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The Superior Retirement Account – Will that be Traditional or Roth?

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Weighing the Costs

Lon Jeffries[By Lon Jefferies MBA CFP®]

As an informed investor and reader of this ME-P, you’re likely familiar with the difference between a traditional IRA/401(k) and a Roth IRA/401(k).

While the traditional account enables you to postpone taxes on both the income invested and its growth until the funds are withdrawn, a Roth account does not provide an initial tax benefit but investment growth is tax free. So which is better?

Let’s answer the question with some simple math. Suppose an investor in the 25 percent federal tax bracket invests $1,000 of pre-tax income, obtains an 8 percent annual return over the next 10 years, and is still in the 25 percent tax bracket in the future. Would this investor profit more investing in a traditional or a Roth account?

As the chart below illustrates, the investor in this scenario would end up with the exact same amount in either a traditional or a Roth account.

So does the decision to invest in a traditional or Roth retirement account not matter? Not so fast.

Constant Tax Rate
Traditional Roth
Initial Tax Bill (25%) $0 $250
Invested Amount (after-tax) $1,000 $750
Future Investment Value $2,159 $1,619
Future Tax Bill (25%) $540 $0
After-Tax Value in 10 Years $1,619 $1,619

Lower Tax Bracket in Future

Let’s assume our investor will have a reduced income when she retires in 10 years, causing her to be in the 15 percent tax bracket in the future. Perhaps the worker is in her prime earning years and will have less income during retirement. In this scenario, due to the up-front 25 percent tax bill, investing the funds in a Roth would lead to the same after-tax value of $1,619. But investing the funds in a traditional account would allow the full $1,000 to experience growth for 10 years, with a reduced future tax bill of 15 percent, leaving $1,835 of after-tax value in the account. This investor would benefit from delaying taxes into the future when she would be in a lower tax bracket.

Lower Tax Rate in the Future
Traditional Roth
Initial Tax Bill (25%) $0 $250
Invested Amount (after-tax) $1,000 $750
Future Investment Value $2,159 $1,619
Future Tax Bill (15%) $324 $0
After-Tax Value in 10 Years

$1,835

$1,619

Higher Tax Bracket in Future

On the other hand, if the investor was in the 15 percent tax bracket this year but expected to be in the 25 percent bracket during retirement (potentially a young employee expecting his earnings to rise), paying taxes now at 15 percent would allow $850 to be invested, which after 10 years of 8 percent growth would be worth $1,835 tax free.

Higher Tax Rate in the Future
Traditional Roth
Initial Tax Bill (15%) $0 $150
Invested Amount (after-tax) $1,000 $850
Future Investment Value $2,159 $1,835
Future Tax Bill (25%) $540 $0
After-Tax Value in 10 Years $1,619 $1,835

Roth Advantages

What if you expect to pay a comparable tax rate both now and in the future? A Roth account offers several advantages in this scenario.

First, as taxes have already been paid on a Roth account, the government doesn’t require investors to take required minimum distributions (RMDs) from these accounts, whereas RMDs are required from traditional retirement accounts beginning at age 70½. Without RMDs, Roth accounts can grow tax free for the investor’s entire lifespan.

Additionally, upon death, Roth accounts pass to an investor’s heirs without any tax liability, while those who inherit a traditional retirement account must pay taxes on the assets.

***

IRA

***

Second, money withdrawn from a traditional retirement account before the investor is 59½ may be subject to a 10 percent penalty. Yet contributed funds to a Roth account (but not the growth on the contributed funds) can be withdrawn at any time without penalty. While withdrawing funds before retirement isn’t advisable, the added liquidity of the Roth account can prove useful in emergencies.

Finally, even if your income is expected to remain constant, investing in a Roth account allows you to lock in your taxes at today’s rate as opposed to taking the risk that national tax rates might be raised in the future.

If you’re unsure how your future tax bracket will compare to your current rate, diversify. Nothing prevents you from having both a traditional and a Roth retirement account. This not only allows you to hedge your bets, but puts you in a position during retirement to take distributions from your tax-deferred account in low-income years and from the tax-free account in years when you are in a high tax bracket.

Assessment

http://www.utahbusiness.com/articles/view/weighing_the_costs/?pg=1

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How Obama’s 2015 Proposed Budget Impacts Retirement Accounts

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Fore Warned is Fore Armed!

By Lon Jefferies MBA CFP®

Lon Jeffries

President Obama recently unveiled his proposed budget for 2015. Included in the proposal were the following potential changes to investor retirement accounts:

Apply Required Minimum Distribution Rule To Roth IRAs

There are currently two main reasons to invest in a Roth IRA – to pay taxes at your current rate in anticipation of being in a higher tax bracket in the future, and to invest in an account that does not require minimum distributions when the investor reaches age 70½. However, President Obama’s 2015 budget calls for Roth accounts to be subject to the same RMD requirements as other retirement accounts.

This change would make Roth IRA accounts much less appealing for a good portion of the investment community. Additionally, if enacted, the rule would dramatically reduce the benefit for many individuals to convert their traditional retirement accounts to Roth accounts. Lastly, this rule would essentially betray all investors who already converted their accounts to Roths by taking away a benefit they were counting on.

Eliminate Stretch IRA

Non-spouse beneficiaries of retirement accounts currently have the option of either withdrawing the funds from the inherited retirement account within five years of the original IRA owner’s death or stretching IRA distributions over their expected lifetime. Stretching distributions is considered favorable because it allows the investor to spread the tax liability from the income over their lifetime and continue taking advantage of the tax-deferral provided by the retirement account. However, Obama’s proposal would eliminate non-spouse beneficiaries’ ability to stretch distributions over a period of more than five years.

If implemented, this change would have severe tax implications on people inheriting a retirement account and drastically reduce the value of tax-deferred accounts as estate planning tools.

Cap on Tax Benefit for Retirement Account Contributions

Currently, investors obtain a full tax-deferral benefit on all contributions to retirement accounts. Under Obama’s proposal, the maximum tax benefit that would be allowed on retirement contributions would be 28%. Consequently, an investor in the 39.6% tax bracket would only be able to deduct 28% and would still need to pay taxes at 11.6% (39.6% – 28%) on all contributions made.

Eliminate RMDs For Retirement Accounts Less Than $100k

Currently, investors over the age of 70½ must begin taking taxable distributions from their retirement accounts in the form of required minimum distributions (RMDs). Under Obama’s proposal, individuals whose retirement accounts have a total value of less than $100k would no longer be subject to required minimum distribution rules. This would enable retirees with less in their retirement accounts to take greater advantage of the tax-deferral benefit an IRA provides.

Retirement

Retirement Account Value Capping New Contributions

Under the new proposal, once an individuals’ retirement account value grew to a certain cap, no further contributions would be allowed. This cap would be determined by calculating the lump-sum payment that would be required to produce a joint and 100% survivor annuity of $210,000 starting when the investor turns 62. Currently, this formula would indicate a cap of $3.2 million. This cap would be adjusted for inflation.

Proposal, Not Law…

Keep in mind that these potential changes are currently just proposals and are not certain to be implemented into law. In fact, with the exception of RMDs for Roth accounts, all of these suggested adjustments were proposed by Obama last year and none were approved by congress. Consequently, history suggests that Obama may have a hard time getting these changes implemented. Still, examining the proposals provides some insight into the direction President Obama would like to proceed.

Conclusion

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IRA Strategies for Physicians in 2012

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Money Flows-In Even as Volatility Continues in Mid-Year

By Martha J. Schilling AAMS CRP ETSC CSA

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The amount of money in IRAs is climbing even as the volatility continues.

Most of us have at least one IRA and eventually many people roll over their main retirement assets, 403(b) and 401(k) accounts to IRAs.

Unfortunately, a lot of the value in IRAs isn’t being maximized.

By focusing on a few key strategies you can make an IRA more valuable in your lifetime and beyond.

Now, doctors and all medical professionals should consider the following:

OWN THE RIGHT ASSETS

An IRA has the advantage of tax deferral. Gains and income compound free of taxes until they are distributed. They have the disadvantage of converting long-term capital gains into ordinary income. All taxable distributions from an IRA are taxed as ordinary income. Research reveals that assets that pay high ordinary income are best held in IRAs. High-Yield bonds, Real Estate Investment Trusts and investment grade bonds as well as stocks, mutual funds and other investments that tend to be owned for less than a year generate short-term capital gains. Nontraditional, or alternative investments can be utilized, however know which are prohibited in retirement accounts.

PRACTICE TAX DIVERSIFICATION

No one can forecast how the tax code will alter. Different scenarios are in the works, perhaps one will be put into place late this fall. Different types of accounts have different tax treatments now, and that could change. Instead of forecasting one tax outcome and arranging your finances accordingly, it’s safer to have different types of accounts so you won’t be burned in any scenario. Try to own investments in taxable accounts, traditional IRAs, and Roth IRAs

CONVERT TO A ROTH

Every year, consider whether it makes sense to convert all or part of your traditional IRA into a Roth IRA. Discuss with your Tax advisor factors such as your expected rate of return, the difference between your current tax rate and future tax rates, the source of the cash to pay the taxes and whether future required minimum distributions would exceed your spending needs.

Your CPA/advisor will add other questions as he would know your personal situation and needs.

CONSOLIDATE or SPLIT?

Simplifying your finances often means consolidating all your accounts at one financial institution. Many people have multiple IRAs and simplifying means rolling them over into one IRA when practical. But suppose you have multiple heirs and expect IRAs to be a significant legacy. You could name all heirs as joint beneficiaries and let them decide what to do with the account. On the other hand, you could split the IRA now and name one person as the primary beneficiary for each.

SPEND ACCOUNTS in the RIGHT Order

As a general rule, it’s best to spend taxable accounts first, traditional IRA’s next and ROTH IRAs last. Not in all cases. When you visit your advisor and review what you need in cash flow at retirement, you may find that taking your RMD at 70 ½ puts you into a higher tax bracket. It may be less taxing to take normal distributions on a regular basis after 591/2.

REVIEW your BENEFICIARIES. There are horror stories of people who haven’t changed beneficiaries for decades and find a sibling or a parent is the beneficiary rather than your spouse.

CONSIDER CHARITY. Should you decide to leave part of your estate to charity, the most tax efficient way to do that might be to name the charity as beneficiary of your IRA? Individuals pay tax on distributions, Charities do not.

CATCH-UP CONTRIBUTIONS

When you’re still working and making contributions to IRAs, you can make higher contributions when age 50 or older. In 2012, the maximum for those over 50 is $6000 rather than $5000.

CONSIDER SPOUSE Generally IRA contributions can be made only to the extent you have earned income from a job or business. When filing a joint return, contributions can be made for both spouses up to the maximum of $6000.

REQUIRED DISTRIBUTIONS It appears people continue to make mistakes when taking and computing their RMD after 70 ½. The IRS has been lax on this in the past but is stepping up its tracking and enforcement.

Assesment

Can you think of any others?

Conclusion

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