Winning IRA Strategies for 2014
IRAs are among the most valuable assets most of us own, especially after we leave an employer and roll over the 401(k) account to an IRA. For people who spent most of their careers as employees, the principal home and the IRA vie for the most valuable asset. Even small business and rental real estate owners often have substantial sums in IRAs. The amount of money in IRAs is climbing as the population gets older, and most people have more than one IRA.
That’s why it is a shame that the value of most IRAs and other qualified retirement plans isn’t being maximized. IRA wealth is drained by unnecessary taxes and fees and by strategies that are less than optimal.
People don’t focus on the key strategies that can make an IRA more valuable in their lifetimes and beyond. Of course you plan for the IRA to ensure your financial independence, and many people would like to leave at least part of their IRAs to their heirs. Actions you take now can increase or decrease the amount your heirs will receive after taxes.
Resolve this year to adopt at least a few of the strategies that will improve the management and after-tax value of your IRA. (Many of these strategies apply to other qualified retirement plans, such as 401(k)s.) You probably won’t benefit from each of these strategies, but you should consider them and decide which will increase the value of your IRA.
Own the right assets. IRAs have some tax advantages. With traditional IRAs, you might receive a deduction for contributions. Earnings and gains of the IRA compound tax-deferred until they are withdrawn. With the Roth IRA, you receive no upfront tax benefit for contributions. The income and gains compound tax free, and distributions from the Roth generally are tax free.
You pay a price for the tax benefits of the traditional IRA, a price you can think of as a mortgage on the IRA. When money other than nondeductible contributions is withdrawn from the IRA, it is taxed as ordinary income. That means tax-advantaged long-term capital gains and dividends are converted to higher-taxed ordinary income.
You can minimize the negative effects of this conversion by having the IRA own the right assets when possible. My research, which has since been backed by other research, reveals that assets paying ordinary income are best held in IRAs, either a traditional or Roth. These investments include high-yield bonds, real estate investment trusts, and investment grade bonds. Also, stocks, mutual funds, and other investments that tend to be owned for less than one year generate short-term capital gains and are best owned through an IRA. Investments that generate long-term capital gains, such as stocks and mutual funds held for more than one year, should be owned in taxable accounts, as should those that earn qualified dividends.
You also might own nontraditional investment assets, such as real estate, small business interests, gold, and master limited partnerships. There could be tax consequences to owning these investments in IRAs, and some are prohibited in IRAs. Be sure you know the tax rules for investing IRAs before you buy nontraditional assets. You can find details in our November 2013 and December 2013 visits and more details in my report, IRA Investment Guide, available through the Bob’s Library tab on the web site.
Owning assets in the right accounts reduces your tax burden, increasing after-tax wealth for you and your family. Of course, you don’t want to let the tax law dictate your portfolio allocation. For example, if you don’t have enough money outside an IRA to fully fund your desired stock allocation, buy some of the stocks through an IRA. Asset allocation comes first, and tax strategies second.
Practice tax diversification. No one can forecast how the tax code will change over time. Different types of accounts have different tax treatments now, but that could change. Tax rates also could change. You shouldn’t try to predict these changes.
Instead of forecasting one tax outcome and arranging your finances accordingly, it’s safer to have different types of accounts so you won’t be burned completely in any scenario. Try to spread your investments among taxable accounts, traditional IRAs, and Roth IRAs. You might even want to put some money in an annuity if that’s appropriate for you.
Spend accounts in the right order. The order in which you draw down your different accounts affects how long your nest egg lasts, primarily because of the tax law. As a general rule, it’s best to spend taxable accounts first, traditional IRAs and other tax-deferred accounts next, and Roth IRAs last. Spending in this order makes your wealth last a few years longer. This is another issue we discussed in detail in past visits and the details are available on the web site Archive and in my books.
Review your beneficiaries. Most estate planners have horror stories of people who haven’t changed their beneficiaries for decades and have their IRAs going to ex-spouses, siblings instead of their spouses, or deceased relatives. There are some interesting court cases in which ex-wives and other unexpected beneficiaries inherited IRAs because the beneficiary form wasn’t updated.
Other people name their estates or other entities as beneficiaries (or fail to name a beneficiary). Those actions trigger rules that require the IRA to be distributed quickly after they pass away, causing unnecessary tax bills.
Be sure to review your beneficiary forms regularly and any time there is a change in your family. This should be part of a regular estate plan review. In some cases, you’ll want to name a trust as beneficiary, but you’ll have to navigate complicated tax rules to do this effectively. Discuss with your estate planner the effects of choosing different beneficiaries.
Convert to a Roth. Every year, consider whether it makes sense to convert all or part of a traditional IRA into a Roth IRA. We discussed in detail in past visits how to decide, and those discussions are available in the IRA Watch section of the Archive on the members’ web site and in my books. Whether conversion is a good idea for you depends on factors such as the expected rate of return, the difference between your current tax rate and future tax rates, the source of the cash to pay the taxes, whether future required minimum distributions would exceed your spending needs, and more.
Many people find as they get older the required minimum distribution rules generate much higher annual distributions than they need, causing unnecessary tax bills. Converting to a Roth IRA avoids this and allows you to control when taxes are paid.
It could be that most years an IRA conversion doesn’t make sense for you. Yet, one year you might have an unexpected opportunity to make a conversion at low cost when you have a sharp drop in income or a large offsetting deduction. That’s why you review the decision every year. You don’t want to miss an opportunity to create a stream of tax-free income.
Consolidate or split? I’m a big advocate of simplifying your finances, and that often means consolidating your finances at one financial institution and in as few accounts as possible. Many people have multiple IRAs, and simplifying means rolling them over into one IRA when practical.
There are exceptions to every rule. Suppose you have multiple heirs and expect an IRA to be a significant legacy to them. You could name all the heirs as joint beneficiaries of the IRA and let them decide what to do with the account after they inherit. Or you could split the IRA now and name one person as the primary beneficiary of each. If the heirs aren’t likely to agree on how to manage an IRA, you might want to split the IRA now.
Consider charity. When you’re going to leave part of your estate to charity, the most tax efficient way to do that might be to name the charity as a beneficiary of an IRA. When individuals receive distributions from an inherited IRA, they must pay income taxes on the distributions just as the owner would have. The beneficiary receives only the after-tax value of the IRA. But individuals can receive most other types of assets from an estate free of income and capital gains taxes. A charity, on the other hand, doesn’t pay taxes on IRA distributions it receives as a beneficiary. The charity receives the full benefit of its share of the IRA. It’s more tax efficient to make a charitable bequest through an IRA when you can.
Don’t forget catch-up contributions. When you’re still working and making contributions to IRAs, you can make higher catch-up contributions when you’re age 50 or older. In 2013, the maximum contribution for those 50 and over is $6,500, instead of $5,500, for both traditional and Roth IRAs and is unchanged for 2014.
Consider spousal contributions. Generally IRA contributions can be made only to the extent you have earned income from a job or business. There’s an exception for married couples when one spouse has earned income and the other has little or no income. When they file a joint return, contributions to separate IRAs for each spouse can be made up to the maximum. That means a couple age 50 or older can contribute $6,500 to an IRA for each spouse for a total of $13,000, even when only one spouse has a job.
Required distributions. People continue to make mistakes when taking and computing required minimum distributions after age 70½. The IRS has been lax on this in the past but is stepping up its tracking and enforcement. We’ll discuss details of RMDs in next month’s visit.
RW January 2014.
