Monday, December 10, 2018

Should I convert all or part of my traditional IRA into a Roth IRA?

It depends on your age, your appetite for investment risk, and whether or not you have cash available in a non-retirement account to pay the income taxes that will be due on the conversion. 

The main advantage of a conversion is that neither you nor your heirs will ever have to pay income taxes on money earned in the Roth IRA. The main drawback: when you do the conversion, you'll have to pay income taxes on the amount of money you convert. 

Conversion eligibility is limited to taxpayers whose annual household income is 100,000 or less. (The money you're converting will be added to your annual income for tax purposes, but it doesn't count toward this $100,000 ceiling.) 

When calculating their annual household income to determine eligibility for a Roth conversion, retirees must include their mandatory distributions from traditional IRAs and qualified retirement plans but only until December 31, 2004. After that date, mandatory distributions will no longer count toward the $100,000 ceiling on conversions. 

Unlike the decision to open a new Roth IRA, a Roth conversion isn't a no-brainer. However, it's certainly worth considering:

All withdrawals from a converted Roth IRA are taxfree after you've owned the account for five years and are over age 59 and a half. If you're over 59 and a half, you can withdraw your principal i.e., the money you put in tax-free no matter how long you've owned the account. If you're under 59 and a half, you'll owe a 10 percent penalty on principal withdrawn within five years of doing the conversion. 

You never have to tap a Roth IRA: It can pass income tax-free to your beneficiaries. (Your spouse can roll your Roth IRA into a Roth of his or her own. A non-spouse beneficiary must empty your account over his or her lifetime.)

By contrast, a traditional IRA is only tax-deferred. All your withdrawals are taxable as ordinary income, and there's a 10 percent penalty on money taken out before you're 59 and a half. After you turn 70 and a half, you must take money out of a traditional IRA every year. 

But a Roth conversion isn't free: You pay income taxes on the money you convert. (There's no 10 percent early-withdrawal penalty on this money, regardless of your age, as long as it goes into a Roth IRA.) The conversion makes sense only ifyour tax-free Roth IRA earnings will more than make up for the the tax going in. That depends largely on your answers to the following questions: 

Can you pay the taxes on the conversion out of a non-IRA account? 

If not, it's probably not worth doing. Let's say you have $100,000 in your IRA and the tax on the conversion is $30,000. If the taxes come out of the $100,000, you'll deposit only $70,000 into the Roth IRA. And if you're under 59 and a half, you'll owe a 10 percent early-withdrawal penalty on the $30,000 you're using to pay the taxes an extra $3,000 cost. 

How long will your money grow tax-free in the Roth IRA? 

If you're under 45, or intend to leave the Roth IRA untouched for your kids or grandchildren, the conversion makes more sense than if you'll have to start emptying the account in just a few years. And how aggressively will you invest the account? The more you can expect to earn in a Roth IRA, the more sense the conversion makes.

What investments are appropriate or inappropriate for college?

It depends on who owns the investment and how much time you have before freshman year. 

Consult your tax adviser as well as your financial planner before buying investments for your child's account. You want to avoid buying a tax-advantaged investment that loses its tax advantage when owned by a minor. 

Most parents instinctively look for safety and tax breaks in a college investment. Unfortunately, investments that are promoted for safety and tax advantages also have low rates of return and high sales and management costs a fact that isn't always mentioned by the people who sell them. 

Some of these investments also charge hefty redemption fees that at best make it costly to change investments and at worst may still be in effect when you need to tap the account for the first tuition payment. 

Annuities, a type of insurance contract sometimes sold as a tax-sheltered college investment, are a prime example. A fixed-income annuity guarantees you a specific rate of interest that changes every one or two years not unlike a CD that keeps rolling over. Avariable annuity lets you invest in a menu of mutual funds. In both cases, the annuity's earnings are untaxed until the money is withdrawn. 

But annuities are the last thing to buy for a custodial account: any withdrawal that's taken before the annuity owner turns 59 and a half years old is subject not just to income taxes but to a 10 percent federal excise tax as well. Don't even consider an annuity as a college investment unless it's owned by a parent or grandparent who will be 59 and a half by the time the money is needed.

Even then, annuities aren't a good college investment. The redemption charge can last from five to nine years after you buy the product. Just because you're old enough to escape the government's 10 percent tax penalty doesn't necessarily mean you'll avoid the insurer's surrender penalty. 

Annuities also have hefty ongoing expenses. In 2005, the average variable annuity invested in a U.S. diversified stock fund cost 2.05 percent a year, according to Morningstar; the average variable annuity invested in a fixed-income fund cost 2.00 percent a year. Those charges are deducted from annual returns. That's why, despite the tax-deferral, a variable annuity invested in a stock fund typically doesn't outperform a comparable taxable stock investment until you've held it for 15 years.

Cash value life insurance is also marketed as a college investment. In cash value policies, part of your premium buys insurance coverage and the rest goes into an investment account whose earnings grow untaxed until withdrawn. You can take tax-free withdrawals equal to the premiums you've paid; you can also use the policy's accumulated cash value as collateral for a loan at favorable interest.

The life insurance pitch is that when your child is ready for college, you take a policy loan to pay his tuition. In a well-structured policy, loans aren't considered taxable distributions. And agents point out that when you save in a life insurance policy, you don't reduce your child's eligibility for financial aid because under most current college aid formulas life insurance and annuities aren't considered assets available to pay tuition. 

Meantime, the insurance protects the child if you die.

Here's the downside that many insurance agents don't mention: The policy's high ongoing expenses substantially reduce your return on investment. Cash value policy sales charges alone can range up to 100 percent of the first year's premium. Even if you buy a variable policy, which allows you to invest in stock funds, it typically takes 15 to 20 years to earn more in the policy than you would in a taxable investment because the policy expenses are so high. 

What's more, the death benefit that's actually guaranteed by many variable life policies is small. Its ultimate value depends on the performance of the investments you choose. If they tank just before you're hit by a truck, the death benefit is unlikely to pay enough to cover college. Finally, college aid formulas change every year. Assets that are currentiy exempt may not be exempt next year let alone a decade or more into the future. 

Series EE bonds are worth considering for some parents. Ask your tax adviser if you meet the income test that qualifies you for a special tax exemption on the interest earned on the bonds if it is used to meet eligible college expenses.

Other pitfalls for unwary EE bond buyers: For purposes of the tax exclusion, college tuition is an eligible expense but the cost of room, board, and books is not. And to qualify for the exemption, you must spend the money in the same year the bonds are redeemed. In other words, if you cash them in a year before your child goes to college and park the proceeds in a money market fund to earn higher interest, you blow it. 

So what should you buy for a custodial account? Assuming your child won't enter college for eight years or more, you need a growth investment to beat inflation. Many financial planners recommend that you buy diversified stock funds until your child is within five years of college, and then start transferring the money into CDs or Treasuries that will mature during each of your child's college years. That investment strategy also makes sense from a tax viewpoint: Growth stock funds that focus on long-term gains won't generate much in the way of currentiy taxable income; most of the investment profit won't be taxable until you sell shares after your child is 14. 

Zero coupon bonds can also be a good college investment when interest rates are high, because they let you lock in the prevailing rate for the life of the bond. They're much less attractive in a low-rate environment. (You can forget about zero coupon bonds if everyone you know is thinking of refinancing his mortgage.)

A zero coupon bond is sold for a fraction of its face amount. As the name implies, you get no periodic interest payments. Instead, you receive all the interest in a lump sum along with your principal when the bond matures. Depending on current rates, you might pay as little as $300 for a Treasury zero coupon bond that returns $1,000 in 2010. 

The great attraction of zeroes is their predictability: You know exactly what you'll earn, and you can buy bonds that mature in each year your child will be in college. But zeroes have two significant drawbacks: First, if you must sell them before maturity, you may take a substantial loss, since their market value fluctuates dramatically. And second, the bonds' owner (you or your child) owes taxes every year on the interest they earn, even though it isn't actually paid until the bonds mature. Interest on federal zeroes the safest to own, since they carry no default risk is exempt from state and local taxes. But it is federally taxable.

Does it make sense for me to set up a custodial account for my child's college costs?

It depends on: 

1 Your tax bracket; 

2 Whether or not your child is likely to qualify for need-based financial aid to college; and 

3 Your gut reaction at the prospect of making a nostrings six-figure gift to an 18-year-old. 

Custodial accounts are owned by children. If you're in a higher tax bracket than your kids, putting money in their names is a good way to reduce the tax bite on college savings. But there is a downside: You can't take the money back. As custodian, you can spend it only on the child's behalf. And she gains control of the account as soon as she reaches legal majority. Also, the fact that she has money in her own name may reduce her eligibility for financial aid, including low-cost college loans. 

To set up a custodial account under the Uniform Gift to Minors Act or the Uniform Transfer to Minors Act, all you need do is fill out a one-page form available at any bank, brokerage, insurance, or mutual fund company and start depositing money. 

In 2000, the first $700 of income earned in the account is tax-free. In other words, assuming an 8 percent annual return, you'd need to have $8,750 in the account before its earnings became taxable. The second $700 of income is taxable at the child's rate, which is 15 percent, assuming she has no other income. Earnings over $1,400 a year are taxed at the parents' rate until the child turns 14. After the child's 14th birthday, all custodial account earnings are taxed at her rate. 

There's nothing to be gained from a custodial account if you're in the same 15 percent tax bracket as your child. Its benefit is also questionable if you think your child will qualify for need-based financial aid to college. 

Financial aid is designed to fill the gap between the cost of college and your family's ability to pay it. Aid formulas assume a student can pay up to 35 percent of her own assets each year for college. Parental assets, by contrast, are assessed at up to 5.65 percent. 

In other words, keeping assets in your own name instead of a custodial account might let your child qualify for a bigger financial aid package. 

But the biggest drawback is that when you put money into a child's custodial account, you've made an irrevocable gift. You can't take it back and as custodian, you control the money only until the child attains legal majority. In most states, that's 18 an age at which your kid may be more interested in buying a Lexus and financing a rock band than investing in a postsecondary education. 

What recourse do you have if that adorable baby grows into a teenager who can't handle a modest monthly allowance, let alone a six-figure college fund? Legally, none. Your child can sue you if the money isn't turned over to her. 

On the other hand, few 18 year olds seek legal advice about their rights to take possession of custodial accounts. Many parents consider it prudent to describe a custodial account as a legacy or a gift earmarked for college only or even to let its existence slip their minds if their kid doesn't turn out as they'd hoped.

Which bonds are tax exempt?

It depends on your tax bracket. 

Too many people assume municipal bonds must be a great investment because rich people buy them, not realizing that municipal bonds don't make anybody rich. 

Rich people buy municipal bonds to minimize their taxes. If you're in a 39.6 percent marginal tax bracket, a 4.5 percent tax-free return is like a 7.45 percent taxable return. To someone in the 15 percent bracket, the same 4.5 percent tax-free return is only the equivalent of a 5.29 percent taxable return. 

Municipal bond interest is federally tax-free, and free of state and local taxes to residents of the municipality. That always sounds enticing. But if you're in a low tax bracket, ask your adviser how much you'd earn in Treasuries instead. It might be more. Treasuries are free of state and local taxes, and they're also safer than municipal bonds.

Another advantage of Treasuries is that unlike munibonds, they aren't callable. A callable bond can be redeemed before its scheduled maturity date. Issuers call their bonds for the same reason you refinance your mortgage: to take advantage of lower rates. When your bonds are called you must reinvest in a lower-rate environment.

Should I open a Roth IRA?

Yes, if you're eligible. Roth account earnings are tax free, you have greater access to your principal than you would in a traditional IRA, and you never have to empty the account. In fact, the new Roth is superior to the traditional IRA in every way but one: Roth IRA contributions are not tax deductible.  

You can contribute up to $2,000 a year to a Roth IRA for yourself and up to $2,000 a year for a nonworking spouse, depending on your income: Eligibility phases out for single taxpayers earning between $95,000 and $1 10,000 a year, and for married taxpayers filing jointly who earn between $150,000 and $160,000. Your eligibility is not affected by whether or not you participate in an employer-sponsored retirement plan. Ifyou want to, you can contribute both to a traditional IRA and to a Roth IRA, but your total annual contributions to both accounts cannot exceed $2,000 ($4,000 for a couple.)

How should my spouse and I coordinate our 401(k)s?

Treat your two 401 (k) plans as one portfolio to maximize your investment return. 

Ideally, a retirement portfolio should include good mutual funds in four basic stock categories growth, growth-and-income, small company, and international and a short-to-intermediate corporate bond fund. Chances are you'll need two 401 (k) plans to achieve this broad a mix; many plans don't yet offer a small company fund or an international fund. 

If you can't fully fund both 401 (k)s, give first priority to the one with the biggest employer match, second place to the plan with better investments. A 50 percent match is an immediate, risk-free 50 percent return on your money handsome compensation for a mediocre investment line-up. 

But double-check how long it will take to become vested in the matching contributions. By law, you must be fully vested after seven years; but some companies start vesting after the third year, while others don't begin until you've participated in the plan for five years. A great match isn't worth anything if you're likely to leave the job before you own it.

Friday, December 7, 2018

How much tax do you pay on mutual fund withdrawals?

Taxes on fund profits are often an unpleasant surprise. Ask your adviser about tax consequences before selling shares. 

You'll owe taxes on fund profits every year, whether you sell shares or not, unless you own the fund in a tax-deferred account like an IRA or a 401 (k) plan. Mutual funds pass their annual earnings to their shareholders. You must pay taxes on these distributions, even ifyou automatically reinvest them in additional fund shares. 

And of course, when you sell mutual fund shares, you'll owe taxes on any profit over your Original cost. Your profit when you sell shares you've owned for 12 months or less is taxable at ordinary income tax rates. Your profit on shares that you sold after January 1, 1998, and owned for more than twelve months is taxable as a long-term capital gain at a top rate of 20 percent. If your ordinary income tax rate is 15 percent, your long-term capital gains rate on assets held more than 12 months is 10 percent. 

Starting in 2001, profit on shares bought after 2000 and owned for more than five years will be taxable at a top rate of 18 percent. If your ordinary income tax rate is 15 percent, your profit on these shares will be taxed at 8 percent. 

Just to make your life more complicated, the federal government isn't the only entity taxing capital gains. The states impose capital gains taxes, too and some states don't define long-term and short-term gains the same way as the federal government. (This is why you have a tax adviser.) 

When you sell shares, you owe taxes on the difference between your original purchase price (known in tax jargon as your cost basis) and the sale proceeds. Let's say you originally invested $1,000, and over time you reinvested an additional $800 in dividends. Then you sell the entire fund for $2,000. What's your profit? 

If you think it's $1,000 the $2,000 sale price minus your initial $1,000 investment you're wrong. Your true cost includes that $800 of reinvested dividends as well as the $1,000 initial investment. Your taxable profit is only $200-$2,000 minus $1,800.

If you sell all your shares at once, you're taxed on the difference between your total investment and the sale proceeds. But what ifyou sell only some ofyour shares? What with periodic purchases and reinvested dividends, you've bought shares at many different prices. What's the original cost of the shares you're selling? 

The IRS currently gives you two basic ways to answer this question: You can assume you're selling shares in the order you bought them, using the chronological cost basis recorded in your statements; or you can calculate an average cost per share, regardless of when they were purchased. 

For mind-numbing detail on how to do these calculations, read Internal Revenue publication 564, Mutual Fund Distributions. Alternatively, hand your year-end fund statements to your tax accountant and pay him or her to do the calculation for you. (If you're lucky, the mutual fund company will do it for you. Some big fund companies automatically run these calculations for shareholders every year.)

Ways to minimize mutual fund tax trauma: 

Don't write checks on your mutual fund accounts. 

Every time you write a check, you sell shares and realize a gain or a loss you'll have to report on your tax return. If you want to tap your funds for income, take the distributions in cash instead of reinvesting them. 

Don't trade a lot in a taxable account.

Switching money from one mutual fund to another is as easy as picking up the phone but every switch is a taxable transaction. 

Don't buy a mutual fund for a taxable account in November or December before finding out the date on which it distributes its annual capital gains to shareholders.

If you buy the day before, as a shareholder of record you're immediately presented with a tax bill. Say you buy 2,000 shares at $10 each. The fund declares a $1 per share dividend the next day. The official share price drops to $9 and the extra $1 per share is considered a taxable distribution. You owe taxes on $2,000, whether you leave it in the fund or not. 

Do sell all your shares in a fund at one time instead of in stages if they're in a taxable account. If you're a retiree and need to sell shares regularly for income, do it once a year and put the proceeds in a money market fund. You can write checks on a money market account without incurring any capital gain or loss because money market funds maintain a stable $1 per share value.