Estate Planning: How To Get Started
Proper estate planning can help to increase the size of your estate, whether large or small. Its basic purposes are to (1) choose how your property will be distributed after your death, (2) help assure that your property will be distributed in an orderly and efficient way and (3) minimize taxes.
This Financial Guide gives you a road map to the estate planning process. It will help you to get started: to provide for your heirs, to lessen the administrative burden on your survivors, and to understand what you'll have to do to minimize estate and income taxes. It will enable you to approach your attorney and other professional advisors with a clearer idea of what the process should entail.
What is your "estate"? Simply stated, it includes everything you own at your death minus your debts. However, some rather tricky rules apply, which may bring back into your estate assets you've given away, or thought you'd given away.
Most estates do not need to pay the federal estate tax, in many cases because you can leave an unlimited amount to a surviving spouse without having it being subjected to federal estate tax (i.e., the bequest provides a marital deduction). And in 2010, the estate tax was repealed--but just for that year. In 2014, there is an exemption of $5,340,000 (up from $5,250,000 in 2013) per individual before the federal estate tax kicks in. State inheritance taxes, which vary from state to state, must also be considered in addition to federal estate tax.
In addition to the two primary estate planning tools, wills and trusts, there are other essential tools you should consider such as:
- The post-mortem letter to your spouse and survivors,
- Living wills,
- Life insurance,
- Lifetime gifts, and
- Powers of attorney.
The 2001 Tax Relief Act repeals the federal estate tax in one of the most confusing tax measures ever enacted. The law reduces the overall estate tax burden over the years 2002-2009, until it was repealed in 2010, and then re-instated on January 1, 2011. This revival of the estate tax came about because of a sunset provision that voids all provisions of the 2001 Act, effective 1/1/11. The sunset provision was considered a practical necessity under the parliamentary moves-limited Senate debate and amendments-adopted to put the 2001 Act on a fast track to enactment. There have been other tax sunsets, with less sweeping consequences. As a result, the federal estate tax was repealed only for those dying during the calendar year 2010.
States had death taxes long before there was a federal estate tax, but today, many state death taxes are loosely based on the federal estate tax model. In some cases, the amount subject to the state death tax falls as the amount subject to federal estate tax falls (absent further state action. In other states, death taxes are independent of the federal tax and apply whether or not a federal tax applies. Maine and Connecticut, for example all have exemptions of $2 million, and New York, Maryland, Oregon, and the District of Columbia have exemptions of $1 million, whereas the basic exclusion amount for federal estate tax is $5,340,000 in 2014.
Gift tax. The lifetime gift tax exemption is $5,340,000 ($10.68 million joint) in 2014.
Gifts (apart from the annual exclusion of $14,000 per donee in 2014 (same as 2013) are applied against the $5,340,000 exemption so that gift tax is due when their total exceeds $5,340,000. If estate tax is still in existence when the donor dies, the estate will include prior taxed gifts and prior untaxed gifts counted against the $5,340,000 exemption. If an estate tax results because the estate at death plus these prior gifts exceeds the estate tax exclusion amount applicable in the year of death, that tax is reduced by prior gift tax payments.
Some states impose gift taxes.
Caution: Under the estate/gift tax scheme now applicable, gift tax can result in situations where there would be no estate tax if assets of the same value had been held at death. Gifts that bring the gift total above the lifetime exemption should be made only on the specific advice of a tax professional.
Gift tax is continued after estate tax repeal as a device to limit asset transfers designed to avoid income tax.
Income tax after estate tax repeal. Assets acquired upon another person's death usually take a tax basis to the heir equal to the asset's fair market value at date of death. Thus, for example, if a person bought 1,000 shares of stock at $10 a share and died when the shares were worth $50 a share (a $40,000 unrealized gain), his or her heir takes the shares at a total basis of $50,000. The heir can sell the shares for $50,000, free of income (capital gains) tax.
Fair market value basis at death is usually a step up in basis, though the basis is stepped down at death where value has fallen below cost. Basis step up-by which most inherited assets escape most capital gains tax-has been justified as a kind of compensation for the possible exposure of the entire asset (not just the unrealized gain) to estate tax, whether or not estate tax was actually imposed. The theoretical reason for basis step up is reduced if there is no estate tax. Accordingly, in 2010 the basis step up was repealed, but with a major provision that allows a modified step up basis to continue for up to $4,300,000 of appreciation in a decedent's assets (surviving spouse).
Complex estate planning for making use of this surviving basis step up is possible, but your professional adviser's view of the prospects for estate tax repeal should govern whether such planning should be done now.
The will is the foundation of good estate planning and it's critical to obtain competent legal help when drafting a will. A will that is poorly drafted or does not dot every legal "i" and cross every legal "t" can be the cause of endless trouble for your survivors.
Tip: Do not keep original copies of your will in a safe deposit box. Instead, keep them in a fireproof safe at home and give copies to your attorney and your executor as well.
Many people believe they do not need a will, but there are many good reasons, other than saving estate taxes, for having a valid and updated will.
Why You Need a Will
There are five basic reasons to prepare a will:
1. To Choose Beneficiaries. The laws of the state in which you live determine how your property will be distributed if you die without a valid will. For example, in most states the property of a married person with children who dies intestate (i.e., without a will) generally will be distributed one-third to his or her spouse and two-thirds to the children, while the property of an unmarried, childless person who dies intestate generally will be distributed to his or her parents (or siblings if there are no parents). These distributions may be contrary to what you want. In effect, by not having a will, you are allowing the state to choose your beneficiaries. Further, a will allows you to specify not only who will receive the property, but how much each beneficiary will receive. You may also wish to leave property to a charity after your death, and a will may be needed to accomplish this goal.
2. To Minimize Taxes. Many people feel they do not need a will because they believe their taxable estate is below that taxable amount for federal estate tax purposes. However, your taxable estate may be larger than you think. For example, life insurance, qualified retirement plan benefits and IRAs typically pass outside of a will or of estate administration. But these assets are still part of your federal estate and can cause your estate to go over the threshold amount. Also, in some states an estate becomes subject to state death taxes at a point well below the federal threshold. A properly prepared will is necessary to implement estate tax reduction strategies.
Tip: periodically reviewing your estate plan is advisable to take into account the changes in estate and gift tax rules, as well as rules on items that affect the size of the your estate including retirement and education funding plans. Amounts subject to estate tax, and estate and gift tax rates, are scheduled to change periodically in future years.
3. To Appoint a Guardian. Your will should name a guardian for your minor children in the event of your death and/or the death of your spouse. While naming a guardian does not bind either the named guardian or the court, it does indicate your wishes, which courts generally try to accommodate.
4. To Name an Executor. Without a will, you cannot appoint someone you trust to carry out the administration of your estate. If you do not specifically name an executor in a will, a court will appoint someone to handle your estate, perhaps someone you would not have chosen. Obviously, there is an advantage, as well as peace of mind, in selecting an executor you trust.
5. To Establish Domicile. You may wish to firmly establish domicile (permanent legal residence) in a particular state, for tax or other reasons. If you move frequently or own homes in more than one state, each state in which you reside could try to impose death or inheritance taxes at the time of death, possibly subjecting your estate to multiple probate proceedings. To lessen the risk of this, you should execute a will that clearly indicates your intended state of domicile.
You should review your will every two or three years, or whenever your circumstances change. Changes that warrant revising your estate plan might include:
- Having a child,
- Having children move out of the house,
- Acquiring a large asset,
- Selling a large asset, or
- A change in the tax laws.
Today, trusts are not just used by the very wealthy, people with a wide variety of income levels use them as estate planning tools too, despite the fact that trusts are complex and costly to set up and run, and require a higher level of services from an attorney than wills do.
What is a Trust?
A trust owns its own property (holds the title). When it is set up, the trust appears on official papers and records as the legal owner of any property that is placed into it. The trust's principal is the property that the trust owns, as distinguished from the interest or dividends earned by that property. The terms of the trust dictate who will get the benefit of the income from the trust property, how long the trust will last, and so on.
The trustee is the person or entity whose job it is to administer and manage the trust: make investment decisions, pay taxes, make sure the terms of the trust are carried out, and take care of the trust's property. Generally speaking, the trust must pay income tax on any of its undistributed interest or other income.
There are basically two types of trusts:
- An irrevocable trust is a separate entity, for both legal and tax purposes, and pays its own taxes. The irrevocable trust cannot be revoked or changed.
- A revocable trust is not considered a separate entity for tax purposes, although it may be considered a separate legal entity. The revocable trust can be changed or revoked-taken back-by the creator of the trust.
Another way to categorize trusts is the living (or inter vivos) trust, which is set up by a living person, or a testamentary trust, which is created by a will.
What is a Trust Used For?
A trust can be used for many worthwhile purposes:
- Give property to children.
- Reduce estate taxes.
- Leave assets to a spouse.
- Provide for life insurance used to pay estate tax.
Giving property to children. People generally do not want to just give property to a minor child outright because of the financial risks involved (e.g., the child could squander it). Many people give property to a minor through a trust. The trust's terms can be written so that the child does not get outright ownership until he or she has achieved a certain age, so that the child receives only the income from the trust property until that time. Another way to give property to a minor is via the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. These provisions, which apply in most states, provide for a custodianship over property given to a minor.
Reducing estate taxes. As noted earlier, if you leave everything to your spouse, it passes free of federal estate tax. However, when your surviving spouse dies, anything in his or her estate over the exclusion amount (also called "exemption amount") would be subject to estate tax. The exclusion amount for 2014 is $5,340,000. In 2013 it was $5,250,000, in 2012 it was $5,125,00 in 2011, and it was $5,000,000, and there was no limit in 2010. The credit shelter trust, or bypass trust, is used to shelter up to the exclusion amount from the estate tax. Here's a simplified example of how it might work:
Example: Simon and Sylvia have an estate worth $4 million. Simon's will puts $2,000,000 worth of assets in a bypass trust. The ultimate beneficiary of this trust is Simon and Sylvia's daughter. (The beneficiary can be anyone other than Sylvia.) Sylvia is to receive the income from that trust for her life, but her rights in the trust are limited, so that she is not considered the owner. The rest of Simon's estate ($2,000,000) is left to Sylvia in his will.
Assuming Simon dies in 2012, the $2,000,000 in the bypass trust is sheltered by his estate tax exemption. The $2,000,000 that goes to Sylvia is deducted from the estate because of the marital deduction. Thus, on Simon's death, the federal estate tax due is zero. When Sylvia dies, her estate will include only the $2,000,000 (if she still has it), plus any other assets she has accumulated. It will not include the $2,000,000 put into the bypass trust, which will be exempt from tax because of the $2,000,000 estate tax exemption.
Thus, the federal estate tax on Sylvia will apply only to her assets in excess of $5,3400,000. Result: The family has sheltered assets worth $4 million from estate tax in the Simon/Sylvia generation. Without the bypass trust, the estate tax would have applied to an additional $2,000,000 of the estate.
Caution: Wills may be drafted to leave a bypass trust an amount equal to the exclusion amount in the year of death, rather than a specific dollar amount. However, because amounts change, review of the estate plan may be needed to keep the desired balance between what the spouse is to get and what trust beneficiaries are to get.
Leaving an asset to a spouse. The marital deduction trust allows the first spouse to die to place estate assets in a trust for the surviving spouse, instead of leaving them to him or her outright. If the legal requirements are met, the estate gets the marital deduction, but can still preserve assets for heirs other than the surviving spouse. Typically, the income of such trusts will go to the surviving spouse for life and the principal will go to children. All of the income must go to the surviving spouse for the trust to qualify for the marital deduction. It must be paid out at least once a year. The spouse may have some access to the principal. When the second spouse dies, the property is included in his or her estate for estate tax purposes.
Pay estate tax. Complex and expensive arrangements, life insurance trusts are usually used to finance future estate taxes on an estate that contains a business interest or real estate.
Does anyone but you know where your tax records and supporting tax documents are located? How about deeds, titles, wills, insurance papers? Does anyone know who your accountant is? Your lawyer? Your broker? If you pass away without leaving your heirs this information, it will cause a lot of headaches. Worse than that, part of your estate may have to be spent in needless taxes, claims, or expenses because the information is missing.
The post-mortem letter is an often overlooked estate planning tool. It tells your executors and survivors what they need to know to maximize your estate-the location of assets, records, and contacts. Without the post-mortem letter, you risk losing part of your estate's assets because necessary documentation cannot be located.
Related Guide: Please see the Financial Guide: POST-MORTEM LETTER: How To Prepare It And What To Include.
A living will, sometimes called a health care proxy, makes known your wishes as to what medical treatment or measures you want to have if you become incapacitated and unable to make the decision yourself. It tells family and physicians whether you want to be kept alive through mechanical means or whether you would prefer not to have such means used. If there is no living will, this decision is left up to the family, or the physicians, to decide. Stating your preference in a living will can take some of the burden off family members and decrease the stress in an emergency.
The main purpose of life insurance is to provide for the welfare of survivors. But life insurance can also serve as an estate planning tool. For example, it can be used to finance the payment of future estate taxes or to finance a buy-out of a deceased's interest in a business. It can also be used to pay funeral and final expenses and debts.
Tip: If the decedent owns the policy, the proceeds will be included in the estate and subject to estate tax. However, if the decedent gives away all incidents of ownership in the policy, and names a beneficiary other than the estate, the proceeds will not be included in the estate.
Related Guide: Please see the Financial Guide: LIFE INSURANCE: How Much And What Kind To Buy
The disclaimer is a way for an heir to refuse all or part of property that would otherwise pass to him or her, via will, intestacy laws, or by operation of law. An effective disclaimer passes the property to the next beneficiary in line.
Tip: With a properly drawn disclaimer, the property is treated as if it had passed directly from the decedent to the next-in-line beneficiary. This may save thousands of dollars in estate taxes. The provision for a disclaimer in a will and the wise use of a disclaimer allows intra-family income shifting for maximum use of the estate tax marital deduction, the unified credit, and the lower income tax brackets.
Tip: Disclaimers can also be used to provide for financial contingencies. For example, a beneficiary can disclaim an interest if someone else is in need of funds.
The annual gift tax exclusion provides a simple, effective way of cutting estate taxes and shifting income. You can make annual gifts in 2014 of up to $14,000 ($28,000 for a married couple) to as many donees as you desire. The $14,000 is excluded from the federal gift tax, so that you will not incur gift tax liability. Further, each $14,000 you give away during your lifetime reduces your estate for federal estate tax purposes.
- Army and Air Force Mutual Aid Association (www.aafmaa.com)
An organization that provides information on officers' benefits and estate planning
- Navy Mutual Aid Association (www.navymutual.org)
This veterans' benefit organization provides information for Navy, Marine Corps, Coast Guard, Public Health, and NOAA personnel
- These publications contain estate planning tips for military personnel:
- National Guard Almanac
- Reserve Forces Almanac
- Retired Military Almanac
- Uniformed Services Almanac (Active Duty)
Post-Mortem Letter: How To Prepare It and What To Include
The post-mortem letter, a simple and practical estate planning tool you can put together yourself, can protect your estate, maximize the amount available to heirs and save your spouse and executors a lot of trouble. This important letter tells your executor and survivors where to locate everything they need to carry out your instructions.
Does anyone other than yourself know where your tax records and supporting tax documents are located? How about deeds, titles, wills, insurance papers? Does anyone know who your accountant is? Your lawyer? Your broker? Your financial planner? Your insurance agent? If you pass away without leaving your heirs this information, it will cause a lot of headaches. Worse than that, part of your estate may have to be spent in needless taxes, claims, or expenses because the information is missing.
Related Guide: Please see the Financial Guide: ESTATE PLANNING: How To Get Started
The post-mortem letter is an often overlooked estate planning tool. Tell your executors and survivors what they need to know to maximize your estate-the location of assets, records, and contacts. Without the post-mortem letter, you risk losing part of your estate's assets because necessary assets and documentation cannot be located.
Related Guide: Please see the Financial Guide: DEATH OF A SPOUSE: Financial Steps You Should Take
A post-mortem letter provides executors and survivors with the location of assets, the identity of professionals consulted by you during life, and the location of important records. And while its inclusion in your estate plan is optional, it is often a very helpful document to have during an especially stressful time.
To represent you after your death, your executor must know almost everything you know. He or she must have all of the facts, figures, and proof that you have at your fingertips. This is where the post-mortem letter is most helpful. Only with the aid of this information can the executor carry out your desires.
The post-mortem letter also serves to inform your loved ones of things you would like done in the event of your death and guidance as to how you would like certain items handled. This includes many things which may not be appropriate to include in your will or which need to be handled immediately after death and prior to a reading of your will.
The post-mortem letter cannot be used in place of a properly executed will and does not have the legal force of a will. Similarly, it does not take the place of a living will. The post-mortem letter is designed to convey instructions after your death, as opposed to after a life-threatening injury. It is vital to have both a will and a living will in addition to a post-mortem letter.
Write the post-mortem letter now. Leave several copies of the letter in places where it is certain to be found after your death--for example, attached to your will, in your desk, with your spouse, with your attorney, with your executor, and/or in a safe deposit box.
If you do not want the information in the letter revealed before your death, leave the letter sealed.
Do not leave the only copy of your post-mortem letter in your safe deposit box. It may never be found or may be inaccessible after death.
Caution: It is extremely important that instructions be left with the survivors that none of your papers are to be thrown away until the matter is discussed with your attorney, accountant, or executor. Otherwise your efforts to provide information helpful to your estate may be thwarted.
Tip: It is critical to update the letter periodically to account for changes that occur after you write it.
The following items should be included in the post-mortem letter.
- Notify your employer (remember to include phone numbers).
- Notify certain friends and relatives (provide a list with phone numbers).
- If you have volunteered as an organ donor, provide the information necessary for your family to act on your wishes.
- Notify the Social Security Administration (include your social security number for convenience).
- List of names and contact numbers for an accountant, attorney, financial planner, and insurance agents.
- List of club memberships.
- Any instructions on the care of pets.
Location of Your Will
The location of your final executed will should be mentioned, along with any copies.
Caution: Do not leave a will in a safe deposit box. Safe deposit boxes are sealed on the death of the decedent in many states; this will cause headaches and delay.
Guardians of Children
The names and addresses of guardians for minor children in case they are orphaned should be mentioned in your will. These should also be included in the letter.
Funeral Arrangements and Cemetery Plot
If you have made arrangements for funeral services or have established a pre-need funeral trust, provide details in the letter. The location of your cemetery plot and the location of the deed or certificate relating to the burial plot should be mentioned. Any specific instructions for the executor relating to burial should be mentioned in the letter.
Related Guide: Please see the Financial Guide: FUNERALS: What To Do At This Stressful Time
Tip: For the reasons mentioned above under "Location of Will," do not leave the cemetery plot deed or certificate in a safe deposit box.
Safe Deposit Boxes
The location of safe deposit boxes, the contents, along with the location of keys, passwords, and combinations, should be mentioned. The letter should indicate whether anyone else has access to the boxes.
Tip: If other people have access, ask the executor to take inventory of the box before anyone else is allowed to take items out of the box.
If you have rented a post office box, include the number, location of the box and location of the key.
Bank, Checking, and Credit Card Accounts
All checking and savings accounts and their account numbers should be mentioned. Instruct the executor whether a stop should be placed on withdrawals from these accounts, and whether anyone else has the right to withdraw from them, whether as a co-depositor or under a power of attorney.
Describe where your current and past checkbooks and canceled checks can be found. These may save the estate from having to pay a claim or expense that has already been paid, and can establish the cost of an asset.
Tip: Be sure to mention any accounts that are not in your name, such as deposits in a Swiss numbered account. Otherwise, these accounts may be lost because no one knows about them.
Tip: Keep savings accounts active by periodically sending a request for the balance in writing, or by making deposits. Inactive accounts that are left for a certain period may revert to the state.
A list of credit card accounts and numbers should be included. The executor should be instructed to cancel credit card accounts immediately, and to change joint accounts to single accounts.
Provide information on any outstanding debts. Some loans such as student loans and home mortgages may have an insurance feature which cancels the debt in the event of your death. In the case of student loans, this was often paid for in the form of a fee at the amount the loan was disbursed and many people are unaware of this feature. Examine your loan documents for any such features and detail them in your letter.
The location of copies of your income-tax returns going back as far as possible should be mentioned.
The location of copies of any gift-tax returns filed at any time should also be mentioned. If copies cannot be located, your memory of when and where the gift tax returns were filed, and the gift to which they related, should be mentioned. If there are any refund claims pending, or if you feel a refund should be filed for, mention these as well.
Attorneys and Other Professionals
Mention the names and addresses of any professionals associated with your affairs, or who could be of assistance to the executor. Include accountants, attorneys, insurance agents, financial advisors, bank officers, realtors, and brokers. If you relied heavily on these people, they could save your estate plenty of money and trouble just by answering a few of the executor's questions.
Tip: Also mention your physician, since your executor may need help in proving you were mentally competent.
Mention all life insurance policies owned, with the policy numbers. Give the location of the policies. Do not neglect to mention employer-provided group insurance.
All property, liability, malpractice, business continuation, and other types of insurance policies should be mentioned. These policies may save the estate from having to pay a claim, and may also contain the location and description of properties. Further, access to these policies may allow the estate to obtain reimbursement for expenses incurred immediately prior to death.
Tip: Mention policies that have lapsed, since they may still have some value.
List all assets you own, and give the location of deeds and titles. Include personal and real property.
Tip: If you know of a market for some of your assets that might otherwise be difficult to sell (e.g., a special collection or unique asset), tell the executor about it.
Don't neglect to mention property that will not be easy to locate, e.g., property you have loaned out or sold on consignment.
Tip: If there is any reason why the executor should value a piece of property at less than its fair market value, explain why.
List all brokerage accounts and other investment vehicles, such as limited partnerships or interests in real estate.
Give the location of brokers' confirmation slips for purchases of securities going back as far as possible, in order to establish the cost of securities. The cost is your tax basis, which will affect the amount of tax you pay on a sale for securities you may have sold prior to death. The basis of securities held at the time of death will be determined with reference to their current value. If you cannot locate confirmation slips, then at least make a note of transfer dates shown on stock certificates and registered bonds. These dates will allow you to look up the price of the stock.
Provide information on all retirement accounts, including IRAs. Indicate your designated beneficiary and describe where statements are located. In the case of IRAs, provide information on the tax status of the account. In particular if non-deductible contributions were made a portion of the account may not be taxed to the beneficiary.
Provide a list of all prior employers, no matter how long ago you worked for them. You may be entitled to pension benefits or death benefits.
Tell the executor where to find a description of any pension benefits you are entitled to.
Provide the executor with a record of any governmental employment, past or present. For the armed services, include the branch of service, serial number, and approximate dates. You may be entitled to veterans' benefits or survivors' benefits.
Mention the location of your passport and your birth certificate, which may be needed for Social Security benefits and employee retirement plans and specify the location of your marriage certificate, which may be needed in connection with the marital deduction, joint gifts, and statutory spousal rights. A divorce decree will also be necessary, and should be mentioned.
If you received an inheritance from someone, include the name of that person and the date of death. The executor may be able to claim a state or federal estate tax credit for transfers within ten years of your death. Note the location of any letters from the person's executor, if any.
If you have any future rights in someone else's property, whether by will or by trust, include those details.
If you have ever set up a trust or been named as a trust beneficiary, where the trust instrument is located and when the trust was set up.
Money Owed to You
Mention debts owed to you by others and any proof that the debt exists.
- To obtain the free brochure, "Pre-paying Your Funeral" (#D13188) contact the AARP:
- To order free educational materials visit the Federal Trade Commission
- Funeral Consumers Alliance
A nonprofit organization dedicated to protecting a consumer's right to choose a meaningful, dignified, affordable funeral.
- Army and Air Force Mutual Aid Association
An organization that provides information on officers' benefits and estate planning
- Navy Mutual Aid Association
This veterans' benefit organization provides information for Navy, Marine Corps, Coast Guard, Public Health, and NOAA personnel
- These publications contain estate planning tips for military personnel:
- National Guard Almanac
- Reserve Forces Almanac
- Retired Military Almanac
- Uniformed Services Almanac (Active Duty)
Retirement Plan Distributions: When To Take Them
When must you start withdrawing the funds in your retirement plans? And what happens if the funds aren't withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways the savvy taxpayer can maximize the tax shelter.
The basic rule is that you must begin withdrawing funds--and incurring taxes on these withdrawals--no later than April 1 of the year after you turn 70 ½ . This rule exists so that retirement funds will be distributed-whether or not spent-during what for most people is their retirement years.
An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire, if you are still employed when you reach the mandatory withdrawal age. The exception doesn't apply where you're a 5% or more owner of the business that provides the plan, or to withdrawals from traditional IRAs--in those-cases you are subject to the mandatory withdrawal rules.
Related Guide: Roth IRAs are another exception. For a discussion of Roth IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.
Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution--or the smaller the amount you must withdraw-the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets, and the shelter, for the next generation.
The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.
The rules are complex, but here's a general overview of the timing of retirement plan distributions which will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.
Related Guide: The tax treatment will be dictated not only by the timing of the withdrawal (i.e., when to take it) but also by the form of the withdrawal (i.e., how to take it). This Financial Guide discusses the "when." For a discussion of the "how," please see the Financial Guide: RETIREMENT PLAN DISTRIBUTIONS: HOW to Take Them.
Before You Reach Age 70 ½
Until the year you reach 70 ½, you need not take your money out of your retirement account, although your employer's plan might require you to do so. In fact, there will usually be a 10% early-withdrawal penalty if you make withdrawals from an IRA before age 59 ½. Between the ages of 59 ½ and 70 ½ you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.
Once You Reach Age 70 ½
Once you hit 70 ½, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70 ½ say April 1, 2015, if you reach 70 ½ in 2014. But waiting until April 1 means you must withdraw for two years--2014 and 2015 in 2015. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 ½.
IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.
The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy.
Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.
Example: Joe reaches age 70 ½ in October of this year. Retirement plan assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 70 is 27.4. Joe must withdraw $21,898 ($600,000/27.4) this year.
Example: Two years from now Joe is 72 and his IRA was $602,000 at the end of the preceding year (when Joe reached age 71). The IRS number for age 72 is 25.6. Joe must withdraw $23,517 two years hence.
The distribution period in the IRS table in effect assumes distribution over a period based on your life expectancy plus that of a beneficiary 10 years younger than you. (Distribution after your death is based on the actual life span or life expectancy of your actual beneficiary-see "Withdrawal after You Die" below.) Only where your designated beneficiary is a spouse more than 10 years younger than you is his or her actual life expectancy used to figure the withdrawal period during your lifetime. You may use these rules to prolong distribution for 2003 and after, even though you have been taking withdrawals over a shorter period under previous rules.
Under the current rules, the life expectancy of your designated beneficiary (if you have one) is irrelevant in figuring your withdrawal period (except for a beneficiary spouse more than 10 years younger). Thus, you can change your designated beneficiary at will, or replace one who died, without affecting your withdrawal period (except for a change to or from a spouse more than 10 years younger).
Caution: You can always take out money faster than required--and pay tax on these withdrawals. However, the tax code is strict about minimum withdrawals. If you-or your beneficiaries or heirs-fail to take out what's required, a tax penalty will take 50% of what should have been withdrawn but wasn't.
Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where your beneficiary spouse is more than 10 years younger than you). But it's still needed to prolong the distribution during your beneficiary's lifetime, should the beneficiary want that (some will want the money right away).
Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).
The rules as to how fast your beneficiaries or heirs must withdraw funds from your account-and pay the income tax-differ, depending on your beneficiary choice.
Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has options that no other beneficiary has.
Rollover. A spouse-beneficiary of your IRA can elect to treat the balance in your IRA as his or her own IRA (like a rollover). This provides the optimal extension of the withdrawal period if your spouse is younger than you, since your spouse doesn't have to start withdrawing funds until he or she turns 70 ½ . At age 70 ½ , your spouse can then use the period in the IRS table-or a longer one if he or she then has a spouse more than 10 years younger. Rollover isn't allowed if a trust is the beneficiary, even if the spouse is the trust's sole beneficiary. A similar extension is allowed for a balance you might leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse can roll over a distribution from your retirement plan to another retirement plan in which he or she participates, as well as to an IRA.
Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the deceased participant's account. There's no 10% early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59 ½ .
Tip: Leaving the money in your account makes sense if your spouse is under age 59 1/ 2 and needs the money soon after your death.
Tip: If your spouse remains a beneficiary, he or she doesn't have to start withdrawals until you would have reached age 70 ½ -after which withdrawals will be taken under the IRS table. Generally, there will not be an estate tax on retirement plan assets left to a spouse and the spouse will pay income taxes only as funds are withdrawn.
Someone Other Than Your Spouse. A child or other non-spouse beneficiary of an IRA can choose to start withdrawals by the end of the year after your death and spread distributions over his or her own life expectancy. This method extends the payout period and the tax deferral. The life expectancy for a 55-year-old, for example, is 29.6 years.
A non-spouse beneficiary of funds in a retirement plan can elect after 2006 to have the funds rolled to an IRA, and then spread withdrawals as described above.
Tip: The required payout schedules set the minimum that can be withdrawn. The beneficiary can always take out more.
If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child. On the other hand, if you create a separate share or account for each child, the child uses his or her own life expectancy.
No beneficiary. If you die before April 1 after the year you reach age 70 ½ having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed -and income taxes paid-within five to six years of your death. Heirs don't get the option of using their own life expectancy.
If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years to complete withdrawal.
Death before distributions begin. If you should die before the time (age 70 ½) required distributions are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.
Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.
The above discussion covered the general rules as to the withdrawal of retirement plan distributions both before and after you die. Now let's look at some specific tax planning techniques, particularly as regards the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts (including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your heirs.
How Your Heirs Are Taxed
The general rule is that, while there may be an estate tax bite at your death, inherited assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn't apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it's left to charity (more on giving retirement assets to charity below).
Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)
The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:
- On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
- Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
- The value of a stock bonus is taxable when received as ordinary income, less unrealized appreciation and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
- Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
- There's no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59½, but in general, if your spouse is your heir and rolls over your retirement account to his or her IRA, a withdrawal from the IRA while under age 59½ is subject to the penalty.
Some Tax Planning Opportunities
The federal estate tax isn't a major problem for most Americans. Less than 2% of those who die in any year leave an estate that's hit by estate tax. But the larger a taxpayer's retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above.
Unlike the income tax, which is collected only as amounts are distributed--and thus is deferred on annuities and the like--the estate tax is collected up front, at the owner's death, on the present value of the annuity.
One common planning technique-making lifetime gifts to reduce your taxable estate-is impractical for retirement accounts. Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But here are more practical techniques:
Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
A charitable remainder trust is a sophisticated way to benefit family, as well as charity, at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
Consider buying life insurance to pay estate tax that can't be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.
Retirement Plan Distributions: How To Take Them
If you are thinking of retiring soon, you are about to make a major financial decision: how to take distributions from your retirement plan. This Financial Guide will discuss your various options. And, since the tax treatment of these distributions will influence your decision, we will also review the tax rules.
You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has limited your choices. Essentially, you can:
Before discussing the specific withdrawal options, let's consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.
Tax-free withdrawals. If you paid tax on money that went into the plan-that is, if it was made with after-tax funds-that money will come back to you tax-free. Typical examples of after-tax investments are:
Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you withdraw funds before reaching what the law considers a reasonable retirement age-age 59 ½--you usually will face a 10% penalty tax in addition to whatever tax would ordinarily apply.
As with any other tax on withdrawal, the 10% penalty doesn't apply to any part of a withdrawal that would be tax-free as a return of after-tax investment
Now let's review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.
Take Everything in a Lump Sum
You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to take everything out of a company account because you mistrust leaving funds with a former employer or to take control of investment decisions-though here a rollover (discussed later) might be preferred. Maybe you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably available.
Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans, but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the employer may have decided to preclude the lump sum form.
Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum. For most, this relief, in the form of "forward averaging," explained below, came to an end on 12/31/99-meaning that withdrawals taken after that date don't get that relief.
Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal installments over 10 years (for the relief allowed in limited cases after 1999). Forward averaging isn't allowed if any part of the account is or was rolled over to an IRA.
Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to plan participation before 1974. Capital gain may be taken instead of forward averaging and is available after 1999.
It's a "lump sum" if you take out everything left in your account in a single calendar year. If you took $50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took $250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum relief is available only once in a worker's lifetime.
The limited lump sum relief remaining is the result of a Congressional plan to phase out the relief, as it has brought down top tax rates and liberalized rollover rules.
Roll Over The Distribution
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.
Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:
Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:
Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.
Take A Partial Withdrawal
Partial withdrawals are withdrawals that aren't rollovers, annuities or lump sums or don't qualify for lump sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you are still working as well as withdrawals at or after retirement. They may be made for investment or consumption, including education and health care. Because they are partial, the amount not withdrawn continues its tax shelter.
A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.
A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax investment bears to the total retirement account.
Do Some Combination Of The Above
Combination withdrawals are quite complex and beyond the scope of this Financial Guide.
For an overview of how states tax retirement plan withdrawals, see State Taxes On Retirement Plan Distributions.
Life Insurance Options
Here are your typical options where whole life insurance is held for you in a retirement plan:
The tax shelter ends when cash is received. Otherwise, it continues, to some degree.
Assets Withdrawn In Kind
In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment. Exceptions:
The Economics Of Retirement Annuities
Retirement annuity economics are built around the straight life annuity, where the retiree receives a certain amount for life, however long or short that might be. This amount stops at the retiree's death. The cost of such an annuity is computed, and that's the cost the employer is obligated to provide.
However, you may want, or be obliged to take, something other than a straight life annuity, such as:
These types of annuity are worth more than the straight life annuity. But the employer isn't obliged to pay for more than the cost of a straight single life annuity. So if you opt for something other than straight life, the amount you collect each period will be correspondingly reduced to the "actuarial equivalent" of straight life.
Can Creditors Reach Your Retirement Assets
Federal law generally protects your retirement assets or accounts against claims of your creditors so long as the assets remain in the retirement plan, except for unpaid federal taxes. Generally, this protection is in federal labor law (ERISA). Protection denied under labor law is provided under bankruptcy law (if the case is begun after October 16, 2005) to:
State Taxes On Retirement Plan Distributions
With 50 different state tax systems, only an overview is possible on how states tax retirement plan withdrawals. Here are the highlights:
Roth IRAs: How They Work and How To Use Them
Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices--and why YOU might want one, or more.
With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.
With a Roth IRA, there's never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.
The 2014 annual contribution limit to a Roth IRA is $5,500 (same as 2013). An additional "catch-up" contribution of $1,000 (same as 2013) is allowed for persons age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2014 from personal services and have income (modified adjusted gross income or MAGI) below $114,000 if single or $181,000 on a joint return in 2014. The $5,500 limit in 2014 phases out on incomes between $114,000 and $129,000 (single filers) and $181,000 and $191,000 (joint filers). Also, the $5,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.
You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $11,000, up to $11,000 ($5,500 each) can go into the couple's Roth IRAs. As with traditional IRAs, there's a 6% penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.
You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.
Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings as well as contributions and conversion amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:
- At least 5 years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion, since the conversion occurred and
- At least one of these additional conditions is met:
- The owner is age 59 ½.
- The owner is disabled.
- The owner has died (distribution is to estate or heir).
- Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).
Note: A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first time home buyer who is either yourself, your spouse or you or your spouse's child, grandchild, parent or other ancestor.
To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10% tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.
Exceptions. You may not have to pay the 10% additional tax in the following situations:
- You are disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to pay certain qualified first-time homebuyer amounts.
- The distributions are part of a series of substantially equal payments.
- You have significant unreimbursed medical expenses.
- You are paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10% tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10% early distribution tax, even if the contributions have been included as income in an earlier year.
Ordering Rules for Distributions
If you receive a distribution from your Roth IRA that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.
- Regular contributions.
- Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
- Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
- Nontaxable portion.
Disregard rollover contributions from other Roth IRAs for this purpose.
Aggregation (grouping and adding) rules.
Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.
- Add all distributions from all your Roth IRAs during the year together.
- Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
- Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution was made in 2011 and the conversion or rollover contribution was made in 2012, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2012.
Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.
Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.
Example: On October 15, 2007, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 - $20,000) in his gross income. On February 23, 2007, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2007, at age 60, Justin takes a $7,000 distribution from his Roth IRA.
- The first $4,000 of the distribution is a return of Justin's regular contribution and is not includible in his income.
- The next $3,000 of the distribution is not includible in income because it was included previously.
Distributions after Owner's Death
Qualified distributions after the owner's death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn't met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there's no penalty tax on early withdrawal. However, an owner's surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.
Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.
The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were available to taxpayers.
You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.
You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.
- Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
- Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
- Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.
- An annuity plan,
- A tax-sheltered annuity plan (section 403(b) plan),
- A deferred compensation plan of a state or local government (section 457 plan), or
- An IRA.
Note: Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.
Prior to 2008, you could only rollover (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA. A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
Any amount rolled over is subject to the same rules for converting a traditional IRA into a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.
There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there's no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.
Starting in 2010, conversion is now allowed to all taxpayers. The prior income restriction allowing conversion only for taxpayers of income (again, MAGI) of $100,000 or less in the conversion year has been terminated. All taxpayers are able to convert a regular IRA to a Roth IRA starting in 2010. The conversion is a taxable distribution, which can be taken into income in the conversion year or averaged over the next two years. The conversion will not be subject to the 10% early distribution penalty.
Since everyone recognizes that conversion is a high-risk exercise, the law and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a "re-characterization". This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.
Tip: One reason to do this would be where you find you've exceeded the $100,000 income ceiling for Roth IRA conversions.
Tip: Another reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.
Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you're taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.
Can you undo one Roth IRA conversion and then make another one-a reconversion? Yes-once, subject to these requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.
You are not required to take distributions from your Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs
Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.
Also known as the saver's credit, this credit helps low and moderate income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can't be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2014 for a married filer is below $60,000 ($59,000 in 2013). For heads-of-household MAGI is below $45,000 ($44,250 in 2013) and for others (single, married filing separately) it is below $30,000 ($29,550 in 2013). These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10-50% of each dollar placed into a qualified retirement plan up to the first $2,000. The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50% of $2,000).
Note: Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.
The following table details the percentage of Saver's credit based on Adjusted Gross Income (AGI):
2014 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $30,000
more than $45,000
more than $60,000
2013 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $29,500
more than $44,250
more than $59,000
2012 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $28,750
more than $43,125
more than $57,500
Note: The saver's credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until April 15 of the following year and still be considered in the current tax year.
Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund-largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.
Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.
Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.
A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases-a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there's the question whether Roth IRA benefits currently promised will survive into future decades.
Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call us if you have any questions.