Focus on IRAs
Individual Retirement Arrangement is the technical IRS term for what most investors have come to call Individual Retirement Accounts or (“IRAs”). [Note: this article does not address SEP-IRAs – simplified retirement plans for the self-employed.] As the tax deadline of April 17th for 2011’s calendar year contributions approaches, we are writing to ask our clients and friends to focus on this annual opportunity before it passes again. Below are some lesser known attributes and components of establishing and adding to an IRA account. We look forward to hearing your thoughts on how useful this material is, and as always, we welcome your suggestions for topics for future newsletters.
The IRA Opportunity
IRAs provide investors with the opportunity to defer taxes on the gains in a Traditional IRA or later take out gains tax-free on contributions made to a Roth IRA. And, the government permits a taxpayer to delay that decision up until the time of filing the tax return for the previous calendar year (but not later than April 17th).
We generally advise our clients to prioritize this opportunity among their myriad investment choices. We are happy to work with your tax advisor to ensure you maximize this opportunity each year.
Income Limits and Tax Deductible Contributions
It is a common misperception that income limits can prevent IRA contributions altogether. More accurately, the opportunity to deduct one’s contributions to a Traditional IRA are determined by IRS rules. We have copied links to those IRS tables below for your ease of reference so you can preliminarily assess whether you can make deductible contributions to a traditional IRA whether you are covered by a company retirement plan or not.
HOWEVER, in some cases, it may make sense to contribute to an IRA with non-deductible (after-tax) dollars. Under current tax law, this can be done up to the annual contribution limit (i.e. if they have the commensurate “earned” – not “investment” - income) regardless of whether their current income exceeds the published limits. The time value of money and the ability to convert the account to a Roth may provide you the incentive to make a non-deductible contribution.
Again, we are happy to complete the analysis for you and work with you to decide whether to proceed with investing in a deductible (if you qualify) or non-deductible IRA.
2012 IRA Contribution and Deduction Limits (for those covered by a work retirement plan)
2012 IRA Contribution and Deduction Limits (for those NOT covered by a work retirement plan)
Roth IRA Conversions
In the preceding paragraphs, we articulated the importance of prioritizing IRA contributions. We also have gathered from speaking with our clients that most investors have not taken the time to think through whether they should consider a conversion of their existing IRA accounts to a Roth IRA. While no one can predict how our tax laws will change, we are happy to evaluate and make recommendations to you about whether you should consider a conversion of your existing IRAs to a Roth IRA. There are advantages of the Roth IRA that may be quite beneficial to your plan and/or your goals to pass on assets to your loved ones. As an example, Roth IRA accounts have no required minimum distribution for the account owner and a beneficiary of an inherited Roth is not required to pay income taxes on distributions.
For your ease of reference, we have also included the IRS table for outright contributions a Roth IRA in the below link:
Inheriting an IRA--What You Need to Know
Finally, the rules governing inherited IRAs can be complicated. Here are the major issues to consider.
Transferring inherited IRA assets
If you inherit a traditional or Roth IRA from someone who isn't your spouse, your options are fairly limited. You can't roll the proceeds over to your own IRA, treat the IRA as your own, or make any additional contributions to the IRA. You can transfer the assets to a different IRA provider (or keep the inherited IRA with the existing provider), as long as the registration of the account continues to reflect that the IRA is an inherited (or beneficiary) IRA, and not your own.
If you inherit an IRA from your spouse, however, you have additional options… You can roll over all or part of the IRA proceeds to your own IRA (or to a qualified plan). If you roll the proceeds over to your own IRA (an existing one, or one you establish just for this purpose) the rules that apply to IRA owners, not beneficiaries, will apply from that point on. If you're the sole beneficiary, you can also generally treat the deceased’s IRA as your own by simply retitling the IRA in your name.
But, you aren't required to assume ownership of an IRA you inherit from your spouse. You can, instead, continue to maintain the inherited IRA as a beneficiary. You might want to do this if, for example, you inherit a traditional IRA and you'll need to use the funds before you turn 59½ (distributions from inherited IRAs aren't subject to the 10% early distribution penalty but distributions from IRAs you own are subject to the penalty, unless an exception applies).
A spouse beneficiary can also convert all or part of an inherited traditional IRA to a Roth IRA after paying the income tax on the converted amount. This option is not available to non-spouse beneficiaries.
Required Minimum Distributions (RMDs)
Non-spouse beneficiary: Federal law requires that you begin taking distributions (called required minimum distributions, or RMDs) from an inherited IRA (traditional or Roth) the year after the IRA owner dies.
Spouse beneficiary: If you rollover the deceased’s IRA over to your own IRA (or treat it as your own), the RMD rules apply to you the same way they apply to any IRA owner--you'll generally need to begin taking RMDs from a traditional IRA once you turn 70½ (note: no lifetime RMDs are required at all from a Roth IRA). If you don't roll the IRA assets over or treat the IRA as your own, then the same rules described above for a non-spouse beneficiary generally applies to you, except that you can defer receiving distributions until your spouse would have turned 70½.
Note: In both cases, if the IRA owner died after turning 70½ and didn't take a required distribution for the year of death, you'll need to make sure to take that distribution by December 31 of the year of death in order to avoid a 50% penalty.
Taxation of Inherited Roth IRAs
Qualified distributions to a beneficiary from an inherited Roth IRA are free from federal income taxes. To be qualified, the distribution must be made after a five-year holding period. The five-year period begins on January 1 of the year the deceased IRA owner first established any Roth IRA, and ends after five full calendar years. If you take a distribution from an inherited Roth IRA before this five-year period ends, any earnings you receive will be nonqualified and subject to federal income taxes.
For example, you inherit a Roth IRA from your father on January 1, 2013. Your father established this IRA in June 2012. Your father also established a separate Roth IRA, which you did not inherit, in December 2008. Distributions you receive from the Roth IRA will be qualified, and tax-free, because the five-year holding period (January 1, 2008, to December 31, 2012) has been satisfied.
If you're a spouse beneficiary, and you roll the inherited Roth IRA over to your own Roth IRA or treat the inherited IRA as your own, then you'll be eligible to take tax-free distributions only after you reach age 59½, become disabled, or have qualifying first-time homebuyer expenses. You'll also need to satisfy the five-year holding period, but a special rule applies. The five-year period for all of your Roth IRAs--including the inherited IRA--will be deemed to have started on January 1 of the year either you or your spouse first established any Roth IRA.
It is our responsibility to focus on and keep track of these details for our clients and friends. Whether your situation is unique or it falls into one of the scenarios delineated below, we are happy to assist when:
•You are considering an IRA contribution (deductible, non-deductible, or Roth).
•You are considering a conversion of an IRA to a Roth IRA.
•You inherit an IRA and need help understanding your choices and/or RMDs.
•You don't want or need inherited IRA funds. (You may be able to disclaim the IRA and have it pass to another beneficiary. This must be done in accordance with strict IRA rules.)
Our Fiduciary Standard
Perhaps you missed the announcement, buried on page C7 of the January 24, 2012 issue of the Wall Street Journal, but it caused a stir in the financial planning world. The Securities and Exchange Commission has put off implementing a key part of the Dodd-Frank Act: creating a fiduciary standard for all who give investment advice, whether they are brokers (like Goldman, Merrill , UBS, etc) or SEC-registered registered investment advisors (like PFSI).
Anybody who saw Fabrice "Fabulous Fab" Tourre boast about his prowess selling complex toxic securities to his unsuspecting customers, or watched Goldman Sachs CEO Lloyd Blankfein testifying uncomfortably to Congress that his firm had no duty whatsoever to protect the interests of his customers in these transactions, quickly realized that Wall Street is not totally about creating vast wealth for the people who receive brokerage advice. I hope you were sitting down for that. This was further underscored when Smith Barney traders chortled in their internal e-mails that betting against some of the toxic mortgage pools they had sold their customers was "the best short ever."
Dodd-Frank was supposed to change all that, by asking the SEC to require that brokers who made investment recommendations be held to a fiduciary standard "at least as stringent" as the standard that investment advisors (like PFSI) are held to. Under heavy lobbying pressure from Wall Street, the SEC has dragged its feet on this issue so effectively you might think it was wearing shoes made of cement. And for most investors, this stalled effort at reform has remained completely under the radar.
What does it mean to act as a fiduciary? The fiduciary concept is actually pretty simple, and can be found in the very first written legal code, the Code of Hammurabi (roughly 1770 BC) and in Cicero's orations during the Roman Republic around 50 BC. In the ancient world, a trader would take his caravan (or sailing ship) to some distant land to trade Mesopotamian clay pots or bronze artifacts for furs, tin or copper. Since the trader would be gone for months or sometimes years, somebody had to make basic business and financial decisions on that person's behalf while he was on the road. And it was important that this person make decisions that were in the trader's interest, not his own. When somebody came to offer the merchant a great business opportunity, he wouldn't want somebody who would jump in and buy it for his own profit instead, or buy it and then sell it back to the merchant's account at a fat markup.
As Cicero put it:
“…in cases where we ourselves cannot be present, the vicarious faith of friends is substituted; and he who impairs that confidence, attacks the common bulwark of all men, and as far as another depends on him, disturbs the bonds of society.”
(Oration for Sextus Roscius of America; Cicero 106 – 43 BC)
And so, the basic idea of a fiduciary is a simple standard of behavior. You are watching out for and protecting the interests of someone who has given you their trust. You are making decisions and recommendations that will benefit that other person. You would, under this simple standard, have to avoid triumphantly selling at a markup the same securities that your colleagues are confidently betting will blow up and leave your customers with frightening losses--while generating outsized gains that will flow into the Wall Street bonus pool.
With this in mind, it becomes a lot easier to see why Wall Street has lobbied so hard to stall being held to this standard.
SEC-registered Registered Investment Advisors (like PFSI) have been living under a fiduciary standard--the one referenced in Dodd-Frank--since 1940. It's true; you don't see RIA firms routinely handing out seven-figure bonuses to their brokers and sales agents. But many advisors who live under this business model make a good, honest living--and, most importantly, they don't have to squirm uncomfortably when somebody asks them to explain their recommendations.
As you know, at Pauley Financial we believe the core fiduciary standard is the most transparent and true method of minimizing conflicts of interest. That's not to say that there aren't honest, ethical members of broker firms that do offer advice. Conversely, there are RIA advisors held to fiduciary standards that elect to not comply. Yet, not requiring such a standard leaves wiggle room. Simply put, our choice to adhere to the fiduciary standard offers another layer of protection to our clients. In a nutshell, it comes down to the Golden Rule applied - plain and simple.