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Planning for Fido and Fifi
By: Sandra Atkins, CPA/PFS
Hopefully, you have done your estate planning and made provisions for passing your estate to your children and grandchildren. But have you thought about what will happen to those other important members of the family – your “other” kids – your pets? You may recognize yourself in this article.
Take a look around and you will see that the baby boomers have substituted furry four-legged creatures for their children who have flown the nest. They treat them like children, but they are easier to get along with and don’t talk back. Boomers spare no expense in catering to these special loved ones and, as a result, have created an entire industry dedicated to pampering their “babies”. They have them coifed at pet spas, dress them in designer accessories, feed them organic meals and take them along on vacation.
So what happens to these treasured family members if the owner dies suddenly, or has to go for an extended stay in a hospital due to an unexpected accident? Who will feed and care for Fifi while her owner is hospitalized? And what will happen to her if her owner never returns?
The sad fact is that many of these pets are taken to shelters, where over half of them are euthanized. This horrible fate, fortunately, can be avoided with some careful planning and it is your job, as the family’s advisor, to raise the issue with your clients.
Continue reading →
A Tale of Two Mothers
By: Sandra L. Atkins
This is a true tale of two women, Joan and Mary, whose 80-something mothers died within weeks of each other. They both knew the importance of having their parents do some estate planning, but only one succeeded in getting it done. What a difference it made.
Joan’s story
Joan was a very organized person and made sure that she and her husband went to an attorney to have wills and trusts prepared. She encouraged her parents to do the same, but she could never get them to make an appointment with the attorney. When her father died in 1999, they found an old “I love you” will that left everything to his wife. Fortunately, they had a very traditional marriage and owned all of their assets in joint names. When he passed away, Joan’s mother continued on as before, making basically no changes after his death and leaving everything in joint names.
Joan talked to her mother again about setting up a living trust, so that her assets could be managed easily in the event that she became unable to manage them herself, and also to streamline, or eliminate, the probate process at her death. Her mother agreed that she needed to do some estate planning, but she kept putting it off. Then her mother unexpectedly contracted pneumonia, and within days she died. Not only was the estate planning not done, but she had never updated her original old will, which named her late husband as executor.
One problem after another
Joan’s siblings asked her to take charge of filing of her mother’s will. The first thing she did was look for the original will, but it was not to be found in her papers at home. Joan suspected that it was in the safe deposit box that her parents shared at the local bank. When she went to the bank, they told her that they needed proof that she had qualified as executor or administrator of her mother’s estate before they could give her access to the box.
Joan’s next stop was the county courthouse. She set up a meeting with the probate officer in the clerk’s office, but they could do nothing for her without the original will. So she had a dilemma on her hands. She couldn’t qualify as administrator without the will, and she couldn’t get to the will without qualifying.
Fortunately for Joan, her mother lived in a small town, and the probate clerk agreed to accompany her to the bank. With both of them present, the bank employee gave them access to the safe deposit box so they could get the will. Then Joan had to go through the process of qualifying as the administrator of her mother’s estate.
Unfortunately, this was just the beginning of Joan’s problems. Her mother had become increasingly vague over the last few years of her life, and her financial matters had gotten out of control. Her papers were in total disarray, with unpaid bills and unopened mail stacked on the dining room table. Joan spent hours sorting through the piles to see if she could figure out what bank accounts, certificates of deposit, and other investments she might have owned. What she did find still reflected both her father and mother as joint owners, as her mother had never made any changes after his death.
Joan is still working on identifying the assets and transferring them into the estate bank account. Her plan is to wait for a period of a year to see what other paperwork might show up to reveal other bank accounts, stocks and insurance policies.
Mary’s story
Mary, on the other hand, approached her parents in 1990 and suggested that they do some estate planning. Mary’s father heeded her advice and they went to see an estate planning attorney. They each set up a living trust, naming themselves as trustees of both trusts, with Mary as the successor trustee. Then they titled their savings and investment accounts with the names of their trusts.
Fortunately, before her father died in 2004, he and her mother discussed what would be the best course of action for her mother after his death. Since they had friends living in a continuing care facility, Mary’s mother said she would like to move into an apartment in the independent living section. They told Mary about their plan and it was decided that the initial buy-in cost could be paid with proceeds from the sale of their house, and the on-going costs could be paid with her social security income, along with a monthly distribution from her portfolio.
The advantage of planning
After her father’s death, Mary and her mother put the pre-arranged plan into place. Her mother felt very comfortable selling the house and moving to the continuing care facility because she knew it was what her husband of 62 years wanted her to do.
With respect to the financial aspects of their situation, Mary was able to step into her father’s shoes and take over management of both trusts. She was able to take over paying the bills, as her mother was unable to manage any of her financial affairs. They did not have to file the will at the courthouse, as everything had been placed in the living trust, so it was a seamless transition.
Mary’s mother’s estate
When Mary’s mother passed away, Mary paid her final expenses and was very quickly able to distribute the assets in her trust to her siblings and herself. Again, there was no need to go to the courthouse to file the will, as all of the assets were titled to the trust. Since her mother had lived in the continuing care facility for over 5 years, there was no interest to sell or liquidate.
Joan and Mary
Several months after their mothers died, Joan and Mary found the time to have lunch together to celebrate the lives of two wonderful women. Over lunch, Joan was lamenting about the difficulties she was having trying to figure out how to close out her mother’s estate. Her siblings were anxious to have their share of the estate distributed to them, but Joan was afraid to do anything until she was sure that she had found all of the assets and identified any liabilities that might be outstanding.
Mary just shook her head and chided Joan for letting her parents’ situation get so out of hand. She had already distributed the money in her mother’s estate and closed out the trust.
2010: Beware the Basis Adjustment Rules for Inherited Assets
By: Sandra Atkins, CPA/PFS and Helen Modly, CFP, ChFC
When the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted, planners jokingly told their clients that their best estate plan was to die in 2010, when there would be no estate tax. Surprisingly, Congress really did let the Federal Estate Tax disappear, but don’t overlook the complexities arising from the elimination of the fair market value “step-up” in basis for deaths occurring this year..
With the estate tax expiring on January 1, 2010, and no new legislation in sight, we find ourselves in the interesting position of having no federal estate tax. While that might be a great thing, the elimination of the estate tax also took away the step-up to fair market value of the decedent’s property, and left us with the need to establish the decedent’s original cost basis for the property passing at death.
It is going to be a huge challenge to establish the cost basis of property after the death of the owner. However, Internal Revenue Code Section 1022 adds additional complexity by allowing certain postmortem adjustments to be made to the original basis. These adjustments can be made on an asset by asset basis and can vary according to the type of property and who inherits it.
The Post-Mortem Basis Adjustment
For 2010, the recipients of property transferred at a decedent’s death will receive a “adjusted carryover basis”, which will be the lower of the decedent’s basis in the property, plus any postmortem adjustments as discussed below, or the property’s fair market value on the date the decedent died. The character of the property is also carried over.
The silver lining here is the limited ability for the executor to increase the basis for certain property. The executor is allowed to increase the total basis of the assets transferred by $1,300,000 ($60,000 for non-residents who are not US citizens). The basis of property passing to a surviving spouse or to a qualified terminable interest property (QTIP) trust can be increased by an additional $3,000,000, for a total basis adjustment of $4,300,000. On top of these adjustments, the basis can be further increased by the amount of any unused capital losses, net operating losses and certain “built-in” losses of the decedent. .
These basis adjustments are added to the decedent’s basis in the property to bring the value up to (but not exceeding) the fair market value. If the fair market value on the date of death minus the decedent’s basis in the assets is less than the allowable amount of adjustment, the estate would get a full fair market value step up. Therefore, it will still be necessary to identify the decedent’s original cost basis in order to get the maximum benefit. However, if the total value of the estate is less than allowed basis adjustment, the original basis becomes irrelevant since the adjustments would cover the entire value of the estate.
Allocating the basis adjustment
The executor of the decedent’s estate will determine which assets receive a step up and how the adjustment will be allocated on an asset-by-asset basis. In order to obtain the basis increase, the property must have been “owned by the decedent” and “acquired from the decedent”. Fortunately, assets transferred to a revocable living trust during the decedent’s life will still qualify for the basis adjustment. Joint tenancy property held by spouses can also receive a partial step-up, since the decedent is treated as owning one-half of the property. Section 1022 clearly identifies all the types of property to which the basis adjustment can be made.
No increase in basis is allowed for property considered to be Income in Respect of a Decedent (IRD). Common IRD property includes retirement plans, IRAs, annuities, US savings bonds, deferred compensation plans, and uncollected installment sale payments. Other assets that will not qualify for the basis adjustment include property that was acquired by the decedent as a gift within three years of the date of death, as well as certain foreign stock investments. There are additional special rules that apply only in specific situations included in Section 1022.
Risks to the Executor
Section 1022 provides that the basis adjustments are to be made by the executor of the estate. There are several issues that are not clearly addressed in the Code. For instance, although the executor has no direct authority or responsibility for non-probate assets, he apparently can allocate a portion of the basis adjustments to those assets.
Consider also the situation where the executor is also an heir of the estate. A potential conflict of interest arises when making the adjustment allocation, as it is in the heir’s best interest to allocate as much basis as possible to the assets he will be receiving.
Due to these unresolved issues, there is quite a bit of concern that the executor will be subjected to lawsuits brought by heirs who are not satisfied with the basis allocated to the property they receive. Therefore, if there is a likelihood of your client passing away during the next twelve months, he should be encouraged to consult with his estate planning attorney. It may make sense to revise documents to add additional flexibility for his executor to allocate basis adjustments under the new carryover basis regime for this year. Ideally, the executor should have absolute discretion to allocate basis to all assets of the decedent’s gross estate, including those passing outside the will, in any manner he chooses, without any liability to himself.
Problems for Traditional Estate Planning
The complexities resulting from the allocation of the basis adjustment become apparent very quickly. If a testamentary by-pass trust is established in the will, the basis of the assets used to fund the trust can be increased by only $1,300,000 since this distribution will not be considered as going to the spouse as a QTIP trust would. Since assets passing to the surviving spouse can benefit from the additional $3,000,000 step up, there is an argument for either giving the spouse the assets with the lowest basis, or if allowable in the will, giving all the assets outright to the spouse or used to fund a QTIP trust.
The problem with this solution is that, when the estate tax is reinstated in 2011 or before, the surviving spouse may end up owning assets that exceed the re-instated exemption amount. It appears that the best way to deal with this issue today is through the use of a QTIP trust funded by disclaimer, which qualifies for the full spousal basis adjustment, but will not be included in the spouse’s estate.
Remember that EGTRRA sunsets at the end of 2010. If Congress does not enact new estate tax legislation during 2010, the estate tax rates, exemptions and basis step-up rules will revert to the law in effect in 2001, beginning January 1, 2011. Therefore, these carryover basis rules will be in effect for no longer than twelve months. If Congress does pass new estate tax legislation during the year, it could take effect either at the time the legislation is passed or retroactively to the beginning of 2010.
Do clients need to revise their wills to address these ambiguities caused by the elimination of the estate tax? For most clients, who are in good health, it is hard to make an argument for changing their estate documents for this temporary situation. However, if you have clients who are very elderly or suffering from ill health and may not survive the year, you should review their situation with them and their estate planning attorney.
Helen Modly, CFP, ChFC, and Sandra Atkins, CPA/PFS are the principals of Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. They can be reached at info@focus-wealth.com.
Is it time for TIPS?
By: Tommie Monez, MBA, CFP, ChFC
March 25, 2010
TIPS are garnering a lot of interest from individual investors and their advisors. If you have ever wondered how to buy and sell them or when to choose individual bonds vs. mutual funds or exchange traded funds of TIPS, this article will be a valuable resource for you.
Why TIPS are Becoming So Popular
Record government deficits along with the unprecedented recent monetary stimulus have created valid concern about the prospect of future inflation. The wave of boomers nearing retirement age are still reeling from the recent hit to their investment accounts so it is no wonder that so many are seeking an inflation hedge than can provide safety as well. Nothing fills this need better than TIPS.
Treasury Inflation-Protected Securities (TIPS) have been around since 1997. They are Treasury bonds fully backed by the US government with maturities of 5, 10, and 20 years. The feature that makes TIPS different from other government bonds is the inflation adjustment to the principal. Every six months the Treasury adjusts the principal for inflation, using the Consumer Price Index. This inflation adjustment is taxable in the year it is added to the principal (commonly referred to as phantom income), even though the owner doesn’t actually receive it until the bond matures or is sold. This is the reason many advisors will only consider individual TIPS for tax-deferred accounts such as IRAs.
The fixed interest rate (coupon) is applied to the inflation adjusted principal to determine the actual interest payment. At maturity the investor receives the greater of the face value or the inflation adjusted principal. If the bond is sold, the purchaser pays the seller for the amount of inflation adjusted principal that the bond has received since issue.
In an inflationary environment TIPS can be one of the best deals around, combining safety with ever increasing principal. In a deflationary cycle, the opposite occurs. The interest rate is applied to a decreasing principal amount so interest payments are reduced. However, the amount returned at maturity is still guaranteed to be at least the face value.
How to buy TIPs
There are five ways to buy TIPS: See chart
– Individual bonds bought direct from the Treasury at auction,
– individual bonds purchased in a brokerage account at auction,
– individual bonds purchased on the secondary market through a brokerage account,
– shares of a mutual fund invested in TIPS, or
– shares of an exchange traded fund invested in TIPS.
If TIPS are purchased direct from the treasury at auction, an individual account must be set up at treasurydirect.gov. Direct purchase has two primary advantages: there is no transaction cost and the client can construct a bond ladder with maturities on specific target dates. There are several disadvantages with direct purchase at auction: there are only a few auctions a year, the TIPS cannot be consolidated into a brokerage account with other assets, and there are limited registration types available.
TIPS purchased in a brokerage account either at auction or on the secondary market can also be used to construct bond ladders. They have the added benefit of being included in a consolidated portfolio for inclusion in asset allocation, tax reporting, and performance reporting. As with any individual TIPS, interest cannot be reinvested, necessitating a new investment decision with every payout.
TIPs in mutual funds and exchange traded funds (ETFs) cannot be laddered for specific maturities; however they have the advantage of broad diversification and the ability to reinvest dividends. Because mutual funds are required to distribute all income to shareholders at least once a year, the increase in principal value due to the inflation adjustment is actually passed out to shareholders thus eliminating the phantom income problem. This does require the fund to use cash flow from matured bonds, incoming purchases of the funds, cash reserves, or as a last resort, sales of existing bonds to meet distribution requirements. Some TIPS mutual funds require dividends to be reinvested, thus reducing the actual cash needed to fund distributions.
Buying on the Secondary Market
It’s not always easy to tell what you are buying and how much it will cost. Unlike regular bonds the inflation factor comes into play when buying a bond in the secondary market and some math is required in order to figure out the actual price. Here is an example from a recent TIPS offering:
Coupon: This bond will pay 2.625% per year. Interest is paid twice per year as follows: [Inflation adjusted principal x coupon rate] ÷ 2 payable on July 15th and January 15th.
Maturity Date: The inflation adjusted principal or the face amount, if greater will be paid back on 7/15/2017.
Rating: All Treasury bonds have the highest rating of AAA.
Price Bid/Ask: These are actually percentages. The top number is the “bid” price which is the price this dealer will pay a seller for this bond. The bottom number, or “ask” price, is the higher price that a buyer must pay to acquire the bond. The difference is the bid/ask spread of the bond. The Price Bid/Ask does not include the amount that the buyer must pay the seller for any accumulated appreciation.
Yield Bid/Ask: These numbers are the actual yields to maturity (YTM) expressed as percentages of the bid and asked prices. In this example, the YTM, ignoring any inflation adjustment, is 1.078% for the buyer of this bond at this price.
Inflation Factor: This is the multiplier that is applied to the original face value of the bond to determine the accumulated inflation adjusted principal. The inflation adjusted principal of this bond is $1,044.47 = 1.04447 x $1,000. (When purchasing bonds, one unit/one bond equals $1,000). The inflation factor is adjusted every six months, up or down depending upon the change in CPI.
Adjusted Price Bid/Ask: These are the bid/ask prices multiplied by the inflation factor. The ask price of $110.852 multiplied by the inflation factor of 1.04447 equals $115.781588.
The Cost to purchase this bond can be figured two ways:
$1,044.47 (inflation adjusted principal) x 110.852% (or 1.10852) ask price = $1,157.82 plus accrued interest.
-or- $1,000 (face amount) x 115.781588% (or 1.15781588) adjusted ask price = $1,157.82 plus accrued interest.
This bond, with a current principal amount of $1,044.47, will cost $1,157.82 plus accrued interest. Accrued interest is interest earned before the bond was sold but not yet paid out. The buyer will receive the entire six months of interest so a prorated amount of that interest (the interest that has accrued) goes to the former owner and is added to the price of the bond.
One Caveat with TIPS on the Secondary Market
The buyer of this bond actually pays for the accumulated appreciation from date of issue to date of purchase. If there are periods of sustained deflation after this purchase, this appreciation could disappear and the purchaser would only receive the face amount of $1,000 at maturity. While unlikely, this could result in an actual loss.
What is the breakeven rate?
The breakeven rate is the future rate of inflation that would generate the same return from both TIPS and Treasury bonds with similar maturity. For example, if a 10 year Treasury bond had a 3.5% yield and a 10 year TIPS with the same maturity date had a yield of 1.2%, the breakeven rate would be 2.3% in simple terms. In essence, the Treasury bond market was expecting an inflation rate of 2.3% for the next 10 years. If inflation exceeds that amount the TIPS buyer comes out ahead. If inflation is lower, then the conventional Treasury bond is the better investment.
The value of a TIPS bond depends on the investor’s prediction of inflation. TIPS in any form provide a great diversifier for clients and advisors who are looking for a safe way to hedge against inflation. TIPS track with inflation better than gold, and unlike gold, they pay you while you own them. They have a respectable rate of return with many times the yield of a money market fund. And unlike conventional bonds they do not experience the erosion of purchasing power in an environment of rising rates.
A buyers guide to tips
Oh no! I Just Inherited a Coin Collection!
By Tommie Monez, MBA, CFP, ChFC
March 12, 2010
Grandpa just left you his treasured and valuable coin collection. While it was probably his heart’s desire for you to keep the collection and develop the same numismatic fever that he possessed, chances are you would really prefer cash. You find yourself wondering, now what do I do?
Handling the Coins
Once you have the collection in hand, it is time to take them out and look at them, so that you know what you have and can get an idea of what it’s worth. When looking at your coins, make sure to follow proper coin handling etiquette: handle the coins as little as possible, hold them by the rims so as not to damage the face, and don’t cough, sneeze, or even speak over them, as saliva can cause spotting. Don’t clean or polish any of the coins, as it can damage the surfaces. Collectors prefer the original surface of the coin, and cleaning can actually seriously devalue an old coin. Consider wearing soft gloves.
What Are They Worth?
Taking photographs front and back and making an inventory of your coins is absolutely necessary so that no unscrupulous potential buyer can take or switch any of your coins without your knowledge. Coins are categorized primarily by year and mint of origin. Sometimes there are differences in design or materials that were made mid production, resulting in coins that are rarer than others, and therefore more valuable. There are several guides that can help you figure out what coins you have and how valuable they are, of which the Red Book is the most popular. It should be noted that the Red Book doesn’t accurately reflect market prices, but it DOES give a good idea what different coins are worth in relation to each other. Having even a vague idea of what the collection is really worth is one of your best protections against getting cheated in the selling process.
The next step is taking your collection to a dealer to be appraised. But first, you need to make sure your dealer is reputable. A key thing to look for in a dealer is membership in a respected professional numismatic society, like the Professional Numismatists Guild, which provides protection in the form of a bill of rights, and a binding arbitration process if you have a grievance. You can find a member at www.pngdealers.com. The website includes a comprehensive list of questions to ask when interviewing a prospective coin dealer.
When making an appointment with the dealer, discuss whether you are interested in selling, or seeking an appraisal. Expect to pay a fee for an appraisal. It’s a good idea to get appraisals from more than one dealer if possible. Understand that dealers will offer less than retail price, as they, too, need to make a profit. Avoid letting the dealer cherry-pick the most valuable coins from your collection, as it will be harder to dispose of the rest. And NEVER leave your collection alone with a dealer, even if they are reputable, for your own security and peace of mind.
Transportation and Storage
If Grandpa lived in Florida and you are in Idaho, this can be the trickiest part of the process. You need to take measures to protect and insure what is hopefully a rare and valuable collection. If possible, retrieve it yourself. If you can’t retrieve the coins yourself, make sure whoever is shipping them to you wraps them tightly to protect them and prevent any rattling that might alert thieves as to the package contents.
FedEx and UPS will not accept coins for shipment. The safest means of transportation is by using insured registered mail through the US Post Office. The coins can be sent by registered mail and can be insured up to $25,000. In addition to insurance you will pay for the actual cost of shipping and additional services such as delivery confirmation and delivery restricted to a specific individual. According to Suzanne Stewart of Wayne Herndon Rare Coins, insured registered mail is the preferred method for coin dealers when shipping valuable coins. There should be an itemized list of contents included in the box with exact copies maintained by the shipper and recipient. Suzanne also recommends delivery to a PO Box so that you can have a postal employee witness you opening the package if there is any evidence that the package has been tampered with.
If you need to store the coins for an extended period of time before you have time to sell them, it is advisable to get a safety deposit box.
Insurance
Call your property and casualty insurance company right away to discuss purchase of a Personal Articles Floater which is a stand-alone policy that covers specific items, such as coins.
Other Ways to Sell
If you are convinced that your collection is extremely valuable, you might consider selling it through an auction house. However, take into account that they will usually only take the most valuable coins which may make the remainder of the collection less marketable.
You could also try to sell the collection yourself, but that takes considerably more time. Potential venues for selling your coins are eBay and local coin shows.
The next time you are tempted to buy yet another proof set or Thomas Kinkade masterpiece, remember that collectibles present some unique challenges and that transportation, storage, disposition can be time consuming and expensive. On the other hand you may find pleasure, excitement, and camaraderie by joining the ranks of numismatists or philatelists. Grandpa would be proud.
IRA Rollovers: Land Mines in the Safe Harbor
By: Helen Modly, CFP
January 20, 2010
An obscure IRS notice appears to torpedo the practice of taking a partial distribution of the after-tax dollars from 401k plans while doing a direct rollover of the pre-tax dollars into an IRA. According to a recent IRS notice, any partial direct rollover of plan assets to an IRA or another retirement plan forces the allocation of the after-tax portion to both the funds rolled over and to the funds distributed directly.
Many retirement plan participants, especially those of large employers, have accumulated after-tax funds in their account balances. Whether due to forfeitures, re-characterizations of excess contributions or just additional contributions, these after-tax balances can become significant.
Until Notice 2009-68 appeared on September 28, 2009, the common way to handle these after tax amounts was to bifurcate the distribution into a direct rollover to an IRA of the pre-tax amount and cut a check for the after-tax amount. A direct rollover of pre-tax funds to an IRA is not subject to the 20% mandatory withholding requirement and is not a taxable event. The direct distribution of after-tax contributions to the participant was also not a taxable event.
Congressional Intent
Congress seemed intent on increasing the options available for rolling over employer retirement plan balances thus increasing plan portability. Recently enacted tax laws have mandated that plans allow for these direct rollovers (technically considered to be trustee-to-trustee transfers) for both participants and their beneficiaries in an increasing number of situations. In fact some options for beneficiaries require use of this direct rollover option or they are not available, such as funding an inherited IRA from a non-spouse deceased’s qualified plan.
Recent Department of Labor regulations actually stipulate that plans subject to these direct rollover requirements must automatically set up an IRA to receive direct distributions of balances over $1,000 but less than $5,000 unless the participant elects otherwise. For balances over $5,000; the plans cannot distribute the funds without the direction of the participant or their representative.
Current Law
Current law on rollover distributions is found in IRS Sec. 402, as updated or clarified by numerous Treasury regulations, IRS notices and technical memoranda. Under the law, as most of us know it, there is no difference in tax treatment for amounts rolled over into an IRA via a direct rollover from amounts distributed to the participant, and then rolled into an IRA within the 60 day timeframe. The only difference has been that taxable amounts distributed directly to the participant are subject to a mandatory 20% withholding tax. This meant that the participant would have to replace the 20% withheld within 60 days or the amount withheld would be considered to be a taxable distribution and the balance would be the amount of the tax-free rollover.
The Opportunity
Relying on this understanding that partial distributions via a direct rollover are not taxed any differently than partial distributions that are rolled over using the 60 day process, seemed to create a brand new, exceptional planning opportunity for those leaving retirement plans (or folks able to take in-service distributions before retirement) who had significant after-tax balances. By instructing the plan administrator to bifurcate the balance into pre-tax and after-tax portions, then rolling the pre-tax funds directly to an IRA and the after-tax funds directly to a ROTH IRA appeared to be one way to fund a ROTH with no extra tax liability, regardless of income level. A stellar planning strategy.
The Opportunity Lost
IRS Sect.402(f) requires that plan trustees provide written notice to the recipients of plan distributions that describe “in plain language” all their various rollover options. To facilitate this requirement, the IRS produced Notice 2009-68. This notice provides sample language that plan fiduciaries can rely upon as a Safe Harbor to fulfill this notice requirement. Buried in this routine notice is one little section that seems to rewrite the actual tax code, without the assistance of congress:
“If you do a direct rollover of only a portion of the amount paid from the
Plan and a portion is paid to you, each of the payments will include an allocable portion of the after-tax contributions.
If you do a 60-day rollover to an IRA of only a portion of the payment made to you, the after-tax contributions are treated as rolled over last. For example, assume you are receiving a complete distribution of your benefit which totals $12,000, of which $2,000 is after-tax contributions. In this case, if you roll over $10,000 to an IRA in a 60-day rollover, no amount is taxable because the $2,000 amount not rolled over is treated as being after-tax contributions.”
This language appears to eliminate the ability to bifurcate distributions and preserve the segregation of pre-tax and after-tax funds if any portion is being rolled over directly. If you read the above carefully, you’ll come to the conclusion that the only way to preserve the segregation of pre-tax and after-tax funds is with a complete distribution and partial rollover within 60 days. This requires the plan to completely distribute the entire plan balance directly to the participant (subject to 20% withholding on the taxable amount), then within 60 days, the participant must rollover the taxable amount (plus funds to replace the withholding) to keep the after-tax separate.
They could still fund a ROTH IRA with the after-tax money, but it would have to be done the old fashioned way of funding a traditional IRA and then converting it. Alas, now the pro-rata rule would apply to the amount converted which states that the amount of after tax contribution being converted from an IRA to a ROTH IRA is the same proportion of the amount of after-tax funds divided by the total of all IRA accounts.
Questions to Be Resolved
Apparently, I am not the only one confused by this notice. One of the key questions is whether two direct rollovers from one account are considered to be one distribution or two distributions? According to Jan Jacobsen, senior counsel of the American Benefits Council-an advocacy group for retirement plans-the tax law is murky on this issue.
“Existing guidance is not a model of clarity on when two payments are treated as one or two distributions. Compare Treas. Reg. § 1.401(a)(31)-1, Q&A-9 (treating partial rollover with a cash payment as a single distribution) with Treas. Reg. § 1.401(a)(31), Q&A-10 (characterizing two direct rollovers made as part of a single distribution request as two distributions). The Roth distribution regulations explicitly state that a direct rollover is treated as a separate distribution from an amount paid directly to an employee. Treas. Reg. § 1.402A-1, Q&A-5(a). However, the Roth regulations do not discuss the basis recovery rules. Moreover, the regulations also treat two payments – rollover and cash — as a single distribution in other respects. Id.”
Notice 2009-68 seems to make a brand new distinction between the taxation of direct rollovers and those accomplished using the 60 day rollover method. It suggests that if any portion of the balance is being rolled directly to an IRA (or other retirement plan), then each of the payments will include an allocable portion of the after-tax contributions. In many cases, plan administrators cut two checks, one to an IRA account for the pre-tax amounts, and one directly to the participant for the after-tax amounts.
Are they both going to be considered to be partially pre-tax and partially after-tax? Even if the plan provides separate 1099-Rs for each portion, will they both reflect an allocable share of the after-tax funds? According to this notice, it appears that they must. What if the plan balance is split between two direct rollovers, one to a traditional IRA and one to a ROTH, are both portions considered to be a mixture of pre-tax and after-tax funds?
How this is going to work in the real world is baffling to me. In fact, I am working on a large plan distribution from a Fortune 100 company now where the client wants to rollover the pre-tax money directly to his IRA and convert the after-tax funds by direct rollover to a ROTH IRA. We have still not heard back from the plan as to how this Notice will affect his distribution options or how they would complete the 1099R.
I think we will wait a bit before flipping this switch. It may be that we have to rethink our entire strategy.
The author would like to thank Natalie Choate, Esq. for her contributions to this article.
Rethinking Retirement
By Sandra Atkins, CPA/PFS
August 21, 2009
The economic crisis of the past year has challenged our entire concept of retirement. The normal retirement age of 65 has been with us for decades, but is it still realistic for us today?
When the US government established Social Security (which was to be a type of social insurance) in 1935, they set the stage for us by establishing age 65 as the qualifying age to receive full retirement benefits. Since the average life expectancy of a male at that time was around 62, the intention clearly was not to have to “insure” the retirement of 100% of the retirees. Currently, the life expectancy of a male is 76 years, but the retirement age for Social Security is still 66 to 67, depending on when you were born. It is no wonder that the Social Security Administration is at risk of running out of money.
In addition to the notion of retirement at age 65, many companies allowed their employees to take retirement as early as age 55. Now that there are so few companies offering pensions, and with social security at risk, it seems that the hey-day of early retirement has come and gone – and was it ever realistic to expect a pension and an investment portfolio to sustain 30 to 40 years of retirement? Even 65 now seems like too soon to retire.
Last year, many people in their early 60s had a great retirement plan ready to implement when they decided the time was right. They would sell their home, use the equity to purchase a smaller home with no mortgage, and live comfortably on the retirement savings that they had accumulated (plus social security and a pension, if they were lucky). Now, one year later, we can see all the things that have gone wrong with that plan: the equity in the real estate has eroded (and in some cases, disappeared); there is a good chance that the house won’t sell any time soon; any new home purchase will require a mortgage to pay for it; and the remaining value in retirement savings won’t support the on-going lifestyle expenses. And, if you were expecting a pension, it might have been reduced or eliminated, as well.
That paints a pretty bleak picture for those planning to retire this year, or in the next few years. To accomplish the original plan successfully, you may need to defer retirement for several years. Everyone expects housing and the stock market to rally once again, but it is likely that it will happen at a much slower pace than we have experienced in the recent past.
How does retirement at age 70 (or 75?) sound? This is likely to become the norm, as the healthy, active Boomers approach this age bracket. Many will choose to stay engaged in full time or part time work, since they are not willing to curtail their living expenses while they are still healthy and active. It will be interesting to see how this trend plays out and what effect it will have on the job market. Those who retire from their primary employment and wish to begin a second career may face age bias, as they compete to find a job.
If you are still several years from retirement, now is the time to save as much as possible. You need to take a hard look at the amount of your current spending. Using a software program like Quicken or Managing Your Money, you should identify your essential expenses that have to be paid every month (mortgage, utilities, car payment, food, etc.) and your discretionary expenses (country club dues, vacations, furniture purchases, and so forth). Once you know the amount of your essential expenses, then you can identify what is left over from your paycheck each month. At that point, you need to make choices about how much you will save and how much you will spend on discretionary expenses.
The bottom line is that you are totally responsible for your own successful retirement. You cannot count on your employer or the government to provide funds that will sustain you throughout the remainder of your life after work. Therefore, it is imperative that you take charge of that responsibility now by making smart choices regarding your saving and spending.
Inherited IRAs-Who Gets What?
By: Helen Modly, CFP ©/ChFC
August 6, 2008
Inherited IRAs are so complex that beneficiaries acting without guidance are almost guaranteed to make mistakes. To make matters worse, the institutions involved are all over the board in terms of what processes they will allow for these accounts.
Retirement accounts such as IRAs and 401(k)s are becoming a significant part of the enormous generational asset transfer from the greatest generation to the baby boomers. New rules are adding to the obstacles that beneficiaries, and their advisors, must navigate to preserve this wealth.
The Stretch Can Make You Rich
A 40 year old client who inherits a $1 million IRA from a parent can stretch the required distributions over 42 years. With a modest 6% return over those years, her withdrawals will equal over $3 million. While new rules make stretching IRAs available to more types of beneficiaries than ever, there are many quirks to these rules. So, where do you begin when the IRA owner dies?
First, Consider the Status of the Owner
Did the owner reach their Required Beginning Date (RBD) on or prior to the date of death? The RMD is April 1st, of the year following the year they reached age 70 ½. If yes, then a Required Minimum Distribution is due for the year of death. The distribution will go to the beneficiary(s), but will be calculated using the deceased owner’s age at death. The estate does not take this distribution, unless the estate is the beneficiary. This distribution must be made prior to December 31st of the year following the year of death.
Next, Consider the Status of the Beneficiary(s)
Beneficiaries are either Designated or Non-Designated. Beneficiaries can be named in many different ways, some of them not so obvious.
- They may be named on a beneficiary form.
- They may be selected by default within a custodial agreement when there is no named beneficiary.
- They may be otherwise identifiable, such as the beneficiaries of a trust.
In order to be a designated beneficiary, they must be a living, breathing, natural person or a group of natural persons, or a qualifying trust for the benefit of identifiable natural persons. They do not have to be identified by name, although this is usually a good idea. “All children of this marriage to share equally” will suffice to make each child a designated beneficiary.
Spouse as Sole Designated Beneficiary
The IRS likes spouses so they have the most options with inherited retirement assets. They can elect to treat the IRA as if it were there own and delay taking distributions until their RBD or the RBD of the deceased, if later. This option is attractive when the surviving spouse does not need the funds and wants to delay taking RMD for as long as possible.
A surviving spouse can also treat the IRA as an Inherited IRA and begin taking distributions by the later of December 31st of the year following the year of death or by the decedent’s RBD (April 1st of the year following the year the decedent would have reached age 70 ½). This option is attractive when the spouse needs the funds now, since distributions from inherited IRAs are income taxable but not subject to the 10% penalty. The surviving spouse can elect to treat the IRA as their own at any point, even after taking years of distributions as a beneficiary.
Non-Spouse as Sole Designated Beneficiary
This situation is where the majority of costly mistakes will be made. A non-spouse is allowed to stretch an inherited IRA over their lifespan (provided that certain requirements are met). The wrench in the works will usually be the actual institution holding the account, since the transfer of funds MUST be done via a direct trustee-to-trustee process between the institution holding the original IRA and the institution holding the new Inherited IRA, if different.
The Inherited IRA must be titled as an Inherited IRA and include at a minimum the name of the original owner/depositor, the word deceased, the name of the living non-spouse beneficiary. For example, “John Doe, deceased, Inherited IRA for the benefit of John Smith”. Every institution is going to do this a bit differently. Distributions must begin by December 31st of the year following the year of death, with the age of the beneficiary using the single life table minus one to determine the amount of each distribution.
No Do-Overs for a Roll-Over
A non-spouse cannot do a rollover with inherited retirement funds, whether an IRA or an employer retirement plan. The transfer of funds must be a non-reportable trustee-to-trustee transfer, sometimes referred to as a “direct roll-over”. Non-reportable means that neither the sending nor the receiving institution will be coding this as a taxable distribution or generating a 1099-R.
Many institutions simply will not allow a non-spouse beneficiary to move funds via a trustee-to-trustee process. This is especially true of employer retirement plans. You may be able to get them to cut a check to the new custodian for the benefit of the non-spouse. As long as the check is drafted properly, it will also qualify for a trustee-to-trustee transfer, but you will need to shepherd this through the cashiering departments. For some reason, even major national custodians are having a hard time processing these distributions and an even harder time processing the contributions to the inherited account.
The no-rollover rules make it impossible to undo a faulty transfer. If the receiving institution rejects the transfer and it is gets made to the non-spouse, it is fully taxable. Fortunately, this will change next year as all plans and custodians must allow direct transfers (roll-overs) for non-spouses beginning in January 2010.
Non-Designated Beneficiaries
A non-designated beneficiary is an entity such as the estate, a charity, or a non-qualifying trust. In this case, go back to the first step and consider the IRA owner. If they died prior to reaching their RBD, then and only then, is the 5 year distribution rule required. This rule requires the entire balance of the inherited IRA to be distributed by December 31st of the year containing the 5th anniversary of death.
If the original owner died after reaching their RBD, then the RIA can be stretched over the decedent’s life expectancy using the single life table minus one for each year.
Multiple Beneficiaries-Split It if You Can
If none of the beneficiaries are considered non-designated, then the IRA should be split into separate accounts so each designated beneficiary can be considered the sole designated beneficiary for their account. This must be done by December 31st of the year following the year of death or the age of the oldest beneficiary will be used to determine everyone’s RBD. Note that the beneficiaries of a qualifying trust never receive this separate account treatment even if their accounts are split.
If one or more of the beneficiaries are considered non-designated, they should be cashed out prior to September 30th of the year following the year of death (Determination Date) or all the beneficiaries will be treated as non-designated. In the case where a beneficiary chooses to disclaim in favor of other primary or contingent beneficiaries, this must also be done by the Determination Date.
There will be a lot of money at stake with these inherited accounts. Make sure you keep your share.
Click here for a printable decision tree chart: HLM-Inherited IRA
Repellent for the Bond Bear
By: Helen Modly, CFP/ChFC
July 27, 2009
A very real bond bear trap may be developing just over the horizon. Interest rates are at historical lows and investors are hungry for yield. When 3-month T-bills are earning only 0.16% and one year Certificates of Deposit are earning less than 1%, investors looking for yield are tempted to seek out longer and longer maturities in an attempt to earn higher interest rates.
This is the classic set-up for a bond bear trap; owners of very long-term bonds will see the market values of their “safe” bonds drop significantly as interest rates tick upward.
Why the Bond Bear is so Scary
Investors have just been whipsawed by a terrifying stock decline from September, 2008, until March, 2009, followed by a quick rise in stock prices by July. Many did not fully participate in this year’s rally because of the fear that drove them to the sidelines earlier this spring. Many were eager for the perceived safety of cash and US Treasuries even though their prices surged to a point recently where yields were, and still are, almost non-existent.
Remember that a bond’s price, just like a stock’s price, will fluctuate after purchase causing the market value of the bond to fluctuate. Absent any defaults, the bond will still make its stated coupon interest payments and will return the full principal amount upon maturity.
Many investors are surprised to learn that bonds have a fluctuating market value. In olden days, bonds were kept in safety deposit boxes with little coupons attached. When an interest payment date came around, the owner would go to the bank, clip off the little coupon and present it to the teller for their interest payment. When the maturity date arrived, the bond itself was turned in for a return of the principal.
Since the bond was safely locked away, the owner didn’t receive a monthly statement with the current market valuation as brokerage account investors do now. We’ve had clients ask how it is possible for a guaranteed US Treasury bond to “lose value” from one monthly statement to the next. Investors expect to see their stocks fluctuate in value, but many are actually surprised to learn that bonds prices are volatile as well. It is important to remember that a bond owner will still receive each and every interest payment, as well as the return of principal at maturity (assuming no defaults). A bond owner’s yield for the life of the bond is determined at purchase based upon what they paid for the bond. Most brokerage statements however, reflect the current yield for bonds based upon the current price.
The Relationship Between Yield and Price
Clients often struggle to understand why their yield is improving, but the value of their bond is falling. I’ve had a client say to me, “If the yield is getting better, why isn’t the price improving?”
Bond prices and yields move inversely (opposite) to one another. Think of a seesaw. The fulcrum is the bond’s stated coupon. As the price of the bond goes up, the yield goes down. As the price goes down, the yield goes up. If you already own the bond, your yield is based upon what you paid for the bond. If you paid more than par (higher price) then your yield is less than the coupon percentage rate. If you paid less than par (lower price), then your yield is greater than the coupon rate.
The financial media makes this relationship even more confusing by sometimes referring to daily changes in yield and sometimes referring to changes in price. Normally, when we hear that bonds are gaining, they mean that the yield is improving. Of course this means that the prices are falling. When they talk about bonds losing ground, they mean that the yield is falling, which means that the prices are improving. Whether this is good or bad depends upon whether you already own a bond or are planning to buy one.
When the Bond Bear Roars
Going forward, when interest rates and inflation begin to march upward, bonds with 20- and 30-year maturities (and very low coupon rates) are going to look downright ugly in a portfolio. To get any yield today, investors need to seek out maturities of 10-years or more. A ten year Treasury bond is currently yielding just over 3.5%, while a 20-year Treasury is returning just north of 4.5%. Other than briefly last October and briefly again in 2003, yields have never been that low going back to 1962. That is almost 50 years of history showing that now is not the time to go long on the yield curve. A very real concern is that investors may need to sell a long maturity bond before it matures, thus taking a very real loss. At the very least, the performance of the portfolio is likely to suffer should current yields return to more historical norms than today’s incredibly low rates.
High-quality corporate bonds are fairing a bit better, with the yield on AAA 10-year corporate bonds just over 4% and 20-year AAA corporates at just over 6%. Bear in mind that only five corporations still hold the AAA rating from S&P: Berkshire Hathaway, American Data Processing, Exxon Mobile, Johnson & Johnson, and Microsoft. Great names, but if we’ve learned anything it is the terrible consequences of concentrating a portfolio into too few securities considering that 20 years is a lifetime for many corporations.
Today’s environment for fixed income is less than attractive, but using short maturities for government bonds and bond mutual funds or exchange traded funds to own corporate issues will help to inoculate portfolios against the bite of the bond bear.
Where Did All The Money Go?
By: Tommie Monez, MBA, CFP/ChFC
May 12, 2009
Sow It, Grow It, Blow It
It has been estimated that 70-80% of all wealth transfers fail by the third generation. As financial advisors we see it all the time. The first generation plants the seeds either through hard work, thrift, or invention. The second generation typically is raised with the same ethic of hard work and initiative and builds on what has come before. But they are also beginning to enjoy the material and monetary rewards that have been building through the generations. Their children may grow up in an atmosphere of luxury, indulgence, and freedom from responsibility that has the effect of breaking the chain of ingenuity, energy, and hard work that provided the family wealth.
The “blow it” generation has a sense of entitlement that can quickly erode the foundation of all that has come before. They may have little understanding of financial matters and expect the money to always be there no matter how fast they are spending it. They have always relied on others to provide for their needs.
We can help our children by teaching the value and joy of hard work along with humility, gratitude, and generosity. We are cheating them out of a sense of accomplishment and depriving them of a sense of self worth when we make things too easy. We are also setting them up for a nasty dose of reality when the money runs out.
An Ounce of Prevention
Can it be that 80% of all family wealth flows to ne’er do well relatives? What about families who continue to promote the values of hard work and manage to live within their means? The other part of successful wealth transfer is to minimize taxation. Here are some of the pitfalls to be avoided.
No wills, no trusts – If you die intestate the state gets to decide on the distribution of your assets and it will take a really long time.
Out of date estate documents – Wills, trusts, powers of attorney that no longer reflect your wishes.
Too much joint property – For spouses, if the value of the estate will exceed the exclusion amount when the second owner dies, taxes can be 45% or more. Proper planning can prevent this. The exclusion amount for 2009 is $3,500,000. Keep in mind that this number has been a moving target for many years.
Leaving everything to your spouse – The same issue as with too much joint property. There are strategies to provide the surviving spouse with access to the funds without having ownership for tax purposes.
Life insurance ownership that increases the taxable estate – The ownership of life insurance can be structured to keep the proceeds out of the estate.
Lack of liquidity – Families whose assets are tied up in land, sports teams, businesses, or other illiquid assets can be hard pressed to come up with money to pay estate taxes. Very often they are forced to sell the family holdings, no matter what the market conditions, to meet the tax deadlines. Sufficient cash or properly structured life insurance can prevent such disasters.
Financial education and advance planning can make the difference in keeping it all in the family or watching the family wealth evaporate.
In 1934 Judge Learned Hand said, “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.” So why does it have to be so complicated?
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