The Roth IRA has existed for ten years but is under utilized by financial advisors and retirees alike.  Converting your retirement money to a Roth IRA holds outstanding potential, but unfortunately many that need it most cannot qualify and most that can qualify have bypassed the opportunity.  You can qualify if your total annual income is not more than $100,000.  While higher income individuals cannot currently convert qualified retirement money to a Roth IRA, the income limit will be suspended in 2010.  If you can qualify now, you need to immediately check into this opportunity.  If you do not currently qualify, now is the time to start preparing for 2010 when you can. Following are suggestions you may find helpful.

As I mentioned in this retirement blog, the reasons for converting IRA, 401(k) and other retirement moneys to a Roth IRA are many.  Among the most important is that principal and earnings withdrawn from a Roth are not subject to income taxes.  This tax-free status survives the death of the owner and is passed to the spouse and beneficiaries.  The non-spouse beneficiary must start Required Minimum Distributions (“RMD”) but can stretch withdrawals over their life expectancy – with every withdrawal being totally tax-free.  If future tax rates rise – and the consensus opinion is that they will – paying the taxes now on retirement accounts could make a great deal of sense.  If you plan to pass the money forward to heirs, their prospective tax rate must also be taken into consideration.  If your current retirement accounts are depressed in value – and most are – it is smart to buy out your partner (the IRS) at rock bottom prices (smaller accounts mean fewer taxes).  There are numerous other advantages to a Roth conversion which can be found in the book Go Roth by Kaye A. Thomas (Fairmark Press, 2009).

If your retirement money is now in a 401(k), it probably cannot be moved to a Roth IRA because most 401(k) Plans allow withdrawals only upon death, retirement, termination, disability or financial hardship. But, there is a little known provision in the Employee Retirement Income Security Act (“ERISA”) of 1974 that permits some or all 401(k) money to be trustee-to-trustee transferred regardless of age, without triggering taxes, while still working for the same employer and without giving up participation in your employer’s 401(k) Plan.  This escape hatch is called an In-Service, Non-Hardship Withdrawal provision and is fully explained in Tapping into Your 401(k) Money before Retirement, a book I co-authored and is available free at theretirementpros.com.  Thus, if you currently have your retirement money in a 401(k) Plan but might want to covert some or all of it to a Roth IRA now or in 2010, talk to your employer about changing your 401(k) Plan by adding the In-Service, Non-Hardship Withdrawal provision.  This provision is easy to add, can be done immediately and cost your employer nothing.  The exact steps are explained in my book referenced above.

While Required Minimum Distributions are not required for qualified retirement accounts in 2009, they will again become effective in 2010.  If you are currently taking RMD from your retirement accounts but wish to avoid them, a conversion to a Roth IRA may be the answer.  You, and your spousal beneficiary, are exempt from RMD if your money is in a Roth IRA.  Parenthetically, not having to count Roth withdrawals as income in future years will yield dividends in two ways:

1. Keep you in a lower tax bracket overall;
2. Shelter more of your Social Security money from income taxation.

A Roth conversion is not for everyone, but you may be able to benefit and, therefore, need to investigate the opportunity.  You’ll hear a lot more about Roth conversions as we get closer to 2010.  If you think converting to a Roth IRA makes sense, talk to your financial advisor about the specifics. Also, learn all you can on your own by referencing the Newsletter, articles and webinars on TheRetiriementPros.com and read the books I’ve mention above.  This is a great opportunity for you to shelter some or all of your retirement money from income taxes without taking risks, but you’ll need to start preparing now.

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

Most of us measure our retirement money by how “tall” it is rather than how “long” it is. It’s not how much money you’ve got that’s important, but how long it will last. Because of uncertainties like inflation, taxes, investment losses, emergencies and more, retirees don’t know how long they might live; thus, it is hard to determine how long the “tall money” will last. This is why retirees’ greatest fear is outliving their money, referred to as “longevity risk”. If the “tall money” is laid down over the retirement years it becomes “long money” and longevity risk can be managed. How can this be done?

Insurance companies manage all types of risk by spreading it among many individuals to make the probability of loss predictable. For example, historical records yield the probability of fire occurring in your home and how sprinkler systems, proximity to fire stations and structure type can lower the risk. Insurance premiums are based on these data which make coverage affordable for you and profitable for the insurance company. Everyone pays premiums but only a few file claims for damages; thus, the lucky ones subsidize the unlucky one. Longevity risk is handled the same.

By insuring the longevity risk of many retirees, insurance companies can offer affordable coverage, because those who die too soon (the unlucky) subsidize those that live too long (the lucky). Longevity insurance comes in the form of a Guaranteed Lifetime Income Benefit contained in an annuity. Here’s the way it works: You use your “tall money” to purchase an annuity that pays a competitive rate of interest plus allows you to turn it into “long money” at any time without penalty. The guaranteed lifetime income for the rest of your life means your money will last as long as you do. There are safeguards that keep you from losing money if you die too soon, but never can you run out of money if you live too long. What’s more, you don’t have to turn all your “tall money” into “long money” – just enough, when combined with Social Security and your other lifetime income, to assure you an adequate 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 to get a given income. 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 ones that insure your home, car, health, life and business. 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 want to turn your “tall money” into “long money”, take the time to learn more about the guaranteed lifetime income benefits of annuities. A great place to start is your financial advisor – he or she can help you select the best annuity and needed features to meet your needs, and then shop the market to get you the highest lifetime income. Living too long is a risk just like home fires, auto wrecks, medical problems and other risks that we pay an insurance company to manage for us – so why not longevity risk?

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

There has been a lot in the press recently about the solvency of Social Security and how it could go broke by 2016. As has been previously mentioned in this Retirement Blog, seniors and late boomers are concerned about their future Social Security benefits and want answers. The following will shed some light on the matter.

POLITICAL REALITY
Over 50 millions American families get Social Security benefits, mostly 60+ in age.  All these people vote and they consider Social Security their God-given right because they paid Social Security taxes all their working life.  Coming behind the current recipients of Social Security are 78 million baby-boomers that are now reaching SS age – and they, too, consider SS an entitlement and most of them vote as well.  The first politician that votes to do away with Social Security will be a loser at the next election – regardless of party or tenure: they are GONE.  So, the political reality is that Social Security cannot go bankrupt. Yes, benefits can be eroded [in fact that is what’s happening as taxes go up and the Social Security taxability thresholds are not inflation adjusted], workers and employers will pay more from their wages, plus accounting tricks will be used, but SS benefits for those in need will not be terminated.

ECONOMIC REALITY
Every working American and their employer (even the self-employed) must pay FICA taxes which go into the Social Security Trust Fund.  Most people think the Social Security Trust Fund is a big vault of money that is judiciously managed so that it will be available when benefits must be paid – in fact, you can even get a statement of “your Social Security account”. They are mistaken.  The money that was placed into the Social Security Trust is invested for sure…in U.S. Treasury bonds, bills and notes, also known as I.O.U.s.  All the money put into the SS Trust has been spent but not to worry because the Trust Fund has dollar-for-dollar I.O.U.s from the villain that spent the money: Uncle Sam.  What’s more, these I.O.U.s draw interest – and this interest is paid with more I.O.U. from the same Uncle Sam.  This means that the U.S. Government is really responsible for SS benefits and they have simply used an accounting trick to fool the citizens.  So, if Social Security fails that means the U.S. Government has failed…and should that unlikely event ever happen, the least of our worries will be loss of SS benefits.

PHYSICAL REALITY
The cause of the SS problem is people are living longer than they were when Social Security was enacted.  Of course, giving benefits to those who never worked and/or are not U.S. citizens has worsened the problem.  Currently, most Americans are overweight and far too many are smokers – both of which shorten life. With the alarming rise in medical insurance and costs, it won’t be long before only the rich can afford to see a doctor. This means that obesity and smoking-related illnesses will go untreated and life expectancies will plummet.  And this, my friends, will take care of the Social Security problem.

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

Related Resources: The Guide to Social Security & a Better Retirement (Video & eReport).     Erasing Your Biggest Retirement Worry (10min Video)   Addressing Your Greatest Retirement Worry (10min Video)

Outliving their money is the greatest fear of most retirees.  Because of massive market losses since 2007, high and rising medical costs and more taxes & inflation as fallout from the unprecedented federal deficit spending, retiree fear is at an all-time high.  But for the stronger gender, females, it is especially alarming, because they are expected to live longer and more likely to encounter financial problems late in life.

According to the U.S. Census Bureau’s latest data, females at birth are expected to live 80.4 years compared to the 75.2 years for males.  This gap narrows as age increases, but even at age 65 the female is expected to live another 20.8 years, while her male counterpart is given only 17.8 more years.  What’s more, women are much more likely to be living alone in old age than are men.  Census data show that at age 75 women are 2.5 times more likely to live alone than men.  About three-fourths of the women age 80-84 live alone, whereas only one-fourth of the men of the same ages live alone.

The Census data show that over one-half of married men are two or more years older than their wife, whereas only one-tenth of wives are older than their husbands.  These marriage statistics, combined with longer life expectancy, cause women to have greater fear about outliving their money in retirement.  In addition to being generally younger and having longer life expectancy, other reasons fuel longevity fear among women:

1. they are more likely to lose Social Security benefits due to a spousal death;
2. end-stage medical expenses can decimate retirement savings;
3. medical costs and/or convalescent care expenses rise dramatically with age.  How are women protecting themselves financially from the longevity risk they face?

In recent years the insurance industry has begun offering guaranteed lifetime income riders on fixed and index-linked annuities.  Unlike variable annuities, fixed/index-linked annuities are free of market risks if held for the stated term.  Retirement money can be placed in a fixed/index-linked annuity at any age and then at retirement turned into a lifetime income that cannot be outlived, even if the underlying retirement account is zero.  The beauty of this retirement option is that at any time the annuity-holder can change their mind and withdraw some or all of the remaining money in their account.  The issuing insurance company makes available a variety of options (inflation protection, joint spousal coverage, guaranteed earning until income is started, etc.) which permits the coverage to be tailored to fit most circumstances.  When combined with Social Security benefits, this innovative development permits retirees of both genders, but especially the female, to have peace of mind in retirement knowing that outliving their money is no longer possible.  If interested in securing this safe money option with some or all of your retirement money, you should discuss annuities and guaranteed lifetime income benefit riders with your financial advisor.  Parenthetically, annuities are the only retirement option that offers you the lifetime security of a guaranteed income.

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

Related Resources: Erasing Your Biggest Retirement Worry (10 min Video Webinar),   Tax-Free Retirement Income & More (12 min Video Webinar)   Where You Should Put Your Retirement Money (10 min Video)

Many Americans of yesteryear relied on employers to provide a defined benefit pension at retirement.  They were guaranteed a lifetime income whose amount was based upon how long they worked for the employer and their ending salary. For example, a defined benefit pension plan might pay a retired worker 2% of their last year’s salary for every year over twenty they worked for the employer.  This meant a 40-year employee could expect to receive 80% of their final year’s income as a lifetime pension at retirement.  The income would continue for their lifetime and then the surviving spouse might be entitled to reduced income until death.

Some large unionized employers still provide such lifetime income but mostly employers have switched to defined contribution plans such as 401(k).  These new-type plans require employees to make contributions which their employer may match up to a certain amount.  At retirement employees can keep their retirement money in their ex-employer’s retirement plan [not a good idea] or move it to a self-direct IRA [which should be done].  At retirement the task of managing the money falls on the retiree and this is when potential problems surface.  There is a bewildering array of investment choices each offering different benefits, limitations and risks.  Retirees are repeatedly bombarded with advertisements to invest in mutual funds, stocks, bonds, variable annuities and more, but seldom are the risky edges exposed until it is too late. At the other end of the options continuum are bank CDs and U.S. Savings Bonds whose rates do not keep pace with inflation.  Wouldn’t it be nice to have yesteryear’s guaranteed lifetime income and be totally immune from market and interest rate risk? You might be surprised to know that such is possible, even easy.

Insurance companies have risen to the occasion in response to the greatest fear of most retirees: outliving their money.  This fear is so common that it has been given a name: longevity risk.  Pooling risks across many people makes losses predictable and allows insurance companies to manage risk.   Insurers have transformed one of their common products, annuities, to pool longevity risks and provide guaranteed lifetime incomes.  The insurance principle is simple: those who live shorter than expected subsidize those who live longer than expected.  By careful pricing insurance companies offer a valuable service and also make a profit.  So how does this translate into a guaranteed lifetime income?

Let say you now have $250,000, are age 60 and want a guaranteed lifetime income at age 70 when you plan to retire and start Social Security.  You would enter into a contract with an insurance company (the same one that insures your home, car, life, health, etc.) whereby you deposit with them the $250,000.  In exchange, they guarantee you at least 8% growth annually for the ten years until you reach age 70 and then pay you 6% of your account balance annually for the remainder of your life.  At age 70 your account will total at least $539,731 (8% annual growth) and the guaranteed annual income paid to you by the insurance company will be at least $32,384 (6% of $539,731) regardless of how long you live. Combined with your SS benefits, you’re assured of never running out of money.  You’ll also have options to protect your spouse, adjust for inflation, pass to heirs all unused money and can even withdraw your money lump-sum if you change your mind.  You have successfully transformed your defined contribution retirement plan (401k, IRA or other) into a defined benefits plan (guaranteed lifetime income).  The best plan is to ask your financial advisor how to get started and which options are best for you.  Don’t hesitate, start your investigation today.

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

Related Resources: Erasing Your Biggest Retirement Worry (10 min Video Webinar),   Tax-Free Retirement Income & More (12 min Video Webinar)   Where You Should Put Your Retirement Money (10 min Video)

When leaving an employer at retirement, changing jobs, down-sizing or starting your own business, leave behind only what belongs to your ex-employer. That means not forgetting your retirement plan money! About forty percent of departing employees, ages 60 to 65, leave their retirement money behind in former employers’ plans. They cite several reasons: loyalty, hassle of transferring, fear of managing the money or bad advice. There are many good reasons why you should take your retirement money with you, but we’ll discuss only the very important ones.

First, the fees and changes associated with an employer’s plan are relatively high and, unbeknownst to many employees, are not paid by the employer but by the employees. If you move the money you can invariably lower the fees. Lower fees can add up to serious money over long periods of time. For example let’s say you are now paying 1.75% annual fees on your mutual funds managed inside the employer’s plan. You can transfer these moneys to a low-load or no-load account under your control and pay a fraction of the fees. The savings of 1.75% on $100,000 annually over a ten year period amounts to about $22,000 if you assume an earnings rate of 5%. Don’t fret about the loss of investment advice because you were getting none from the broker or company managing the employer’s plan. You’ve lost nothing except the fees.

You’ll generally find that your employer’s retirement plan has a limited number of investment options, mostly mutual funds (or variable annuities) and possibly the stock of your employer. By transferring your money and assuming the responsibility for management, you can increase the investment options to a virtually unlimited number. In fact, you’ll be able to select mutual funds, annuities, stocks, bonds, bank CDs, real estate, precious metals, and many other choices except life insurance. This means you can move your money from “risky places” like stock, bonds, mutual funds and variable annuities to “safe places” like bank CDs, fixed annuities and government savings bonds. Sadly, most employer retirement plans do not provide lower risk alternative for those nearing retirement age. The consequence is that many in retirement’s red zone have their plans derailed by a market meltdown. Remember 2000-2002 and late 2007–present?

Most faced with the “move it or leave it” decision are needlessly concerned about tax consequences. You can transfer tax-free your money from a company-sponsored retirement plan to your control with a trustee-to-trustee transfer. You simply direct your employer to transfer your money directly to another trustee (annuity company, bank, brokerage firm, etc.) that you have chosen. If you have the money sent directly to you there is a 60-day time limit to get it to the new trustee and taxes may be withheld that can be recovered only when you next file your tax return. Trustee-to-trustee transfer is the way to go. There should not be a charge to move your money or to open a new account with another trustee. If you are still concerned about transferring and want to make double sure no mistake is made that triggers taxes, ask a financial advisor for help. In fact, it is always prudent to find and use a financial advisor to help you plan a safe and secure retirement.

One last word of caution: if your employer has provided you a “lifetime pension” at retirement and you have a lump-sum settlement option, you’ll need to do some homework. Specifically, find out how much your lump-sum settlement will be and have your financial advisor shop the market for a lifetime income that can be purchased. You can then compare the outside option with your employer’s lifetime income guarantee. Naturally, you’ll want the advice of your financial planner because the two options may involve other considerations that merit analysis. When you leave an employer and become an ex-employee – for whatever reason – always take your retirement money with you.

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

As I mentioned in a previous retirement blog post, at the end of the day, all retirement money is treated in one of three ways: taxable, tax-deferred or tax-free.  Taxable income is taxed during the year in which it is received, but can also be tax-favored if from capital gains, dividends, Social Security, etc. Interest rates on tax-free municipal bonds are lower than their taxable counterparts; thus, taxes are implicit and municipals are in reality the same as taxable.  Tax-deferred earnings are not taxed as income now but will be in the future when withdrawn.  If passed to the next generation, the deferred taxes will be paid by the beneficiary or the estate of the deceased.  Tax-free income may have been taxed earlier but is not again taxed when withdrawn.  The best example of tax-free income is the Roth IRA.

How much of your retirement money should be in each of these categories?  The correct answer is ‘it depends’ because the best strategy hinges on factors that cannot be predicted: changing tax rates, life expectancy, future income, allowable deductions and more.    Since the future taxes and circumstances is uncertain, tax-liability diversification would appear to be prudent.  The exact composition of the diversification will be a matter of personal preference, but it seems logical that tax diversification might be better than the risk of guessing wrong.  Unfortunately, most retirees, probably including you, have little tax diversification. It is conspicuously absent among those with substantial assets and this is interesting given that future taxes are expected to be higher to address federal deficits, refinancing entitlement programs and the wealth redistribution trend.  In fact, most retirees and near-retirees – regardless of income or net worth – have no tax-free holdings and this is not wise, especially for affluent families.

Tax-deferred annuities are a great supplement to qualified retirement money, and many of the retirement minded have utilized them along with their tax-deferred pension accounts like IRAs and 401(k)s.  Likewise for the taxable bucket since investment/business income, rents and salary/wages, plus Social Security benefits are common.  The empty bucket, even for the affluent, is the tax-free one.  Municipal bonds do not fill this niche because of the implicit taxes.  Also, tax-free municipal bond interest counts in the tax calculation for Social Security benefits.

The logical choice for tax-free income is the Roth IRA.  Most employers have not added the Roth option to their 401(k); thus, working families have not had this access. Also, many high-income families cannot qualify for Roth IRA contributions or conversions.  In 2010 the Roth conversion income limit will be suspended, allowing higher income families to take advantage of tax diversification.  You need to start preparing now so you can convert your qualified money to Roth IRAs in 2009 and during 2010 when the income limit is suspended.  Since partial conversions are permitted, you’ll want to carefully select the amount your convert to keep your total income in the lowest marginal tax bracket as possible.  Also, keep in mind that you can change your mind and undo the conversion up to the date your file your taxes, including extension, for the conversion year.

The window of opportunity for Roth conversions in 2010 cannot be ignored.  If your adjusted gross income exceeds $100,000 you do not now qualify for a Roth conversion but will in 2010.  As icing on the cake, the taxes from a 2010 Rot conversion can be spread equally over 2011 and 2012.   Unfortunately, many who can benefit will miss the Roth opportunity because their retirement money is unnecessarily locked in a 401(k) and other employer-sponsored plan which prevent withdrawals prior to retirement.  This impediment can easy be removed by asking your employer to add an in-service, non-hardship withdrawal provision to your Plan (See the report I co-authored: “Tapping Into Your 401(k) Before Retirement”).  Once retirement money is converted to a Roth, it will not be subject to income taxes nor required minimum distributions. Additionally, all money in the Roth IRA and future earnings will be tax-free to you, your spouse and eventual to your beneficiaries.  If you need help understanding Roth IRA conversions, you’ll want to talk to your financial advisor or do some independent research (see IRS Publication 590).  You may also want to look at the guaranteed lifetime income riders on fixed annuities because, when combined with a Roth IRA, this is your pathway to a lifetime of tax-free income that will overcome your biggest retirement fear: longevity risk.  If you want to take advantage of the Roth IRA conversion, you need to start planning today – especially if your money is locked in a 401(k), 403(B), 457, etc. plan sponsored by your employer.

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

As I mentioned in my retirement blog, the greatest fear of most retirees is the risk of longevity: outliving their money. The meltdown of retirement accounts, rising medical costs, uncertain entitlement programs and higher taxes have added to the risk. Facing 30 years of retirement living on past savings and Social Security benefits is a scary reality. What can be done?

To handle other unaffordable risks your buy insurance. The same companies that protect your home, life, health and auto can also protect you from the risk of longevity. The basic principle of all insurance that makes coverage affordable is “pooling of risks”. Since the greatest fear of retirement is outliving your money and your remaining life span is uncertain, the solution is to insure the unaffordable risk. Let’s see how this is done.

Insurance companies issue fixed annuities which can be turned into guaranteed lifetime incomes. You can accumulate your retirement money in an annuity over time or you can fund the annuity lump-sum. Fixed annuities are backed by the assets of the insurance company, guaranteed to give you a positive rate of return which is free of income taxes until the earnings are withdrawn, and offer you numerous other choices. At the date you select, you can turn your annuity into a lifetime of monthly checks you cannot outlive. The insurance company guarantees you a lifetime of income, regardless of how long you live. You can later change your mind, stop the income and take your money lump-sum. If you die prematurely, your heirs are paid the balance of your account. Let’s look at a typical example that most insurance companies offer.

Let say you are age 57, have $350,000 in an IRA account and plan to retire at 65. Parenthetically, you can put money in an annuity at any age and can start immediately to take an income. You’ll get the following by moving your IRA money to an annuity: (1) a 10% premium bonus that boosts your income account to $385,000; (2) a guaranteed growth in your income account of at least 8% annually; (3) the right to start a monthly income at anytime after 59½; (4) an annual lifetime income equal to 5.5% times your income account value at age 65; (5) the right to withdrawn your money lump-sum if you change your mind; (6) no taxes on the annuity earnings until you start withdrawals; (7) no fees or commissions except 0.40% annual premium taken from earnings for the lifetime income guarantee. At age 65 and retirement what can you expect?

At age 65 the income account will be at least $712,608 since you were guaranteed at least 8% annual growth on your initial annuity premium plus the 10% bonus. Your annual guaranteed lifetime income will be $39,193 (5.5% of your $712,608 income account balance). If you should die prematurely, your account balance, if any, will go to your beneficiaries. If you change your mind, have an emergency, find a better value or whatever, you can take your remaining money lump-sum. There are no medical requirements or other hassles. You are now insured against the risk of longevity and cannot outlive your money.

Insurance companies charge for their services and make a profit; thus, retirees that die too soon will subsidize those that live too long. The same as those whose homes were not damaged subsidizes those whose homes were damaged. Your retirement objective of a guaranteed lifetime of income was insured at a reasonable cost by pooling your longevity risk with that of other retirees. Combine your guaranteed lifetime income with Social Security benefits, and you have a comfortable and safe retirement with very little planning. Ask your financial advisor today about a fixed annuity with a Guaranteed Lifetime Income Benefit Rider.

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

Related Resources: Erasing Your Biggest Retirement Worry (10 min Video Webinar),   Tax-Free Retirement Income & More (12 min Video Webinar).

At the end of the day, all of your retirement money is treated in one of three ways: taxable, tax-deferred or tax-free.  Taxable income is taxed during the year in which it is received, e.g., pension or investment income.  Taxable income may also be tax-favored if from capital gains, dividends or certain other activities. Earnings from tax-free municipal bonds are lower than their taxable counterparts; thus, taxes are implicit, so put these bonds in the taxable classification.  For many retirees, Social Security benefits are taxable also; as I mentioned before in my Retirement Blog.  Tax-deferred earnings are not taxed as income now but will be in the future when withdrawn and used, e.g., IRA, 401(k) and annuity earnings.  If passed to the next generation, the deferred taxes will be paid by the beneficiary or the estate of the deceased.  Tax-free income may have been taxed earlier but is not again taxed when withdrawn and used, for example money take from a Roth IRA.   

Which of these three tax strategies is best?  The correct answer is “it depends” because the best strategy depends on factors that cannot be predicted: changing tax rates, life expectancy, future income, allowable deductions and more.    Since the future is uncertain, diversification would appear to be prudent.  The exact composition of the diversification will be a matter of personal preference, but it seems logical tax diversification might be better than the risk of guessing wrong.  Unfortunately, most retirees have little tax diversification.

The tax deferred bucket can be accomplished by using qualified retirement accounts such as IRAs, 401(k), 403(b), etc. or tax-deferred annuities.  The taxable bucket is generally filled with investment/business income, rents and salary/wages, plus Social Security benefits are generally taxable.  The difficult bucket to fill, especially for the affluent, is the tax-free one.  While income from municipal bonds is tax-free, the lower returns offset this feature.  The logical choice for tax-free income is the Roth IRA.  Most employers have not yet added the Roth option to their 401(k) and most high-income families cannot qualify for Roth contributions or conversions.  In 2010 the Roth conversion income limit will be suspended, allowing higher income families to take advantage of tax diversification.  

With tax diversification you can hedge the uncertainties of future tax changes.  This is why the window of opportunity for a Roth conversion in 2010 should not be ignored.  If your current adjusted gross income exceeds $100,000, you do not now qualify for Roth conversion but you will in 2010.  As icing on the cake, the taxes from a 2010 Roth conversion can be spread equally over 2011 and 2012.   Unfortunately, many will miss the opportunity because their retirement money is unnecessarily locked in 401(k) and other employer-sponsored plans which prevent withdrawal unless an easy, but relatively unknown, provision is added to the plan.  Once converted to a Roth it will not be subject to income taxes nor required annual distribution, plus all money and future earnings will be tax-free to the beneficiaries. If you need tax diversification, ask your financial advisor about converting your qualified retirement money to a Roth IRA.  

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

Helpful Resources:    Tax-Free Retirement Income & More (12 min Video Report), You, Taxes & Retirement (eReport PDF & 10min Video Report).

As I mentioned in my retirement blog, many retirees with money in the “market” face a dilemma: outliving their money UNLESS the market recovers. They now know as “myths” what heretofore were known as “facts”.  Facts such as: diversification works; blue chips stocks are safe; dividends can be counted on; retirement accounts are secure; market risks are suitable.  Among these “myths” is: you’ll do fine in the market long-term.  Ever noticed that “long-term” is never quantified?  Let’s look at the long-term from the prospective of retirees or those in the retirement red zone.

Let’s say you and your spouse have saved all your working years, and at age of 63 (in late 2007) your retirement accounts totaled $450,000.  Given your expected Social Security of $2,000 at age 66 (when you plan to retire) and your spouse’s $1,000 (50% of yours as a dependent), your retirement “nest egg” was adequate.  In fact, by taking equal annual payments over 30 years, assuming a 5% earnings rate, you could count on about $30,000 yearly from your retirement money.  You’ll have about $65,000 a year, with your SS benefits adjusted annually for inflation.  With the house paid for, the kids educated and self-sufficient and your modest lifestyle, you’re feeling secure as long as your health holds up.  Then along came the Great Recession and the market meltdown.  Back to the drawing board!

It is now March 2009 and you’re one year away from the planned retirement.  The $450,000 has shrunk to $225,000 and you’re afraid the carnage is not over.  You’ve lost 50% of your nest egg.  How much of your “long-term” will it take to dig out of this financial hole? Your first surprise was that a 50% loss means you’ll need 100% growth to get back to where you started.  Your most recent calculation was a shocker: if $30,000 a year is withdrawn from your current retirement savings and the rest grows by 5% annually, there is nothing left in less than 10 years.  Is that “long-term”?  Plan-B is to withdraw $20,000 annually: your $225,000 is now gone in less than 17 years, still short of the “long term”.  Also, prices (inflation) will surely be a factor over the next ten to fifteen years, so your “long term” could be even shorter.  You decide to work another year in hopes things get better.

If you can save $25,000 during the extra year of working you’ll be helped because (a) you’ll have money for one more year of retirement and (b) you’ll have one less year of retirement: you’re two years closer to your goal but is that good enough? For your nest egg to recover fully, you’ll still need 80% growth to cover the 50% loss.  At 7% compounded annually, which is not unreasonable, it will take almost nine years to reach $450,000.  In the meantime just a 3% annual rate of inflation means a dollar today is worth $0.74 ten year from now – but one of your needs in retirement, medical services, has been growing at 8% annually.  Another blind alley!

Now you know why “you’ll do fine in the long-term” is a myth for most retirees.  You simply do not have the time to recover from a major market meltdown like that suffered since late 2007.  No one knows the future direction or recovery time of the market.  It may be logical to assume that given the precipitous drop in the market over the past 18 months, it will recover soon.  But, in 1929 the market nosedived until 1932 and was then mostly anemic before diving again in the last 30’s.  The wartime economy of the 1940’s put recovery on hold.  The market did not again reach the October 1929 level until November 1954. Could it happen again?  Anything is possible, but we sure hope recovery is soon and the 50% loss is erased quickly – but that’s not likely.  So, when you next hear that “long term” the market is always the place to be, ask yourself: how long is the long term?

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