Too Much Too Soon

As we discussed last week, the purpose of the recently passed Secure Act was to make it easier for workers to save for retirement. Pretty much everybody acknowledges there’s a retirement savings shortfall in our country, so every little bit helps. The downside, however, is that laws making tax deferred savings easier must be paid for, and this was largely accomplished on the backs on those set to inherit retirement accounts.

Remember that IRAs, 401(k)s, and other types of retirement accounts weren’t originally intended to pass on wealth to heirs. They were meant to fund retirement and perhaps help with a surviving spouse. As we’ve seen over time, too-good-to-be-true-for-long tax loopholes eventually get closed. This is what happened several years ago with the Social Security “file and suspend” loophole that created a cottage industry of books, seminars, and so forth that for years helped folks “maximize” their benefits.

I’m a firm believer in understanding the rules of the game and playing the game hard, but I also try to acknowledge when something has to give. The victim this time around was the concept of “stretching” inherited retirement accounts.

Beneficiaries used to have two main options for retirement accounts they inherited. If the deceased owner was taking required minimum distributions (RMDs), heirs could start taking them on their own the year following the account owner’s death. Or, they could choose to clean out the account within five years. With some good investment management and proper planning, it was possible to try to stretch some of the money for decades, or even into the next generation. This also allowed more control over the timing and amount of taxes. No longer. Those inheriting retirement accounts will now have just one choice, to draw down the balance within ten years.

While these changes impact a broad array of beneficiary scenarios, here’s one that’s likely to start coming up:

Too much income too soon…

Jane’s mother passed away and left her a 401(k) worth $300,000 and a Roth IRA worth $150,000. While she’s mourning the loss of her mother, Jane is 60 and wondering how the extra money and extra taxes will impact her retirement plans.

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Quarterly Update

Volatile markets, recession fears, trade war rhetoric, flagging manufacturing, and rising interest rates were on the minds of investors as we entered 2019. We had just seen a market rout in December and some investors were starting to head for the hills. But then to keep investors on their toes, some of these issues turned around abruptly and economic headwinds became tailwinds.

This shift in outlook led to an impressive year for stocks that continued during the 4th quarter (Q4). Here’s a roundup of how major markets performed in Q4 and for the year, respectively:

  • Large Cap Stocks – up 8.6% and 31%
  • Small Cap Stocks – up 10% and 26%
  • Developed Foreign Markets – up 7.4% and 22%
  • Emerging Markets – up 11.3% and 17%
  • Core Bonds – flat during Q4 and up 8.6%

Stocks behaved so poorly so quickly in late-2018, that a turnaround was to be expected. The S&P 500, a common benchmark for the US stock market, had declined almost 20%. But the turn of the year was almost like flipping a switch. Stocks surged in January, up almost 8% that month alone and were ultimately up ten months out of twelve in 2019.

Individual investors had been decidedly bearish but eventually began to turn more optimistic. While still far from being exuberantly bullish, investors showed more interest in stocks as the year progressed. Positive headlines about our trade dispute with China helped with this in Q4, even though no major deal was agreed to.

The Fed helped to juice up returns with three rate cuts during the year. The rate-setting body reversed its “hawkish” tone and indicated it won’t raise rates until inflation is significant and persistent. That could be awhile.

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Year-end Topics: Roth Conversions

Roth conversions are one of those planning ideas that make a lot of sense on paper. You take money that’s currently in a regular retirement account like an IRA or 401(k), stick it in your Roth and then viola, it turns into tax free money! Sounds great, right? The problem is that several things have to happen first, such as paying a big tax bill. Nobody likes paying taxes and paying them in advance just cuts against the grain for most people, so that’s usually where the conversation stops.

But since it’s still a great planning idea when used correctly, let’s review some of the situations where it makes sense to convert retirement money to a Roth.

Low income now, high income later – Say you’re retiring at 60 and your Full Retirement Age for Social Security is 67. You’ve planned well and want to live off your non-retirement savings (brokerage accounts, cash at the bank, etc) between now and then while letting your retirement money sit. Since you’re not starting Social Security yet, your only taxable income is from interest and dividends in your brokerage account. Your lifestyle remains the same but on paper your taxable income drops off a cliff.

If you’ve been used to paying taxes on $100K per year of income but now interest and dividends is, say, $15K, you have room to convert the other $85K and stay within what you’re used to paying in taxes. You could even do Roth conversions every year until starting Social Security.

Why would you want to do this? Wouldn’t it be nicer to have an extremely low tax bill for a while? Yes, but the looming issue is that your tax bill would rise once Social Security income starts, and then would rise again a few years later when Required Minimum Distributions (which is taxable) kick in. Roth money isn’t subject to an RMD, so making conversions now when taxable income is lower helps smooth out taxes over time. Depending on account balances, you could convert your regular retirement accounts all the way to $0 and eliminate future RMDs altogether.

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SECURE Act Becomes Law

As you may have heard, right before the end of 2019 the government gave us the SECURE (Setting Every Community Up for Retirement Enhancement) Act. There’s a lot to it, but I’ll try to stick to the high points that are likely the most relevant to you.

No more stretching…

Let’s look at what will probably have a negative impact for many families. If you are planning to leave a retirement account to your kids or grandkids, they will generally no longer be able to take the proceeds over their life expectancies. This was known as “stretching” and allowed non-spouse beneficiaries to slowly withdraw (and pay taxes on) inherited retirement account balances that they didn’t necessarily need right away.

Going forward they’ll have to draw down the balance within ten years, paying taxes at a faster rate than would normally be the case. I recently read that this could generate almost $16 billion in tax revenue for the Treasury over the next ten years. This, at least in part, is how Congress paid for other changes in the new law.

Here are some important details:

1) This doesn’t apply to leaving retirement accounts to your spouse. The surviving spouse simply treats it as their own. This hasn’t changed.

2) The ten-year window doesn’t apply if you have already inherited a retirement account, just newly inherited accounts going forward.

3) If your estate planning documents leave your retirement account to a trust for the benefit of heirs, you should re-evaluate that decision. The reasons have to do with taxes and potentially different stretch provisions available to some types of trusts.

4) If your traditional (non-Roth) retirement account balances are likely to create distributions for your heirs that could cause them to pay higher taxes than you currently do, Roth conversions to prepay their taxes could help.

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Happy Holidays!

As has been my practice over the last few years, I’m taking a brief break from writing these Tuesday morning posts to spend a little more time with family and friends over the Holidays. I’ll be back with another post in early January. There’s a lot to talk about but it will have to wait until then.

I’m still working, of course, so let me know if you have any questions or need any year-end assistance.

Otherwise, we have a lot to be thankful for and this is best celebrated in person. I hope you’re able to spend time in the coming days with the people who are most important to you.

From my family to yours, Merry Christmas and Happy Holidays!


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Year-end Topics: RMDs

There’s a multitude of tasks that financial planners like me focus on as we approach the end of the year. Among them is the complicated issue of Required Minimum Distributions. This is a simple yet potentially thorny issue to contend with, so here’s a rundown of some of the important aspects.

You’ve saved for years and earned a tax deduction on contributions most (or all) of the time along the way, so the tax man eventually wants to generate some revenue. This is why distributions are taxed as ordinary income. Also, forcing minimum distributions from your retirement account is the government’s way of reducing how much you can accumulate tax-free during your lifetime.

The result is that once retirement savers pass age 70, they have to start taking out a required minimum each year. This is a percentage of a retirement account’s value as of the end of the previous year. Initially a modest amount of about 3.6%, the required percentage increases each year as the saver ages. This is based on a table published by the IRS easily found by simply Googling “RMD table”.

But what happens at age 70.5? All that half year means is that you’ll start taking your first RMD in the year that occurs. This leads to confusion. Say someone turns 70 in December and wants to know when to take their first RMD. It’s the following year because that’s when they turn 70.5. Nothing else needs to happen on that date; it’s just a marker.

The following year, and every year after for life, you take your distribution by the end of the calendar year. You can do so monthly, sporadically throughout the year, or all at once at year-end, it doesn’t matter so long as you’ve at least distributed the minimum. And the price of failure is steep – a penalty of 50% of the amount you were supposed to distribute!

Fortunately, the government gives you a pass on messing up the first time. Instead of the year-end deadline, savers have until April 1st of the following year to take their first RMD. The problem with this, however, is that during that second year you’d take two RMDs, the one missed plus the current one, leading to extra income to pay tax on.

All of this leads to some common questions, so I thought I’d answer them below:

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