Tax Busters

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Two techniques to combat a rising tax environment: Roth IRA conversions and Muni Bonds

Text of Tax Busters

  • 1. TAX BUSTERS 2010 Roth IRA Conversions and Muni BondsReducing Uncertainty Leon LaBrecque, JD, CPA, CFP, CFA

2. Why Tax-Busters? Nightmare on C Street: Lame Duck Congress 20 Bills Three possible scenarios Extension Amendment Expiration 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 2 3. Lame Ducks Defense authorization bill DREAM act for illegal immigrant Extension of unemployment Freeze on Medicare reimbursements Renewable energy standard START Arms Treaty EPA carbon emissions Oh yeah, taxes10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 3 4. Tax Expiration & Health Care Bill = ??? Expiration of tax cutsraises all rates 2013 add 3.8% surtaxon interest,dividends, capitalgains to upperbrackets Over $250K MAGI forMFJ Over $200K MAGI forSingle 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 4 5. Tax Busting Strategies Higher Brackets affect: IRA and 401(k)distributions Investment income ontaxable accounts Roth conversions: No income tax oninvestment return No RMD Michigan muni bonds Federal tax freeTAXBUSTERS Michigan tax free10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 5 6. Roth IRAs Three types of IRAs: Deductible (contributions and earnings are tax-deferred) Nondeductible (earnings are tax-deferred) Roth (income is tax-free) Roth, Roth 401(k) (DRAC) Roth qualifying distributions are tax-free 5 years or age 59 , or Death, disability, qualifying special purpose distribution 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 6 7. Roth Basics No Required Minimum Distributions (age 70 ) Conventional IRA investment choices (virtually unlimited) Qualifying Roth distributions excluded from: Computation of taxation of Social Security benefits Medicare Part B premium (need based calculation) FIFO withdrawals Earned income requirement for contributions Not included in MAGI for Health Care UIMC10/14/2010 Copyright 2010, All Rights Reserved.LJPR, LLC 7 8. Contributions Lesser of earned income or: $5,000 (under age 50) $6,000 (turning 50 or older in year of contribution) AGI Limits MFJ: $166,000 - $176,000 (phase out) Single: $105,000 - $120,000 (phase out) AGI Limit Loophole: Nondeductible IRA for 2009 and 2010, then convert (Aggregation rule) Rollovers from 401(k), 403(b) and 457 allowed10/14/2010 Copyright 2010, All Rights Reserved.LJPR, LLC 8 9. Conversions Existing Traditional IRAs can be converted to a Roth IRA by paying the tax on the fair market value of the taxable portion. Job Bill now allows internal 401(k) conversion Beware of tax bracket creep. Conversions can be recharacterized (so can contributions) 2010 conversions have no income limit 2010 conversions have two tax options: Pay all tax in 2010 Split income equally between 2011 and 2012 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 9 10. To Split or Not to Split? Splitting is automatic: you have to split income on Roth conversions in 2010 unless you elect otherwise by paying the tax. One spouse can split, one can pay in 2010 If your income and rates stay the same, you save taxes by splitting. Example: Married Couple over 65, standard deduction. They have income in 2010 of $89,900 before any Roth conversion. They convert $300,000 in 2010. They can elect to pay the entire tax on the conversion in 2010, which would be $93,219. Otherwise, they would split the taxes over 2011 and 2012 and pay $40,380 in each year. This saves $12,459 in taxes, plus the time value of money, since they pay no taxes on the conversion in 2010, and spread the $40,380 over the next two years. 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 10 11. Recharacterization Tax Mulligan. You can reverse a conversion byputting the funds back into the Traditional IRA. Can recharacterize once a year (30 day rule), perRoth conversion. Timeline for recharacterization: 10/17/11 for 2010 conversions if return is timely filed or extended; 04/15/11 for 2010 conversions if return is filed late and not extended.10/14/2010 Copyright 2010, All Rights Reserved.LJPR, LLC 11 12. Who Should Convert? Taxpayer in the same or higher bracket at distribution time: Other income sources RMD considerations Taxpayers Heirs Spouse (RMD and filing status) Children and grandchildren Estate Tax situation Unneeded RMDs (must be taken before conversion)10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 12 13. RMDs Roth IRAs are not subject to RMDs. RMD calculation has a decreasing denominator. RMDs shift the taxpayers bracket higher if the rate of return is higher than the initial withdrawal rate. RMDs, if unneeded, are merely a tax burden at the highest marginal bracket.10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 13 14. The Unneeded RMD Conversion You must take an RMD before conversion This strategy used the remaining unneeded RMD to pay the taxes on a Roth conversion $585,000$57,011IRARoth IRA$23,684 $6,951$16,733 RMD taxnetNote: In the second year, given 7.5% growth, the Regular IRA would bedown to $546,403, and the Roth would be up to about $61,000. 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 14 15. Higher Brackets Taxpayers can be in a higher bracket by virtue of RMDs. The death of a spouse leaves the other in the higher single bracket. Example: Older couple, C&D, over 70 , same age. Have income consisting of primarily IRA distributions from their rollover IRAs, plus Social Security. Income for both with Social Security is about $156,000. They take standard deduction. Total Federal tax is $26,687. C dies, D loses Cs Social Security of $15,000 (taxable portion). Ds income drops to $141,000. However, now she is single (lower standard deduction, one less exemption and higher bracket). Her tax would go up to $30,571; $3,887 more. Roth conversion helps the surviving spouse.10/14/2010 Copyright 2010, All Rights Reserved.LJPR, LLC 15 16. Higher Brackets: Kids Another scenario is a parent in a low bracket with successful kids in a higher bracket. Example: mom or dad with basic pension and Social Security. RMDs are unneeded and also are forcing the Social Security to be taxed (possible Medicare B premium as well). Kids are in high brackets. Convert and reduce taxes, plus pass tax-free annuity to kids. Dont forget grandkids (and dont forget GST). 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 16 17. Estate Tax Current estate tax situation requires a food taster for the well-off. (No tax in 2010, then $1M and 55% in 2011). Probable outcome is a $3.5M exclusion and 45% rate (possible $5M and 35%). Roth conversion reduces estate taxes by the income tax paid on the conversion. 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 17 18. Estate Tax Example Bill has an estate worth $4M, of which $1M is in an IRA. He dies (and estate exclusion goes to $3.5M), leaving estate to kids. Kids pay $225,000 of estate taxes and will pay income taxes on the $1M IRA (with a prospective income tax deduction of IRD of $225k). If he converts IRA to Roth, he pays $350,000 in income taxes. Estate taxes are only $67,500 and kids get $1M Roth IRA tax-free. $531,900 total taxes (if kids are in upper bracket) on traditional IRA, versus $417,500 with Roth conversion. 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 18 19. More Estate Issues Roth conversion provides a tax-free annuity for children or grandchildren. GST could be minimized or eliminated with an IRA trust Accumulation Trust Income Trust Formula in Trust Charity illogical QDOT 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 19 20. Segregated Roth Conversions Multiple Mulligan opportunities by converting multiple Roths. Recharacterization can only be done once a year, so having multiple Roth IRAs allows for selective recharacterization. Vertical segregation would allow asset picking Individual securities Asset classes10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 20 21. Conversion Example 02/03/10 12/10/10Traditional IRA280,000 Roth Roth ConversionConversion IRA IRA 308,000One Roth worth $308,000No recharacterization, tax on $280,000. $28,000 tax-free gain10/14/2010 Copyright 2010, All Rights Reserved.LJPR, LLC 21 22. Segregated Example02/03/10 12/10/10 EM EMITraditional IRA $34,000 $25,200280,000LC IGFSCLCIGF SC $42,000 $28,000 $42,000 $51,000$29,400$52,000GFIILCFHY GFI ILC FHY $28,000 $42,000 $28,000 $29,400$52,000$33,000 EM EMIEM EMI $42,000 $28,000 $34,000 $25,2006 Roth's worth$ 248,800, 2 recharacterizations, 10/14/2010tax on $210,000. $38,800 tax-free gainCopyright 2010, All Rights Reserved.LJPR, LLC 22 23. What Can Go Wrong? Congress could eventually tax Roth IRAs Necessity of proactive law Income tax VAT or excise tax would tax distributions (andeverything else) on consumption. Congress could prohibit or limit conversions. 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 23 24. Michigan Muni Bonds Muni bonds are tax-free Federal and state (if Michigan bonds) Types of munis General obligation (GO), secured by tax revenues Limited Tax GO Unlimited tax GO Revenue, secured by revenue stream, like sewer and water Private-use provide a service with a private function,riskier Insured, Principal and interest guaranteed by an insurer(junk question)10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 24 25. Taxable Equivalent Yield Since munis are tax-free, their yield can be measured against a taxable investment using a formula. TEY = [i/(1-t)], where i is the bonds yield, and t is the tax rate So for a low bracket taxpayer (15% fed/4.35% MI), a 4% MI muni might have a TEY of 4.96% High bracket (35% fed/4.35% MI, TEY might be 6.53% Health Care Act and tax increases, maximum fed and Michigan rate goes to about 46%, and the TEY on a 4% bond is 7.31% 10/14/2010 Copyright 2010, All Rights Reserved. LJPR, LLC 25 26. Overpricing of Risk Wall Street is pricing all of M