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.

Short-term gains carry an additional 20% tax cost over long-term gains, motivating the manufacturing of transactions designed to convert short-term to long-term gains. But as you’d expect, these transactions attract undue attention from the IRS and are often disregarded by the Service. The IRS recently considered the tax treatment of one of these gain-recharacterization schemes, a basket option contract, in a generic legal advice memorandum (AM 2010-005).

The IRS recharacterized the contract, viewing it as if the investor purchased the securities in a margin account, paying cash equal to 10% of the value of the securities and borrowing 90% of the value from the investment bank. Just as was the case with the “option,” the investor had almost total control over investment of the securities and would reap all appreciation and income from the securities, less interest and brokerage fees.

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 in-depth analysis of options, see Advisor’s Main Library: G—Options and Futures.

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.

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? Presents a new planning tool that is being used by wealth managers whose clients may have 401(k) plans. The enactment of new legislation has created an opportunity for clients who may be interested in combining the aspects of traditional “Roth IRAs” with the 401(k) structure. The blogticle provides in-depth analysis of the new law and how it applies to clients.

The Small Business Jobs Act of 2010 [1] added to the Internal Revenue Code sections relating to rollovers from § 401(k) plans to designated Roth accounts in the same plan (“in-plan Roth rollovers”). [2]

Section 2112 of the Small Business Jobs Act, effective for distributions made after September 27, 2010, permits plans that include a qualified Roth contribution program to allow individuals to roll over amounts from their accounts other than designated Roth accounts to their designated Roth accounts in the plan.

Currently § 401(k) plans and § 403(b) plans are permitted to include qualified Roth contribution programs, as well as governmental § 457(b) plans which include designated Roth accounts.

An “in-plan Roth rollover” is a distribution from an individual’s plan account, other than a designated Roth account, that is rolled over to the individual’s designated Roth account in the same plan, pursuant to new § 402A(c)(4) of the Code.

Generally speaking the Code provides that any distribution described as an in-plan Roth rollover is included in gross income as if it were not rolled over to a designated Roth account. Further, the Code provides that in-plan Roth rollovers of eligible rollover distributions may only be made within a plan containing a qualified Roth contribution program from accounts other than designated Roth accounts and only if the otherwise applicable rollover requirements of Code are satisfied.[3]

The rollover may be accomplished by a direct rollover (an “in-plan Roth direct rollover”) or by a distribution of funds to the individual  who then rolls over the funds into his or her designated Roth account in the plan  within 60 days (an “in-plan Roth 60-day rollover”).  In addition, an amount is eligible for an in-plan Roth rollover only if the plan provides for such rollovers.

Generally, any vested amount held in a plan account for a plan participant (other than an amount held in a designated Roth account) is eligible for an in-plan Roth rollover to a designated Roth account in the same plan.

However, an amount is not eligible for an in-plan Roth rollover unless it otherwise satisfies the rules for distributions under the Code. Thus, in the case of a § 401(k) plan participant who has not had a severance from employment, an in-plan Roth rollover from the participant’s pretax elective deferral account is permitted to be made only if the participant has reached age 59½, has died or become disabled, or receives a qualified reservist distribution. [4]

Next week’s blogticles will discuss topics relating to financial planning.

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

[2] See generally, IRC § 402A(c)(4).

[3] IRC  § 402A(c)(4)(B); See IRC §§ 402(c), 403(b)(8), 457(e)(16).

[4] IRC § 72(t)(2)(G)(iii); See also Rev. Rul. 2004-12, 2004-1 C.B.

Why is this Topic Important to Wealth Managers? Presents discussion on the basics of Simplified Employee Pension (SEP) plans.  Discusses the requirements of SEP plans for employers as well as providing the necessary steps to establish a SEP plan.    

SEP is a written plan that allows a business to make contributions toward executive’s retirement and employees’ retirement without getting involved in a more complex qualified plan.

Under a SEP, the business makes the contributions to a traditional individual retirement arrangement (called a SEP-IRA) set up by or for each eligible employee.   A SEP-IRA is owned and controlled by the employee, and the business makes contributions to the financial institution where the SEP-IRA is maintained.

SEP-IRAs are set up for, at a minimum, each eligible employee.  An eligible employee means an individual who meets all the following requirements: the individual has reached age 21, has worked for the business in at least 3 of the last 5 years, and has received at least $550 in compensation from the business in 2010. [1]

There are three basic steps in setting up a SEP.

1. The business must execute a formal written agreement to provide benefits to all eligible employees.
2. The business must give each eligible employee certain information about the SEP.
3. A SEP-IRA must be set up by or for each eligible employee.

In many situations, a SEP’s formal written agreement requirement can be satisfied by adopting an IRS model SEP using Form 5305-SEP.

The SEP rules permit the business to contribute a limited amount of money each year to each employee’s SEP-IRA.  Also, generally, the business does not have to make contributions every year.   But if it does make contributions, they must be based on a written allocation formula and must not discriminate in favor of highly compensated employees.  [2]

When the business contributes, it must contribute to the SEP-IRAs of all participants who actually performed personal services during the year for which the contributions are made, including employees who die or terminate employment before the contributions are made.  These contributions are deductible within limits, so long as the contribution is made by the due date for the taxable year, and are generally not taxable to the plan participants.  [3]

Deductible contributions the business makes for 2010 to a common-law employee’s SEP-IRA cannot exceed the lesser of 25% of the employee’s compensation or $49,000. [4]

Example 1: Employee 1, Mary Plant, earned $21,000 for 2010.  The maximum contribution the business may make to her SEP-IRA is $5,250 (25% x $21,000).

Example 2: Employee 2, Susan Green, earned $210,000 for 2010.  Because of the maximum contribution limit for 2010, the business can only contribute $49,000 to her SEP-IRA.

Further, if a business made SEP contributions that are more than the deduction limit (nondeductible contributions), the business may carry over and deduct the difference in later years.   Nevertheless, the carryover, when combined with the contribution for the later year, is subject to the deduction limit for that year.

For more information on SEP plans, please visit our subscriber library through Advanced Markets Advisor FX: SEPs And Simple Plans. 

Tomorrow’s blogticle will begin our discussion on additional changes and hot topics in 2011. 

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

[2] I.R.C. §408(k)(3). 

[3] I.R.C. §402(h)(2).

[4] I.R.C. §402(h)(2).;  I.R.C. §415(c)(1)(A).

As reported earlier this month in Advisor’s Journal [Qualified Charitable Distributions from an IRA (CC 11-03))], a qualified charitable distribution (QCD) of up to $100,000 made from an IRA will not be included in the taxpayer’s gross income, as long as the contribution is made directly from the trustee to a public charity or conduit private foundation when the account owner is at least 70½ years old.

One benefit of taking a QCD is that it can qualify as a required minimum distribution (RMD). For the taxpayer who does not have a financial need for the distribution, making a QCD is an opportunity to take the RMD—avoiding the severe tax penalties for not taking the distribution—while excluding the distribution from taxable income.

But because the QCD provision lapsed during 2010, taxpayers who took an RMD during 2010 are out-of-luck.  

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).

Why is this Topic Important to Wealth Managers? Discusses retirement plan investments with regards to client retirement planning.  Provides types of investments retirement plans can and cannot make.

What types of investments can a retirement plan make?

Although there is no list of approved investments for retirement plans, there are special rules contained in the Employee Retirement Income Security Act of 1974 (ERISA) that apply to retirement plan investments.

In general, a plan sponsor or plan administrator of a qualified plan who acts in a fiduciary capacity is required, in investing plan assets, to exercise the judgment that a prudent investor would use in investing for his or her own retirement.[1]

In addition, certain rules apply to specific plan types.  For example, there are different limits on the amount of employer stock and employer real property that a qualified plan can hold, depending on whether the plan is a defined benefit plan, a 401(k) plan, or another kind of qualified plan. [2]

Nevertheless, certain plans, such as 401(k) plans, that permit participant-directed investment can avoid some fiduciary responsibilities if participants are offered at least three diversified options for investment, each with different risk/return factors. [3]

As many wealth managers already know, however, individual retirement accounts are not permitted to invest in life insurance. [4]

Moreover, under the Code, both participant-directed accounts and IRAs cannot invest in collectibles, such as art, antiques, gems, coins, or alcoholic beverages, and they can invest in certain precious metals only if they meet specific requirements. [5]

Are there other transactions that are prohibited?

A prohibited transaction is a transaction between a plan and a disqualified person.  Prohibited transactions generally include the following transactions:

• a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
• any act of a fiduciary by which plan income or assets are used for his or her own interest;
• the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
• the sale, exchange, or lease of property between a plan and a disqualified person;
• lending money or extending credit between a plan and a disqualified person; and
• furnishing goods, services, or facilities between a plan and a disqualified person.

How do prohibited transactions affect IRAs?

A prohibited transaction with respect to an IRA occurs if the owner or beneficiary of the IRA engages in any of the transactions prohibited transactions described above.  In the case of an individual retirement account the Code provides that the account is no longer an individual retirement account, and it is treated as if the assets were distributed on the first day of the taxable year in which the prohibited transaction occurred.[6] Of course, this may trigger an early withdrawal penalty.

Tomorrow’s blogticle discusses additional changes wealth managers can expect in 2011.

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

[2] ERISA § 407.

[3] See generally, Labor Reg. §2550.404c-1.

[4] IRC §408(a)(3).

[5] IRC §408(m).

[6] IRC §408(e)(2).

Why is this Topic Important to Wealth Managers? Provides information and action steps wealth managers can use and take with regards to acting in the capacity as a trustee for retirement account purposes.    

Recently some wealth managers have established trustee services with regards to retirement accounts.  It’s a good fit, generally, when the wealth manager can offer clients information regarding deductible contributions to a retirement account, and further act as a fiduciary vis-à-vis trustee of those funds. 

What are the basic requirements in order to act in the capacity as a trustee for IRA and other retirement account purposes? 

First, an Individual Retirement Account (IRA) must be a trust created or organized in the United States for the exclusive benefit of an individual or his beneficiaries. Such trust must be maintained at all times as a domestic trust in the United States. The instrument creating the trust must be in writing. [1]

Secondly, the trustee of an IRA trust may be a person other than a bank if the person demonstrates to the satisfaction of the Commissioner of the Internal Revenue Service that the manner in which the person will administer trusts will be consistent with the requirements of the tax code.  The person must submit a written application including the information discussed below. [2]

The trustee applicant must demonstrate its ability to act within the accepted rules of fiduciary conduct. Such demonstration must include the person’s: [3]

(1) ability to provide continuity (generally satisfied when a legal entity which is owned by one individual who holds more than 20 percent of the voting stock, in the aggregate, but no more than 50 percent of such stock),

(2) ability to provide for an established location within the United States. 

(3) fiduciary experience or expertise sufficient to ensure that it will be able to perform its fiduciary duties.

Furthermore, the trustee applicant must show its capacity to account demonstrating its experience and competence with respect to accounting for the interests of a large number of individuals. [4]  The applicant must also demonstrate its experience and competence with respect to other activities normally associated with the handling of retirement funds. [5]

In addition, the trustee applicant must show proper net worth (generally at least $250,000) to accept retirement funds acting as a fiduciary. [6]  Also, at least once during each period of 12 months, the applicant is required to cause a detailed audit of the fiduciary books and records to be made by a qualified public accountant. [7]

Generally, the trustee applicant is also required to maintain retirement funds in a manner whereby investments of each account will not be commingled with any other property. [8]   This also includes the requirement that the applicant keep its fiduciary records separate and distinct from other records. [9]

Special, less stringent rules apply to passive trustees which may waive some of the specific requirements in an application as discussed above. [10]  A trustee is a passive trustee only if under the written trust instrument the trustee has no discretion to direct the investment of the trust funds or any other aspect of the business administration of the trust, but is merely authorized to acquire and hold particular investments specified by the trust instrument.

Tomorrow’s blogticle discusses additional changes wealth managers can expect in 2011.

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

[2] 26 CFR § 1.408-2(e). 

[3] 26 CFR § 1.408-2(e)(2).

[4] 26 CFR § 1.408-2(e)(3).

[5] 26 CFR § 1.408-2(e)(4). 

[6] 26 CFR § 1.408-2(e)(5(ii).

[7] 26 CFR § 1.408-2(e)(5)(iii).

[8] 26 CFR § 1.408-2(e)(5)(v).

[9] 26 CFR § 1.408-2(e)(5)(vii).

[10] 26 CFR § 1.408-2(e)(6).