Retirement Plans and IRAs
The Big IRA Mistake
Many investors pay a great deal of attention to how they invest their IRA, but ignore the
“end game.” The end game is when the IRS splits the IRA with you through taxation.
You could lose gobs of money if you make mistakes in designating your beneficiaries.
First, do not designate your living trust as your beneficiary, because this action
will cause your IRA to be immediately taxable in full upon death. Always name a person
(or an irrevocable trust) as beneficiary. By doing this, your beneficiaries gain the option
of deferring the IRA distributions and the taxes for many years.
Next, be careful about the method you select to make IRA withdrawals. Most
people are still using the “old” tables to calculate their IRA withdrawals. However, the
“new” tables can be used which will reduce the minimum mandatory withdrawal and of
course, the tax you need to pay. Here‟s an example:
Under the old rules, an IRA owner age 71 with no beneficiary and a $200,000
IRA using the term certain method was required to distribute $13,060 (6.53% of their
IRA) and pay taxes on it and that withdrawal percentage would increase each year with
age. Under the new rules, the distribution at age 71 is $7,900 (3.95% of their IRA)—a
whopping 39% reduction in the amount required to distribute and the tax required to be
paid. The percentage required to be distributed each year still increases with age, but
more slowly than under the old rules.
More about that in this chapter.
Should You Convert to the Roth IRA?
Maybe. I wish I could give a blanket answer to everyone who calls me with this
question, but it‟s not that easy. There are two important variables which determine the
Do you have the cash to pay the taxes with non-IRA funds? You will
pay the income tax on your already accumulated IRA balance, and the
conversion will only make sense if you can transfer the entire amount of
your existing IRA to a Roth and use non-IRA funds to pay the taxes due.
Will you be able to let the money continue to grow without
withdrawal for at least five years? If you will need to take more than
nominal amounts (e.g. interest), then converting to a Roth probably does
not pay. The benefit of the Roth is the tax-free accumulation of the assets.
If you need to use the assets before too long, you will not allow the
necessary accumulation to make the Roth worthwhile.
If your answer is yes to both questions above, then the conversion to a Roth IRA
is probably beneficial for you. I say “probably beneficial” because there are other factors
involved, such as your tax bracket (and if it‟s likely to change), and the rate of earnings
you achieve on the IRA assets, and if you even qualify to make the conversion (adjusted
gross income must be below $100,000 to convert).
If your IRA or retirement plan is $250,000 or above, you may benefit from other
methods to shelter large portions of your retirement plan from taxes. These details are
explained in the following websites: www.gsladvisory.com and
Ready to Retire? Don’t Miss This Huge Tax Savings!
Many retirees have employer stock in their 401(k) and profit sharing plans. In these
cases, there is an opportunity for converting ordinary income (which could be taxed at
rates up to 39.6%) into capital gains income (taxed at only 20%).
Here‟s how. Rather than rolling over the employer stock into an IRA, take actual
distribution of the shares. You will pay tax (at ordinary income rates) on the basis of that
stock. The basis is the value of the shares when they were originally put into the plan.
When you eventually sell the shares, you will be taxed on the unrealized appreciation as a
capital gain. If you roll-over the shares into an IRA, you would pay ordinary income on
the entire value of the shares, since they are withdrawn from the IRA.
Let‟s look at an example. Joe has a 401(k) plan at ABC Manufacturing. He
invests his contributions into company stock during his tenure—a total investment of
$100,000. When Joe is ready to retire, the shares are worth $600,000. Let‟s first assume
that Joe rolls over the shares into an IRA. He then reaches age 70½ and must begin
taking distributions from his IRA and paying taxes on those withdrawals at ordinary
income rates (up to 39.6%). He will pay these full rates on all of his shares. Assuming
no further appreciation above the $600,000, Joe would pay tax of $237,600 on all the
shares (at the 39.6% rate).
But let‟s assume that Joe read this chapter. Instead of rolling over the shares, he
takes them as a distribution and pays tax of $39,600 immediately on the basis (39.6% of
$100,000). Later, he decides to sell the stock (at his discretion because he is not subject
to the age 70½ rule because the shares are not in an IRA), and he pays a capital gains tax
of $100,000 (20% of $500,000).
His total tax bill is $139,000 rather than the $237,600 he would have paid if he
rolled his shares into an IRA. That‟s a cool savings just shy of $100,000—enough to pay
for plenty of great vacations for Joe and his wife.
Are you retiring in the next three years? If so, don‟t miss out on the many
planning opportunities that the mutual fund companies did not explain or your CPA
forgot to mention.
Don’t Put That in an IRA!
Here‟s a simple idea that can save you significant taxes—place certain assets in your IRA
and leave other assets out of your IRA. (Note that this discussion pertains to traditional
IRAs and not Roth IRAs.)
You should place assets that have the highest tax bite in your IRA. For most
taxpayers, these items include income assets such as CDs, bonds, bond fund and many
mutual funds. These assets, which generate ordinary income and short term capital gains,
have their income taxed at the highest rates (e.g. federal rates up to 39%). By placing
these items in an IRA, you defer the high taxes as long as possible.
Try to keep stocks out of your IRA. Long term capital gains are taxed at a
maximum of 20% for stocks outside your IRA. However, if you place stocks inside your
IRA, when you eventually remove the money, it gets taxed at regular rates (e.g. the
federal rates up to 39%), since IRA withdrawals are always taxed as ordinary income.
Are you paying more taxes than necessary? Do you have the right assets in your
IRA? Check your investments against the way they are taxed to make sure you have the
right investments in the right spots.
Age 70? Are You Taking Minimum IRA Distributions?
I meet many people who have reached age 70½ and are taking only the minimum
required distributions from their IRAs. By taking only the minimum requirement, their
income taxes are minimized. But this tactic can create another problem. If only the
minimum amounts are being taken, the IRA balance continues to grow and it could be
subject later to double taxation—income and estate taxes.
For example, an IRA owner age 70 has a sixteen-year life expectancy.2 Assume
he has a $100,000 IRA and takes only the minimum distributions each year and the IRA
earns a hypothetical 10% annually. By life expectancy, that IRA balance will be
$100,449.3 If our IRA owner‟s total estate exceeds $650,000, then the remaining IRA
balance could be subject to income tax and estate tax, which could exceed 70%.4
By taking only minimum distributions and saving taxes today, our investor could
create a huge estate problem for tomorrow. Can this be avoided? Yes! If instead of
IRS Publication 590.
Using annual recalculation figures, single life IRS Publication 590.
Assuming a combined state and federal income tax of 35% and estate tax of 55%.
taking only the minimum distribution, our IRA owner takes an additional $7,000 annually
(and pays the additional tax of $2450 based on a 35% tax bracket out of this $7,000) and
invests the remaining after-tax amount of $4550 in a life policy owned outside of his
estate, then at his life expectancy, he leaves his heirs a death benefit of $170,672,5 which
is free of estate and income taxes. The family just increased its net worth by $140,537.6
If your current plans involve leaving an IRA to your family, you can leave them a
lot better of if this technique fits your situation.
Do You Own an Annuity Inside Your IRA?
In general, from a tax perspective, it does not make a lot of sense to invest in an annuity
inside your IRA. The primary advantage of annuities is the tax deferral. However, your
IRA is already tax deferred, so why did your broker advise you to buy an annuity inside
Your broker or agent might work for a company that pushes annuity sales or pays
him or her a better commission for annuity sales. Or possibly, your advisor might not
know any better. You might have been told that the advantage of the annuity was that it
allowed you to annuitize it later (get a fixed monthly income). However, you can also get
the same results by using systematic withdrawals from mutual funds or other
In the case of a variable annuity, you might have been told that your heirs would be
guaranteed to get back at least your original investment, regardless of the performance of
your investment choices. While that‟s true, in most cases, you are paying an extra 1% or
more annually for that guarantee. If you plan to hold the investment for ten years or
more, in only 3% of all ten-year periods since 1926, has the market declined (as
measured by the S&P 500 Index).7 So, payment for the guarantee to protect your
principal doesn‟t seem very worthwhile for a long term investor.
In fact, four insurance companies were hit with class action lawsuits for selling
variable annuities as appropriate IRA investments and using misleading sales practices.
Regulatory authorities also realize that variable annuities have often been recommended
What should you do if you find an annuity in your IRA? If the surrender charges
have passed, you can surrender the annuity at no charge and convert it to other, more
suitable investments. In fact, if you have surrender charges left of 1% to 3%, it may still
Quotation of First Colony Life First Choice Gold™ guaranteed for 21 years at 4% minimum guaranteed
The difference between the tax-free death benefit of $170,672 and the $100,449 subject to a 70% tax of
$70,314. Note that this analysis is not accurate for everyone, since not all taxpayers are subject to estate
Derived from Ibbotson and Sinquefeld 1999 Yearbook.
www.insure.com 6/22/99: “NASD cracks down on variable annuity sellers.”
make sense to make a change, pay the charges and get your funds working in a more
If the annuity is young and surrender charges are still high, you may be able to
take advantage of the “free” annual withdrawal that typically allows you to withdraw
10% of your balance annually without surrender charges. You do have some options as
Some potential advantages of owning an annuity inside your IRA include: a fixed
annuity provides a guarantee of principal from the issuer, a variable annuity offers a
death benefit, and an annuity can be annuitized providing a fixed-period income.
Rolling Over Your IRA—Other Considerations
Many people roll their company 401(k) or other company retirement plan into an IRA.
While this is generally a good idea, because you can then obtain total control over the
assets (e.g. you can choose from any stock, bond or mutual fund), there are other
important considerations to think about.
A balance in an ERISA plan (401(k), profit sharing, pension, etc.) is
protected by federal law from bankruptcy and alienation. In other
words, if you get sued or declare bankruptcy, your balance in an ERISA
plan is protected. However, once you roll over your ERISA plan to an
IRA, that protection disappears. It is then up to your state government or
judicial system to determine how your IRA gets treated in the case of
bankruptcy or creditor pursuit.
IRAs cannot own life insurance. There are some very powerful
techniques for saving taxes by placing life insurance into a non-IRA
retirement plan and then distributing that policy at a reduced tax basis.
Therefore, if you do roll over an IRA from a company plan, then make
sure you do not mix it with your contributory IRA (the IRA that you
accumulated with $2000 annual contributions). If you keep the rollover
IRA separate, you can always “reconvert” it to a qualified plan, under the
right circumstances and enjoy additional tax and estate planning options.9
As mentioned earlier, you may want to take distribution of employer
stock held in an employer plan. In so doing, you will pay ordinary
income tax on the original cost of the stock, but then obtain capital gains
treatment on the appreciation when you sell the stock. This tactic can be
advantageous to rolling over all of the stock and having the entire balance
exposed to ordinary tax rates.
IRS Publication 590.
Selecting IRA Distribution Choices—New Regulations Make It Simple
Up until IRS changed the rules on January 11, 2001, seniors were forced to start
taking distributions from their IRAs on an irrevocable schedule upon reaching ages 70½.
Many people did not need or want to take these distributions which increased their
taxable income and taxes. However, IRS wanted to collect taxes and thus the forced
distributions. Now, the withdrawals are still forced, but at a lower rate and the IRS will
collect less tax during the IRA owner‟s lifetime.
In addition, the new rules allow IRA owners change beneficiaries after they start
taking distributions (not allowed under old rules) and when the beneficiary inherits the
IRA, they can spread the IRA payments over their lifetimes (allowed only for spouses
under prior rules). The bottom line: IRA accounts will be allowed to grow over longer
periods of time (2 generations or more) and the IRS tax take will be deferred for may
years—for people who take advantage of the new rules that is.
Take a look at the old tables (the one your financial institution may still be using
to calculate your IRA distributions) as compared to the new tables:10
Old Tables (Single Life
Age Expectancy) New Tables
71 15.3 25.3
72 14.6 24.4
73 13.9 23.5
74 13.2 22.7
75 12.5 21.8
76 11.9 20.9
77 11.2 20.1
78 10.6 19.2
79 10.0 18.4
80 9.5 17.6
The above table shows the number you divide into your IRA balance to calculate
your distribution. For example, an age 71 male with a $100,000 IRA would need to
withdraw $6536 ($100,000/15.3). Under the new tables, he needs to withdraw only
$3952 ($100,000/25.3). At a 28% federal tax rate, he saves $723.
Note that the new rules are effective January 1, 2002, but you can use them to
calculate your 2001 distributions. The sooner you switch to the new tables, the faster you
The other big change to your benefit is the ability to change beneficiaries.
Although many IRA owners did not realize this before, once you started taking
mandatory distributions, you were locked into the IRA beneficiaries you had selected.
Now, you can change beneficiaries anytime, even after death! You can give the person
settling your estate (your executor or successor trustee) the right to change the
beneficiary. This may be a flexible tool as the beneficiary‟s situations may have changed
significantly between the time you named them as beneficiary and the time the estate is
Using Your Retirement Funds for Liquidity
Many employers‟ retirement plans allow for loans to participants. Although IRS
provisions allow for loans, some employers opt not to include this provision in order to
ease their administrative burden. There are limits on the size of the loans that can be
Once you roll over the plan balance to your own IRA or Keogh account, you may
not take any loans or pledge the retirement accounts as collateral for a loan (if you do,
they become taxable). You can, however, use your IRA as a temporary source of
liquidity, particularly if you split it into pieces.
Let‟s assume that you have $200,000 in an IRA. You can withdraw the balance
and avoid paying taxes, as long as you return the funds within sixty days to that IRA or a
new IRA account.
In another scenario, you can take the $200,000 IRA and split it into four $50,000
IRAs. Then you can take $50,000 from the first IRA. Within sixty days, you can
replenish that $50,000 by taking the $50,000 from the second IRA and so on with the
four IRAs. In this manner, you have extended the 60-day rule into the 240-day rule (four
IRAs x sixty days each) to give yourself a longer loan period.
How Your IRA Could Face an 80% Tax
Large IRAs face the double whammy of income and estate tax. Without proper planning,
the combined tax could exceed 80%. The Individual Retirement Account Answer Book
by Panel Publishers illustrates an example of a $2 million IRA exposed to taxes.
NY State Death Taxes (16%) $320,000
Net Federal Estate Tax (39%) $780,000
Net Income Tax (43% combined rate) $533,099
Total Taxes $1,633,099
Beneficiaries Receive $366,901
(18.3% of Original IRA)
What can you do to avoid this excessive taxation?
1. Take distributions from your IRA and spend it.
2. Take distributions from your IRA and make gifts ($10,000 per year/per donee
or $20,000 per donee if you are married).
3. Take distributions from your IRA and contribute the money as premiums for
life insurance and have the tax-free death benefit offset the above taxes.
4. Use your IRA (rather than other assets) for charitable bequests or to establish
a testamentary charitable remainder trust.
5. Distribute your IRA and contribute the balance to a charitable family limited
partnership to offset the tax (see the tax section of this book).
6. Use the Pension Asset Transfer Strategy to rescue your IRA (see the tax
section of this book).
From Kiplinger’s Retirement Report of August 1999, comes the following advice:
“Plan for estate taxes. If you have a large IRA and a few other liquid
assets, consider using required distributions to pay for second-to-die life
insurance premiums. This insurance pays on the death of the second
spouse and is usually owned by an irrevocable life insurance trust or the
IRA‟s beneficiary so that insurance proceeds stay out of your estate. (A
single person can also use a life-insurance trust to pay estate taxes.)
„Whatever you take out of the IRA for premiums, you‟ve removed from
your taxable estate and replaced it with an estate-tax-free asset,‟ points out
Edward Slott, a CPA in Rockville Centre, N.Y.”
If this applies to your situation, then do not wait! The IRS is very happy to take
taxes from people who procrastinate. Any one or combination of the above options is
better than leaving your IRA as tax fodder.