When your clients roll over a retirement account into an annuity, stay alert. They could lose significant tax benefits if they don’t document their investment in the contract.

Gains realized on surrender of an annuity are taxed as ordinary income, but the entire amount received on surrender might not be taxed, since a taxpayer is entitled to receive their investment in the contract back tax-free.

Keeping track of investment in the contract is simple enough when a person pays premiums out a checking account into the annuity—the total amount of the premiums will constitute investment in the contract. But when a rollover is made from a pre-tax retirement account like an IRA, things get more complicated, and documenting investment in the contract is essential to preserve its tax benefit.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of annuities  in Advisor’s Journal, see Annuity Respect: Earning It! (CC 11-150), IRS Streamlines Partial Exchanges of Annuities (CC 11-153), and GAO Report Touts Annuities in Uncertain Retirement Environment (CC 11-141).

For in-depth analysis of the taxation of distributions from an annuity, see Advisor’s Main Library: A—Amounts Received As An Annuity & B—Amounts NOT Received As Annuities.

Individual retirement account holders may find themselves brokerless if the Department of Labor (DOL) adopts a recently proposed rule that would subject investment professionals associated with the accounts to a fiduciary standard. Testifying before the U.S. House Education and Workforce Committee (the Committee) Kenneth Bentsen, a vice president at the Securities Industry and Financial Markets Association (SIFMA), a securities industry lobbying group, warned that brokerages will drop millions of IRA account owners if the proposed rules are finalized.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the SEC’s forthcoming universal fiduciary duty regulations in Advisor’s Journal, see Financial Planners and Insurance Producers at Odds over Fiduciary Standard (CC 11-131), SEC Fiduciary Standard Study Answers Few Questions (CC 11-25), Study Finds that Universal Fiduciary Standard Will Hurt Investors (CC 10-97), What You Don’t Know Yet Might Hurt You: A Broker’s Duties under the Financial Reform Act (CC 10 40), & SEC Unprepared to Implement a Fiduciary Standard for Broker-Dealers (CC 11-33).

Author: Jesse Mackey

The saying goes that “the best way to gain money is to avoid losing it.” It is also said that “nothing is certain in life except death and taxes.” If there is truth to either of the above kernels of wisdom, a logical conclusion is that the most assured way to avoid losing money is to minimize, defer, and eliminate taxation to the greatest extent possible. This article begins a 3-part article series that will briefly outline some of the most common and effective means of limiting the over-taxation of the individual investor’s portfolio. The techniques described here will be most beneficially applied if diligently overseen and executed through a competent financial planner and portfolio manager.

Tax Deduction and Deferral – The IRS allows for tax deductions of contributions made to certain types of accounts in the year in which they are made. Most of these accounts are commonly known as “Qualified” plans or assets. Some examples are the 401(k), Traditional IRA, Defined Benefit Pension Plan, SEP IRA, etc. Non-qualified deferred annuities may also be used for the purposes of tax deferral (though not necessarily for tax deductions). Once money is invested under the provisions of one of these plans, the growth in value of the assets over time is free from taxation until the time at which it is distributed from the plan (which is typically not allowed until age 59 ½ without a 10% federal tax penalty). The money may be invested in virtually any series of marketable securities that the investor wishes, as long as it is contained within the plan wrapper (although this may be subject to any limitations imposed by a plan provider). This results in more money working for the investor over a longer time period than would be possible in a currently taxable account, ultimately resulting in a greater future income or lump sum to be received.  This most basic technique of investment planning is usually appropriate only for assets that are earmarked for use in retirement.

Tax Elimination – Within the tax code, there are limited instances in which investors may choose to pay their taxes now, and never pay taxes on the same set of assets again. Two of the most widely used accounts of this type are the Roth IRA and the 529 College Savings Plan. Although the contributions that one may make to these accounts may be limited by the income level of the investor and the amount that may be invested each year, if the assets are earmarked for specific purposes (Retirement for a Roth IRA and qualified educational expenses for the 529 Plan), the assets will grow tax free and may be withdrawn tax free at the permitted time. This technique is especially useful for investors that are currently in a lower tax bracket than they expect to be at the time of withdrawal of the assets. A similar methodology may be utilized when accumulating assets through the cash value of a dividend paying life insurance policy, such as Whole Life. While not considered an “investment” from a regulatory standpoint, a portion of premiums contributed to a whole life insurance policy can produce dividends* over time and will grow on a tax deferred basis. The policy owner may take “policy loans”** from the cash value to be used for any purpose, and the loans will remain tax free provided that the policy remains in-force. However, if the policy lapses or is discontinued, the portion of cash value attributed to gains becomes taxable as ordinary income.

To be continued tomorrow…

*Dividends are not guaranteed, any may be declared annually by a company’s Board of Directors.

**Policy benefits are reduced by a loan, loan interest and/or withdrawals. Dividends, if any, are affected by policy loans and loan interest.

Jesse Mackey is a partner and Investment Officer of 4Thought Financial Group Inc. 4Thought was created with the base vision of advancing individual freedoms and the human quality of life through economic means. This vision is pursued by applying the firm’s four specialties – Economic Theory and Research; Multi-Contingency Investment Management; Financial Planning for Business Owners and Individuals; and Support for Partner Firms and Advisors.

Contact:

Jesse Mackey

4Thought Financial Group Inc.

www.4TFG.com

jmackey@4TFG.com

Traditional IRAs allow deferral of income tax on contributions, but that deferral ends when assets are withdrawn from the account. But in recent years Congress has given individuals the option of converting a traditional IRA accounts to a Roth IRA, paying income tax on the amount rolled over into the Roth. In contrast to a traditional IRA, withdrawals of both principal and income can be made tax-free.

The attraction of Roth conversion is muted by the fact that the taxpayer has to pay tax on the lump sum that’s rolled over into the Roth. But what if you could convert a traditional IRA to a Roth IRA without paying income tax on the conversion?

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of Roth conversion in Advisor’s Journal, see Small Business Bill Extends the Roth Restructure Window (CC 10-64).

For in-depth analysis of Roth IRAs, see Advisor’s Main Library: G—Roth IRAs.

Partners in a partnership and members of an LLC taxed as a partnership cannot have individual SEP IRAs (Simplified Employee Pension Individual Retirement Account) plans, according to the IRS.

Only employers are allowed to maintain SEP plans for their employees. Because partners are employees of the partnership for retirement plan purposes, they cannot have an individual SEP plan. If partners in a partnership wish to utilize a SEP plan, the partnership as an entity must maintain and contribute to the plan for the partners.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of IRAs in Advisor’s Journal, see Qualified Charitable Distributions from an IRA (CC 11-03) & How Are IRA Owners Investing Their Money? (CC 11-112).

For in-depth analysis of SEPs, see Advisor’s Main Library: IRAs and SEPs.

Why is This Topic Important to Wealth Managers? Today we discuss one issue that is a concern to most taxpayers. The Tax Gap—The difference between the amount of taxes due and those actually paid. The blogticle provides information and facts which makes for interesting discussion among wealth managers and clients.

The Government Accountability Office (GAO) recently released a report on the tax gap and taxpayer compliance and complexity. The report summarizes that the tax code compliance issues caused by complexity resulted in an increase to the overall tax gap.

It is no surprise that the federal tax system contains complex rules. These rules may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance. However, these complex rules also impose a wide range of recordkeeping, planning, computational, and filing requirements upon businesses and individuals.

It has been shown in the past and is also no secret that complying with these requirements costs taxpayers time and money. In 2005 GAO reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product) per year; other studies estimate costs 1.5 times as large. In addition, economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, are estimated to be even larger.

Although many taxpayers have simple forms of income, others do not—especially those who receive income from capital gains, rents, self-employment, international and other sources—and they may be required to do complicated calculations and keep detailed records.

Tax expenditures add to tax code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning because taxpayers must “predict” their own future circumstances as well as future tax rules to make the best choice among provisions.

Taxpayer errors also contribute to the tax gap. For example, in 2001 taxpayers underreported $6.3 billion in net income due to misreported Individual Retirement Arrangement (IRA) distributions. In addition, taxpayers may underclaim benefits to which they are entitled. According to GAO’s past  analysis, of tax filers who appeared to be eligible for a higher-education tax  credit or tuition deduction in tax year 2005, about 19 percent, representing  about 412,000 returns, failed to claim any of them.

The Internal Revenue Service (IRS) has estimated that the gross tax gap—the difference between taxes owed and taxes paid on time—was $345 billion in 2001.

The gross tax gap is an estimate of the difference between the taxes—including individual income, corporate income, employment, estate, and excise taxes—that should have been paid voluntarily and on time and what was actually paid for a specific year.

Of the estimated $345 billion tax gap for tax year 2001, IRS estimated that it would eventually recover about $55 billion of that through late payments and enforcement actions, for a net tax gap of $290 billion.

The estimate is an aggregate of estimates for the three primary types of noncompliance: (1) underreporting of tax liabilities on tax returns; (2) underpayment of taxes due from filed returns; and (3) nonfiling, which refers to the failure to file a required tax return altogether or on time.

Tomorrow’s blogticle will discuss issues related to life insurance.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is This Topic Important to Wealth Managers? This blogticle discusses one avenue for retirement planning solutions for small businesses. Wealth managers who have small business clients may consider a discussion on the automatic payroll deduction IRAs as one simple way to help employees save for retirement.

A payroll deduction individual retirement account (IRA) is one simple way for businesses to give employees an opportunity to save for retirement. The program is easy to implement; the employer sets up the payroll deduction IRA program with a bank, insurance company or other financial institution, and then the employees choose whether and how much they want deducted from their paychecks and deposited into the IRA. Depending on the IRA service provider, some employees may also have a choice of investments depending on the IRA provider. Wealth managers can add value to employees and employers by, not only establishing a plan, but by also working with employees to help them manage their IRAs.

Under a payroll deduction IRA, the employee makes all of the contributions, thus there are no employer contributions. By making regular payroll deductions, employees are able to contribute smaller amounts each pay period to their IRAs, rather than having to come up with a larger amount all at once.

One advantage of these accounts is that there is little administrative cost and no annual filings with the government. Moreover, businesses of any size can participate as there is no requirement that an employer have a certain number of employees to set up a payroll deduction IRA.

Another element that makes the program attractive to some small businesses is that the program will not be considered an employer retirement plan subject to Federal requirements for reporting and fiduciary responsibilities as long as the employer keeps its involvement to a minimum.

Here’s how the IRAs generally work: The employer sets up the payroll deduction IRA program with a financial institution, such as a bank, mutual fund or insurance company. The employee establishes either a traditional or a Roth IRA (based on the employee’s eligibility and personal choice) with the financial institution and authorizes the payroll deductions. The employer withholds the payroll deduction amounts that the employee has authorized and promptly transmits the funds to the financial institution. After doing so, the employee and the financial institution are responsible for the amounts contributed.

Generally however, the employer needs to remain neutral with respect to the IRA provider. It cannot negotiate with an IRA provider to obtain special terms for its employees, exercise any influence over the investments made or permitted by the IRA provider, or receive any compensation in connection with the IRA program except reimbursement for the actual cost of forwarding the payroll deductions.

Commonly, any employee who performs services for the business (or “employer”) can be eligible to participate. The decision to participate is left exclusively up to the employee. The employees should understand that they have the same opportunity to contribute to an IRA outside the payroll deduction program and that the employer is not providing any additional benefit to employees who participate.

Employees’ tax-deferred contributions are generally limited to $5,000 for 2011. Additional “catch-up” contributions are permitted for employees age 50 or over. This special catch-up amount is currently limited to $1,000 per year.

Tomorrow’s blogticle will continue to discuss simple wealth management solutions.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers? In this edition we present a discussion of the 60 day rollover provisions for retirement accounts. Sometimes the transaction does not always go as planned. Thus wealth managers should be aware of unique situations that apply to traditional planning circumstances.

Can a widow rollover, past the 60 day statutory window, distributions from an employee trust to an IRA on behalf of a husband who passed away mid-transaction? The IRS has recently said no. [1]

In a private letter ruling issued last week the Service determined that since the widow had funds in a joint account with her husband who later passed away that she was precluded from rolling over that amount to a tax advantaged arrangement in her name.

Widow’s husband received a distribution from an Employee Retirement Plan totaling Amount X. The Widow asserts that the failure to accomplish a rollover within the 60-day period prescribed by section 402(c)(3) was due to the fact that her husband entered the hospital and passed away during the 60-day period.

The husband had ended his employment earlier in the year. Unbeknownst to him, the plan had a “cash out” provision that mandated complete distribution of plan assets upon the participant’s attainment of 65 years of age. The husband then received a check, and initiated arrangements to move the funds to an individual retirement account in order to maintain the funds in a tax free vehicle. In the meantime, the husband had deposited the funds into a joint account with his wife. Between the time of the distribution from the plan and his scheduled rollover, the husband became ill and passed away. The widow sought to complete the rollover intended by her husband.

Generally, if any portion of the balance to the credit of an employee in a qualified trust is paid to the employee in an eligible rollover distribution, and the distributee transfers any portion of the property received in such distribution to an eligible retirement plan, then such distribution (to the extent transferred) shall not be includible in gross income for the taxable year in which paid. [2]

The Code states that such rollover must be accomplished within 60 days following the day on which the distributee received the property. An individual retirement account (IRA) constitutes one form of eligible retirement plan. [3]

The Code however allows a waiver by the Secretary where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.[4]

Moreover, the Code provides that if any distribution attributable to an employee is paid to the spouse of the employee after the employee’s death, the preceding provisions of this subsection will apply as if the spouse was the employee. [5]

In addition, when determining whether to grant a waiver of the 60-day rollover requirement pursuant to section 402(c)(3) of the Code, the Service will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error, (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.[6]

The Service held in summary that because the husband is now deceased, it is impossible for him to complete the proposed transaction. Since the amount was received by the husband from the retirement plan prior to his death, his wife (widow) was precluded from rolling the funds over into a tax-deferred account in her name under section 402(c)(9) of the Code.

Tomorrow’s blogticle will discuss tax and market issues relating to wealth management.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] IRC Section 402(c).

[3] IRC Section 402(c)(3)(A).

[4] IRC Section 402(c)(3)(B).

[5] IRC Section 402(c)(9).

[6] See Rev. Proc. 2003-16, 2003-4 I.R.B. 359, (January 27, 2003).

More than 25 percent of all US retirement assets are held in individual retirement accounts (IRAs), but up until now, little data existed on asset allocations in IRAs. As a result, the retirement prospects of retirees owning IRAs have remained a mystery.

New research from the Employee Benefit Research Institute (EBRI) gives us a first peek into self-directed accounts like IRAs, providing hard data on the investing behavior of account owners and giving us insight into common problem areas in these accounts.

EBRI’s database includes information on 11.1 million individuals’ 14.1 million individual retirement accounts. Assets in the tracked accounts amount to $732.9 billion.

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of IRAs in Advisor’s Journal, see Maximize IRA Stretch with Individual Inherited IRA Accounts (CC 10-69) and To Convert or Not to Convert, That is the Question (CC 07-40).

For in-depth analysis of IRAs, see Advisor’s Main Library: A – Introduction to Individual Retirement Plans (IRAs).

Why is this Topic Important to Wealth Managers? This blogticle represents part two of five in a series on the unified estate and gift tax as well as the portability of the spousal credit. Most wealth managers are aware of the new changes to the federal estate and gift tax structure with the unification and increased exemption amount of five million dollars. This week we discuss the estate and gift tax in detail so that wealth managers are well prepared to address client planning needs.

The Tax Relief Act of 2010 first reinstates the estate taxes effective for decedents dying and transfers made after December 31, 2009. The estate tax applicable exclusion amount is $5 million under the provision and is indexed for inflation for decedents dying in calendar years after 2011, and the maximum estate tax rate is 35 percent. [1]

Additionally, for gifts made after December 31, 2010, the gift tax is reunified with the estate tax, with an applicable exclusion amount of $5 million and a top estate and gift tax rate of 35 percent.

Also, for transfers made at death after December 31, 2010, the new law generally provides for ‘stepped-up” basis in property passing from the decedent; the carryover basis rules for gifts is unaffected. Gain or loss, if any, on the disposition of property is measured by the taxpayer’s amount realized (i.e., gross proceeds received) on the disposition, less the taxpayer’s basis in such property.[2] Basis generally represents a taxpayer’s investment in property, with certain adjustments required after acquisition. For example, basis is increased by the cost of capital improvements made to the property and decreased by depreciation deductions taken with respect to the property.

Under the new law the basis of property passing from a decedent’s estate is given the fair market value on the date of the decedent’s death (or, if the alternate valuation date is elected, the earlier of six months after the decedent’s death or the date the property is sold or distributed by the estate). This step up in basis generally eliminates the recognition of income on any appreciation of the property that occurred prior to the decedent’s death. If the value of property on the date of the decedent’s death was less than its adjusted basis, the property takes a stepped-down basis when it passes from a decedent’s estate. This stepped-down basis eliminates the tax benefit from any unrealized loss. [3]

Under the modified carryover basis regime, recipients of property acquired by gift, bequest, devise, or inheritance receive an adjusted basis or the fair market value of the property. Thus, the character of gain on the sale of property received from a gift is carried over to the donee. For example, real estate that has been depreciated and would be subject to recapture if sold by the donor will be subject to recapture if sold by the donee. [4]

Tomorrow’s blogticle will continue our weeklong series on the gift and estate tax.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

[2] IRC Sec. 1001.

[3] There is an exception to the rule that assets subject to the Federal estate tax receive stepped-up basis in the case of ‘‘income in respect of a decedent.’’ See IRC Sec. 1014(c). The basis of assets that are ‘‘income in respect of a decedent’’ is a carryover basis (i.e., the basis of such assets to the estate or heir is the same as it was in the hands of the decedent) increased by estate tax paid on that asset. Income in respect of a decedent includes rights to income that has been earned, but not recognized, by the date of death (e.g., wages that were earned, but not paid, before death), individual retirement accounts (IRAs), and assets held in accounts governed by section 401(k).

[4] U.S. Congress. Joint Committee on Taxation. General Explanation of Tax Legislation Enacted in the 111th Congress, 556 (JCS-2-11). Text from: Committee Reports. Available at: http://www.jct.gov/publications.html?func=showdown&id=3777 (last accessed April 6, 2011).