Pay Now or Pay Later?

As if you didn’t have enough to do around the holiday, add this to your list … start thinking about contributing to your retirement plan, if you haven’t already. You have until April 15^th to make a contribution for 2011, but first you need to figure out what kind of IRA to fund … a traditional or a Roth. Do you take the tax hit now with a Roth or do you pay later with a traditional IRA? First things first -- consider that most people will have somewhat less annual income later in life, when they are done working.  If working years are typically our high income years, then why choose a Roth or convert savings to a Roth when we are working? Why pay a higher tax on retirement dollars now than you will later? 

It may come as a surprise, but there are some situations when it makes sense to go ahead and bite the tax bullet now. If you happen to have a special situation where your income is considerably lower now (or during a working year), then consider a Roth or Roth conversion. Maybe you have excessive business expenses or losses that can be deducted in a year, or perhaps you've had a very low income year due to the slow economy or due to a job loss. Maybe you or your spouse went back to school or stayed home with a baby and the household income has been cut in half … all are good reasons to go with a Roth. 

There is another important consideration. If you believe that the tax brackets and/or tax system will be changed on us, your decision could be much different depending on your expectation. For example, if you feel that tax rates on your retirement dollars will be increased substantially between now and retirement, you might want to hedge your bets and implement a larger Roth allocation into your overall tax strategy. Even if it means you pay some unwanted taxes now, obviously this could help you from paying an even larger tax later. 

It's important to consider a diversified tax strategy as you would a diversified portfolio and to treat each year as a new decision for contributions and/or conversions.  It’s never a one-time solution.

Withdrawals on a traditional IRA are subject to income taxes and, if withdrawn prior to age 59 1/2, may also be subject to a 10% federal penalty.  Contributions to a traditional IRA may be tax-deductible depending on the taxpayer’s income, tax-filing status and other factors.  In a Roth IR, contributions are made after-tax.  The account grows tax-deferred and qualified distributions are tax-free.  Unless certain criteria are met, Roth IRA owners must be 59 ½ or older and have held the IRA for five years before tax-free withdrawals are permitted. 

In a Roth IRA conversion, each converted amount may be subject to its own five-year holding period.  Converting a traditional IRA into a Roth IRA has tax implications.  You should discuss any tax or legal matters with the appropriate professional.

Hold the Check, Please

Many of us will never need to worry about deferring compensation. In fact, the idea of waiting to get paid for work we do now until a year or more in the future would seem ludicrous. But if you're in a position where you're being offered a Nonqualified Deferred Compensation Plan, first count yourself lucky because you're likely a high-paid executive, then take a close look at your options. 

Simply put, deferred compensation is an agreement between an employer and an employee to hold back a portion of earnings for work performed today for payment in the future. Deferred compensation plans are a benefit most commonly offered in executive pay packages. Because the planning and tax implications associated with deferred comp are complex we recommend consulting with your financial advisor before making the decision to sign on. But the following points will help give you a basic understanding.  

Key takeaways from a tax and financial planning perspective: 

• Participation will reduce current taxable income
• Earnings grow tax deferred until distribution
• Consider maxing out 401k savings first; then NQDC, since this will provide the opportunity to save more, potentially filling the gap that can arise between income needed in retirement and income received from 401 (k) plans, pensions and Social Security
• Consider flexible distribution options - either during employment or in retirement. To qualify for a tax advantage, the IRS requires a written agreement stating the specified period of deferral of income.  An election to defer income must be irrevocable and must be made prior to performing the service for which income deferral is sought (Ex: An election to participate for 2012 must be filed in December 2011).            

A big challenge when it comes to saving for retirement is creating alignment between current income needs and saving for the future. If you are eligible to participate in a Nonqualified Deferred Compensation Plan then the next step is to see how this type of retirement savings fits into your overall plan for wealth accumulation and financial independence. 

The good news is that the decision is up to you and there is a great deal of flexibility. Plus, the impact of working now and getting paid later can be invaluable.  Talk with your financial advisor to see if it makes sense for you. 

Note:  Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation.  While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors with RJFS, we are not qualified to render advice on tax matters.  You should discuss tax matters with the appropriate professional.

No Free Lunch – But Maybe a Free Capital Gain?

fThe financial and investment profession is full of acronyms, jargon, and common phrases such as “buy low – sell high” and is “there’s no free lunch when it comes to investing”.  Believe it or not, some things are free in personal finance (and our role is to help you find them) such as the 0% capital gain rate for many taxpayers.  Yes…..0%....and hopefully we don’t have to argue that that is a good rate! 

Single taxpayers with taxable incomes of less than $34,500 and married couples filing jointly with taxable incomes below $69,000 are considered to be in the 10% or 15% marginal bracket.  One of the luxuries of being in the 10% or 15% marginal tax brackets is a 0% capital gain rate through the end of 2012. Those in marginal brackets higher than the 10% and 15% currently are subject to a 15% capital gain rate.   

Here are a few examples of who might benefit from such a rate: 

• Those holding appreciated securities that have been hesitant to sell because of the tax implications.
• Those interested in selling an appreciated security in order to reset the cost basis. (Don’t forget to avoid the wash sale rules)
• Those in higher tax brackets looking to make gifts to relatives that are in lower brackets (say a child that has moved back into their high school bedroom). 

Example:   John and Mary’s son Steven recently graduate and is finding full time employment illusive.  John and Mary expect to help Steven out with expenses for the near future.  John and Mary are in the 28% marginal bracket and Steven (with little income) is in the 10% marginal bracket.  John and Mary can gift Steven appreciated securities….Steven can then sell them and take advantage of the 0% capital gain rate. 

As always, work with your professional advisors before implementing any tax strategies….and possibly enjoy a free lunch thanks to a free capital gain.

Note: Changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation.  While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters.  You should discuss tax or legal matters with the appropriate professional.

Taking IRA Distributions Before You Need Them?

My wife truly enjoys talking to our two dogs – not that she expects them to talk back (I don’t think so at least) – but who doesn’t enjoy seeing their heads turn as if that will really help them understand what she has to say.  I had a client give me a similar look a few years back when I suggested taking money from his IRA even though he didn’t need it for current spending.  (The client was past age 59.5 but younger than age 70.5 so he didn’t have to take a distribution quite yet.) 

While, like my dogs, he didn’t say anything his look suggested that he was thinking “why would I take a distribution that I don’t need and accelerate income taxes?”  His head started to turn straight again when I illustrated that he might want to maximize the lower tax brackets.  A married couple filing jointly can have taxable income up to $69,000 in 2011 and still remain in the 15% marginal income tax bracket (remember taxable income is adjusted gross income minus exemptions and deductions). For this client, they could take out roughly $25,000 from their IRA and still be within the 15% marginal bracket.  While no one knows what income tax rates will be for sure in the future –locking in a 15% rate seemed attractive. 

2011 IRS Tax Brackets

To find out if accelerating IRA distributions is the right move for you, work with your financial planner and tax preparer to run “what if” scenarios.

Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Timothy W. Wyman, CFP®, JD, and Center for Financial Planning, Inc., and not necessarily those of RJFS or Raymond James. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS we are not qualified to render advice on tax or legal matters.