Retirement Withdrawals Without Penalty

Retirement Withdrawals Without Penalty

If you have multiple retirement accounts, when can you start withdrawals without penalty? This is very important if you want to retire before age 59 ½ and be able to access your money. The rules vary by the type of account, so advance preparation can make it easier to plan your withdrawals.

In our retirement income planning, we carefully choose the order of withdrawals. This can make a big difference in your tax bills. It’s also helpful to have multiple types of accounts so you can select from capital gains, tax-deferred accounts, and tax-free accounts. Let’s start with the early retirement penalties, by account type.

Five Retirement Plans with Different Rules

  1. 401(k) and 403(b): 10% penalty on distributions prior to age 59 ½.
  2. A 457 Plan can be accessed after you retire without penalty, regardless of your age. This is the easiest plan for accessing your money.
  3. Traditional IRA: 10% penalty for distributions prior to age 59 ½. This also applies to a SEP-IRA.
  4. SIMPLE IRA: 10% penalty prior to age 59 ½. Additionally, any distributions within the first two year of participation are subject to a 25% Penalty. Ouch. Don’t do that.
  5. Roth IRA. 10% penalty on earnings before age 59 ½, AND the five-year rule. You must have had a Roth open for five years before taking penalty-free withdrawals. So, if you open your first Roth at age 57, you’d have to wait until age 62 to get the tax-free benefit. However, you can access your principal at any time without tax or penalty. It is only when you start drawing down your earnings that the tax and penalty might apply. To withdraw tax-free and penalty-free, you must be over 59 ½ and have had a Roth for at least five years.

Read more: The Secret Way to Contribute $35,000 to a Roth IRA

Exceptions to the Penalty

  1. For 401(k) and 403(b) Plans: if you are at least age 55 and have separated from service, the penalty is waived. This means that if you retire between 55 and 59 ½, you can access your account without penalty. You would lose this exception if you roll your money into an IRA.
  2. 72(t) / Substantially Equal Periodic Payments (SEPP). If you are before age 55 and want to access your 401(k), 403(b), or Traditional IRA, you can take Substantially Equal Periodic Payments and waive the penalty. This means that you commit to taking the same amount from your account, annually, for at least five years or until age 59 ½, whichever is longer. Even if you later don’t want or need the distribution, you must continue to withdraw the same amount.  
  3. You may be able to avoid the 10% Penalty on an IRA or 401(k)/403(b) distribution if you qualify for these exceptions:
    • Total and Permanent Disability
    • An IRS Levy
    • Unreimbursed Medical Expenses in excess of 10% of AGI
    • Qualified Military Reservists called to Active Duty
  4. There are some exceptions which are available to IRAs (including SEP and SIMPLE), but not allowed from a 401(k) or 403(b). For these exceptions, you may want to roll your 401(k) into an IRA to qualify.
    • Qualified higher educational expenses
    • Qualified first-time homebuyers, up to $10,000
    • Health insurance premiums paid while unemployed

Full List from IRS: Exceptions to Tax on Early Distributions

Using Exceptions and Planning Your Income

I’m happy to let people know about these exceptions for retirement withdrawals without penalty before age 59 1/2. However, you should be very careful about tapping into your retirement accounts in your 30’s, 40’s or 50’s. This money needs to last a lifetime. I sometimes hear of people who take from their 401(k) accounts to buy a car or build a pool. And they have no idea that taking $50,000 now is stealing $400,000 from their future. Here’s the math: At 8%, your money will double every 9 years. That’s the Rule of 72. $50k will become $100k in 9 years, then $200k in 18 years, and $400k in 27 years. (Yes, this is a hypothetical rate of return, not a guarantee.)

The order of withdrawals does matter when planning your retirement income. While we can work to avoid the 10% penalty before age 59 ½, distributions from “Traditional” retirement accounts are still taxable as ordinary income. It’s often better to access your taxable accounts first. When eligible for long-term capital gains rate, that will be lower than IRA distributions which are taxed as ordinary income. And you have a cost basis on a taxable position, so only a portion of your sale ends up as a taxable gain.

Many retirees avoid touching their retirement accounts until they have to take Required Minimum Distributions. RMDs used to be at age 70 ½, but now are age 72. If there are years when you are in a low tax bracket (sabbatical, retired, year off, etc.), it may make sense to do a partial Roth Conversion. Start shifting money from a tax-deferred account into a tax-free account and save yourself on future taxes.

Once you reach age 72, you could be subject to a lot of taxes from RMDs. That’s the problem with being too good at waiting to start distributions from your retirement accounts. You’re creating a bigger tax bill for yourself later. While you are accumulating assets, it pays to plan ahead and know when and how you will be able to actually access your accounts. Have a question about retirement withdrawals without penalty? Let me know how I can help.

457 403b Plan

Choosing a 457 or a 403(b) Plan

Does your employer offer both a 403(b) and a 457 Plan? What should you do and what is a 457 anyways? A 457(b) Plan is an employer sponsored retirement plan for state or local government employees. It is a pre-tax, salary deferral plan, with an annual contribution limit of $19,500. Sounds just like a 401(k) or 403(b), right? Yes, but with one very interesting difference.

If you have more than one 401(k) or 403(b), your combined contribution to all 401(k) and 403(b) accounts cannot exceed $19,500 a year. 457 Plans are not included in this rule. That means that if you work for a government employer who offers both a 403(b) and a 457, you can contribute the maximum to both!

IRS Publication 4484: Choose a Retirement Plan for Employees of a Tax-Exempt Government Entity

457 Versus 403(b)

Besides the amazing tax-savings of doubling your contributions, there are a couple of other unique features of 457 plans.

The 457 has the same catch-up feature as a 403(b). Participants age 50 and higher can contribute an extra $6,500 a year. Additionally, if you are within three years of normal retirement age, you may be able to contribute up to two times the usual limit. Instead of $19,500, you could contribute up to $39,000 to a 457. Eligibility for this catch-up is limited by your previous contributions, so check with your HR to calculate your actual amount.

Most employers do not contribute to a 457 Plan. If they do, their contribution is counted towards your $19,500 limit. That’s a difference from a 403(b), where an employer contribution is on top of your individual limit.

There is no 10% penalty on distributions before age 59 ½. At whatever age you retire, you can access your 457 Plan without penalty. This is a big advantage compared to a 403(b) or IRA for people who want to retire early. And it’s a good reason to not rollover a 457 into an IRA. Once it’s in the IRA you would have to wait until after 59 ½ to avoid the penalty.

Let’s Evaluate Your Options

If your employer offers a 457 in addition to a 403(b), look into the 457. Want to contribute the maximum to both plans? That would be $39,000 for 2020, or $52,000 if you are age 50 or above. And potentially even higher if you are within three years of normal retirement age. Of course, you will also want to compare both plans being offered to you. Consider if any match is available, as well as the investment options and expenses of each plan.

You’d love to do both, but not sure you can contribute more than $19,500? Start here: 5 Steps to Boost Your Savings

Whatever type of retirement plan you have, let’s make sure you are taking full advantage of the benefits available to you. Not sure where to begin? I’m here to help, just send me a note.

2020 RMDs

2020 RMDs Fixed

At the end of March, the CARES Act waived 2020 RMDs (Required Minimum Distributions) from retirement accounts. This will help people who do not need to take distributions. They can leave their IRAs alone and not be forced to take a taxable withdrawal while the market is down.

Unfortunately, this change created a couple of problems. People could have started their 2020 RMDs as early as January 1, but the waiver didn’t occur until late March. Some people set up monthly distributions from their IRA, but can only put back one, due to the rules regarding 60-Day Rollovers. Later, the IRS said that if you took a withdrawal between February 1 and May 15, you could put it back before July 31. But that left out people who took RMDs in January.

This week, the IRS corrected both of those situations with IRS Notice 2020-51. The ruling will provide relief for anyone who wants to put back their RMDs taken after January 1. You have until August 31 to roll them back into your IRA. Also, if you took multiple withdrawals, you can put them all back. That’s because this one-time rollover is not going to be considered a 60-Day Rollover. (You con only do ONE 60-day rollover in a 365 day period.)

Also, Inherited IRAs (Stretch or Beneficiary IRAs) were never allowed to do 60-day rollovers. Under this week’s ruling, if you had taken your RMD from an Inherited IRA, you can put now return the money to the account through August 31. Unprecedented!

As a reminder, the age for RMDs increased to 72, from 70 1/2, last year. It’s good that the IRS has provided relief from the quagmire Congress created with CARES Act changes in March. So, if you don’t want to take an RMD, you don’t have to. And now you can reverse your RMDs if you had already started.

Planning Opportunities

Currently, tax rates are low, but the Federal rates are supposed to sunset after 2025. So, if you have a choice between paying some taxes now at 12% or 22% that might be better than paying 15%, 25%, or more down the road. Also, if you anticipate needing to take more than your RMD next year, you might be better off spreading that amount over 2020 and 2021, if it will keep you in a lower marginal tax bracket.

Another opportunity afforded by the 2020 RMD waiver is to do a Roth Conversion. If you had planned to pay the taxes on a $50,000 RMD, you could do a $50,000 Roth Conversion instead. Once in the Roth, your $50,000 is growing tax-free with no future RMDs. You paid some taxes at today’s lower rates, and reduced your future RMDs by doing a conversion in 2020.

A Roth Conversion does not count towards your RMD amount. So for people over 72, most never want to do a conversion because they are already paying a lot in taxes on their RMD. It’s best to do conversions after you retire – and are in a low bracket – but before you start RMDs. For people who missed that window, 2020 is the year to do a Roth Conversion.

Retirement Income Expertise

Creating tax-efficient retirement income is our mission and passion. If you want professional advice on establishing your retirement income plan, we can help. Here’s how:

  • We stay informed. Rules regarding your IRAs and 401(k) accounts have actually seen significant changes in the past couple of years.
  • Tools, not guesses. We analyze the likelihood of success of your retirement income plan through MoneyGuidePro. You will create a baseline scenario, which we will monitor and adjust based on market changes.
  • Asset location. Improving tax-efficiency through placing investments which generate ordinary income into tax-deferred accounts, and keeping long-term capital gains and qualified dividends in taxable accounts. Research and select more tax-efficient investment vehicles.
  • Sequence of Withdrawals. Determine the optimal order of withdrawals by account type and asset. Evaluate when you begin Pension payments and Social Security.

I suspect that there are not a lot of my readers who need to put back RMDs from January and are impacted by Notice 2020-51. But, I do have clients in this exact situation, and this type of detailed work is how I can add value to your financial life. Whether you are already retired, soon to be retired, or it’s just a dream at this point, we can create a plan to take you through the steps you need to feel comfortable about retirement.

Unplanned Retirement

Unplanned Retirement

With job losses this year reaching 40 million, many Americans are being forced into an unplanned retirement. Maybe they wanted to work until age 65 or later and find themselves out of work at age 60 or 62. Job losses due to Coronavirus layoffs may be the most common reason today. However, many people also enter early retirement due to their health or to care for a spouse or parent.

Each year, the Employee Benefits Research Institute publishes a Retirement Confidence Survey Report. Here are some findings from their 2020 report published in April:

  • 48% of current retirees retired earlier than they had planned. Only 6% retired later than they originally planned.
  • Less than one-half of workers have tried to calculate how much money they will need to live comfortably in retirement.
  • Of workers who reported their employment status would be negatively effected by the Coronavirus, only 39% felt confident that they will have enough money to last their entire life.

Half of all retirees retired at a younger age then they had planned. That statistic has remained very consistent over the years. In the 1991 report, it was 51%. This is a reality that more people should be preparing for. If you want to retire at 65, 70, or “never”, will you be prepared if you end up retiring at 64, 60, or 55? Certainly, if you enjoy your work, keep on working! But sometimes, the choice is not ours and people find themselves in an early, unplanned retirement.

If you have lost your job or just want to be better prepared should that happen, you need to plan your retirement income carefully.

Unplanned Retirement Steps

  1. You should begin with a thorough and accurate calculation of your spending needs. Not what you want to spend but what you actually spend. Determine your health insurance costs until age 65 and for Medicare after age 65, including Part B premiums, and Medicare Advantage or Medigap coverage, and Part D prescription drug coverage. Read more: Using the ACA to Retire Early.
  2. Reduce your expenses. This will require setting priorities and determining where you can do better. Still, there may be some low hanging fruit where you can save money with little or no change in your lifestyle. Read more: Cut Expenses, Retire Sooner
  3. Calculate your sources of retirement income. Read more: When Can I Retire?
  4. Be careful of starting Social Security at age 62. This is very difficult for people to not access “free money”, everyone wants to do it. Be sure to consider longevity risk and the possible benefits of spending investments first and delaying Social Security for a higher payout later. Read more: Social Security, It Pays to Wait
  5. Consider going back to work, even part-time, to avoid starting retirement withdrawals. The more you delay your retirement, the more likely you will not run out of money later. Here’s the math on why: Stop Retiring Early, People!

Be Prepared for the Unexpected

I think the best way to survive an unplanned retirement is to achieve financial independence at an early age. If you could retire at 50, plan to work until 65, and end up retiring at 60, it’s no problem. This requires saving aggressively and investing prudently from an early age. And that’s why retirement planning isn’t just for people who are 64. Retirement planning should also be for people who are 54, or 44, or even 34. Plan well, and an early retirement could be a good thing. It’s your chance to begin a new adventure!

If – surprise! – you do happen to be facing an unplanned retirement, let’s talk. We can help you evaluate your options for retirement income and establish a process and budget. Our retirement planning software can help you make better informed decisions, including when to start benefits, how much you can withdraw, and if you have enough money to last your lifetime.

It certainly is a shock to people when they end up retiring earlier than they had originally planned. However, it is very common and about half of all retirees are in the same situation. Unfortunately, not everyone who has an unplanned retirement will be having the comfortable years they had hoped. Basing your retirement on the assumption that you will work until age 70 or later may not be realistic. It could even set you up for failure if you end up needing to retire early. Whatever your age, retirement planning is too important to not seek professional help.

Retirement Income at Zero Percent

Retirement Income at Zero Percent

With interest rates crushed around the world, how do you create retirement income at zero percent? Fifteen years ago, conservative investors could buy a portfolio of A-rated municipal bonds with 5 percent yields. Invest a million dollars and they used to get $50,000 a year in tax-free income.

Not so today! Treasury bonds set the risk-free rate which influences all other interest rates. Currently, the rate on a 10-year Treasury is at 0.618 percent. One million dollars in 10-year Treasuries will generate only $6,180 in interest a year. You can’t live off that.

You can do a little better with municipal bonds today, maybe 2-3 percent. Unfortunately, the credit quality of municipal bonds is much worse today than it was 15 years ago. A lot of bonds are tied to revenue from toll roads, arenas, or other facilities and are seeing their revenue fall to zero this quarter due to the Coronavirus. How are they going to repay their lenders?

Debt levels have risen in many states and municipalities. Pension obligations are a huge problem. The budget issues in Detroit, Puerto Rico, Illinois, and elsewhere are well known. Shockingly, Senator McConnell last week suggested that states maybe should be allowed to go bankrupt. That would break the promise to Municipal Bond holders to repay their debts. This is an appalling option because it would cause all states to have to pay much higher interest rates to offset the possibility of default. And unlike Treasury bonds which are owned by institutions and foreign governments, Municipal Bonds are primarily owned by American families.

With Treasuries yielding so little and Municipal Bonds’ elevated risks, how do you plan for retirement income today? We can help you create a customized retirement income plan. Here are three parts of our philosophy.

1. Don’t Invest For Income

We invest for Total Return. In Modern Portfolio Theory, we want a broadly diversified portfolio which has an efficient risk-return profile, the least amount of risk for the best level of return. We focus on taking withdrawals from a diversified portfolio, even if it means selling shares.

Why not seek out high dividend yields and then you don’t have to touch your principal? Wouldn’t this be safer? No, research suggests that a heavy focus on high yields can create additional risks and reduce long-term returns. Think of it this way: Company A pays a 5% yield and the stock grows at zero percent; Company B pays no yield but grows at 8%. Clearly you’d be better off with the higher growth rate.

When you try to create a portfolio of high yield stocks, you end up with a less diversified portfolio. The portfolio may be heavily concentrated in just a few sectors. Those sectors are often low growth (think telecom or utilities), or in distressed areas such as oil stocks today. The distressed names have both a higher possibility of dividend cuts, as well as significant business challenges and high debt.

The poster child for not paying dividends is Warren Buffett and his company, Berkshire Hathaway. He’s never paid a dividend to shareholders in over fifty years. Instead, he invests cash flow into new acquisitions of well-run businesses or he buys stocks of other companies. Over the years, the share price of BRK.A has soared to $273,975 a share today. If investors need money, they can sell their shares. This is more tax-efficient, because dividend income is double taxed. The corporation has to pay income taxes on the earnings and then the investor has to pay taxes again on the dividend. When a company grows, the investor only pays long-term capital gains when they decide to sell. And the company can write off the money it reinvests into its businesses.

2. Create a Cash Buffer

Where a total return approach can get you into trouble is when you have to sell stocks in a down market. If you need $2,000 a month and the price of your mutual fund is $10/share, you sell 200 shares. But in a Bear Market when it’s down 20%, you’d have to sell 250 shares (at $8/share) to produce the same $2,000 distribution. When you sell more shares, you have fewer shares left to participate in any subsequent recovery.

This is most problematic in the early years of retirement, a fact which is called the Sequence of Returns Risk. If you have a Bear Market in the first couple of years of retirement, it is more likely to be devastating than if you have the same Bear Market in your 20th year of retirement.

To help avoid the need to sell into a temporary drop, I suggest keeping 6-12 months in cash or short-term bonds so you do not have to sell shares. Additionally, I prefer to set dividends to pay out in cash. If we are receiving 2% stock dividends and 2% bond interest, and need 4% a year, we would have to sell just two percent of holdings. This just gives us more flexibility to not sell.

Also, I like to buy individual bonds and ladder the maturities to meet cash flow needs. If your RMD is $10,000 a year, owning bonds that mature at $10,000 for each of the next five years means that we will not have to touch stocks for at least five years. This approach of selling bonds first is known as a Rising Equity Glidepath and appears to be a promising addition to the 4% Rule.

3. Guaranteed Income

The best retirement income is guaranteed income, a payment for life. This could be Social Security, a government or company Pension, or an Annuity. The more you have guaranteed income, the less you will need in withdrawals from your investment portfolio. We have to be fairly conservative in withdrawal rates from a portfolio, because we don’t know future returns or longevity. With guaranteed income, you don’t have to fear either.

We know that Guaranteed Income improves Retirement Satisfaction, yet most investors prefer to retain control of their assets. But if having control of your assets and the ability to leave an inheritance means lower lifetime income and higher risk of failure, is it really worth it?

I think that investors make a mistake by thinking of this as a binary decision of 100% for or against guaranteed income. The more sophisticated approach is to examine the intersection of all your retirement income options, including when to start Social Security, comparing lump sum versus pension options, and even annuitizing a portion of your nest egg.

Consider, for example, if you need an additional $1,000 a month above your Social Security. For a 66-year old male, we could purchase a Single Premium Immediate Annuity for $176,678 that would pay you $1,000 a month for life. If you instead wanted to set up an investment portfolio and take 4% withdrawals to equal $1,000 a month, you would need to start with $300,000. So what if instead of investing the $300,000, you took $176,678 and put that into the annuity? Now you have guaranteed yourself the $1,000 a month in income you need, and you still have $123,322 that you could invest for growth. And maybe you can even invest that money aggressively, because you have the guaranteed annuity income.

Conclusion

It’s a challenge to create retirement income at zero percent interest rates. Unless you have an incredibly vast amount of money, you aren’t going to get enough income from AAA bonds or CDs today to replace your income. We want to focus on a total return approach and not think that high dividend stocks or high yield bonds are an easy fix. High Yield introduces additional risks and could make long-term returns worse than a diversified portfolio.

Instead, we want to create a cash buffer to avoid selling in months like March 2020. We own bonds with maturities over five years to cover our distribution or RMD needs. Beyond portfolio management, a holistic approach to retirement income evaluates all your potential sources of income. Guaranteed income through Social Security, Pensions, or Annuities, can both reduce market risk and reduce your stress and fear of running out of money. The key is that these decisions should be made rationally with an open mind, based on a well-educated understanding and actual testing and analysis of outcomes.

These are challenging times. If you are recently retired, or have plans to retire in the next five years, you need a retirement income plan. We had quite a drop in March, but recovered substantially in April. The economy is not out of the woods from Coronavirus. I think global interest rates are likely to remain low for years. If you are not well positioned for retirement income, make changes soon, using the strength in today’s market to reposition.

12% Roth Conversion

The 12% Roth Conversion

If you make less than $105,050, you’ve got to look into the 12% Roth Conversion. For a married couple, the 12% Federal Income tax rate goes all the way up to $80,250 for 2020. That’s taxable income. With a standard deduction of $24,800, a couple could make up to $105,050 and remain in the 12% bracket. Above those amounts, the tax rate jumps to 22%.

For those who are in the 12% bracket, consider converting part of your Traditional IRA to a Roth IRA each year. Convert only the amount which will keep you under the 12% limits. For example, if you have joint income of $60,000, you could convert up to $45,050 this year.

This will require paying some taxes today. But paying 12% now is a great deal. Once in the Roth, your money will be growing tax-free. There will be no Required Minimum Distributions on a Roth and your heirs can even inherit the Roth tax-free. Don’t forget that today’s tax rates are going to sunset after 2025 and the old rates will return. At 12%, a $45,050 Roth conversion would cost only $5,406 in additional taxes this year.

Take Advantage of the 12% Rate

If you have a large IRA or 401(k), the 12% rate is highly valuable. Use every year you can do a 12% Roth Conversion. Otherwise, you are going to have no control of your taxes once you begin RMDs. If you have eight years where you can convert $40,000 a year, that’s going to move $320,000 into a tax-free account. I have so many clients who don’t need their RMDs, but are forced to take those taxable distributions.

Here are some scenarios to consider where you might be in the 12% bracket:

  1. One spouse is laid off temporarily, on sabbatical, or taking care of young children. Use those lower income years to make a Roth Conversion. This could be at any age.
  2. One spouse has retired, the other is still working. If that gets you into the 12% bracket, make a conversion.
  3. Retiring in your 60’s? Hold off on Social Security so you can make Roth Conversions. Once you are 72, you will have both RMDs and Social Security. It is amazing how many people in their seventies are getting taxed on over $105,050 a year once they have SS and RMDs! These folks wish they had done Conversions earlier, because after 72 they are now in the 22% or 24% bracket.

Retiring Soon?

Considering retirement? Let’s say you will receive a $48,000 pension at age 65. (You are lucky to have such a pension – most workers do not!) For a married couple, that’s only $23,200 in taxable income after the standard deduction. Hold off on your Social Security and access your cash and bond holdings in a taxable account. Your Social Security benefit will grow by 8% each year. The 10 year Treasury is yielding 1.6% today. Spend the bonds and defer the Social Security.

Now you can convert $57,050 a year into your Roth from age 65 to 70. That will move $285,250 from your Traditional IRA to a Roth. Yes, that will be taxable at 12%. But at age 72, you will have a lower RMD – $11,142 less in just the first year.

When you do need the money after 72, you will be able to access your Roth tax-free. And at that age, with Social Security and RMDs, it’s possible you will now be in the 22% tax bracket. I have some clients in their seventies who are “making” over $250,000 a year and are now subject to the Medicare Surtax. Don’t think taxes go away when you stop working!

How to Convert

The key is to know when you are in the 12% bracket and calculate how much to convert to a Roth each year. The 12% bracket is a gift. Your taxes will never be lower than that, in my opinion. If you agree with that statement, you should be doing partial conversions each year. Whether that is $5,000 or $50,000, convert as much as you can in the 12% zone. You will need to be able to pay the taxes each year. You may want to increase your withholding at work or make quarterly estimated payments to avoid an underpayment penalty.

What if you accidentally convert too much and exceed the 12% limit? Don’t worry. It will have no impact on the taxes you pay up to the limit. If you exceed the bracket by $1,000, only that last $1,000 will be taxed at the higher 22% rate. Conversions are permanent. It used to be you could undo a conversion with a “recharacterization”, but that has been eliminated by the IRS.

While I’ve focused on folks in the 12% bracket, a Conversion can also be beneficial for those in the 22% bracket. The 22% bracket for a married couple is from $80,250 to $171,050 taxable income (2020). If you are going to be in the same bracket (or higher) in your seventies, then pre-paying the taxes today may still be a good idea. This will allow additional flexibility later by having lower RMDs. Plus, a 22% tax rate today might become 25% or higher after 2025! Better to pay 22% now on a lower amount than 25% later on an account which has grown.

A Roth Conversion is taxable in the year it occurs. In other words, you have to do it before December 31. A lot of tax professionals are not discussing Roth Conversions if they focus solely on minimizing your taxes paid in the previous year. But what if you want to minimize your taxes over the rest of your life? Consider each year you are eligible for a 12% Roth Conversion. Also, if you are working and in the 12% bracket, maybe you should be looking at the Roth 401(k) rather than the Traditional option.

Where to start? Contact me and we will go over your tax return, wage stubs, and your investment statements. From there, we can help you with your personalized Roth Conversion strategy.

SECURE Act Abolishes Stretch IRA

The SECURE Act passed in December and will take effect for 2020. I’m glad the government is helping Americans better face the challenge of retirement readiness. As a nation, we are falling behind and need to plan better for our retirement income. 

It’s highly likely that the SECURE Act will directly impact you and your family. Six of the changes are positive, but there’s one big problem: the elimination of the Stretch IRA. We’re going to briefly share the six beneficial new rules, then consider the impact of eliminating the Stretch IRA.

Changes to RMDs and IRAs

1. RMDs pushed to age 72. Currently, you have to begin Required Minimum Distributions from your IRA or 401(k) in the year in which you turn 70 1/2. Starting in 2020, RMDs will begin at 72. This is going to be helpful for people who have other sources of income or don’t need to take money from their retirement accounts. People are living longer and working for longer, so this is a welcome change.

2. You can contribute to a Traditional IRA after age 70 1/2. Previously, you could no longer make a Traditional IRA contribution once you turned 70 1/2. Now there are no age limits to IRAs. Good news for people who continue to work into their seventies!

3. Stipends, fellowships, and home healthcare payments will be considered eligible income for an IRA. This will allow more people to fund their retirement accounts, even if they don’t have a traditional job.

529 and 401(k) Enhancements

4. 529 College Savings Plans. You can now take $10,000 in qualified distributions to pay student loans or for registered apprenticeship programs.

5. 401(k) plans will cover more employees. Small companies can join together to form multi-employer plans and part-time employees can be included

6. 401(k) plans can offer Income Annuities. Retiring participants can create a guaranteed monthly payout from their 401(k). 

No More Stretch IRAs

7. The elimination of the Stretch IRA. This is a problem for a lot of families who have done a good job building their retirement accounts. As a spouse, you will still be allowed to roll over an inherited IRA into your own account. However, a non-spousal beneficiary (daughter, son, etc.) will be required to pay taxes on the entire IRA within 10 years.

Existing Beneficiary IRAs (also known as Inherited IRAs or Stretch IRAs) will be grandfathered under the old rules. For anyone who passes away in 2020 going forward, their IRA beneficiaries will not be eligible for a Stretch.

If you have a $1 million IRA, your beneficiaries will have to withdraw the full amount within 10 years. And those IRA distributions will be taxed as ordinary income. If you do inherit a large IRA, try to spread out the distributions over many years to stay in a lower income tax bracket. 

For current IRA owners, there are a number of strategies to reduce this future tax liability on your heirs.
Read more: 7 Strategies If The Stretch IRA Is Eliminated

If you established a trust as the beneficiary of your IRA, the SECURE Act might negate the value and efficacy of your plan. See your attorney and financial planner immediately.

IRA Owners Need to Plan Ahead

The elimination of the Stretch IRA is how Congress is going to pay for the other benefits of the SECURE Act. I understand there is not a lot of sympathy for people who inherit a $1 million IRA. Still, this is a big tax increase for upper-middle class families. It won’t impact Billionaires at all. For the average millionaire next door, their retirement account is often their largest asset, and it’s a huge change. 

If you want to reduce this future tax liability on your beneficiaries, it will require a gradual, multi-year strategy. It may be possible to save your family hundreds of thousands of dollars in income taxes. To create an efficient pre and post-inheritance distribution plan, you need to start now.

Otherwise, Uncle Sam will be happy to take 37% of your IRA (plus possible state income taxes, too!). Also, that top tax rate is set to go back to 39.6% after 2025. That’s why the elimination of the Stretch IRA is so significant. Many middle class beneficiaries will be taxed at the top rate with the elimination of the Stretch IRA. 

From a behavioral perspective, most Stretch IRA beneficiaries limit their withdrawals to just their RMD. As a result, their inheritance can last them for decades. I’m afraid that by forcing beneficiaries to withdraw the funds quickly, many will squander the money. There will be a lot of consequences from the SECURE Act. We are here to help you unpack these changes and move forward with an informed plan.

Using the ACA to Retire Early

A lot of people want to retire early. Maybe you’re one of them. The biggest obstacle for many is the skyrocketing cost of health insurance. It’s such a huge expense that some assume they have no choice but to keep working until age 65 when they become eligible for Medicare.

However, if you can carefully plan out your retirement income, you may be eligible for a Premium Tax Credit (PTC) when you purchase an insurance plan on the health exchange, under the Affordable Care Act (“Obamacare”). The key is to know what the income levels are, what counts as income, and then to have other sources of savings or income to cover you until after the year in which you reach age 65 and enroll in Medicare. If we can bridge those years, maybe you can retire early by having the PTC cover a significant portion of your insurance premiums.

You are eligible for a PTC if your income is between 100% and 400% of the Federal Poverty levels. For a single person, those income amounts are between $12,140 and $48,560 for 2019. For a married couple, your income would need to be between $16,460 and $65,840. The lower your income, the larger your tax credit. Please note that if you are married filing separately, you are not eligible for the PTC. You must file a joint return.

The PTC will be based on your estimate of your 2020 income. If your actual income ends up being higher, when you file your 2020 tax return in April 2021, then you have to repay the difference. So it is very important that you understand how “income” is calculated for the PTC.

Under the ACA, income is your “Modified Adjusted Gross Income” (MAGI), which unfortunately is not a line on your tax return. MAGI takes your Adjusted Gross Income and adds back items, such as 100% of your Social Security benefits (which might have been 50% or 85% taxable), Capital Gains, and even tax-free municipal bond interest.

Read more: What to Include as Income

Here are some examples of the Premium Tax Credit, based on Dallas County, Texas, for non-tobacco users:

  • Single Male, age 63 with $45,000 income would be eligible for a PTC of $580 a month
  • Single Male, age 63 with $25,000 income, PTC increases to $811 a month.
  • Married couple (MF) age 63, with $60,000 income would have a PTC of $1,404/month
  • Married couple (MF) age 63, with $40,000 income would have a PTC of $1,633/month

(Same sex couples are eligible for a PTC under the same rules: they must be legally married and file a joint tax return.)

For this last example of a 63 year old couple making $40,000, the average cost of a plan after the Premium Tax Credit would be $332 (Bronze), $428 (Silver), or $495 (Gold) a month, for Dallas County. That’s very reasonable compared to a regular individual plan off the exchange, or COBRA. 

Check your own rates and PTC estimate on Healthcare.gov

Here’s how you can minimize your income to maximize your ACA tax credit and retire before 65:

  • Don’t start Social Security or a Pension until at least the year after you turn 65. Consider that if you start taking $2,000 a month in income, it means you could lose a $1,400 monthly tax credit.
  • Don’t take withdrawals from your Traditional IRA or 401(k). Those distributions count as ordinary income.
  • You can however take distributions from your Roth IRA and that won’t count as income for the PTC. Just make sure you are age 59 1/2 and have had a Roth open for at least five years. 
  • Build up your savings so you can pay your living expenses for these bridge years until age 65. 
  • If you have stocks or funds with large capital gains, consider selling a year before you sign up for the ACA health plan. Although you might pay 15% long-term capital gains tax, you can avoid having those sales count as MAGI in the year you want a PTC.
  • In your taxable account, you can sell funds or bonds with low taxable gains in the years you need the PTC. That can be a source of liquidity. Rebalance in your IRA to avoid creating additional gains.  
  • You can pay or reimburse yourself from a Health Savings Account (HSA) for your qualified medical expenses. Those are tax-free distributions.
  • If you still have earned income when “retired”, a Traditional IRA contribution (if deductible) or a 401(k) contribution will reduce MAGI. 
  • If you sell your home (your primary residence), and have lived there at least two of the past five years, then the capital gain (of up to $250,000 single or $500,000 married) is not counted towards MAGI for the ACA.  

An important point: your goal is not to reduce your income to zero. If you do not have income of at least 100% of the poverty level, you are ineligible for the premium tax credit and will instead be covered by Medicaid. That’s not necessarily bad, but to get a large tax credit and use a plan from the exchange, you need to have income of at least $12,140 (single) or $16,460 (married).

If you can delay your retirement income and have other assets available to cover your expenses until after 65, you may be able to take advantage of the Premium Tax Credit. This planning could add years to your retirement and avoid having to wait any longer. If you want to retire before 65, let’s look at your expenses and accounts, and create a budget and plan to make it happen using the Premium Tax Credit.

Consider, too, that the plans on the exchange may have different deductibles and co-pays than your current employer coverage. Check if your existing doctors and medications will be covered in-network and create an estimate of what you might pay out-of-pocket as well as what your maximum out-of-pocket costs would be. 

7 Strategies If The Stretch IRA is Eliminated

On May 31, I sent a newsletter about US House of Representatives approving the SECURE Act and six changes it would create for retirement plans. To pay for the cost of new rules, like extending the RMD age from 70 1/2 to 72, the legislation proposes to eliminate the Stretch IRA starting in 2020. While the Senate has yet to finalize their own version of this legislation, odds are good that something is going to get passed. And if the Stretch IRA manages to survive this time, it will likely be back on the chopping block in the near future.

A Stretch IRA, also known as an Inherited IRA or Beneficiary IRA, allows the beneficiary of an IRA to continue to enjoy the tax-deferred growth of the IRA and only take relatively small Required Minimum Distributions over their lifetime. Congress has recognized that while they want to encourage people to contribute to IRAs to save for their retirement, they’re not as happy about the IRAs being used as an Estate Planning tool.

If you have a large IRA, one million or more, you might have more in assets than you will need to spend. If you leave it to your spouse, they can still roll it into their own IRA and treat it as their own. Once the Stretch IRA is eliminated, and you leave the IRA to someone other than a spouse, they will have to withdraw the entire IRA within 10 years. Those distributions will be treated as ordinary income and there could be substantial taxes on a seven-figure IRA.

Now is the time to start planning for the end of the Stretch IRA. There are ways that could potentially save many thousands in taxes on a million dollar IRA. But these methods may take years to work, so it pays to start early. Here are seven considerations:

1. Charitable Beneficiary. If you are planning to leave money to a charity (a church, arts organization, university, or other charity), make that bequest through your IRA rather than from your taxable estate. The charity will receive the full amount and as a tax-exempt organization, not owe any taxes on the distribution. It will be much more tax efficient to leave taxable assets to individual beneficiaries and IRA assets to charities than the reverse.

2. QCD. Better than waiting until you pass away, you can donate up to $100,000 a year in Qualified Charitable Distributions after age 70 1/2 that count towards your RMD. This reduces your IRA but preserves a tax benefit today, which is even better than leaving it as an inheritance. Plus you get to see the good your donation can make while you are still alive. (And you don’t have to itemize your tax return; the QCD is an above the line deduction.)

3. Start withdrawals at age 59 1/2. The traditional approach to IRAs was to avoid touching them until you hit 70 1/2 and had to start RMDs. With today’s lower tax brackets, if you have a very large IRA, it may be preferable to start distributions as early as 59 1/2 and save that money in a taxable account.

For a married couple, the 24% tax bracket goes all the way up to $321,450 (2019). Those rates are set to sunset after 2025. Additionally, while any future growth in an IRA will eventually be taxed as ordinary income, IRA money that is withdrawn and invested in ETFs now will become eligible for the preferential long-term capital gains rate of 15%. Your future growth is now at a lower tax rate outside the IRA.

4. If you’re going to take annual distributions and pay the tax gradually, an even better way is through Roth Conversions. Once in the Roth, you will pay no tax on future growth and you heirs can receive the Roth accounts income tax-free. Conversions don’t count as part of your RMD, so the best time to do this may be between 59 1/2 and 70 1/2. Look at gradually making partial conversions that keep you within a lower tax bracket.

5. A lot of owners of large IRAs want to leave their IRA to a Trust to make sure the funds are not squandered, mismanaged, or taken by a child’s spouse. Unfortunately, Trust taxes are very high. In fact, Trusts reach the top tax rate of 37% once they hit just $12,750 in taxable income. In the past, trust beneficiaries were able to still use the Stretch IRA rules even with a Trust. However, if the Stretch IRA is eliminated, most of these IRA Trusts are going to pay an egregious amount of taxes.

One alternative is to establish a Charitable Remainder Trust (CRT). This would allow for annual income to be provided to your beneficiaries just like from a Stretch IRA, but once that beneficiary passes away, the remainder is donated to a charity. This preserves significant tax benefits as the initial IRA distribution to the CRT is non-taxable. The downside is that there are no lump sum options and the payments will not continue past the one generation named as beneficiaries. 

Still, if you have a Trust established as the beneficiary of your IRA, you will want to revisit this choice very carefully if the Stretch IRA is eliminated.

6. Life Insurance. I usually recommend Term Insurance, but there is a place for permanent life insurance in estate planning. If the Stretch IRA is repealed, it may be more efficient to use your IRA to pay for $1 million in life insurance than to try to pass on a $1 million IRA. Life insurance proceeds are received income tax-free by the beneficiary.

For example, a healthy 70 year old male could purchase a Guaranteed Universal Life Policy with a $1 million death benefit for as little as $24,820.40 a year. Take the RMD from your $1 million IRA and use that to pay the life insurance premiums. Now your heirs will receive a $1 million life insurance policy (tax-free) in addition to your $1 million IRA. This policy and rate are guaranteed through age 100. If you don’t need income from your IRA, this could greatly increase the after-tax money received by your heirs. 

7. If you are an unmarried couple, you might want to consider if it would be beneficial to be married so that one spouse could inherit the other’s IRA and be able to treat it as their own.

The elimination of the Stretch IRA has been proposed repeatedly since 2012. In some ways, its repeal is a new inheritance tax. Billionaires typically have little or insignificant IRA assets compared to the rest of their wealth and have access to complex trust and legal structures. However, working professionals who have diligently created a net worth of $1 to 4 million, likely have a substantial amount of their wealth in their retirement accounts. And these are the families who will be impacted the most by the elimination of the Stretch IRA.

If you are planning on leaving a substantial retirement account to your beneficiaries, let’s talk about your specific situation and consider what course of action might be best for you. 

6 Changes Congress Wants to Make to Your Retirement Plan

In a rare bipartisan vote of 417-3, the House of Representatives approved the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. The Act now goes to the Senate, which may make modifications, but is likely to still pass and reconcile a version of this legislation.

The version passed by the House has provisions which will indeed enhance 401(k)s, IRAs, and other retirement plans for all Americans. Hopefully, this will get more people saving and starting their contributions at a younger age. There are also provisions which will help retirees and people over age 70.

Here’s a partial list of the changes in the legislation:

  1. Pushing back the age for Required Minimum Distributions (RMDs) from 70 1/2 to 72.
  2. Allowing workers over age 70 1/2 to continue to contribute to a Traditional IRA.
  3. Allowing up to $5,000 in penalty-free withdrawals from IRAs to cover birth or adoption expenses for parents (taxes would still apply, but the 10% penalty would be waived).
  4. Allowing up to $10,000 in withdrawals from 529 College Savings Plans to pay off student loans. 
  5. Requiring 401(k) statements to show participants how much monthly income their balance could provide.
  6. Eliminating the “Stretch IRA”, also known as the Inherited or Beneficiary IRA. Currently, a beneficiary can take withdrawals over their lifetime. Instead, they will be required to withdraw all the money – and pay taxes – within 10 years.

The first two reflect the reality of how poorly prepared some Baby Boomers are for retirement and that more people are working well into their seventies today. Pushing back the RMD age will help people save for longer and reflects that life expectancy has gone up significantly since the original RMD rules were established decades ago.

Read more: Stop Retiring Early, People!

I am also a fan of showing the expected income from a 401(k). The SECURE Act will make it easier for 401(k) plans to offer participants the ability to purchase an immediate annuity and create monthly income from their retirement account. Lump sums tend to look very impressive, but when we consider making that money last, it can be a bit disappointing. 

For example, a 65-year old male with $100,000 could receive $529 a month for life. $100,000 sounds like a lot of money, but $529 a month does not. I would point out that $529 for 12 months is $6,348 a year which is a lot more than the 4% withdrawal rate we usually recommend for new retirees. (But the 4% would increase for inflation, whereas the annuity will remain $529 forever.)

Read more: How to Create Your Own Pension

The provision eliminating the Stretch IRA will be problematic for people with large IRAs. I am hoping that they will continue to allow a surviving spouse to treat an inherited IRA as their own, as is currently the law. If they do eliminate the Stretch IRA, there are several strategies which we might want to consider to reduce taxes on death. 

  • Rather than leaving taxable accounts to charity, it would be preferable to make the charity a beneficiary of your IRA. They will pay no taxes on receiving your IRA, unlike your family members. Also, you can change the charities easily through an IRA beneficiary form and not have to rewrite your will or hire an attorney.
  • You might want to leave smaller portions of your IRA to more people. Four people inheriting a $1 million IRA will pay less in taxes than one person, unless all four are already in the top tax bracket. Consider if making both children and grandchildren as a beneficiaries might help lower the tax bill on your beneficiaries. (Check with me about the Generation Skipping Tax, first. Your estate may be below the GST threshold.)
  • You could convert your IRA to a Roth, pay the taxes now and then there are no RMDs and your beneficiaries will inherit the Roth tax-free. You can spread the conversion over a number of years to stay in a lower tax bracket. Today’s low tax rates are supposed to sunset after 2025.

I will plan a full article on these strategies if the Stretch IRA is in fact repealed; we don’t know yet if existing Stretch IRAs will be grandfathered in place. This is the only negative I see in the legislation, and it will impose a higher tax burden on many beneficiaries of my clients’ retirement plans. There have been proposals to eliminate the Stretch IRA since at least 2012, but it just might happen this time.

While someone with $1 million or $2 million in a 401(k) is fairly well off, the reality is that this would be imposing a much higher tax burden on the beneficiaries of an IRA than for a genuinely wealthy family who has $10 million in “taxable” assets which will receive a step-up in cost basis upon death. The Ultra-Wealthy don’t have significant assets in IRAs, so this won’t really have an impact on them or their families, but for middle class folks, their retirement accounts are often their largest assets. Stay tuned!