Spotting Overlooked IRA Opportunities

IRAs hold the bulk of most people’s retirement nest eggs. They are vital to successful retirement. Yet, many people leave a lot of IRA money on the table. They don’t realize the many strategies available to increase the after-tax value of IRAs.

IRAs are deceptive. They seem simple at first, no more complicated than opening an account and making a deposit. In fact, there is a lot more to IRAs, and those who take the time to learn supplement their knowledge will stretch their nest eggs much further. We’ll take a look at the opportunities people miss and mistakes they make with IRAs.

The emergency account fallacy. A number of retirees have enough income and assets outside IRAs that they don’t emphasize IRAs in their planning. They decide to let the IRAs com-pound as long as possible and hope to leave them to their children or grandchildren.

That can be a good strategy with a Roth IRA, but it is a poor use of a traditional IRA. Required minimum distributions must be taken each year after age 70½. That’s going to deplete the IRA and also trigger higher income taxes for you. The RMD income can trigger the stealth taxes on people with higher incomes, including the Medicare premium surtax. Also, when your loved ones inherit the IRA, they’ll have to pay income taxes on distributions they take just as you would. They’re really inheriting only the after-tax value of the IRA.

It’s better to start early thinking strategically about your IRAs. Should you draw down the IRA early and let other assets continue to compound? Or should you convert to a Roth IRA? In past visits we’ve shown how tactically taking spending cash from different sources each year allows you to stay in the 20% tax bracket. You’ll have some long-term capital gains, some ordinary income, and some tax-free Roth IRA income. That reduces lifetime taxes and also reduces the bite from RMDs as the years go on. (See our July 2014 visit for details.)

Thinking conversions are all or nothing decisions. Converting a traditional IRA to a Roth IRA can be a good long-term strategy. You pay taxes now to generate future tax-free income for you and your heirs. We’ve covered the details about the conversion decision in past visits, such as February 2015.

Too often, people believe they have to convert all of a traditional IRA or none of it. The fact is, you can convert any amount, and you can do conversions in as many different years as you want. One good strategy is to convert enough of an IRA each year to keep you from being pushed into the next higher tax bracket. These installment conversions reduce the overall tax cost of the conversion by keeping you from being pushed into the next bracket.

Thinking conversions are a one-time decision. It’s not unusual for someone to con-sider an IRA conversion, conclude that it doesn’t make sense for them, and forget about it. Don’t push the idea aside. Reconsider a conversion any time there is a change in your finances. There might be a year when your income is lower or you have a deductible loss or other increase in tax deductions. These one-time events could be opportunities to convert some of your traditional IRA to a Roth IRA at a low cost. Always be alert for times when a conversion opportunity might have been created.

Once you’ve done a conversion, continue to monitor it. A conversion can be reversed (called a recharacterization) without tax cost up to the day your tax return for the conversion year is due, including extensions. So you have until October 15 the following year to change your mind. One reason you’ll want to reverse a conversion is that the IRA’s value declined significantly after the conversion date, because the conversion tax is calculated as of the IRA’s value on the day of the conversion.

Minimize the damage from RMDs. You have a lot of flexibility when taking RMDs from IRAs. When you have multiple IRAs, you compute the RMDs as though the IRAs were one, and then you can take the RMDs from the IRAs in any ratio you want. You can, for example, use the RMD to rebalance your portfolio by taking it from assets that have appreciated the most. Or an RMD can be a good excuse to get rid of a laggard fund that should have been pruned earlier.

RMDs don’t have to be made in cash. You don’t have to sell an asset you like and distribute cash. Instead, you can have the property distributed to you, count the fair market value on the day of distribution as the RMD, and continue to hold the asset. For example, if you choose to distribute shares of a mutual fund, you instruct the IRA custodian to transfer the shares from your IRA to a taxable account at the custodian. The transfer counts as a distribution. You treat the fair market value as the RMD and that amount now is your tax basis in the shares. In the future you’ll pay capital gains only on any appreciation after that day. 

Taking your RMD in property is a good way to avoid spending RMDs. Too many people think they should spend RMDs instead of reinvesting them. More details about managing RMDs are in our March 2015 visit.

Not using a traditional IRA for charitable gifts. If you plan to make charitable gifts through your estate, it’s a good idea to make them through an IRA. Name the charity as a beneficiary. You can set up a separate IRA with the charity as beneficiary or name the charity as one of the beneficiaries of an IRA, stating a dollar or percentage limit the charity will receive.

Recall that when your loved ones inherit an IRA as beneficiaries, they pay income taxes on distributions just as you would have. They benefit only from the after-tax value. But a charity is tax-exempt. When it receives IRA distributions as a beneficiary, it benefits from the full distribution. Also, when your loved ones inherit non-IRA assets, they generally increase the tax basis to the current fair market value. They can sell the assets right away and not owe capital gains taxes. If you’re going to make bequests, your loved ones are better off if you make the bequests through an IRA.

Not taking RMDs in conversion years. No matter what day during a calendar year you convert a traditional IRA to a Roth IRA, if you’re over age 70½ you have to take the RMD for the year. And the converted amount doesn’t count as your RMD.

Optimize investments for IRAs. The most important investment consideration is the asset allocation. But when you can, pay attention to which assets are held in traditional IRAs and which in other accounts.

Taxable distributions from a traditional IRA are ordinary income. That means if you held stocks or mutual funds for the long term in a traditional IRA, you’re converting long-term capital gains and qualified dividends into ordinary income. When possible, stocks and mutual funds that you plan to own for more than one year should be held in a taxable account or a Roth IRA. A traditional IRA is best for an income-generating investment such as bonds, real estate investment trusts, and preferred stock.

Also, be careful about holding master limited partner-ships, real estate, small businesses, and other nontraditional investments in an IRA. These could incur additional taxes, penalties, or simply inconvenience. Details are available in my report, IRA Investment Guide, available through the Bob’s Library tab on the web site.

Plan for the next generation. Be sure the beneficiary designations on your accounts are reviewed every year or two and that they reflect your wishes. Your will doesn’t determine who inherits an IRA. Only the IRA designation form does. And if you name your estate or fail to name a beneficiary, taxes on the IRA could be accelerated.

Also, your heirs also need advice on what they should do with an inherited IRA. We discussed this in detail last month and in the July 2014 visit. There also is a report available in the Bob’s Library tab on the web site, Bob Carlson’s Guide to Inheriting IRAs.

RW June 2015.