Republican presidential nominee Mitt Romney has an IRA valued at $60 million or more. While IRAs are the most valuable asset most people have, not many have IRAs as valuable as Romney’s. There are several factors that contributed to Romney’s IRA growth, as explained in this article. Some of these strategies aren’t available to most of us. As a partner in a private equity firm, for example, Romney could invest in company shares before they were taken public and early in the development of the companies, when their shares were fairly cheap.
But all of us can invest in non-traditional assets in IRAs. You need a non-traditional IRA custodian, but it’s perfectly legal. With a true self-directed IRA, you can invest in real estate, private partnerships, private equity, small non-public companies, hedge funds, and other assets. Like other IRA owners, Romney’s IRA grew largely as a result of retirement benefits received from his employer. He’s had access to some opportunities most of the rest of us don’t, but you aren’t stuck with mutual funds and stocks. For details, you can obtain my IRA Investment Guide.
The latest innovation in retirement planning is the Roth 401(k). Not all employers offer them, but more are including them in their plans. Like Roth IRAs, the tax benefits are back-ended. No deduction or exclusion is available for contributions, but distributions are tax-free. Here’s a guide with nine frequently-asked questions about the plans.
Q: Can I convert money in a traditional 401(k) into a Roth 401(k)? Is there an income limit on who can do this conversion? Will I owe tax when I convert?
A: You can convert money in a traditional 401(k) into a Roth 401(k). There is no income limit to do this conversion, but it is a taxable transaction.
A lot of people still don’t realize you can own assets other than stocks, bonds, and mutual funds in IRAs. The major IRA custodians (brokers and mutual funds) don’t allow you to own these assets in most cases, but the tax law does. You can read some anecdotes and an overview of the law about how to do it here. For even more details, get a copy of my report, The IRA Investment Guide.
Matt Lutz of Bethel Park, Pa. owned a chain of dry cleaning stores in 2006 when he rolled over a $70,000 IRA into a self-directed account at Equity Trust Co. in Elyria, Ohio. Since then he has more than tripled its value—mostly by making loans from his IRA to car dealers to finance their inventory. Three years ago Lutz, 38, sold his dry cleaning business to work full-time putting together similar loans for other people to use as IRA investments.
Despite such success stories, there are risks to getting creative with your IRA. “Self-directed IRAs are not for the faint-hearted,” says Patrick J. Felix III, the Pittsburgh lawyer who helped Rodriguez. “You better damn sure know the rules.” These pointers should help keep you safe.
Retirees are a major source of the “tax gap,” according to the IRS. The tax gap is the difference between what Americans actually pay in income taxes and what they’re supposed to pay if they followed the law exactly. The IRS says about $4.2 billion of the tax gap is attributable to underpaid taxes on retirement income. The tax gap generally is the fault of Congress and the IRS for making the rules too complicated. Sophisticated lawyers and CPAs write rules that are supposed to be followed by regular people who rarely even balance their checking accounts and of course struggle with the cognitive decline that often accompanies aging. The Inspector General of the Department of Treasury recently identified ways the IRS could reduce the tax gap, though they don’t include simplifying the law.
The IRS’s main tool for ensuring retirement income is properly reported is to have payers of retirement income (IRA sponsors, annuity insurers, pension funds) issue Form 1099-R identifying the gross amount paid to people during the year. When people don’t report the gross amount, they receive a letter from the IRS saying they owe additional taxes.
But the form is confusing and incomplete. Many forms say the taxable amount of the distribution isn’t determined. People who made after-tax contributions to IRAs, annuities, and employer pensions get to exclude part of that amount from each distribution until the contributions are recovered. That isn’t accounted for on the forms and is up to the taxpayer to compute.
The IRS conceded in its response to TIGTA that the rules around reporting taxable retirement income represent one of the more complex areas of the tax law many individuals face, and agreed that it would revise the instructions for Form 1099-R to make it clear that taxpayers are responsible for determining the taxable amount of their retirement income. And the IRS plans to study the feasibility of capturing additional information on a form to be filed with the tax return.
The IRS dismissed another TIGTA recommendation to include dates of retirement income distributions on the 1099-R as largely unworkable. (This would catch folks who, instead of doing direct institution-to-institution transfers, cash out their retirement money and miss the 60-day rollover period for moving it back into a qualified plan).
The Department of Labor issued new regulations last week that allow fiduciaries of 401(k) plans and IRAs to offer investment advice under some circumstances. The law prohibits such advice, but the DOL carved out some exceptions. Fiduciaries may offer advice, beginning Dec. 27, if their compensation doesn’t depend on the investment recommendations or they use a computerized investment system from a certified third party. The first exception means the fiduciary is paid the same amount for the advice regardless of the investment that is recommended, such as receiving a flat fee or a flat percentage of the account’s value. Many fiduciaries already offer advice based on separate exemptions they received from DOL.
These regs don’t resolve a very hot issue that’s been debated in Washington. The DOL issued proposed regulations not long ago that essentially provided that anyone who offered investment advice or had almost any role with a retirement plan would be a fiduciary. The regulations were withdrawn after a lot of complaints from financial services companies and members of Congress. The DOL still is working on those regulations. The financial services industry argued that if the proposed regulations stood, then many firms would decide not to provide advice to retirement plan members. Currently, brokers and investment advisors can offer paid advice to participants without being considered fiduciaries. Fiduciaries have a higher level of legal scrutiny than non-fiduciaries.
Employer 401(k) plans generally are fairly good at helping employees save for retirement and providing decent investment options. But as the first Baby Boomers turned 65 this year, employer plans still are very weak at helping plan retirement income. A new survey reports only one-third of Fortune 1000 companies report that helping employees create retirement income is an important objective of their plans.
The survey, Qualified Retirement Plan Barometer, also finds that while two?thirds of plan sponsors say that retirement income is an important objective of their retirement plans, many are struggling to translate this sentiment into action.
Granted, since the survey was sponsored by MetLife we can assume its purpose was to help boost sales of annuities. But it’s another example that most of us are on our own when planning retirement and especially when trying to convert a lifetime of savings into a steady stream of retirement income. That’s what we help readers with in Retirement Watch. There’s no silver bullet. You have to combine a good investment strategy with Social Security, annuities, and other resources.
There are more than five pitfalls, but this article picks five key pitfalls to avoid with your retirement finances. We’ve covered these all in depth in past issues of Retirement Watch but they’re worth another review. An example:
Given that cavalcade of savings, it’s not surprising that so many retirees fall back on the conventional wisdom that they’ll only need to replace 80% of their income during their working years when they actually retire. In reality, that 80% rule is at best a rule of thumb; some retirees spend actually spend more than they did while they were working, while others spend much less. (Health-care costs are one of the biggest wild cards.)
The last-minute tax changes Congress made in 2010 make one decision easier.
Taxpayers who converted a traditional IRA or employer plan into a Roth IRA in 2010 have a choice. They can include the converted amount in gross income in 2010 and pay taxes at their 2010 rate, or they can defer recognition of the gross income. The deferral allows the converters to include half the income in 2011 gross income and half in 2012. But Congress extended the 2010 tax rates for the next two years. For most people that means there isn’t much of a decision. You’ll face the same tax brackets in all three years, so for most people there isn’t the potential you’ll pay higher taxes by deferring. You might as well choose deferral and hold onto the money for a while. Maybe you’ll earn a little income on it.
People who should consider paying the taxes in 2010 are those who expect to have lower tax rates in 2010. They might have a large amount of deductions for the year or a shortfall in income. Or perhaps you expect to have higher income in the next couple of years from the sale of a business, collection of deferred income, or some other action. Another reason not to defer is that you expect to have significantly fewer deductions after 2010. Maybe you paid off your mortgage or soon will.
I suspect for most people it will be an easy decision and they’ll defer the income.
Investment manager and best-selling author Ken Fisher has a new book, Debunkery. His goal in the book is to refute common investment beliefs that he believes are wrong. His approach seems to be similar to ours in Retirement Watch. Fisher tries to look behind the beliefs and rules-of-thumb to the underlying data. Often, as we’ve found, the data don’t support the belief, or over time people forget the qualifications and assumptions that originally were part of the belief.
I haven’t read the book, but here’s an interesting review. The review’s main point is that Fisher does a good job of demolishing a lot of myths but makes poor arguments when addressing other myths. This reviewer hints that Fisher’s presentation is influenced by his business of managing stock portfolios for investors in separate accounts. Here’s a sample:
Let’s turn to chapter 26, “Low P/Es Mean Low Risk.” In it, Fisher states, “Using P/Es to forecast risk and return over any reasonable time period is about as useful as using an Ouija board.” Fisher is talking about P/E ratios based on 12-month trailing earnings, and in this narrow sense he is correct. When calculated in that manner, P/E ratios provide little useful information.
Fisher does not mention, however, the predictive power of normalized P/E ratios, popularized by Yale professor Robert Shiller, which use earnings averaged over the last 10 years. Those P/E ratios have been shown, by Shiller and others, to be reliably predictive of returns over long (e.g., 10-year) time horizons. That finding has been used, for example, by Michael Kitces to show that sustainable withdrawal rates can be increased by increasing equity allocations when markets are undervalued.
Fisher compounds that oversight when, in chapter 20, he writes, “There is absolutely no way – none – to predict stock market direction 7 or 10 years out unless you can somehow predict future stock supply shifts.”
The notion that stock prices are driven by the supply and demand of securities is one that Fisher advances several times in the book, notably in chapter 10. By contrast, I looked for a discussion of the role that a company’s free cash flow generation plays in determining its stock price and could not find one.
I continue to receive a lot of questions about the five-year waiting period for taking distributions after Roth IRA contributions and conversions. There’s a lot of confusion about the rules. It is slightly different for conversions and for contributions. It also is different for income taxation of distributions and the 10% early distribution penalty on distributions. Here’s how I described the rules in the May 2010 issue of Retirement Watch.
The five-year waiting period also generates many questions.
Only qualified distributions from a Roth IRA are tax-free. For a distribution to be qualified, the Roth IRA must be open at least five years. For regular Roth IRA contributions, the five-year rule is met if any Roth IRA owned by the taxpayer is at least five years old. If you opened a Roth IRA in 2000, for example, any distributions you take out of any regular Roth IRA now are tax-free.
The rule is different for converted Roth IRA amounts. A new five-year waiting period starts for each conversion. That means income and gains from the converted amount are taxable if withdrawn within five years of the conversion.
For most people, however, the five-year waiting period doesn’t matter. The rules for taxing Roth IRA distributions are that distributions are first considered to be of after-tax contributions. Distributions of after-tax contributions (such as converted amounts on which you paid the conversion tax) are tax-free. Only after all after-tax contributions (whether regular contributions or converted amounts) are withdraw are you withdrawing potentially taxable income and gains. So, the five-year rule doesn’t matter, unless you withdraw all or most of the IRA within five years. Even then, you’ll pay taxes only on the accumulated income and gains distributed not on the after-tax contributions.
The five-year period for either type of contribution begins on Jan. 1 of the year of the contribution or conversion, not on the date of the contribution or conversion.