop year over year.

Over four in ten said their tolerance for investment risk has gone down since last year, and many were concerned about the possibility of inflation (45%), not having enough time to recover from the downturn (39%), concern about the economy (79%) and change in house value (28%).

But the real kicker comes from page 10 of the Report, a stunning observation that 34% of retirees from the 2009 survey had not estimated how long their assets and investments might last in retirement and fully 11% had never thought about it!

My goodness! People, what are we thinking here? At least the Report showed that retirees had increased their willingness to involve a financial planner in their decision-making, growing from 56% in 2008 to 61% today. Another data point showing that when it comes to our finances we may be our own worst enemies.