Tax-free Roth IRA conversion is a topic that can help many of you have more money for retirement … an important law change in 2010 has been a real game changer. Everyone needs to find out if a tax-free Roth IRA is right for them.

Before we get into the specifics of Roth IRA Conversion, let me tell you a story…

I live in a big city and frequently have to pay to park my car. The other day I was downtown, pulled into a parking garage, briefly read the sign which said $2.00 an hour for hours 1 through 24…I didn’t read the small print which said something about prices could be changed …I took a ticket and parked. When leaving 8 hours later I stopped at the booth and handed the attendant my ticket – she said that’ll be $42. I asked her to read the ticket again because the total should be $16 – she pointed to the fine print on the sign I had not really read and told me prices had changed since I came in … $42 was right. Fuming I paid the $42 and vowed to not make that mistake again.

A couple days later I was again downtown but this time I selected a parking lot that allowed you to pay in advance — $5 a day paid in advance. No payment when you leave. So this time, I paid in advance and just smiled when I left – there was no attendant with her hand out wanting payment.

What’s the moral of this story?

When you put your money in an IRA, 401(k), 403(b), Thrift Savings Plan or whatever “qualified” retirement account you have, no taxes are paid when the money “goes in”. How much you have to pay “going out” will depend on the tax rates in effect at that time. Just like the first parking lot.

Do you think taxes are going up? Well, I do because someone is going to have to pay for the government’s overspending and the staggering debt they’ve accumulated – and I strongly suspect it is going to be us. Now taxes can go up even though the politicians tell you they are going down! How is that possible? Fewer or lower deductions, not indexing your Social Security benefits to inflation, tying entitlement programs like Medicare to “means” testing … I could go on for a long time … but you already know the slight-of-hand practices of Washington. You know taxes are headed higher.

With a Roth IRA you pay going in and nothing coming out – just like the second garage. So if you think prices – taxes – are going to increase before you take your money out, why not pay going in? Or if you retirement account is still depressed because of stock market losses, why not buy out your partner – the IRS – while prices are low? After you convert to a Roth IRA your money no longer grows “tax-deferred”, it grows “tax-free”. And, the government can’t change the law and make your tax-free Roth IRA and the money you’ve earned on it taxable in the future because the U.S. Constitution prohibits ex-post facto laws … at least that what lawyers tell me. Of course, they could do away with the income tax…fat chance!

And, there are lots of other good benefits you’ll like about Roth IRAs … so let’s discuss the pros & cons of converting your money to a tax-free Roth IRA.

First of all, everyone is eligible to convert money to a tax-free Roth IRA – no age, income or wealth limits. The only requirement is that you must have a tax deferred retirement account to convert to a tax-free Roth IRA: traditional IRA, 401(k), 403(b), 457, TSP and any of the others.

Okay if you convert what about the taxes? Well, that’s the bummer because you have to pay them…but this is really good news rather than bad news: here’s why…:

1. You can spread the taxes out over three years if you convert in 2010 – none have to be paid with your 2010 tax return but you’ll pay 50% with your 2011 return and the other 50% when you file your 2012 taxes in calendar year 2013.
2. You can pay the taxes with other money and in effect change taxable money into tax-free money. Let me give you an example: Let say you have $100,000 in a regular IRA and are in the 25% tax bracket – this makes the arithmetic easy. Since you’re in the 25% tax bracket, you only own $75,000 of the $100,000 IRA – the other $25,000 belong to your good Uncle Sam who lives in Washington DC. If you convert all the $100,000 to a Roth IRA and pay the taxes from other money like from a bank CD, you will have $100,000 growing tax-free and you’ll own it all. So you’ve really converted $25,000 from the “taxable” category to the “tax-free” category – and that is a powerful advantage, especially if taxes rise and really an advantage if it will be along time before the money is withdrawn from the Roth IRA.

Of course, you don’t have to convert all your money – you can just convert some of it. And, you might want to do this so you can stay in a lower tax bracket. You might want to convert some this year, more next year and so on. I suggest you visit with your financial advisor about whether or not a Roth IRA conversion would be good for you and if so how much and when should you convert.

Once converted to a tax-free Roth IRA, you do not have to withdraw it unless you want to. Many of you probably have to take Required Withdrawals from your qualified retirement accounts now even though you don’t need the money and would prefer to leave it in your tax-deferred retirement account. The reason for the mandatory withdrawals is because the tax-man – the IRS – wants his share when you reach 70½. He really don’t care that you would prefer not to take it and don’t need the money for retirement. But, if your money is in a Roth IRA you don’t have to withdraw it unless you want to – and that’s a big advantage because you can enjoy the tax-free growth for the rest of your life, and as we’ll see in a moment your kids and grandkids can also enjoy tax-free income.

What happens if you die before using your Roth IRA money? Bad news for you but more good news for the money you left behind – it can be transferred to your surviving spouse tax-free and he or she can withdraw it – principal and earnings – tax-free. No taxes will be paid by your surviving spouse. But, it gets even better. You or your surviving spouse can even leave it to your loved ones – children, grandchildren, nieces, nephews, or anyone you choose – and they get to withdraw it tax-free too – both the amount you left them and any earning it makes. Now, non-spouse beneficiaries have to start withdrawing a minimum amount each year…but they can spread the tax-free withdrawals out over their lifetime. They will pay nothing when leaving the tax garage – and they may not be leaving for decades. I don’t know about you, but I like the idea of leaving my family tax-free money that grows tax-free until they actually use it. Of course, you can make arrangements to control how the money is paid out after you depart – nothing very complicated … your financial advisor or lawyer can give you the details.

You can change your mind and undo your tax-free Roth IRA conversion – you have until October 15th of the following year. Why October 15? This is the last date you can file your income taxes for the previous year. Why might you change your mind? Let’s say you have your money in mutual funds and on the day of the conversion they were worth $100,000 – you’d pay taxes on the $100,000 because that is the “fair market value”. So you convert the $100,000 and time ticks forward … and six month after conversion the market sinks like a rock — your mutual funds are now only worth $50,000. Can this happen? Yes it can…in fact it has happened twice since 2000 – remember the dot.com bust? The stock market as measured by the Dow Jones Industrial Average – a broad measure of market value – dropped by over 50% over 2000-02 — and the same thing happened again between October 2007 and March 2009…this time the culprit was the Great Recession. So it can happen and if it does, you’ll want to change your mind and undo the Roth conversion so that you only have to pay taxes on $50,000 instead of a $100,000. Think about this “loophole” – if taxes go against you, you can change your mind but if they go your way you can stay put. Nice!

You don’t have to move your money or select another investment when you convert to a tax-free Roth IRA … but conversion is usually a great time to review your investments with your financial advisor to make sure they are still suitable for you and your family.

Of course you can’t convert to a tax-free Roth IRA if your money is still locked up in a 401(k) or another employer-sponsored retirement plan. But, there are ways to free up all or some of this money while still working and regardless of your age. Again, your financial advisor – if they’re on the top of their game – can help you by telling you about in-service, non-hardship provisions that can be easily added to most 401(k) plans.

I’ve covered a lot of territory about tax-free Roth IRA conversion in a short time. So let me leave you with two main points:

1. Everyone need to find out if a tax-free Roth IRA conversion is suitable for them and if so how much, when and what investments;
2. You should never attempt to convert your retirement money to a tax-free Roth IRA without professional help.

So, what should you do? Talk to your financial advisor and find out if a tax-free Roth IRA will help you have more money in retirement. The biggest fear of retirees is running out of money – and using the tax-free Roth IRA conversion just might be a great way to insure this doesn’t happen to you.

Shelby J. Smith, Ph.D.
February 24, 2010

What will you do if you run out of money during retirement? What are the consequences if your surviving spouse doesn’t have enough money? These serious questions are reality for many retirees. Nonetheless as I mentioned in my retirement blog, the fear of running out of money  has not kept many retirees from speculating with their retirement money. Much of this “speculative mentality” is driven by constant advertising bombardments telling retirees the best places to keep their money. Most of this advice is directed toward making retirement money taller, or bigger, when the real problem is making it longer. It appears that Wall Street has promised but not delivered: as a result many retirees are now back in the job market or have scaled down their retirement lifestyle. Your objective in managing your retirement money should be to avoid running out of money rather than trying to make a financial killing by speculating and taking unsuitable risks. How can you overcome the risk of living too long (longevity risk) and running out of money?

In recent years insurance companies have begun offering longevity risk coverage. The classic insurance principle of managing risk by spreading it over many people works in this arena. Those who die too soon (the unlucky) subsidize those that live too long (the lucky), the same insurance principle employed for protecting homes, cars, health, life and other valuables. A Guaranteed Lifetime Income Benefit is now a routine feature of an annuity contract. Here’s the way it works: you purchase an annuity that pays a competitive rate of interest plus allows conversion into a guaranteed lifetime income at your option. The amount of lifetime annual income depends on the amount of money in your annuity when converted and your age. There are safeguards that prevent you from losing money if you die too soon, but never can you run out of money if you live too long. For many retirees, and those contemplating retirement, it would be wise to consider this lifetime income option. Combining a guaranteed lifetime income from an insurance company with Social Security benefits assures an income regardless of how long you live.

There are other benefits like inflation protection and spousal coverage that can be added to annuities, but each will raise the amount of money needed for a given income guarantee. You can change your mind and withdraw your money lump-sum from the annuity both before and after your lifetime income starts; however, there might be penalties for doing so. Your lifetime income is safe because it is guaranteed by an insurance company – the same insurer that protects homes, cars, health, lives and businesses. What’s more, many insurance companies are giant corporations that have been in business for hundreds of years and weathered depressions, wars, failure of governments and financial meltdowns. Your money is safe.

If you do not like the insurance company solution, consider “laddering” your retirement money in investments that mature at the exact time you need income. For example, you might put money into a liquid account to cover living expenses for up to five years. The money to be used from years five through fifteen could be placed in tax-deferred annuities with staggered maturities and serially turned into income when needed. For income beyond fifteen years, a more adventuresome option might be chosen if the risks are acceptable. Whether you select the “insurance company” or the “laddering” option, work with a financial advisor to tailor a plan for your circumstances. Developing plans without help or failing to plan are common retiree mistakes. Set your course now with professional help.

Shelby J. Smith, Ph.D.
January 2010

This is a question I get constantly on this Retirement Blog. Like most decisions in life the answer is: maybe and maybe not! It depends on what you’re trying to accomplish. Historically, gold has been used to hedge against government failure, inflation, economic uncertainty or as an investment. For example, when governments have been on the brink of toppling (wars, coup d`etat, monetary collapse and more) the demand for gold, along with diamonds, soars in that country. Generally as monetary excesses erode the purchasing power of currency (inflation), gold goes up in price. During depressions and recessions (economic uncertainty) gold generally moves up in price. As the probability of any of these occurrences rise, the demand for gold as an investment also rises. If you want to own gold, what is your motivation?

If as an investment, you need to know that gold has, historically, been very volatile in price. For example, in January 2000 the price of gold was about $300/ounce and is currently near $1200/ounce. The low price in 2008 was about $750/ounce and the high was $1000/ounce, and in 2009 the difference in high and low has been about $300/ounce. What’s more, if you buy your gold as bullion or coins, it should be stored in a safe place and that involves an expense. Also, neither interest nor dividends are paid on stored gold and this is an opportunity cost. Additionally, when buying physical gold you have to worry about the credibility of the dealer that is selling you the bullion or coins. Adding another layer of cost is the fact that you generally buy physical gold at a premium and sell it at a discount. You can skirt many of these problems by buying stocks of gold mining and producing companies, gold future contracts, gold focused exchange traded mutual funds and other financial instruments, but these add another layer of risk: can you liquidate your investment in economic Armageddon? Any way you slice it, gold is a speculative investment and not for the faint of heart or those that are risk adverse. But if you want to take risk and can afford the consequences, investing in gold offers the same challenges as other investments.

Many current-day investors in gold are concerned about “the country going to pot” or Washington just printing so much money it becomes worthless. Some of these investors are real whackos who sit on their pile of gold coins with a loaded shotgun while others have not clearly thought about the end-game of actually using the gold. If the expectation of economic Armageddon followed by bands of armed thugs roaming the country is your motivation for buying gold, there are several things you need to consider.

First, you can’t buy financial products because an economic collapse would shutter the markets and you’d have no way to “cash in”. Furthermore, you can’t leave your gold in a broker’s gold vault or your bank’s safety deposit box, because you might not be able to access it – you must take physical possession which means you’ll need a gun and a safe place to store your treasure. If you hide it, be sure and tell someone else where it is in case something happens to you… and that involves more risk. But, let’s say you have your gold in a safe place and have the firepower and ammunition to protect it from the roaming bandits. How are you going to spend it?

You’ll need your gold to buy food and the other necessities of life. Gold has no nutritional value, will not keep you warm, and will not quench your thirst. So you’re in a barter situation with someone who has what you need until a government can be established to create a currency. The last time the U.S. Government got involved in gold was in 1933 when the Gold Standard was abandoned, gold was demonetized and citizens were instructed to exchange their gold for paper money at a bank. My advice to those holding gold as a hedge against societal collapse would be to buy a walled fortress in a moderate climate and make sure it includes a truck garden and farm animals.

My conclusion is that holding gold makes sense only if your motivation is investment – whether to protect purchasing power or speculate on price volatility. Make sure you can shoulder the risk and afford the potential loss. Investing in gold is probably best done by purchasing your gold already in the ground, i.e., shares of gold mining or producing companies stocks. Stocks are easy to buy, have small spreads between the bid and ask, involve no storage costs and can be sold during business hours. Additionally, you can protect your investment’s downside with puts, calls, stop and limit orders and more.

Here’s a historical aside: man goes to great expense, even the loss of life, to dig gold from the depths of the earth, bring it to the surface, purify it and stamp into shiny gold bars. This preparation is a prelude to transporting it to Fort Knox, Kentucky and re-burying it in a high security vault. This “round trip” for gold is exceedingly expensive and serves little purpose beyond satisfying a strong emotional need. Beyond the use of gold in jewelry, electronics and dentistry, does our fascination with gold really make sense?

Shelby J. Smith, Ph.D.
December 2009

No other savings vehicle is as misunderstood, under appreciated and maligned as fixed annuities. Most people who can benefit from annuities have been bombarded by misinformation, biased opinions and outright lies. The truth is: fixed annuities are safe because they are guaranteed by insurance companies, a great place to keep retirement money because they pay tax-deferred competitive returns, and all of your money is working 100% of the time. Like all investments, fixed annuities are sometimes not suitable nor should anyone have all their retirement money in fixed annuities.

Sometimes those providing information about fixed annuities have hidden agendas, biased opinions and/or little knowledge. Many personal financial columnists for newspapers and magazines fall into this category: their opinion is tainted by their brokerage background, the agenda is to get you to put your money in market investments that compete with annuities, and their limited knowledge was supplied by the brokerage industry. Why is the brokerage industry biased? Because they offer investments that compete with fixed annuities! In their mind an “annuity purchased” is a “brokerage commission lost”. Unfortunately, the biases of many columnists and brokers may be unknown even to them.

Notwithstanding all the misconceptions about fixed annuities, it is important that you always understand your investments and confirm they are suitable for you. The best way to get fixed annuities “right” is to work with a financial advisor you like, trust and whose best interest is your best interest. Below are the ten biggest misconceptions of fixed annuities and a short rebuttal of why they are not true.

1. Come with huge surrender penalties: like all contracts, penalties are assessed for breaking the rules, otherwise there are no penalties.
2. All charge high fees: like bank CDs, annuity fees are built-in and not taken from the principal amount you put into an annuity or the interest you earn.
3. Are extremely hard to understand: no more so than any investment or savings option, in fact, annuities are far easier to understand than most investments.
4. Money is tied up for a long period of time: you have access to your money at all times and without penalties if you abide by the annuity contract.
5. Nothing is left for my family if I die: not only is this not true, your money bypasses probate without delay if you’ve named a beneficiary.
6. Different types of annuities are confusing: there are only four main types of annuities compared to thousands of mutual funds.
7. Not good for older folks: they are especially good for seniors because they are safe, tax-deferred and convertible to a guaranteed lifetime income.
8. They are not safe: rock-solid safe with never a penny of principal lost due to the guarantee by the same insurance companies protecting our other assets.
9. Agents are paid huge commissions to sell: agent commissions are paid by the insurance company, not taken from the principal or earnings.
10. Annuities are a substitute for life insurance: annuities are great for retirement savings but not good for wealth transfer like life insurance.

The next time you hear a scary story about fixed annuities, consider the source to determine if it is biased, misinformed or just plain lying. If you put your money in an annuity, make sure you understand how it works and is suitable for you. Like all savings and investment places, fixed annuities work great if used for their intended purpose: annuities are intended for risk adverse, safety conscious, retirement-minded savers who are satisfied with a competitive rate of return.

Shelby J. Smith, Ph.D.
December 2009

Many retirees live on income from their portfolio of stocks, bonds, mutual funds and other market-related securities. On October 09, 2007, the market [as measured by the DJIA] peaked at 14164.53 and then started a dramatic decline until March 09, 2009, when a trough of 6547.05 was reached. This 53.8% shrinkage played havoc with retirees’ portfolios and forced many back to work or slimmed down their lifestyles. If you had $500,000 at the peak and were withdrawing $25,000 [5%] annually to support retirement, the same withdrawal of dollars at the trough amounted to 10.82%. This alarming acceleration of the “burn rate” is why Congress suspended the required withdrawals from IRA accounts in 2009. Events of the Great Recession punctuate the dangers of investing for income. Let’s look at some details and a solution some retirees are using.

Not only did portfolio values fall, but so did dividend and interest income from these portfolios. The credit crunch left many companies strapped for cash, and they drastically reduced their dividends. The S&P 500 companies cut dividends by over $40 billion in 2008 and by another $50 billion in the first half of 2009. Retirees counting on dividend income from stocks and mutual funds suffered a major setback. While dividend income may have served some retirees well in the past, the risks of relying on stock dividends are now apparent and certainly not suitable for everyone.

What about fixed rates, either from bank deposits or bonds? Bank rates are at historical lows and those relying on interest income from CDs have suffered severely. Income from fixed rate bonds and income [bond] mutual funds is now less dependable as companies have defaulted and variable rates forced coupon yields drastically lower. Given the current level of domestic and global uncertainty, no one can reliably forecast the future level of interest rates and assess the creditworthiness of bond issuers. The flight to the security of Treasury bonds has been especially traumatic since these rates are currently hovering near zero. Retirees living on interest income from bank CDs and bonds have fared no better than those with portfolios of securities.

There remains, however, one reliable way to assure a future income for retirement that you cannot outlive. This reliable source has been around for centuries and has withstood the ravages of natural disasters, failures of government, wars, depressions and financial meltdowns. When you have risks you cannot shoulder on your own – like the possibility of outliving your money, the diagnosis of a critical illness or losing your home to fire, wind or flood – where do you turn?

The insurance industry specializes in managing catastrophic events by pooling risks of a large number of people. Those not suffering losses help pay for the misfortune of those who do, and the insurance company profits by managing the risk. You can now insure the fear of outliving your money [longevity risk] by entrusting an insurance company with some or all of your retirement money in exchange for the guarantee of a lifetime income. The more money you transfer to your longevity insurance policy, the higher your guaranteed income-for-life will be. This solution removes the danger and uncertainty of investing for income. While this is a relatively new coverage offered by insurance companies, it is rapidly finding favor with retirees fearful of outliving their money. By combining your SS benefits with a guaranteed lifetime income from an insurance company, you can lock-up lifetime retirement paychecks you cannot outlive. If you’re tired of low rates, high risks, uncertainties and worries of outliving your money, this could be the perfect solution for you – find out by discussing the suitability with your financial advisor.

Lower interest rates have spilled over into banks, and one-year CDs paying 1.5% or less are commonplace. This is a huge decline from a year or two ago when comparable CDs were paying more than 3%. As I mentioned in my Retirement Blog, CD rates are marching in an unclear direction, you may be uncertain about how to keep your income at the level you need and still get the security you have with FDIC. Keep these points in mind: your new rate a year from now may be higher or lower, and CD interest is subject to income taxes. Before you renew that CD with the ridiculously low rate, consider another alternative that offers a guaranteed income stream, with safety, AND can leave you with more money.

In what follows, taxes of 25% are assumed and an investment of $100,000 is used. The 1.5% bank CD earning $1,500 annually provides you $1,125 “take home income” after taxes. Thus, your after-tax interest rate is only 1.125% with the rest being paid to Uncle Sam in taxes. Of course, a lower tax bracket means your earnings will be higher, and vice versa. You can substitute your tax bracket and adjust the results accordingly. Let’s use a recently introduced technique called an “Income Annuity” (a garden variety deferred annuity equipped with a guaranteed life income rider) to see if we can improve on the results. But first a word about annuities!

Annuities are issued by insurance companies and, by courtesy of the U.S. Congress, enjoy income tax deferral: meaning no income taxes are due until the earnings are actually withdrawn. Insurance companies are some of the world’s largest, oldest and financially strongest companies: you use them to safeguard your life, health, home, business, car and virtually everything else you value. Annuities are broadly classified as “variable annuities” and “fixed annuities”. Variable annuities are nothing more than mutual funds inside an insurance company “wrapper” to give them tax-deferred status and, as such, their value is determined by the ups and downs of the stock market. In other words, variable annuities have risk of loss, because the stock market can lose substantial value from time to time – witness 2007/2009 when many variable annuities lost over 50% of their value. In fact, the stock market’s last high was in October of 2007 and currently is about 5,500 points short of that high water mark. Fixed annuities, on the other hand, are guaranteed by the insurance company to not lose value if they are held to maturity; thus, they are more conservative and we’ll use them since most retirement-minded investors are risk averse.

There are numerous ways that fixed annuities credit interest, but that is a discussion for a later time. Suffice it to say that if you hold a fixed annuity until maturity, you’re guaranteed to earn a minimum stated rate of interest regardless of what happens to interest rates or stock market indexes. Of course, you have the opportunity to earn a rate higher than the guaranteed minimum. Unlike the bank CD where interest is subject to income taxes even if you don’t withdraw it, interest from an annuity is not taxable until it is actually withdrawn. If you take this tax deferral feature and add an Income Annuity, you have the opportunity to maintain your “take home” income and have more later. Let’s illustrate with an example.

Let’s take most of that $100,000 and buy an Income Annuity. Back in 2007 you were probably making 5% interest on your CD and you got used to that $5000 of pre-tax income. We are going to set up an annuity designed to pay you more than $5000 annually AND we can set it up for LIFE. Now here is a special note… since you are used to receiving the $5000 each year from your CD, we are going to hold out $5000 from the $100,000 to cover your income during the first year of the annuity policy. This will leave $95,000 to deposit into the annuity. Don’t worry, we will make it all back during the first year. The annuity will include two very important features – a 5% cash bonus AND a no-cost life income benefit rider. Without boring you with the details, you can start taking your guaranteed lifetime income any time after the first anniversary of the policy. For a 59-68 year old, depositing $95,000 into this annuity with a 5% cash bonus and starting the income exactly one year after purchasing the annuity, the income will equal NO LESS THAN $5,236.87 per year… an increase of 4.7%! Imagine never having to shop for CD rates again or ever having to worry about adjusting your lifestyle to fit the movements of some banker’s whim! Annuities can readily deliver that “sleep insurance” we all desire so much!

Shelby J. Smith, Ph.D.
October 2009

The Great Recession has probably thrown your investments in reverse, and you’re hoping to soon “get back to break even”. Not only may this be wishful thinking, it is probably bad strategy – because this is the exact strategy that got you to the bottom in the first place. What’s more, your investments – and the market – may not cooperate by coming back. If your portfolio was General Motors, Ford, AIG, Citicorp, Lehman Brothers, WaMu, Frontier Airlines, Mervyn’s, Circuit City and other victims of the Great Recession, there is no “coming back”. Least you think the stock market’s recovery is certain, consider Japan’s Nikkei index. It was at 40,000 in 1990 and is now at 10,500. This can also happen in the USA: the NASDAQ index was 6,000 in 2002 and today is at 2,100. Granted, the market may recover longer-term, but in the meantime there are several complications.

First, it takes a bigger percentage gain than the percentage loss to get back to break even. This sounds confusing until you do the math. If you had $1000 in the market and it dropped to $500, you’d have a 50% loss. If the market reversed and gained 50%, your balance would be $750 ($500 + [50% x $500] = $750). It takes a 100% gain to recover a 50% loss. The stock market, as measured by the DJIA index, peaked at 14,165 in October 2007 and then nosedived over 50% to 6,547 in March 2009. While the market index is now 48% above the March low, 116% growth is needed to reach the previous peak (break even); therefore, further gains of 68% are needed for full recovery. While individual stocks can move dramatically in a short period of time, the market indexes move in lockstep with the overall economy. Currently the economy’s health is anemic, and it appears many years will be needed to heal from the Great Recession. Even if there is a rapid snap back of the market, problems remain.

The Great Recession fostered a dramatic rise in the federal deficit. Massive amounts of money were injected to thaw credit markets, bailout critical industries and institutions, ease the economic pain of the unemployed millions, save the quasi-government housing agencies from failure, fund stimulus payments and more. This deficit explosion is the seed of future inflation. Unless taxes are raised dramatically or expenditures are cut drastically, more money chasing fewer goods will prime the inflation pump. The double digit rise in prices of the late 70’s and early 80’s comes to mind. If sharply higher inflation materializes, rapid market growth will be needed to maintain the purchasing power of your portfolio. Let’s be optimists and assume 10% market growth and only 5% inflation. Under these conditions, the 68% real growth needed for break even will take about 14 years. Ironically, a typical retiree, age 70, is expected to live 14 years. Since Uncle Sam does not consider inflation when designing tax tables, you’ll pay taxes on nominal gains even though you had a real loss in purchasing power.

There are great ways to manage risk; defer-lessen-eliminate taxes; lock in guaranteed fixed rates as high as 8% for a later guaranteed lifetime income; integrate money from retirement-savings-investment accounts with Social Security benefits to maximize income and minimize taxes. So don’t wait for the market break even before you change your strategy. Meet with your financial advisor and chart a new course. Remember the definition of insanity: doing the same thing over and over and expecting different results.

Shelby J. Smith, Ph.D.
October 2009

You are saving money in your 401(k), 403(b), IRA or other retirement accounts so you can have an income in retirement. Unfortunately, “defined contribution” plans do not guarantee you a lifetime income nor do you get a guarantee against losses if you selected market investment choices. Most retirement-minded people would much prefer to have a defined benefit plan that guarantees a lifetime come; however, most companies no longer sponsor such plans because they are too expensive. But, wouldn’t it be nice to have this lifetime income guarantee like your father and grandfather? You can easily create your own defined benefits plan to provide guaranteed lifetime income. Here’s how!

You are generally permitted to remove your money from an employer-sponsored retirement plan when you retire, quit, die, become disabled and maybe borrow from your money if you have a financial hardship. On rare occasion your employer will be enlightened about ERISA regulations and know about In-Service, Non-Hardship Withdrawals provisions. Such provisions, when made available by your employer, permit withdrawals regardless of age, without triggering taxes (must be trustee-to-trustee transferred), while still working and participating in the same employer’s plan. The ISNHW provisions have only recently been brought to the forefront because of litigation associated with the high fees, losses and fiduciary lapses. Ironically, many large firms have added this flexibility to their plans as a litigation-prevention device. Most small businesses have not taken action because they are unaware of the provisions and those responsible for alerting them (outside third-parties who manage the money or administer the plan for the employer) have not done so. The notice has been withheld because (a) the parties advising the small business are unaware or (b) they do not want to lose fees which are based on the amount of money in the plan. If money is withdrawn from the plan, third party fees are likely to be reduced. But, unless you can get your money out of your employer’s retirement plan, you cannot take steps to convert it into a guaranteed lifetime income. If you wait until you retire or quit to move your money, it may be too late because the market values could drop precipitously at any time. Of course, they could also rise precipitously at any time. This “not knowing” is the “risk” that could ruin your retirement.

Assuming you can get your money from your employer’s retirement plan (and if you can’t you need to hand your employer a copy of my book “Tapping Into Your 401(k) Money Before Retirement”), how do you turn it into a guaranteed lifetime income? If you face a risk you do not want, or cannot, manage, what do you do? You transfer the risk to an insurance company. Insurers are professional risk managers who use sophisticated mathematical methods to assure they make a profit. Whether they are insuring cars, homes, lives, wellness, businesses or race horses, they price their services based on the probability of loss. The policyholders who are not losers (their house did not burn, their car was not wrecked and they remained healthy) subsidize the losers. For example, if you have life insurance and live longer than expected (you lost because you may not have needed the life insurance) you will be helping pay death benefits for those who died prematurely (from an insurance standpoint, they won…ouch!). The same is true when guaranteeing a lifetime income. Let’s see how this works.

Living too long is called “longevity risk” and all of us face it in retirement. In exchange for the payment of money, a life insurance company will pay you a guaranteed lifetime income. How much monthly income you receive will be based on the amount of money you paid, your age (the older you are the more income you’ll get), your gender (women will get less than men because they are expected to live longer), the level of interest rates (the higher the rates the more you’ll get for a given amount and age), and other factors. If you determine that you need $50,000 a year in retirement and only $20,000 is assured from Social Security, you’d have your financial advisor shop insurance companies for a policy that paid you an income of $30,000 a year regardless of how long you lived. Once you purchase the policy, you’re assured of an income for as long as you live – guaranteed by the same insurance companies that insure your home, car, life, health and everything else of value. Of course, a married couple can purchase a joint-life policy and you may even be able to add an inflation rider than will adjust your income as prices rise. Since a large number of retirees are transferring their longevity risks to insurance companies, the predictability of large numbers allows them to manage the risk and make a profit. Those that die too early subsidize those that live too long, and the insurance company prices their services to make a profit. This is the same principle used for home, cars, boat and health, and is the foundation of all insurance.

You generally purchase policies to address longevity risk by buying an annuity with a guaranteed lifetime income benefit rider. Not only are you assured of a lifetime income, but you retain the flexibility of being able to change your mind and get all or some of your money returned. Insurance for longevity risk is the latest insurance product to be offered to the public and demand is growing rapidly with the increasing number of retirees. The reason for the rapid growth is because the greater fear of most retirees is running of money before death, and everyone wants a defined benefit retirement plan rather than the defined contribution plan sponsored by most employers. If you haven’t talked to your financial advisor about creating your defined benefit retirement plan to assure you and your loved ones a guaranteed lifetime income, you need to call and ask for a meeting. There is no way to lose: if you die prematurely you’ll be subsidizing those that live too long but you’ll be in a place where “money worries” are a thing of the past; if you live too long you’ll never run out of money. I’d say that’s win-win and something you need to consider. Ask your financial advisor about insuring against longevity risk.

Shelby Smith, Ph.D.
July 2009
TheRetirementPros.com

As you are painfully aware, the before-tax money you’ve put away for retirement, and which has been growing tax deferred, has a co-owner: Uncle Sam.  The tax laws say you must start withdrawing and paying taxes on this money when you reach age 70½.  If you fail to take the Required Minimum Distribution (“RMD”) there is a penalty tax of 50% on the amount you should have taken and did not.  The reason the government mandated the RMD is to assure they get their share in taxes before you expire.  For 2009, the government will not impose a penalty for skipping the RMD, because withdrawing money would compound the market losses suffered by many.  But, in 2010 you will again be required to withdraw from your qualified retirement money if you are 70½ or older.  What can you do if you don’t want to take withdrawals?

The only solution is to convert some or all of your qualified retirement to a Roth IRA if you can qualify. If you make more than $100,000 in taxable income during 2009, you cannot convert money to a Roth IRA; however, in 2010 this income limit will be suspended and you can qualify.  When you convert your retirement money to a Roth IRA, you will pay income taxes on the amount converted, but the converted amount will not be included in the $100,000 income qualification limit.  Thereafter, all the principal converted and future earnings will be 100% tax-free to you and whoever inherits the money after your death. What’s more, annual distributions from a Roth IRA are not required.  You can let it accumulate tax-free, or you can make tax-free withdrawals: your choice.  There is one small drawback: even if you’re over 59½, you cannot withdraw earnings tax-free until after five years.  You will still have immediate tax-free access to 100% of the money converted to a Roth, but withdrawn earnings will be taxed during this five-year period.  Withdrawals come from converted money first.

If you cannot now qualify for a Roth IRA conversion due to your annual income, you will qualify in 2010.  If you convert in 2010, you will get all the benefits discussed above, but you will have to take your RMD for 2010 prior to converting.  You can stretch the taxes on the amount converted over the following two tax years.  One-half of the taxes will be due with your 2011 return filed in 2012 and the remainder with your 2012 tax return.  Best of all, you can change your mind on a Roth conversion up until the time you file your tax return for the year in which you converted, including extensions.  This means that if you convert in 2009, you can change your mind, undo the conversion anytime before October 15, 2010, and avoid the taxes.  If you think you could benefit from a Roth, you should convert knowing that you can change your mind anytime up to the tax filing deadline for the year of conversion.

Other than avoiding the RMD, why would you want to convert to a Roth IRA?  First of all, the IRS now owns a percentage of your qualified retirement money, and the best time to buy them out is when the price, and tax, is the lowest. If you have suffered market losses – and who hasn’t – your tax bite will be less than if you wait until after the market recovers. What’s more, if you expect future tax rates to rise – and that is the consensus forecast – you’ll want to pay now in advance of the tax hike.  Additionally, if you move retirement money from the “taxable” category to “tax-free” you will probably pay fewer taxes on your Social Security benefits since Roth IRA income is not counted when computing taxes on SS benefits.

Converting to a Roth IRA is not for everyone, especially if you’ll need to use part of your qualified retirement money to pay the associated taxes.  If you have investment losses to offset the taxes associated with Roth conversion, you certainly need to consider converting some retirement money to a Roth IRA.  You’ll want to work with your financial advisor to make sure you can benefit.  If converting to a Roth makes sense for you, it can be done easily, without delay and at no cost other than the taxes.  The Roth IRA conversion is undoubtedly one of the best ways to lower taxes and manage your estate without giving up flexibility.  If you haven’t already, you need to investigate this opportunity immediately.

Shelby J. Smith, Ph.D.
August 2009
TheRetirementPros.com

Related Resources: Managing Retirement Money Withdrawals

If you had a plan for retirement, chances are it has been up-ended in the latest market meltdown. As I mentioned in this retirement blog, Retirement-minded savers and retirees that committed their hard earned money to the “market” have been on a roller coaster ride since 2000. First came the dot.com craze that drove stock prices to dizzy heights. The bubble burst and stock prices sunk dramatically with tech stocks as a group dropping 80%. From 2003 until late 2007, the market trended upward and came close to its inflation adjusted pre-2000 level before again plummeting dramatically. From late 2007 until March 2009, the market shrank by 50%, abruptly surged upward by 30% and for the past two months has vacillated around this plateau. Keep in mind that a 50% loss means a 100% gain is needed to get back to breakeven. Where will the market go from here?

There is only one thing certain about the market: no one knows its future direction. Of course there are always those that make reasoned forecasts, but to my knowledge there is not now, nor has there ever been, anyone who has consistently predicted the future direction of the market. Forecasts are simply “educated guesses” and as such are wrong as often as they are right. Guessing is not a good way to invest your retirement money, unless you are prepared to lose it. Thus, what should you do if your retirement money is in the market?

Start by asking yourself: What am I trying to accomplish? If your answer is “to make a gain” then you must determine if you “can afford a loss” because you have a chance for either. If you can’t afford losses, then the market is not the place for your money. You can keep in the market that part of your money you can afford to lose or don’t plan to use. You’ve been told that “in the long run you’ll do just fine in the market”. The questions are: Do you have a “long run”? Exactly how long is the “long run”? As this is being written in June 2009, the DJIA [widely used barometer of the market] closed at 8750 – exactly the same closing level as in March 1998. Before accounting for inflation, that’s eleven years without growth. If inflation is taken into account, you would have lost 40% of the purchasing power of your retirement money during these eleven years. For the retirement- minded, eleven years – or one-third of an average retirement – is the “long run” and they’ve not done “just fine”. It could get better or worse going forward.

If your objective is to make sure you do not outlive your money, you could be in the wrong place. Instead of measuring how “tall” your money stands, you need to focus on how “long” it will last. Ideally you’d like to have a guaranteed lifetime income you simply cannot outlive. There is only one place to get such a guarantee, regardless of what the market does in the future. That one place is the industry that manages the risk of your home being destroyed, car being wrecked, medical emergencies leaving you bankrupt, and more. That’s right: an insurance company that manages the risk of outliving your money. You can cover this risk by putting some of your retirement money into an annuity with a Guaranteed Lifetime Income Benefit rider. This option is safe, easy to understand and eliminates the risk of living too long.

So if you’re still at Point A and have made no adjustments to your retirement for the new financial landscape, you need a Plan B. Don’t waste another day; get with your financial advisor and review your investments, retirement plans and lifestyle. This will move you from Point A to Plan B… you’ll sleep better and have a much better retirement.

Shelby J. Smith, Ph.D.
June 2009
TheRetirementPros.com