1 Retirement Tax Reduction Report Introduction For many years now, Americans have been plowing money into Qualified Plans like IRA s, 401(k)s, 403(b)s, and the like. They have received a tax deduction for their contributions, enjoyed tax-deferred growth, and in some cases, employers have matched their contributions. These well-intentioned folks are blissfully motoring down on a path towards retirement. What they don t know is that they will soon be clobbered by an out of control freight train known as the IRS. This report will delve into a hypothetical (and very normal) couple, Bob and Amy Smith. Bob and Amy are like many Americans, working hard on their careers and getting ready for their retirement. They want to be financially educated, so they read periodicals like Money magazine, and even peruse the Wall Street Journal from time to time. They follow common sense thinking regarding their retirement planning, and we are going to learn together how that ends up biting them in their backsides when it counts! Bob and Amy are in their mid-60s, and they are ready to retire. Bob has a nice pension, and between that and
2 social security, they have enough income to be comfortable. Their home is paid for, and it s time to relax Bob and Amy s Plan After putting the numbers together, Bob and Amy feel pretty good about their retirement. Their income looks like this: Bob s Pension: $24,000 per year Bob s Social Security: $15,000 per year Amy s Social Security: $9,000 per year Total Income: $48,000 per year Since they don t have any debts, and their home is paid off, they believe that they will be in good shape. If Bob dies before Amy, she receives 100% of his pension. In addition, she would be able to choose the higher Social Security check, so she would lose $9,000 of annual income, and they feel as though this would be sufficient for her. They have about $40,000 in the bank (some in savings and checking and a couple of CD s) and their 401(k) s have around $300,000 in them combined.
3 Bob and Amy see no reason to take money out of their 401(k)s today, and decide that they should continue to defer those accounts for now. After all, they ve read that they do not have to take any distributions until they are 70 ½ years of age. Continued deferral, they ve read, is the best course. As far as Bob and Amy are concerned, this is rainy day money and is a nice cushion for their peace of mind. They figure that they can tap into that money for a nice trip every couple of years, and it can help finance potential long-term care needs down the road. As a final piece of their puzzle, they are NOT interested in leaving a huge inheritance to their 3 children. They simply want any monies left over when they die going to the children in the easiest, most tax-efficient way possible. This money is for them first, and anything left over goes to their children equally. Bob and Amy are both reasonably healthy for their age, and expect to live to an average life expectancy. For Bob, we will assume that he lives to age 85 and for Amy, age 88. Summary: Pension and Social Security Income takes care of their needs.
4 401(k) plans total $300,000 which is rainy day money and will be taken out only when forced by the IRS. $40,000 in the bank for liquid needs. Assets to their 3 children equally after they are gone. Ignorance is Bliss Until You Get Caught! Bob and Amy have made one little, (but very important!) mistake. They have put their 401(k) s out of their minds for now. This will come back to haunt them! Why you ask? After all, isn t this what most people encourage you to do continue to defer your 401(k)? You are correct! Many advisors DO encourage you to continue to defer. Unfortunately, this advice places you in the trap of so-called common sense thinking. And when it comes to your retirement plans, this can become a real problem! Why? Beause when you defer your IRA, 401(k), 403(b), etc., you are growing your accounts in a TAXABLE environment. That means that the bigger they get, the MORE TAX YOU PAY! Let s see how this applies to Bob and Amy. They are both 65, and the table on the next page projects their 401(k) growth and forced distributions as they reach and surpass age 70 ½.
5 (Note: I am NOT illustrating any specific investment this is hypothetical only and designed to help increase your understanding of potential consequences.) Age Beginning 7.00% RMD Required Cumulative Ending Bob Amy Balance Earnings Divisor Distribution Distributions Balance $300,000 $21,000 $0 $0 $321, $321,000 $22,470 $0 $0 $343, $343,470 $24,043 $0 $0 $367, $367,513 $25,726 $0 $0 $393, $393,239 $27,527 $0 $0 $420, $420,766 $29, $15,356 $15,356 $434, $434,863 $30, $16,410 $31,766 $448, $448,893 $31, $17,535 $49,301 $462, $462,781 $32, $18,736 $68,037 $476, $476,439 $33, $20,018 $88,056 $489, $489,772 $34, $21,387 $109,443 $502, $502,668 $35, $22,849 $132,292 $515, $515,007 $36, $24,293 $156,584 $526, $526,764 $36, $25,949 $182,533 $537, $537,689 $37, $27,574 $210,107 $547, $547,753 $38, $29,292 $239,399 $556, $556,804 $38, $31,106 $270,505 $564, $564,674 $39, $33,022 $303,527 $571, $571,180 $39, $35,042 $338,569 $576, $576,120 $40, $37,169 $375,738 $579, $579,280 $40, $39,141 $414,878 $580, $580,689 $40, $41,184 $456,062 $580, $580,153 $40, $43,295 $499,357 $577, $577,469 $40, $45,470 $544,827 $572,422 Total Taxable Distributions: $1,117,249 As you can see, if Bob and Amy live to normal life expectancy, they will end up paying tax on the following distributions: Bob and Amy: $544,827
6 Children: $572,422 Total TAXABLE Distributions: $1,117,249 (OUCH!!!) WOW! Were you expecting that result? Bob, Amy, and their children end up paying tax on $1.1 Million of distributions from an account that started out at $300,000! What do think the tax bill on $1.1 million of taxable distributions is? (A lot!) Did following common sense thinking help them so far? Bob and Amy Learn About Taxes The Hard Way! So Bob and Amy are enjoying retirement, deferring their 401(k) s and paying no debt. They take a couple of trips, play some golf, and generally have a good time. Along comes January of the following year, and they are starting to get their tax information in the mail. They are a little worried about what taxes will look like for them, as this is their first tax return during retirement. Imagine how happy they are to learn that they only owe a little less than $1,000 on their federal 1040 (assuming
7 2006 tax rates with a standard deduction). And they owe nothing to the state! Yessiree, retirement sure is great! In fact, this continues for several years, until Bob and Amy are now 70 ½. We go back to our projection chart and we see that they are forced to withdraw $15,356. No big deal, they figure. How much of an impact can a $15,000 distribution have on their tax bill anyway? An additional $3,600 of federal tax (again assuming 2006 tax rates with standard deduction)! And each year it s only going to get worse! What happened??? Their accountant told them that they were in the 15% tax rate, which would have only added $2,200 to their tax bill. What happened was that their 401(k) distributions INCREASED the tax on their Social Security Income (a very common result). So what does that mean? Not only did they have to pay tax on their 401(k) distributions, they also had to pay tax on more of their Social Security income. Talk about double taxation! And remember, next year, they will be forced to withdraw more from their 401(k) s (Even if they don t want to!). What will that do to next years tax return? And the year after that? And the year after that?
8 You ve got it each year, the tax bill keeps going up! Bob and Amy s Final Kick in the Pants One They ll Never Know Bob and Amy go through life in retirement, still enjoying it, but becoming more and more upset about their rising tax burden. Their accountant tells them: you shouldn t worry about paying some tax, it means you have money! Exactly how is that advice supposed to help their situation??? At some point Bob passes away. Amy hangs on a few more years, but after 60 years of marriage, she quietly joins Bob in the afterlife. Their 3 children stand to inherit the balance of the 401(k) money equally. Unfortunately two mistakes come into play. The first mistake was that their eldest son tragically died from cancer before Amy did. Amy knew that their trust
9 specified that her son s inheritance would go to his children, so she didn t worry about things. She should have worried about the 401(k) s! Why? Because the 401(k) s listed the 3 children as contingent beneficiaries equally. And 401(k) money gets paid out to the listed beneficiaries regardless of what your will or trust says. The only way a retirement plan gets distributed through your will or trust is if the will or trust is listed as the beneficiary. Remember, Bob and Amy s 401(k) s had listed all 3 children equally as contingent (or secondary) beneficiaries. That means that upon Amy s death, the money goes to the children equally. What s the problem? Simple! One child died, how many are left? Answer: Two. So if the money gets distributed equally among the children, how much does each surviving child get? Answer: 50%! How much is left for the children of the eldest child that died before Amy? Answer: $0. Is that what Bob and Amy wanted NO! This is a common problem with beneficiaries. Please take the time to make sure that your beneficiary arrangements will be paid out exactly how you desire.
10 The second mistake is that they died with money in 401(k)s. With almost every single 401(k), a non-spousal beneficiary must distribute the money in a lump sum. This means that the children end up paying tax on their inheritance all at once. Just imagine your tax bill if you had to take out a couple hundred thousand dollars from your IRA in one year! What could Bob and Amy have done instead? They could have rolled over their 401(k) s into self-directed IRAs. This way, they would have had the freedom to continue to invest their portfolios as they desired while providing their children additional options on how they receive their inheritance. For example, with an IRA, the children could set up a stretch in which they only have to withdraw a minimum amount each year (and pay tax on their distribution only) while continuing to defer the balance. Or they could take the money out over a 10-year period if that works best. The point is this IRA s provide more flexibility when it comes to your beneficiaries options. Please don t make
11 the same mistake Bob and Amy did. Get those 401(k) s and 403(b) s moved into IRA s! Potential Solutions This is the area that gets a little tricky. The problem is that no two people are identical. Everyone has a different situation, so a solution for one person may be different than a solution for the next. But I can give you some big picture options that you can consider. You have four alternatives that could potentially be incorporated, depending on your unique circumstances. 1. Tax Deductions Personal 2. Tax Deductions Business 3. Tax Credits 4. Roth Conversions Tax Deductions Personal These represent personal expenses that for some reason or other the government has allowed you to deduct from your personal income. Examples include interest you pay on home
12 loans, medical expenses above a certain level and charitable contributions. Depending on your circumstances, these types of deductions may be a helpful way for you to offset the tax, either partially or in full, of your Qualified Plan distributions. I ve seen cases where charitable planning has eliminated tax on IRA distributions. Other people have used the interest on home loans to reduce tax on IRA distributions. The possibilities are endless it all depends on your unique circumstances. Tax Deductions Business Some people own a business, even into retirement. Even rental homes are a business, and business owners often have several potential deductions. These deductions can be used to offset tax on Qualified Plan distributions. I ve known some people to take money out of their IRA (taxable distribution) and use the money towards repairs on their rental real estate (tax-deductible offset). You name your business, and you can probably figure out a way to use Qualified Plan distributions to pay for a tax-deductible expense.
13 Tax Credits Tax credits (authorized by section 42 of the tax code) are available primarily for people who invest in low-income housing. I personally like the housing for low-income seniors who are much easier on real estate than others. The neat thing about tax credits is that you receive a dollar for dollar reduction of tax on your return. For example, say you withdraw $30,000 from your IRA. In a 25% tax bracket, this costs you $7,500 of tax ($30,000 X 25%). If you had a $7,500 tax credit, your net tax owed would be $0 ($7,500 tax - $7,500 credit). It s just that simple! Roth Conversion We touched on this one before. The benefit of a Roth Conversion is that your IRA goes from a taxable account to a tax-free account from that point on. As a bonus, taxfree distributions from Roth IRA s do NOT count against your Social Security Income for tax purposes. The big downside with a Roth Conversion is that you have to pay income tax on the amount of money you convert in the year you convert.
14 For example, if you convert $100,000 of IRA to Roth IRA this year, then by April 15 th of next year, you have to pay tax on $100,000 of extra income. Now, from that point on, the new Roth IRA is tax-free for the rest of your life, your spouse s life, and your children s lives. Some people will use one of the previous techniques to reduce or eliminate tax on Roth Conversions. Some will pay the price of the tax in order to eliminate tax forever. Again, it all depends on your situation. Conclusion Bob and Amy start out retirement financially comfortable. Unfortunately, they overlooked their 401(k) s and the consequences of continuing to defer the tax. Because they were blissfully ignorant, they got blindsided when the IRS came to collect. If Bob and Amy would have paid more attention, they could have incorporated any combination of potential solutions to reduce, and perhaps even eliminate the tax on their 401(k) plans. Ignorance may be bliss, but it s just not smart! Hopefully, you now know enough not to get caught in the same trap.
15 Here s how you can take the information in this report to help yourself: 1. Start with your own Qualified Plans (401(k), 403(b), IRA, KEOGH, Profit Sharing, etc.) and run a projection on your future taxable distributions. 2. Determine from that analysis if you have a potential tax problem. 3. Figure out a game plan that uses deductions, credits and/or Roth Conversion that allows you to efficiently use your resources to accomplish the desired result. If you believe that having a professional review your circumstances may be helpful, I invite you to complete and return the enclosed Retirement Plan Questionnaire. For those who spend the time to order this report and read through it, I am happy to invest my time to analyze your unique circumstances. What s in it for me? It s pretty simple. For every 10 people who return their Retirement Plan Questionnaire, I find five or six folks that I can help dramatically. Of that five or six, three to four of them are a good fit for my company, and it turns out that I am a good fit for them.
16 So I am willing to invest a little free time up front to find those three to four great people. So why not complete and return your Retirement Plan Questionnaire you never know what you ll learn! I wish you the very best with your planning! David David M. McKay McKay Financial Group 7505 Waters Ave. Suite F5 Savannah, Georgia (912)
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