Retirement Planning Fundamentals - Don't Pay Taxes Now.  Pay Taxes Later.
by James Lange, JD, CPA

IRA owners and 401(k) participants face a staggering array of options regarding their retirement plans. And the choices you make can have a profound effect on your net worth. Futhermore, the Taxpayer Relief Act of 1997 significantly increased the ability of many retirement plan participants to accumulate wealth and reduce taxes.  This article provides guidelines for IRA owners and 401(k) participants to optimize the benefits of their retirement plans.

Always Make Contributions into an Employer Matching Plan

If your employer offers a retirement plan where your contributions are partially or fully matched, then you should always contribute the maximum amount.  Both contributions are tax deferred for federal tax purposes. State and local taxation of retirement contributions vary. You will pay taxes on dividends, interest, capital gains, and appreciation of the invested funds when you begin making withdrawals from the retirement plan.

Normally, participants are provided with a choice of investment vehicles. This choice will often include a family of mutual funds, such as Fidelity or Vanguard funds, and possibly the company’s own stock, if it is publicly traded. While choosing the type of investment is certainly important, it is not as important as the choice to make tax-deferred contributions.

Should You Make Non-Matching Contributions?

In my opinion, the financial goal for the majority retirement of plan participants in their working years should be to accumulate as much wealth as possible in the tax-deferred environment. Most individuals who are employed can make non-matching, tax-deductible contributions to IRAs, 401(k)s, SEPs, Keoghs, SIMPLE plans, 403(b)s, 401(a)s, and other defined contribution plans.  For simplicity, this article refers to all of these plans as Supplemental Retirement Annuities (SRAs).  After you have contributed the maximum amount that will be matched by your employer, I highly recommend making the maximum allowable additional tax-deductible, non-matching contribution that you can afford.  Please keep in mind, however, that age 59½ is usually the earliest time you can access your SRA funds unless you retire or terminate services.

Investing in SRAs is better for long-term wealth accumulation than investing in the after-tax environment.  For example, if you are in the 28 percent tax bracket, then you must earn $1.39 before taxes to accumulate $1.00 after taxes.  After that dollar is invested, you then must pay income taxes on the interest, dividends, and capital gains that are earned on that dollar. To accumulate $1.00 in the before-tax or SRA environment, however, you only have to earn $1.00. In addition, the earnings and accumulations in your account will not be taxed until they are withdrawn. A graphic comparison of the accumulations in a taxable versus a tax-deferred environment is displayed in Exhibit One.

EXHIBIT ONE

Many clients ask if it would be better for them to make SRA contributions or to pay off their mortgage at a faster rate. Under most circumstances, making contributions to the SRA will be the preferred answer, if the goal is to attain the greatest accumulation of dollars in the future. There are two reasons for this recommendation.  First, you have the opportunity to defer income taxes on retirement plan contributions and on your earnings and accumulations. Second, the mortgage interest expense can be deducted on your tax return.

Are Early Withdrawals from a Tax Deferred Plan Ever Appropriate?

There are times when it may be wise to make earlier than required distributions from a tax-deferred plan. One instance is when there will be significant estate taxes, and the plan holds the only funds available to pay the estate taxes after the participant’s death. Under these circumstances, it might be desirable to make a withdrawal, pay the income tax, and give the after-tax proceeds to your beneficiaries. This strategy will, in limited circumstances, be beneficial not only by reducing the amount of the estate, but also by providing the beneficiaries with funds to pay the estate taxes.

Another exception to the goal of accumulating money in the tax-deferred environment is to use the funds to establish a Roth IRA and/or pay the taxes for a Roth IRA conversion. (This subject is discussed later in this article.) Finally, methods of leveraging gifts with second-to-die life insurance policies, grantor retained annuity trusts, family limited partnerships, charitable remainder trusts, and other techniques may be appropriate for wealthy individuals.

What Does the “Required Beginning Date” Mean?

The Required Beginning Date (RBD) refers to the date when the participant must begin to receive annual distributions from his/her retirement accumulations. (Roth IRA are governed by different regulations, see below).  After 1996, the RBD is April 1st of the year following the later of the year in which the participant reaches age 70½ or retires.  You cannot use the date you retire to determine the RBD for an IRA or for funds earned with previous employers.  The minimum withdrawal amount is calculated based on the actuarial life expectancy of the participant and the participant’s named beneficiary.  The older the participant, the larger the minimum distribution amount.  Please note that pre-1987 funds in 403(b) plans are not subject to minimum distributions until age 75.

Taking Distributions from Your Retirement Plan

In general, it is preferable to spend principal from your after-tax investments rather than taking taxable distributions from your IRA account. A graphic comparison of the benefits of spending after-tax savings before pre-tax accumulations follows. (See Exhibit Two.) One possible exception to the general rule, that it is wiser to spend non-IRA assets before IRA assets, is when there are significant capital gains upon sale of after-tax assets. A more thorough explanation of the benefits of spending after-tax savings before retirement accumulations can be found in my article, Maximizing IRA Benefits, published in the September 1997 issue of Financial Planning.

EXHIBIT TWO

If you retire before reaching age 70 ½, you may find that your combined social security, other non-IRA income, and/or spending the principal of non-IRA assets produces enough funds for your living expenses. If this is the case, you should only take the minimum required distribution from your IRA based on the joint life expectancy of you and your named beneficiary. The minimum distribution is calculated by using actuarial life expectancy tables published by the Internal Revenue Service in Publication 590 (subject to revisions).

Let us look at a Minimum Distribution Option (MDO) example for a regular IRA participant who has named his partner as the beneficiary and has one million dollars in his IRA accounts.  Assume that Mr. Wise is age 71 and his partner is 65.  According to the IRS tables, their joint life expectancy is 22.8 years. Their 22.8 year joint life expectancy is used to determine the MDO i.e., $1,000,000 ÷ 22.8 = $43,859.  Thus, the MDO for the first year is $43,859.

There are two different methods for calculating the life expectancies for both the participant and the primary beneficiary: the recalculation method and the term certain method.  Under the term certain method, on each anniversary of the required beginning date, you would subtract one year from your original life expectancy determination.  Under the recalculation method, you recalculate your life expectancy each year. Note that as we age one additional year, our life expectancy decreases, but not by a full year. Using a higher life expectancy will result in a lower minimum required distribution.

Minimum Required Distributions After Your Death

The general rule for a non-spouse beneficiary is that the beneficiary must take distributions at least as rapidly as the deceased participant.  If, however, certain conditions are met and the proper elections have been made, the beneficiary will be able to use his or her own age to determine the required minimum distribution. 

Taxpayer Relief Act of 1997

In August of 1997, the President signed into law new tax legislation, which has had far-reaching implications for retirement plan and estate planning participants.  For some, the legislation is almost too good to be true.  The scope of the changes in the retirement plan area was so broad and so important that it deserved a separate article. I wrote an article titled IRAs After the TRA ‘97--What Hath Congress Roth?, which was published in the May 1998 issue of The Tax Adviser, the most prestigious CPA journal in the country.  Here are some of the more important considerations.

First, the new legislation permanently eliminates both the excess distribution and excess accumulation taxes. Avoiding these taxes was the major reason that some financial planners had recommended withdrawing funds from retirement plans before age 70½.  Since avoiding these two taxes is no longer necessary, there is little motivation to withdraw funds from your retirement plans before you need the money (except for the gifting strategy previously discussed).

Roth IRAs And Roth IRA Conversions

Second, and more importantly, the legislation created a new type of IRA called the Roth IRA. In effect since 1998, you are allowed to make a non-deductible contribution of $2,000 to a Roth IRA if you are single and have an adjusted gross income (AGI) of less than $95,000.  The money will grow tax-free and withdrawals will be tax-free if the funds are held for five years and the IRA owner is age 59½ or older when distributions begin.  In effect, the IRS is taxing the seed, not the harvest.  All income and capital gains earned within the Roth IRA are never taxed.  With regular IRAs, the income and capital gains are only tax-deferred.  Another favorable feature is that Roth IRAs are not subject to the minimum distribution rules that apply to regular IRAs.

The following exhibit shows the accumulations in a deductible IRA versus a Roth IRA.  Please note that we are illustrating the case of a 55-year-old in the 28 percent tax bracket who makes a $2,000 contribution that is invested at 10 percent.  All amounts shown are measured in after-tax dollars.  (See Exhibit Three.) 

EXHIBIT THREE

Of even greater interest to regular IRA owners is the possibility of converting a portion of your existing retirement plan to a Roth IRA.  Although you have to pay income tax on the amount converted, the account grows tax-free after the conversion.

To qualify for a Roth IRA conversion, your adjusted gross income must be less than $100,000. The Roth IRA conversion is something every participant in a retirement plan should seriously consider. A Roth IRA conversion runs contrary to the general principle that it is usually better to postpone the payment of any taxes. In most of the scenarios that we have analyzed, however, the retirement plan participant—and particularly the participant’s heirs—will have more wealth in the long run if the participant makes the Roth IRA conversion on at least a portion of the total retirement plan accumulation.  The huge income tax savings in the future more than offsets the current income tax bite.

Regular IRAs are eligible for the Roth IRA conversion. The general rule to determine whether your retirement plan is eligible for conversion, is that all retirement plans that can be rolled into a regular IRA can be converted to a Roth IRA.  The following chart shows whether your assets will likely be eligible for the Roth IRA conversion.  (See Exhibit Four.) 

EXHIBIT FOUR

RETIREMENT PLAN CONVERSION ELIGIBILITY TO ROTH IRAs, PROBABLE RESULT *
	YES	NO
IRA
CREF OR VANGUARD RETIREMENT ANNUITIES OR GRAS:
STILL WORKING
RETIRED OR SERVICE TERMINATED
TIAA
SUPPLEMENTAL RETIREMENT ANNUITIES (NO EMPLOYER MATCH):
BEFORE 59 1/2 - STILL WORKING
AFTER 59 1/2 - STILL WORKING
RETIRED OR SERVICE TERMINATED
OTHER 403(B), OR 401(A), OR (K) FUNDS - EMPLOYER'S AND MATCHED CONTRIBUTIONS:
STILL WORKING
RETIRED OR SERVICE TERMINATED
NON-EMPLOYER MATCHED PORTION:
BEFORE 59 1/2 - STILL WORKING
AFTER 59 1/2 - STILL WORKING
RETIRED OR SERVICE TERMINATED
*Employers can choose different options regarding "in-service" withdrawals from their Plans.

As an example, assume Mr. Wise is 55 years old and he chooses to make a $100,000 Roth IRA conversion. Mr. Status Quo is in an identical financial position except that he chooses not to make a conversion. Assume both IRA owners have $100,000 of after-tax dollars, they are in the 28 percent tax bracket, and their rate of return is 10 percent.  Exhibit Five shows the amount of after-tax dollars which both would accumulate. 

EXHIBIT FIVE

Now, begin with the previous example and look twenty years into the future. Assume each IRA owner dies at age 75, and they leave their IRAs and their savings account to their 45-year-old child.  Assume the child takes annual distributions from the retirement account.  The first distribution is $48,000 and the subsequent annual distributions are $48,000 increased by an assumed four percent rate of inflation.  The following chart shows the after-tax balances in the funds.  As you can see from Exhibit Six, the differences are staggering. This difference does not take into account the potential estate tax savings of making a Roth IRA conversion.  Had that difference been considered, the results would be even more favorable for making the Roth IRA conversion.

EXHIBIT SIX

There are, however, several potential disadvantages to Roth IRAs and Roth IRA conversions.  The major disadvantage for many individuals is funding the income tax burden caused by the conversion. Another potential disadvantage is the possibility that the participant’s tax rate may decrease after retirement. The Roth IRA conversion also will not be favorable if the intended beneficiary is a charity. Finally, future tax law changes could jeopardize the benefits and might even make the conversion disadvantageous. Nonetheless, Roth IRAs and Roth IRA conversions hold the potential to significantly enhance wealth and reduce taxes. I recommend that you seek professional guidance to determine whether converting would be beneficial to you.

Your Retirement Account’s Beneficiary Designation

If the bulk of your assets are in retirement plans, then the beneficiary designation of your retirement accounts control the disposition of those assets upon your death. It is important to understand that your Will does not control the disposition of those assets. 

Conclusion

Retirees have a wealth of options regarding their retirement plans.  In most situations, the retirement plan participant and beneficiary will be best served by retaining as much money as possible in the tax-deferred environment (except for possibly taking premature distributions under a gifting strategy). Current retirement plan participants who have regular IRAs should consider converting a portion into Roth IRAs. The minimum distribution option will often be the wisest choice for the majority of the funds. Finally, retirement plan participants should also consider establishing a coordinated estate plan which incorporates sophisticated Wills and retirement plan beneficiary designations.

James Lange is a tax attorney and CPA who provides specialized retirement and estate planning services to same sex couples with significant retirement plan accumulations.  He has prepared over 450 simple and complex retirement and estate plans.  These plans include tax-savvy advice, will and trust preparation, and sophisticated beneficiary designations for IRAs and other retirement plans. You can contact Jim by phone at (800) 387-1129, or (412) 521-2732, or by e-mail at admin@outestateplanning.com.