Are you retired and wondering what to do with your retirement money? Did you forget to plan a Valentine’s Day for your significant other this week? Did your last minute purchase not quite meet the desired expectations, of the one you desire? No matter what your deValued experience, if you are over age 59 ½ it’s not too late to earn brownie points this year or too early to start planning for next year’s Feb 14 and for every holiday in between.
Yes, as all those TV ads have said, a diamond may last forever. Still, what can your heart throb do with a diamond other than wear it? That pales beside all the possible things you can do with a thoughtful IRA strategy especially once you have retired. You worked hard and were diligent in saving for your retirement, now that you’re retired you can creatively use it to make wonderful memories with your loved ones. Have you ever considered funding a trip with your Valentine –by The Eiffel Tower in Paris, hiking Machu Picchu in Peru, or walking the Great Wall in China? Or you may decide to stay at home and look into that designing that dream kitchen or tech gadget. You may even consider purchasing for your Valentine—that’s right—diamonds!
Living in the moment
Tap your IRA now for a trip, or for home improvement? Doesn’t that buck the conventional wisdom? After all, the R in IRA actually stands for retirement. However, remember that your plan is to make sure your retirement savings lasts through all of your retirement years. The more you withdraw now, the less you’ll have when you’re in your 70s and 80s and thereafter.
That’s true, but it’s also true that most IRA dollars have never been taxed. The deferred tax will be paid some day, by somebody. The moment you take money out of your tax-sheltered IRA, the tax will be due. Even if you don’t need the money, you’ll be forced to take required minimum distributions (RMDs) at age 70 ½, and each following year. Those RMDs may potentially boost you into a higher tax bracket.
Who knows how high tax rates will be, by the time you reach the RMD stage? If you consider withdrawing money prudently now, and you may be able to treat your loved one with dollars that have been relatively lightly-taxed.
Beware the Widow/Widower Tax
Consider what will happen if you keep all your dollars in your IRA, growing tax-deferred. If your IRA outlives you, the balance will pass to your beneficiary, possibly the Valentine you’re aiming to please. However, RMDs don’t die. At some point, taxable dollars will flow out from the beneficiary’s account, until the IRA is exhausted.
Moreover, married couples often overlook a tax trap. If the spouse with a large IRA dies first, the surviving spouse also must take RMDs, perhaps paying taxes on income that’s not needed. To make matters worse, an unmarried surviving spouse will file tax returns as an individual, instead of as a married couple filing jointly. Again, the widow or widower may be kicked into a higher tax bracket, essentially suffering a tax penalty for being single.
Ironically, dipping into your IRA now to treat your spouse might be a gift of love. You can do anything you want to do together now, while sparing your sweetheart from paying some high taxes on IRA withdrawals in the future.
That said, you still should aim to minimize taxes when dealing with your IRA. Don’t actually make your IRA a Valentine’s gift, as that would generate a distribution from your IRA that would be highly taxable. Moreover, creating a new IRA in the name of your Valentine would be considered an excess contribution, subject to a perpetual 6% penalty, year after year.
For those of you who are already enjoying your retirement and are age 59 ½ or older, the following are 6 ways that you can transform some of your IRA into the ultimate gift of love:
Use the IRA (once age 59 ½)
Financial planning software and financial advisors alike may encourage you to draw down already taxed assets (those held in taxable accounts) first, and tax-deferred IRA assets later. It’s true that this plan can be more tax-efficient now, but what will happen after all of your taxable assets are spent down?
You will be left with only tax-deferred asset to draw from. Add these IRA withdrawals to Social Security benefits plus any pension income and you’ll find yourself at the mercy of Uncle Sam’s tax rates for the rest of your life. Instead, you may want to consider taking out a portion of your IRA, alongside cash from other assets, to spread out the taxability of your IRA distributions gradually over many years? You’ll dilute the taxable impact of IRA withdrawals by selectively tapping those after-tax assets.
Win at tax bracket bingo
To hold down the tax on IRA withdrawals, stay within a relatively modest tax bracket.
To see how this might work, consider the hypothetical example of Al and Beth Smith. As they prepare their 2017 tax return, they discover that their taxable income last year was $100,000. That placed them in the 25% tax bracket, which goes up to $315,000 in 2018 (at 24% based on the new rules), on a joint tax return. Assuming this couple will have about the same income this year, Al could withdraw $5,000 or $10,000 or even $50,000 from his IRA and owe only 24% in tax.
What’s more, many people have made nondeductible IRA contributions, which will trim the tax bite on IRA withdrawals. Assume that Al now has a total of $100,000 in several IRAs, including $20,000 (20% of the total) in after-tax contributions. (Ideally, Al will have tracked the after-tax amount by filing IRS Form 8606 each year.)
No matter which IRA Al taps, 80% will be taxable and 20% will be tax-free. (The math is a bit more complicated, but this is an easy way to estimate the tax bill.) Thus, if Al withdraws $10,000 to treat Beth to a lovely cruise, only $8,000 would be taxable and the tax bill would be around $1,920—an $8,000 taxable withdrawal in the 24% tax bracket for 2018.
Stay out of the penalty box
The above example may work for Al and Beth Smith, assumed to be age 61. However, that’s not true for their neighbors, Chad and Eva Jones, even if their finances are identical to those of Al and Beth. That’s because Chad and Eva are age 56—and IRA withdrawals before 59-1/2 will trigger a 10% penalty. The Joneses would be in the 34% tax bracket, not 24%.
Fortunately, there are workarounds available. The 10% early withdrawal penalty has many exceptions, including one for college outlays. If Chad and Eva pay, say, $20,000 this year on their son Floyd’s higher education, they can take out up to $20,000 from their IRAs, taxable but not penalized. Who is to know that $20,000 is going to build a deck for Eva’s outdoor yoga regimen?
What if Floyd is taking a year off from college and none of the other listed penalty exceptions apply to Chad and Eva? They can ask their tax pro to help put together a series of substantially equal periodic payments (SEPPs). Anyone can do this; the result is a schedule of amounts that can be taken annually from an IRA, taxable but not penalized, for at least five years or until age 59-1/2, whichever comes later. But remember, be sure not to use IRA assets for other people at the risk of jeopardizing your own financial well-being, as your IRAs should first and foremost serve you for your own retirement.
Convert the IRA to a Roth IRA
Suppose your Valentine is not interested in a luxury vacation or a home improvement or anything else you offer to buy with IRA dollars. Instead, he or she is focused on building up a fabulous retirement account. You can comply with those wishes by taking money from your regular (“traditional”) IRA and moving the funds into a Roth IRA.
The ages from 50 to 70 are especially good years to execute this strategy. You’d distribute money from your IRA gradually, paying income tax on small portions that you move to the Roth side each year. The early distribution penalty won’t apply on direct transfers. However, if you are converting a traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted traditional IRA contributions and on all earnings.
For instance, suppose you start at age 60, converting 10% of your IRA to a Roth each year. By the time you reach age 70, you’ll have freed yourself from having to pay tax on those dreaded RMDs. Roth IRA owners never have any required distributions.
In addition, any Roth IRA distributions you take in the future will come to you tax-free! That’s true when you pass age 59-1/2, as long as you have had the Roth for at least five year. This ploy eliminates the risk of future higher tax brackets, securing a retirement in which 100% of the income you take from your IRA will be available for you and your significant other to do anything you’d both like to do.
Leverage the IRA
There’s another way to eliminate future tax bills for your Valentine, from your tax-deferred IRA time bomb. Say your current IRA investments pay 3%-4% income each year, from dividends and income. Arrange for those payouts to flow from your IRA to your bank account, set aside a portion for income tax, and use the remaining dollars for life insurance premiums.
Now your loved one will receive not only the balance remaining in the IRA at your death, but also a tax-free life insurance lump sum, which has been positively leveraged by funding the insurance policy.
For example, suppose that Greg Harris is 65, in reasonably good health. He might be able to take, say, $6,000 a year from his $200,000 IRA, pay $1,440 (24%) in tax, and use the remaining $4,560 to pay the annual premiums on a guaranteed universal life insurance policy. The “guarantee” here is that the policy would pay approximately $250,000 death benefit to Greg’s wife Heidi, as long as Greg keeps up the premiums. This insurance payment, probably untaxed, will provide Heidi with a meaningful sum of ready cash, to help her deal with any issues that will arise soon after Greg’s death. Keep in mind that an annual $6,000 withdrawal from a $200,000 IRA WOULD BE a mere 3% distribution rate, which could potentially be funded from a balanced dividend investment portfolio paying 3-4%. Doing so would not only allow the guaranteed life insurance BENEFIT to be paid out upon death, but also the remaining value of the IRA.
Stretch The IRA
A “stretch” IRA is one that lasts longer, providing extended tax deferral and, hopefully, more wealth to successive IRA owners. Stretching your IRA can’t actually be accomplished until after you’ve passed from this life, but the preparation for and arrangement of the necessary paperwork must be done during your lifetime. Stretch IRA's are only appropriate for investors that will not need the money to fund their retirement. The preparation typically involves one of the most important documents in all of retirement and estate planning, which is often overlooked – your IRA beneficiary designation form.
If that’s your desire, be sure to add your spouse or other loved one (I suggest not both) to your beneficiary form. Confirm that the company where you have your IRA has an up-to-date version of this form; keep copies of your signed completed form, along with a printout from the IRA custodian, with your estate planning papers.
As simple as this beneficiary designation can be, it often gets overlooked. With the proper paperwork in place and good advice, your beneficiary—and possibly the next generation as well—will be able to postpone the tax on most of the IRA money for many years, even decades.
In a best case scenario, if you’ve already applied item #4, converting your IRA to a Roth IRA, your Valentine will eventually inherit a Stretch Roth IRA and collect tax-free distributions for the rest of his or her life, as a reminder of how you truly felt!Sealed with a…..?
All of these steps can help you maximize the value of your IRA while minimizing the tax bite. IRA withdrawals during your lifetime can be spent on, or with, your significant other. Your IRA also can play a leading role in plans for your loved one’s lifestyle and security after you’re gone. Any of these gestures are a true gift of love, enabling many years of potentially unexpected gifts at unexpected times to demonstrate your love for your Valentine. Of course, it never hurts to present any one of these items within a box of jewelry containing diamonds!
This is for informational purposes only and should not be considered tax advice. Please consult with your CPA or tax advisor before acting upon any strategy to affect your taxes. Reference tax figures are estimates only and do not include state income tax. Christian Cordoba, CFP® RFC®, CFS is a CERTIFIED FINANCIAL PLANNNER™ professional, and president & founder at California Retirement Advisors, a financial consulting and services firm in El Segundo, California. Christian is a member Ed Slott’s Master Elite IRA Advisor Group and a Registered Principal offering securities through First Allied Securities, a member FINRA & SIPC Firm.
With a New Year comes a fresh start, which means now may be a good time for you to consider whether or not you’re working with the right tax professional. With the April deadline just a couple of months away, you may have already started reviewing your financial documents for your 2017 return. But do you have a qualified professional on your planning team? There are certain questions to ask and criteria to look for before hiring anyone.For more information, click below to download “Choosing the Right Tax Professional in 5 Easy Steps.”
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