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Tax overhaul risks leaving pension recipients under withheld when it comes time to file for 2018

By Laura Saunders

June 22, 2018

Courtesy of the Wall Street Journal

Millions of Americans receiving pensions could be in for a bad tax surprise next year.

A little-noticed effect of last year’s tax overhaul is that many pension payments are now larger, reflecting the new lower tax rates in effect for 2018. But this bump-up increases the risk that recipients will be under withheld at tax time next year—and therefore owe a penalty. To avoid this, retirees should immediately check their withholding and adjust it if necessary.

One who will be checking is Ann Gardella, a retired music teacher now living in Southbury, Conn. She says most of her income is from her pension and the monthly payments rose earlier this year. Because she already has a tax balance due each April, she plans to review her withholding.

“I really don’t want to owe penalties next year,” says Ms. Gardella.

The situation with pensions is similar to what’s happening with paychecks, says Jonathan Zimmerman, a benefits attorney with Morgan, Lewis & Bockius. Earlier this year, Treasury officials adjusted withholding tables to reflect changes for 2018 made by last year’s tax overhaul, and these changes have been incorporated into many pension payments as well as employee paychecks.

But these adjustments didn’t take into account many of the overhaul’s changes. For example, the current withholding tables include tax-rate changes but not the effect of the new $10,000 cap on deductions for state and local taxes. The withholding tables have never included this information, according to an IRS spokesman.

The upshot is that some pension recipients could wind up under withheld in for 2018 because the automatic adjustments to their pension payments set them too high. In general, people must pay in at least 90% of the tax they’ll owe during the year, or by the following mid-January if they are paying quarterly estimated taxes, to avoid a penalty. The penalty is based on an annual interest rate that’s currently 5%.

Penalized

The growth in filers who owe penalties on quarterly tax payments has far outpaced the growth in individual returns in recent years.

Pension payments and filers’ circumstances vary widely, so it’s hard to predict who’s at risk here. Mr. Zimmerman says that for a typical married pension recipient with a $50,000 annual pension, the reduction in withholding comes to about $818 a year. That may not sound like a lot, but it cuts withholding by about 20%. A pension payer that follows the government’s tables isn’t responsible if the recipient is under withheld.

This new wrinkle in pension payments is yet another reason why retirees—especially those who recently retired or are working part time—should be alert for “tax shocks,” says Gil Charney, a director of H&R Block’s Tax Institute.

For many retirees, income doesn’t just drop, he explains. Often it becomes lumpy, especially if someone has part-time work, Social Security payments, or retirement-plan withdrawals. Medical expenses may become deductible for the first time, and additional “standard deductions” kick in at age 65.

Retirees must also decide what to withhold from Social Security payments and payouts from plans such as 401(k)s or individual retirement accounts at the same time that many are switching to quarterly estimated tax payments.

“The onus is on the taxpayer to make sure the withholding is correct,” says Mr. Charney, rather than on both the taxpayer and the employer.

There’s evidence of rising taxpayer problems in this area. Between 2010 and 2016, the number of filers penalized for underpaying estimated taxes rose 36%, from 7.2 million to 9.8 million.

To help with these issues, the IRS has posted a new withholding calculator. It can be used by most filers, including retirees with multiple sources of income, according to an IRS spokesman.

To use it, you’ll need a copy of last year’s tax return and estimates of this year’s sources of income and withholding so far. Based on the results, you may want to submit a revised Form W-4P, for pension and annuity withholding, to the payer.

Retired or Semi Graph

The form for Social Security withholding is W-4V. Filers can elect to withhold at one of four flat rates—7%, 10%, 12%, or 22%. To change the withholding on the payouts from a retirement plan such as an IRA or 401(k), check with your provider.

What if a filer underpays estimated taxes? The law offers two outs. There’s often no penalty if income is less than $150,000 and the filer has paid in an amount equal to 100% of his tax for the prior year. For those earning more than $150,000, the threshold rises to 110% of the prior year’s tax.

The other is that the IRS often waives estimated tax penalties incurred in the year someone retires or becomes disabled, or sometimes the year after that. To qualify, the taxpayer submits Form 2210 with proof and an explanation that the error wasn’t willful.

But this relief often comes after a scary letter from the IRS and filling out yet another form—so avoid it if you can.

The Wall Street Journal published the article below which prompts further thought: In a lower interest rate environment, a mortgage can actually have a positive effect on personal finances for many. But with the new tax law and cap on deductions, this is new territory to explore.

The further point I would add is: While this does change the math, more importantly, the math should be done via a comprehensive financial plan.  This is where the details like deductions and opportunity costs and long term use of family resources can help in making good financial decisions.

Courtesy of the Wall Street Journal

Should You Pay Off Your Mortgage? The New Tax Law Changes the Math.

Tax-law changes will shut millions out of mortgage-interest deductions, especially if they are married couples

Now is the time to find out if you are one of the millions of Americans who won’t be able to deduct their monthly mortgage-interest payments.

For 2017, 32 million tax filers got a mortgage-interest deduction. For 2018, that number will drop to 14 million. Americans’ total savings from this break are also expected to fall sharply this year, from nearly $60 billion for 2017 to $25 billion for 2018, according to Congress’s Joint Committee on Taxation.

These landmark shifts are the result of the tax overhaul’s direct and indirect changes to the longstanding provision allowing filers to deduct home-mortgage interest on Schedule A. These changes are set to expire at the end of 2025.

As a result, current and future mortgage holders need to consider their options, which range from paying part or all of their debt to sitting tight.

“The changes to the mortgage deduction strengthen the arguments for paying down or off a mortgage,” says Allan Roth, a financial planner with Wealth Logic.

Some homeowners are already reducing their debt. Ken Walsh, an engineer who lives outside Baltimore with his family, says he used a windfall to pay off the remaining $500,000 mortgage on his home in January.

When the tax overhaul passed, Mr. Walsh knew that he and his wife would no longer get an interest deduction, even after their 2.6% adjustable-rate loan reset higher this year.

“It was a perfect storm, so we decided to pay off the loan,” he says.

Mr. Walsh’s move may not make sense for everyone. Here’s what to consider for your analysis.

The key changes. For many people, two revisions to non-mortgage provisions will have the biggest effects on their mortgage-interest deductions.

One is the near-doubling of the “standard deduction” to $12,000 for most single filers and $24,000 for most married couples. As a result, millions of filers will no longer benefit from breaking out mortgage interest and other deductions on Schedule A.

The other key change is the cap on deducting more than $10,000 of state and local income or sales and property taxes, known as SALT. This limit is per tax return, not per person.

These changes will hit many married couples with mortgages harder than singles. Here’s why: For 2017, a couple needed write-offs greater than $12,700 to benefit from listing deductions on Schedule A. Now these write-offs have to exceed $24,000.

Assuming a couple has maximum SALT deductions of $10,000, they’ll need more than $14,000 in other write-offs of mortgage interest, charity donations, and the like to benefit from using Schedule A.

Many couples won’t make it over this new hurdle on mortgage interest and SALT alone. According to the Mortgage Bankers Association, the first-year interest on a 30-year mortgage of $320,000 (the average) at the current rate of 4.8% is about $15,250. Interest payments are smaller if the loan is older or the interest rate is lower.

The new threshold is lower for single filers, as each can also deduct SALT up to $10,000. Their standard deduction is now $12,000, so many will only need more than $2,000 of mortgage interest, charity donations and the like to benefit from listing them on Schedule A.

Even for taxpayers who can still deduct mortgage interest, the expansion of the standard deduction means the value of this write-off will typically be lower than in the past.

Other limits. Following the tax overhaul, most home buyers can deduct only the interest on total mortgage debt up to $750,000 for up to two homes. This limit won’t be an issue for most buyers, but some will be affected.

There’s a “grandfather” exception: Most homeowners with existing debt up to $1 million on up to two homes before the tax overhaul can continue to deduct their interest.

The rules also changed for home-equity loans. To get an interest deduction, the taxpayer must use the debt to buy, build or improve a home. There’s no write-off if it’s used for another purpose, such as paying tuition.

Doing the math. For homeowners with a shrinking or vanishing interest deduction, here’s the key question: Is the after-tax return on an ultra-low-risk investment lower than your after-tax mortgage rate? If it is, consider paying down the mortgage if you can.

Mr. Roth offers this example. Say Bob has a mortgage rate of 3.7%, and he’ll no longer get an interest deduction. He’ll need to earn about 3.7% after-tax on an investment such as a five-year CD to come out ahead by keeping his mortgage. Recently some of these CDs had pretax yields of about 2.8%.

Preserving liquidity. Even if paying down a mortgage makes financial sense, it means restricting access to funds. So consider whether they’ll be needed in an emergency, and what the rate on a (non-deductible) personal loan would be. You need to be able to sleep at night.

Saving the difference. If you pay off a mortgage, Mr. Roth advises setting up an automatic payment of the savings to an investment account to rebuild your liquidity.

This article was prepared by a third party for information purposes only. It is not intended to provide specific advice or recommendations for any individual. It contains references to individuals or entities that are not affiliated with Cornerstone Wealth Management, Inc. or LPL Financial.

Tax services are not offered by Cornerstone Wealth Management, Inc., LPL Financial or affiliated advisors. We suggest that you discuss your specific situation with a qualified tax advisor.

LPL Tracking # 1-737346

You can plan to meet the costs through a variety of methods.

How can you cover your child’s future college costs? Saving early (and often) may be the key for most families. Here are some college savings vehicles to consider.

529 college savings plans. Offered by states and some educational institutions, these plans let you save up to $15,000 per year for your child’s college costs without having to file an I.R.S. gift tax return. A married couple can contribute up to $30,000 per year. (An individual or couple’s annual contribution to a 529 plan cannot exceed the yearly gift tax exclusion set by the Internal Revenue Service.) You can even frontload a 529 plan with up to $75,000 in initial contributions per plan beneficiary – up to five years of gifts in one year – without triggering gift taxes.1,2

529 plans commonly feature equity investment options that you may use to try and grow your college savings. You can even participate in 529 plans offered by other states, which may be advantageous if your student wants to go to college in another part of the country. (More than 30 states offer some form of tax deduction for 529 plan contributions.)1,2

Earnings of 529 plans are exempt from federal tax and generally exempt from state tax when withdrawn, so long as they are used to pay for qualified education expenses of the plan beneficiary. If your child doesn’t want to go to college, you can change the beneficiary to another child in your family. You can even roll over distributions from a 529 plan into another 529 plan established for the same beneficiary (or another family member) without tax consequences.1

Grandparents can start a 529 plan (or other college savings vehicle) just like parents can. In fact, anyone can set up a 529 plan on behalf of anyone. You can even establish one for yourself.1

These plans now have greater flexibility. Thanks to the federal tax reforms passed in 2017, up to $10,000 of 529 plan funds per year may now be used to pay qualified K-12 tuition costs.2,3

Coverdell ESAs. Single filers with modified adjusted gross income (MAGI) of $95,000 or less and joint filers with MAGI of $190,000 or less can pour up to $2,000 annually into these accounts, which typically offer more investment options than 529 plans. (Phase-outs apply above those MAGI levels.) Money saved and invested in a Coverdell ESA can be used for college or K-12 education expenses.3

Contributions to Coverdell ESAs aren’t tax deductible, but the accounts enjoy tax-deferred growth, and withdrawals are tax free, so long as they are used for qualified education expenses. Contributions may be made until the account beneficiary turns 18. The money must be withdrawn when the beneficiary turns 30, or taxes and penalties will occur. Money from a Coverdell ESA may even be rolled over into a 529 plan.3,4

UGMA & UTMA accounts. These all-purpose savings and investment accounts are often used to save for college. They take the form of a trust. When you put money in the trust, you are making an irrevocable gift to your child. You manage the trust assets until your child reaches the age when the trust terminates (i.e., adulthood). At that point, your child can use the UGMA or UTMA funds to pay for college; however, once that age is reached, your child can also use the money to pay for anything else.5

Whole life insurance. If you have a permanent life insurance policy with cash value, you can take a loan from (or even cash out) the policy to meet college costs. Should you fail to repay the loan balance, obviously, the policy’s death benefit will be lower.6,7

Did you know that the value of a life insurance policy is not factored into a student’s financial aid calculation? If only that were true for college savings funds.6

Imagine your child graduating from college, debt free. With the right kind of college planning, that may happen. Talk to a financial professional today about these savings methods and others.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – irs.gov/newsroom/529-plans-questions-and-answers [2/20/18]
2 – cnbc.com/2017/12/29/tax-bill-529-plan-provision-helps-families-save-on-school-costs-taxes.html [12/29/17]
3 – forbes.com/sites/katiepf/2018/04/13/yes-the-coverdell-esa-still-exists-and-heres-why-you-should-care [4/13/18]
4 – irs.gov/taxtopics/tc310 [3/1/18]
5 – finaid.org/savings/ugma.phtml [5/8/18]
6 – collegemadesimple.com/whole-life-insurance-vs-529-college-savings-plans/ [5/9/18]
7 – marketwatch.com/story/a-529-roth-ira-insurance-whats-best-for-college-savings-2017-03-22 [5/13/17]

A recap of the major changes impacting corporations and closely held firms.

The Tax Cuts & Jobs Act changed the tax picture for business owners. Whether your company is incorporated or held closely, you must recognize how the recent adjustments to the Internal Revenue Code can potentially affect you and your workers.

How have things changed for C corps? The top corporate tax rate has fallen. C corps now pay a flat 21% tax. For most C corps, this is a big win; for the smallest C corps, it may be a loss.1

If your C corp or LLC brings in $50,000 or less in 2018, you will receive no tax relief – your firm will pay a 21% corporate income tax as opposed to the 15% corporate income tax it would have in 2017. Under the old law, the corporate income tax rate was just 15% for the first $50,000 of taxable income.1,2

Another notable change impacting C corps involves taxation of repatriated income. Prior to 2018, American companies paid U.S. tax rates on earnings generated in foreign countries; those profits were, essentially, taxed twice. Now they are being taxed differently – there is a one-time repatriation rate of 15.5% on cash (and cash equivalents) and 8% rate on illiquid assets, and those taxes are payable over an 8-year period.2

By the way, the 20% corporate Alternative Minimum Tax (AMT) is no more. The tax reforms permanently abolished it.2

What changed for S corps, LLCs, partnerships, and sole proprietorships? They can now deduct 20% of the qualified business income they earn in a year. Cooperatives, trusts, and estates can do the same. This deduction applies through at least 2025.2,3

The fine print on this deduction begs consideration. If you are a lawyer, a physician, a consultant, or someone whose firm corresponds to the definition of a specified service business, then the deduction may be phased out depending on your taxable income. Currently, the phase-out begins above $157,500 for single filers and above $315,000 for joint filers. Above these two thresholds, the deduction for a business other than a specified service business is limited to half of the total wages paid or one quarter of the total wages paid plus 2.5% of the cost for that property, whichever is larger.2

Salaried workers who are thinking about joining the ranks of independent contractors to exploit this deduction may find it a wash: they will have to pay for their own health insurance and absorb an employer’s share of Social Security and Medicare taxes.2

What other major changes occurred? The business depreciation allowance has doubled and so has the Section 179 expensing limit. During 2018-22, the percentage for first-year “bonus depreciation” deductions is set at 100% with a 5-year limit and applies to both used and new equipment. The maximum Section 179 deduction allowance is now $1 million (limited to the amount of income from business activity) and the phase-out threshold begins $500,000 higher at $2.5 million. Also, a business can now carry forward net operating losses indefinitely, but they can only offset up to 80% of income.4

The first-year depreciation allowance for a car bought and used in a business role is now $10,000; it was $3,160. Claim first-year bonus depreciation, and the limit is $18,000. (Of course, the depreciation allowance for the vehicle is proportionate to the percentage of business use.) The TC&JA also created a new employer tax credit for paid family and medical leave in 2018-19, which can range from 12.5%-25%, depending on the amount paid during the leave.4,5

Some longtime business tax deductions are now absent. Manufacturers can no longer claim the Section 199 deduction for qualified domestic property activities. Business deductions for rail and bus passes, parking benefits, and commuter vehicles are gone. Deductions have also been repealed for entertainment costs linked directly to or associated with the conduct of business.4

Business owners should also know about the new restriction on 1031 exchanges. A like-kind exchange can now only be used for real estate, not personal property.3

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – thebalancesmb.com/corporate-tax-rates-and-tax-calculation-397647 [2/5/18]

2 – investopedia.com/taxes/how-gop-tax-bill-affects-you/ [2/14/18]

3 – americanagriculturist.com/farm-policy/10-agricultural-improvements-new-tax-reform-bill [12/27/17]

4 – cpapracticeadvisor.com/news/12388887/2018-tax-reform-law-has-benefits-for-some-small-businesses [1/2/18]

5 – marketwatch.com/story/use-your-car-for-your-small-business-the-new-tax-law-is-good-news-for-you-2018-03-06 [3/6/18]

Sometimes you can take penalty-free early withdrawals from retirement accounts.

Do you need to access your retirement money early? Maybe you just want to retire before you turn 60 and plan a lifelong income stream from the money you have saved and invested. You may be surprised to know that the Internal Revenue Service allows you a way to do this, provided you do it carefully.

Usually, anyone who takes money out of an IRA or a retirement plan prior to age 59½ faces a 10% early withdrawal penalty on the distribution. That isn’t always the case, however. You may be able to avoid the requisite penalty by taking distributions compliant with Internal Revenue Code Section 72(t)(2).1

While any money you take out of the plan will amount to taxable income, you can position yourself to avoid that extra 10% tax hit by breaking that early IRA or retirement plan distribution down into a series of substantially equal periodic payments (SEPPs). These periodic withdrawals must occur at least once a year, and they must continue for at least 5 full years or until you turn 59½, whichever period is longer. (Optionally, you can make SEPP withdrawals every six months or on a quarterly or monthly basis.)1,2

How do you figure out the SEPPs? They must be calculated before you can take them, using one of three I.R.S. methods. Some people assume they can just divide the balance of their IRA or 401(k) by five and withdraw that amount per year – but that is not the way to determine them.2

You should calculate your potential SEPPs by each of the three methods. When the math is complete, you can schedule your SEPPs in the way that makes the most sense for you.

The Required Minimum Distribution (RMD) method calculates the SEPP amount by dividing your IRA or retirement plan balance at the end of the previous year by the life expectancy factor from the I.R.S. Single Life Expectancy Table, the Joint Life and Last Survivor Expectancy Table, or the Uniform Lifetime Table.1,2

The Fixed Amortization method amortizes your retirement account balance into SEPPs based on your life expectancy. A variation on this, the Fixed Annuitization method, calculates SEPPs using your current age and the mortality table in Appendix B of Rev. Ruling 2002-62.1,2

If you use the Fixed Amortization or Fixed Annuitization method, you are also required to use a reasonable interest rate in calculating the withdrawals. That interest rate can’t exceed more than 120% of the federal midterm rate announced periodically by the I.R.S.1,3

A lot to absorb? It certainly is. The financial professional you know can help you figure all this out, and online calculators also come in handy (Bankrate.com has a good one).

There are some common blunders that can wreck a 72(t) distribution. You should be aware of them if you want to schedule SEPPs.

If you are taking SEPPs from a qualified workplace retirement plan instead of an IRA, you must separate from service (that is, quit working for that employer) before you take them. If you are 51 when you quit and start taking SEPPs from your retirement plan, and you change your mind at 53 and decide you want to keep working, you still have this retirement account that you are obligated to draw down through age 56 – not a good scenario.1

Once you start taking SEPPs, you are locked into them for five consecutive years or until you reach age 59½. If you break that commitment or deviate from the SEPP schedule or calculation method you have set, a 10% early withdrawal penalty could apply to all the SEPPs you have already made, with interest. (Some individuals can claim exceptions to this penalty under I.R.S. rules.)3,4

The I.R.S. does permit you to make a one-time change to your distribution method without penalty: if you start with the Fixed Amortization or Fixed Annuitization method, you can opt to switch to the RMD method. You can’t switch out of the RMD method to either the Fixed Amortization or Fixed Annuitization method, however.2

If you want or need to take 72(t) distributions, ask for help. A financial professional can help you plan to do it right.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments [12/19/17]
2 – fool.com/retirement/2017/05/19/use-your-retirement-savings-early-with-substantial.aspx [5/19/17]
3 – thebalance.com/how-to-use-72-t-payments-for-early-ira-withdrawals-2388257 [9/20/17]
4 – military.com/money/retirement/second-retirement/early-retirement-options.html [5/7/18]

A move that high earners can make in pursuit of tax-free retirement income.

Does your high income stop you from contributing to a Roth IRA? It does not necessarily prohibit you from having one. You may be able to create a backdoor Roth IRA and give yourself the potential for a tax-free income stream in retirement.

If you think you will be in a high tax bracket when you retire, a tax-free income stream may be just what you want. The backdoor Roth IRA is a maneuver you can make in pursuit of that goal – a perfectly legal workaround, its legitimacy further affirmed by language in the Tax Cuts & Jobs Act of 2017.1

You establish a backdoor Roth IRA in two steps. The first step: make a non-deductible contribution to a traditional IRA. (In other words, you contribute after-tax dollars to it, as you would to a Roth retirement account.)1

The second step: convert that traditional IRA to a Roth IRA or transfer the traditional IRA balance to a Roth. A trustee-to-trustee transfer may be the easiest way to do this – the funds simply move from the financial institution serving as custodian of the traditional IRA to the one serving as custodian of the Roth IRA. (The destination Roth IRA can even be a Roth IRA you used to contribute to when your income was lower.) Subsequently, you report the conversion to the Internal Revenue Service using Form 8606.1,2

When you have owned your Roth IRA for five years and are 59½ or older, you can withdraw its earnings, tax free. You may not be able to make contributions to your Roth IRA because of your income level, but you will never have to draw the account down because original owners of Roth IRAs never have to make mandatory withdrawals from their accounts by a certain age (unlike original owners of traditional IRAs).1,3

You may be wondering: why would any pre-retiree dismiss this chance to go Roth? It comes down to one word: taxes.

The amount of the conversion is subject to income tax. If you are funding a brand-new traditional IRA with several thousand dollars and converting that relatively small balance to a Roth, the tax hit may be minor, even non-existent (as you will soon see). If you have a large traditional IRA and convert that account to a Roth, the increase in your taxable income may send you into a higher tax bracket in the year of the conversion.2

From a pure tax standpoint, it may make sense to start small when you create a backdoor IRA and begin the process with a new traditional IRA funded entirely with non-deductible contributions. If you go that route, the Roth conversion is tax free, because you have already paid taxes on the money involved.1

The takeaway in all this? When considering a backdoor IRA, evaluate the taxes you might pay today versus the tax benefits you might realize tomorrow.

The taxes on the conversion amount, incidentally, are calculated pro rata – proportionately in respect to the original, traditional IRA’s percentage of pre-tax contributions and earnings. If you are converting multiple traditional IRA balances into a backdoor Roth – which you can do – you must take these percentages into account.1

Three footnotes are worth remembering. One, a backdoor Roth IRA must be created before you reach age 70½ (the age of mandatory traditional IRA withdrawals). Two, you cannot make a backdoor IRA move without earned income because you need to earn income to make a non-deductible contribution to a traditional IRA. Three, joint filers can each make non-deductible contributions to a traditional IRA pursuant to a Roth conversion, even if one spouse does not work; in that case, the working spouse can cover the non-deductible traditional IRA contribution for the non-working spouse (who has to be younger than age 70½).1

A backdoor Roth IRA might be a real plus for your retirement. If it frustrates you that you cannot contribute to a Roth IRA because of your income, explore this possibility with insight from your financial or tax professional.

Traditional IRA account owners should consider the tax ramifications, age and income restrictions in regards to executing a conversion from a Traditional IRA to a Roth IRA. The converted amount is generally subject to income taxation. The

Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are

considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.
1 – investors.com/etfs-and-funds/retirement/backdoor-roth-ira-tax-free-retirement-income-legal-loophole/ [4/19/18]
2 – investopedia.com/retirement/too-rich-roth-do/ [1/29/18]
3 – irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions [11/16/17]

This popular retirement savings vehicle comes in several varieties.

What don’t you know? Many Americans know about Roth and traditional IRAs, but there are other types of Individual Retirement Arrangements. Here’s a quick look at all the different types of IRAs:

Traditional IRAs (occasionally called deductible IRAs) are the “original” IRAs. In most cases, contributions to a traditional IRA are tax deductible: they reduce your taxable income, and as a consequence, your federal income taxes. Earnings in a traditional IRA grow tax deferred until they are withdrawn, but they will be taxed upon withdrawal, and those withdrawals must begin after the IRA owner reaches age 70½. I.R.S. penalties and income taxes may apply on withdrawals taken prior to age 59½.1

Roth IRAs do not feature tax-deductible contributions, but they offer many potential perks for the future. Like a traditional IRA, they feature tax-deferred growth and compounding. Unlike a traditional IRA, the account contributions may be withdrawn at any time without being taxed, and the earnings may be withdrawn, tax-free, once the IRA owner is older than 59½ and has owned the IRA for at least five years. An original owner of a Roth IRA never has to make mandatory withdrawals after age 70½. In addition, a Roth IRA owner may keep contributing to the account after age 70½, so long as he or she has earned income. (A high income may prevent an individual from making Roth IRA contributions.)1,2

Some traditional IRA owners convert their traditional IRAs into Roth IRAs. Taxes need to be paid once these conversions are made.1

SIMPLE IRAs are traditional IRAs used in a SIMPLE plan, a type of retirement plan for businesses with 100 or fewer workers. Employers and employees can make contributions to SIMPLE IRA accounts. The annual contribution limit for a SIMPLE IRA is more than twice that of a regular traditional IRA.3

SEP-IRAs are Simplified Employee Pension-Individual Retirement Arrangements. These traditional IRAs are used in SEP plans, set up by an employer for employees, and funded only with employer contributions.4

Spousal IRAs really do not exist as a distinct IRA type. The term actually refers to a rule that lets non-working spouses make traditional or Roth IRA contributions as long as the other spouse works and the couple files joint federal tax returns.1

Inherited IRAs are Roth or traditional IRAs inherited from their original owner by either a spousal or non-spousal beneficiary. The rules for Inherited IRAs are very complex. Surviving spouses have the option to roll over IRA assets they inherit into their own IRAs, but other beneficiaries do not. No contributions can be made to Inherited IRAs, which are also sometimes called Beneficiary IRAs.5

Group IRAs are simply traditional IRAs offered by employers, unions, and other employee associations to their employees, administered through trusts.6

Rollover IRAs (occasionally called conduit IRAs) are IRAs created to store assets distributed from another qualified retirement plan, often an employer-sponsored retirement plan. If the original plan were a Roth, then a Roth IRA must be created for the rollover. Assets from a non-Roth plan may be rolled over into a Roth IRA, but the rollover will be viewed as a Roth conversion by the Internal Revenue Service.6,7

Education IRAs are now mainly referred to by their proper name: the Coverdell ESA. A Coverdell ESA is a vehicle that helps middle-class investors save for a child’s education. Taxes are deferred on the assets saved and invested through the account. Contributions to a Coverdell ESA are not deductible, but withdrawals are tax-free, provided they are used to pay for qualified higher education expenses.8

Consult a qualified financial professional regarding your IRA options. There are many choices available, and it is vital that you understand how your choice could affect your financial situation. No one IRA is the “right” IRA for everyone, so do your homework and seek advice before you proceed.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.

1 – thestreet.com/story/14545108/1/traditional-or-roth-ira-or-both.html [4/4/18]

2 – forbes.com/sites/catherineschnaubelt/2018/04/25/choosing-the-best-ira-to-maximize-your-retirement-savings/ [4/25/18]

3 – fool.com/retirement/2017/10/28/2018-simple-ira-limits.aspx [10/28/17]

4 – investopedia.com/university/retirementplans/sepira/ [11/14/17]

5 – investopedia.com/terms/i/inherited_ira.asp [4/30/18]

6 – fool.com/retirement/iras/the-eleven-types.aspx [4/30/18]

7 – investor.vanguard.com/401k-rollover/options [4/30/18]

8 – investopedia.com/terms/c/coverdellesa.asp [4/30/18]

How much attention do you pay to this factor?

Will you pay higher taxes in retirement? Do you have a lot of money in a 401(k) or a traditional IRA? If so, you may receive significant retirement income. Those income distributions, however, will be taxed at the usual rate. If you have saved and invested well, you may end up retiring at your current marginal tax rate or even a higher one. The jump in income alone resulting from a Required Minimum Distribution could push you into a higher tax bracket.

While retirees with lower incomes may rely on Social Security as their prime income source, they may pay comparatively less income tax than you will in retirement; some, or even all, of their Social Security benefits may not be counted as taxable income.1

Given these possibilities, affluent investors might do well to study the tax efficiency of their portfolios; not all investments will prove to be tax-efficient. Both pre-tax and after-tax investments have potential advantages.

What’s a pre-tax investment? Traditional IRAs and 401(k)s are classic examples of pre-tax investments. You can put off paying taxes on the contributions you make to these accounts and the earnings these accounts generate. When you take money out of these accounts, you are looking at taxes on the withdrawal. Pre-tax investments are also called tax-deferred investments, as the invested assets can benefit from tax-deferred growth.2

What’s an after-tax investment? A Roth IRA is a classic example. When you put money into a Roth IRA, the contribution is not tax-deductible. As a trade-off, you don’t pay taxes on the withdrawals from that Roth IRA (so long as you have had your Roth IRA at least five years and you are at least 59½ years old). Thanks to these tax-free withdrawals, your total taxable retirement income is not as high as it would be otherwise.2

Should you have both a traditional IRA and a Roth IRA? It may seem redundant, but it could help you manage your marginal tax rate. It gives you an option to vary the amount and source of your IRA distributions considering whether tax rates have increased or decreased.

Smart moves can help you reduce your taxable income & taxable estate. If you’re making a charitable gift, giving appreciated securities that you have held for at least a year may be better than giving cash. In addition to a potential tax deduction for the fair market value of the asset in the year of the donation, the charity can sell the stock later without triggering capital gains for it or you.3

The annual gift tax exclusion gives you a way to remove assets from your taxable estate. In 2018, you may give up to $15,000 to as many individuals as you wish without paying federal gift tax, so long as your total gifts keep you within the lifetime estate and gift tax exemption. If you have 11 grandkids, you could give them $15,000 each – that’s $165,000 out of your estate. The drawback is that you relinquish control over those dollars or assets.4

Are you striving for greater tax efficiency? In retirement, it is especially important – and worth a discussion. A few financial adjustments could help you lessen your tax liabilities.

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

What are the potential benefits? What are the drawbacks?

 

If you own a traditional IRA, perhaps you have thought about converting it to a Roth IRA. Going Roth makes sense for some traditional IRA owners, but not all.

Why go Roth? There is an assumption behind every Roth IRA conversion – a belief that income tax rates will be higher in future years than they are today. If you think that will happen, then you may be compelled to go Roth. After all, once you are age 59½ and have had your Roth IRA open for at least five years (five calendar years, that is), withdrawals of the earnings from your Roth IRA are exempt from federal income taxes. You can withdraw your Roth IRA contributions tax free and penalty free at any time.1,2

Additionally, you never have to make mandatory withdrawals from a Roth IRA, and if your income permits, you can make contributions to a Roth IRA as long as you live.2

For 2018, the income limits are $135,000 for single filers and $199,000 for joint filers, with phase-out ranges respectively starting at $120,000 and $189,000. (These numbers represent modified adjusted gross income.)2

While you may make too much to contribute to a Roth IRA, you have the option of converting a traditional IRA to a Roth. Imagine never having to draw down your IRA each year. Imagine having a reservoir of tax-free income for retirement (provided you follow Internal Revenue Service rules). Imagine the possibility of those assets passing to your heirs without being taxed. Sounds great, right? It certainly does – but the question is: can you handle the taxes that would result from a Roth conversion?1,3     

Why not go Roth? Two reasons: the tax hit could be substantial, and time may not be on your side.

A Roth IRA conversion is a taxable event. The I.R.S. regards it as a payout from a traditional IRA prior to that money entering a Roth IRA, and the payout represents taxable income. That taxable income stemming from the conversion could send you into a higher income tax bracket in the year when the conversion occurs.2

If you are nearing retirement age, going Roth may not be worth it. If you convert a large traditional IRA to a Roth when you are in your fifties or sixties, it could take a decade (or longer) for the IRA to recapture the dollars lost to taxes on the conversion. Model scenarios considering “what ifs” should be mapped out.

In many respects, the earlier in life you convert a regular IRA to a Roth, the better. Your income should rise as you get older; you will likely finish your career in a higher tax bracket than you were in when you were first employed. Those conditions relate to a key argument for going Roth: it is better to pay taxes on IRA contributions today than on IRA withdrawals tomorrow.

On the other hand, since many retirees have lower income levels than their end salaries, they may retire to a lower tax rate. That is a key argument against Roth conversion.

If you aren’t sure which argument to believe, it may be reassuring to know that you can go Roth without converting your whole IRA.

You could do a multi-year conversion. Is your traditional IRA sizable? You could spread the Roth conversion over two or more years. This could potentially help you avoid higher income taxes on some of the income from the conversion.2

Roth IRA conversions can no longer be recharacterized. Prior to 2018, you could file a form with your Roth IRA custodian or trustee to undo a Roth IRA conversion. The recent federal tax reforms took away that option. (Roth IRA conversions made during 2017 may still be recharacterized as late as October 15, 2018.)2

You could also choose to “have it both ways.” As no one can fully predict the future of American taxation, some people contribute to both Roth and traditional IRAs – figuring that they can be at least “half right” regardless of whether taxes increase or decrease.

If you do go Roth, your heirs might receive a tax-free inheritance. Lastly, Roth IRAs can prove to be very useful estate planning tools. If I.R.S. rules are followed, Roth IRA heirs may end up with a tax-free inheritance, paid out either annually or as a lump sum. In contrast, distributions of inherited assets from a traditional IRA are routinely taxed.3

This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All indices are unmanaged and are not illustrative of any particular investment.

Citations.
1 – cnbc.com/2017/07/05/three-retirement-savings-strategies-to-use-if-you-plan-to-retire-early.html [7/5/17]
2 – marketwatch.com/story/how-the-new-tax-law-creates-a-perfect-storm-for-roth-ira-conversions-2018-03-26 [3/26/18]
3 – time.com/money/4642690/roth-ira-conversion-heirs-estate-planning/ [1/27/17]