Regard Roth conversions carefully, Cont'd (Client Bulletin April 2018)

How it looks in the real world.

 

Example 1:

 

Fred and Glenda Polk would have had $220,000 in taxable income in 2017 without contributing to their employers’ traditional 401(k) plans. However, they contributed a total of $40,000 to the plan, bringing their income down to $180,000. The couple was in the 28% bracket last year, so the income deferral saved a total of $11,200 in tax: 28% times $40,000.

 

Assume they kept their $11,200 of tax savings in the bank. If their employers have a 401(k) plan that offers designated Roth accounts, they could convert the $40,000 they contributed in 2017 to the Roth side if the plans allow such moves.

 

Alternatively, depending on the plan terms and the Polks’ circumstances, they might be able to rollover the $40,000 to a Roth IRA. Yet another possibility, the Polks might leave the $40,000 in their 401(k)s but convert $40,000 of pretax money in their traditional IRAs to Roth IRAs.

 

With any of these strategies, the couple would generate a $9,600 tax bill (24% of $40,000) on the Roth conversion, because their joint income falls into the 24% tax bracket in 2018, in this example. The Polks could pay that $9,600 from their $11,200 of tax savings in 2017 and wind up ahead by $1,600.

 

Therefore, people who move into a lower tax bracket this year might be able to come out ahead with Roth conversions of income that had been deferred at a higher tax rate. Going forward, the money transferred to the Roth side may generate tax free rather than taxable distributions.

 

One-way street

 

Nevertheless, there are reasons to be cautious about Roth conversions now. For instance, U.S. stocks are trading at lofty levels. Roth conversions could be highly taxed at today’s equity values.

 

Example 2:

 

Heidi Morris has $300,000 in her traditional IRA, all of which is pre-tax. Investing heavily in stocks, Heidi has seen her contributions grow sharply over the years. With an estimated $100,000 in taxable income this year, Heidi calculates she can convert $50,000 of her traditional IRA to a Roth IRA in 2018 and still remain in the 24% tax bracket.

 

However, stocks could fall heavily, as they have in previous bear markets. The $50,000 that Heidi moves to a Roth IRA could drop to $40,000, $30,000, or even $25,000. Heidi would not want to owe tax on a $50,000 Roth conversion if she holds only $25,000 worth of assets in the account.

 

Under previous law, Heidi had a hedge against such pullbacks, at least for Roth IRA conversions. These conversions could be recharacterized (reversed) to her traditional IRA, in part or in full, until October 15 of the following calendar year. In our example, Heidi could have recharacterized after a market setback, avoided a tax bill, and subsequently re-converted at the lower value. (Timing restrictions applied.)

 

Such tactics are no longer possible because the TCJA has abolished recharacterizations of Roth IRA conversions. (Conversions to employer-sponsored Roth accounts could never be recharacterized.) Now moving pre-tax money to the Roth side is permanent, so the resulting tax bill is locked in.

In the new environment, it may make sense to take it slowly on Roth conversions in 2018.

 

If stocks rise, boosting the value of your traditional retirement accounts that hold equities, you won’t be sorry about the increase in your net worth; you can convert late in the year at today’s lower tax rate. On the other hand, if periodic corrections occur, they could be an opportunity for executing a Roth conversion at a lower value and a lower tax cost.

Risks of Bond Funds, Con't (CPA Client Bulletin- March 2018)

Reducing the Risks

The aforementioned risks can be mitigated by an adept selection of bond funds. To reduce credit risk, look for funds holding bonds from creditworthy issuers.

           

For instance, bonds issued by the U.S. Treasury have scant risk of default. Corporate bonds are rated by private agencies and those from financially sound companies are considered “investment grade.” Standard & Poor’s, one such agency, gives AAA, AA, A, or BBB ratings to companies considered to have low credit risk.

           

Bonds with lower ratings or no ratings at all are judged to have more credit risk. The term “junk bonds” may be applied to such issues, although they also may be known as “high yield” bonds because they must offer relatively robust payouts to attract investors. Online, you can see the ratings of the bonds held by various funds. A fund with average credit quality of AA, for example, would generally have little credit risk.

           

As for interest rate risk, that’s largely determined by whether the bonds in the fund are long- or short-term. In the previous example, suppose Mark buys bonds that mature in one year. An interest rate rise might not drive down the bond price very much. In a year, Mark can redeem his 3% bonds and reinvest in 4% bonds, assuming interest rates hold steady.

           

Conversely, suppose Mark’s bonds won’t mature for 20 years. A buyer would receive his or her $300 annual payout for decades, locking in that scant return. That prospect could reduce the bonds’ market value a great deal. For risk reduction, Mark should look for funds with relatively short maturity bonds.

Two Five-Year Tests for Roth IRAs, Con't (CPA Client Bulletin- March 2018)

Conversion Factors

 

Example 2: 

 

In 2018, Jim Bradley, age 41, leaves his job and rolls $60,000 from his 401(k) account to a traditional IRA, maintaining the tax deferral. If Jim decides to withdraw $20,000 next year, at age 42, he would owe income tax on that $20,000 plus a 10% ($2,000) penalty for an early withdrawal.

           

Instead, in 2019, Jim converts $20,000 from his traditional IRA to a Roth IRA and includes the entire amount converted in income. However, if Jim withdraws that $20,000 in 2019, he also will owe the 10% penalty because he does not meet the five-year rule for conversions; the rationale is that the IRS doesn’t want people to avoid the early withdrawal penalty on traditional IRA distributions by making a Roth conversion.

           

The good news is that, in this example, Jim will have started the five-year clock with his 2019 Roth IRA conversion. Therefore, he can avoid the 10% early withdrawal penalty on the conversion contribution after January 1, 2024, even though he will only be age 47 then. Jim will owe income tax on any withdrawn earnings, though, until he reaches age 59½ or he meets one of the other qualified distribution criteria.

           

Note that various exceptions may allow Jim to avoid the 10% penalty before the end of the five-year period. Altogether, the taxation of any Roth IRA distributions made before five years have passed and before age 59½ can be complex. If you have a Roth IRA, our office can explain the likely tax consequences of any distribution you are considering. Generally, it is better to wait until the age 59½ and five-year tests are passed before making Roth IRA withdrawals, to avoid taxes.

Annuities, Con't (CPA Client Bulletin- February 2018)

Adding certainty

 

Insurers have come up with various methods of addressing these fears. One method is the period certain annuity.

 

Case Study: Marie pays $100,000 for a single life income annuity that includes a 10-year period certain. If Marie lives for 25 years, the insurer will keep sending her checks. However, if Marie dies after 3 years of payments, the annuity will continue for another 7 years to a beneficiary named by Marie.

 

Again, an annuity with this type of guarantee will produce smaller checks than a straight life annuity because the insurer has more risk. Other features may be added to an income annuity, such as access to principal, but all of these variations will reduce the amount of the checks paid to consumers.

           

Annuity taxation can also be complex. If this type of annuity is held in a taxable account, part of each check to Marie will be taxable, but part will be a tax-free return of her investment (see Trusted Advice box.) Eventually, after Marie has received her full investment tax-free, ongoing checks will be fully taxable.

 

Later rather than sooner

 

Some annuities start distributing cash right away, as described, but others are deferred. The deferral could be a wait for some years until an income annuity starts.

Alternatively, there may be some provision for the invested amount to grow untaxed until the payouts start. These annuities may peg growth to a promised interest rate or to results in the financial markets. Often, there is some type of guarantee from the insurer of a minimum return or protection against loss. The manner of future payouts can be left up to the consumer.

 

Case Study: Marie invests her $100,000 in a deferred annuity taxable account. That $100,000 investment might grow over the years. At some point, Marie can “annuitize” the contract using her account balance to fund an income annuity. As mentioned, Marie’s payments then will be part taxable and part an untaxed return of her investment.

 

As an alternative, Marie can avoid annuitizing the contract. Instead, she can withdraw money from her account balance for cash flow when she wants it. Some annuities guarantee certain withdrawal amounts.

 

Annuity withdrawals may be fully taxable, and a 10% penalty also may apply before age 59½. Critics charge that some annuities, especially deferred annuities, can be complex, illiquid, and burdened with high fees. Read the fine print of any annuity before making a commitment.

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