Child Tax Credits, IRAs and 1099s

by Bruce Fenton

Originally published in The Fenton Report on March 29, 2004

In 2003, the federal government treated nearly 24 million families to a tax credit check. The U.S. Treasury mailed checks to many people who claimed the Child Tax Credit last year as an advance payment for the credit’s increase (tax law changes in 2003 increased the credit from $600 to $1,000 for qualifying families). The IRS used 2002 returns to determine qualified households. Qualifying children must have been born after 1986 in order to be eligible for the advanced payment.

However, to ensure that you do not believe in free lunches, the IRS is reminding taxpayers who plan to claim the credit on their 2003 federal income tax returns that they cannot claim the full $1,000 per child if they received an advance payment last year. Rather, the $400 advance must be subtracted from the credit amount computed for this year.

In the category of other news you can use from our tax authorities, the IRS recently issued new, relaxed guidelines for requesting a waiver of the 60-day deadline for IRA rollovers.

IRA owners may take a distribution from their IRA one time each calendar year without penalty or tax—as long as they get it back into the account within 60 days. Unlike Cinderella, whose coach turns into a pumpkin at midnight, your coach will be hit with tax and possibly a penalty if you are under age 59 ½ when you make this withdrawal and you don’t hit the deadline.

As we all know, sometimes even the best of intentions don’t allow us to make deadlines. For example, if you sent a check to a financial institution and they failed to get the money into your account in a timely manner, it’s too bad for you!

The new kinder, gentler IRS guidelines allow the IRS to consider “all relevant facts and circumstances,” such as whether financial institutions were late getting your check applied to the account, whether health reasons precluded you from acting in a timely manner, or whether “the dog ate the mail” and your payment disappeared. In any case, where there was once an “iron-clad” rule about being late, the IRS is now willing to consider good excuses.

While we are on the subject of IRAs, let’s review the rules for Roth IRA contributions. A Roth IRA accepts deposits of after-tax money that then may grow without taxation of dividends, interest or capital gains inside the account. When the money is paid out, it comes out tax-free, unlike normal IRA distributions, which are taxable.

An individual can contribute $3,000 to a Roth in 2004. This limit goes up to $4,000 for 2005-07 and $5,000 in ’08. The maximum contribution limits are phased out for individuals with adjusted gross incomes between $95,000 and $110,000 and for married couples filing a joint return with AGI between $150,000 and $160,000.

Finally, I have noticed a number of revised brokerage 1099 statements being sent out. A primary reason for revised statements is the reclassification of certain mutual fund dividends from non-qualified to qualified. Qualified dividends are taxed at the lower 15% rate, while ordinary dividends are taxed as ordinary income. The bad news is that you may have to file an amended tax return to properly account for the changes. The good news is that in most cases, this should result in lower taxes.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

IRA Distribution - Section 72(t)

by Bruce Fenton

Traditional IRA distributions are taxable at ordinary income tax rates when distributed, either to the owner or beneficiaries. Setting up an IRA to pay out using the Substantially Equal Periodic Payment (SEPP) is an effective way to begin early withdrawals without unnecessary tax.

If IRA account assets are withdrawn prior to age 59 ½, not only will the owner pay ordinary income taxes on the withdrawal but also a 10% excise tax penalty. Section 72(t) of the Internal Revenue Code allows the plan owner to withdraw funds from a retirement account without the 10% penalty if the withdrawals are a series of substantially equal periodic payments.

Once the owner begins taking distributions as part of a SEPP, the payments must continue for the longer of five years or to age 59 ½. For example, a 53-year-old IRA owner must take distributions for five and a half years until age 59 ½, whereas a 56-year-old owner is only required to take distributions for five years to age 61.

The amount you can withdraw is a function of the account balance and one of three calculation rates allowed by the IRA. Each results in a different allowed withdrawal amount, making it possible to tailor the distribution to meet your specific need.

The amortization method is determined by using the life expectancy of the taxpayer and his or her beneficiary, and a chosen interest rate. This interest rate cannot exceed 120% of the federal mid-term rate, which for January 2005 was set at 4.53%.

The annuitization method is similar to the amortization method; however the amount is determined by using an annuity based on the taxpayer’s age, age of beneficiary and chosen interest rate.

The required minimum distribution (RMD) method calculates an annual payout by dividing the account balance for that year by the life expectancy factor of the taxpayer and beneficiary. Using this method, the amount to be paid will be recalculated each year.

To see how this works, let’s consider John Smith, age 53, wife age 52, who has a $250,000 IRA he wishes to tap for early retirement income. His IRA investment return is 6% annualized. He plans to continue the withdrawals for 8 years, and then tap other retirement accounts, leaving this IRA to accumulate. Using joint life expectancy and an interest rate of 4.53%, his withdrawal amounts would be as follows:

• Amortization Method: Annual payment of $13,908 and account balance at the end of 8 years of $260,809
• Annuitization Method: Annual payment of $14,942 and account balance at the end of 8 years of $250,573
• RMD Method: Annual payment beginning at $6,579 and a balance in 8 years of $315,441.

John’s choice of withdrawal calculation will be based upon his need for income and his plans for his IRA once his required payment to age 59 ½ has been met. He can change his distribution type one time without penalty from the Annuitized or Amortized methods to the Life Expectancy (RMD) method if he feels the fixed amount would prematurely deplete his account.

Other rules that must be followed to avoid the imposition of the 10% penalty tax include the prohibition of withdrawing additional sums, or making transfers from this account. The owner may transfer the full amount without penalty to another custodian or trustee as long as the payments continue. Finally, additional contributions may not be added to the account balance while part of a SEPP plan.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Durable Power of Attorney

by Bruce Fenton

A durable power of attorney should be an integral part of any estate plan. While estate planning is considered by most to be a plan to settle your estate upon your death, it is often overlooked as a way to manage your affairs in the event you become incapacitated and rendered unable to do so yourself.

For example, Jim suffers a stroke. His largest asset is an IRA naming his brother as the beneficiary. The brother needs the money from the IRA to pay Jim’s medical expenses. Without a durable power of attorney giving him authority to act for Jim, he will not have access to this IRA resource without a court order.

Or, consider the case of Mary, who became incapacitated as the result of an automobile accident. Her life partner has no right to make medical decisions on her behalf without the durable power of attorney authorizing her to do so.

If you become incapacitated and you haven’t prepared a durable power of attorney for your finances, a court proceeding is necessary to allow your spouse, closest relatives, or companion to exercise some authority over at least some of your financial affairs. If you are married, your spouse retains some authority over property you own together—to pay bills from a joint bank account, for example.

If your relatives go to court to get someone appointed to manage your financial affairs, they must ask a judge to rule that you cannot take care of your own affairs—a public airing of a very private matter. And like any court proceeding, it can be expensive if a lawyer must be hired. When the courts act and appoint a conservator, or guardian of the estate, you lose the right to control your own money and property.

The appointment of a conservator is usually just the beginning of court proceedings. Often the conservator must post a bond—a kind of insurance policy that pays if the conservator steals or misuses property, prepare (or hire a lawyer or accountant to prepare) detailed financial reports and periodically file them with the court, and get court approval for certain transactions, such as selling real estate or making slightly risky investments.

Properly designed durable powers of attorney will solve these problems. When you execute a power of attorney, you give another person legal authority to act on your behalf. This person is called your “attorney-in-fact,” or sometimes referred to as your agent.

The word “durable” plays an important part in the process. If the word “durable” is not used, the power of appointment lapses, or ceases to be effective, when the person who granted the power is incapacitated.

Durable powers of attorney are most often used to give “attorneys-in-fact” power to act on the financial and health affairs of the grantor of the power. While a revocable living trust will often name a successor trustee to act for the beneficiaries of the trust, many assets and situations that need management are not governed by the living trust, such as property held in joint tenancy, or retirement accounts with a named beneficiary.

A durable power of attorney can be drafted so that it goes into effect as soon as you sign it. But you can also specify that the durable power of attorney does not go into effect unless a doctor certifies that you have become incapacitated. This is called a “springing” durable power of attorney. It allows you to keep control over your financial affairs unless and until you become incapacitated.

Single individuals, those with no immediate family nearby, and certainly anyone with property or investment assets should have current durable powers of attorney for financial affairs and health management. A simple will or even a living trust is not enough.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

IRA Management (Part 2)

by Bruce Fenton

Larger IRAs present major estate planning problems for the owner who wants to maximize the heirs’ legacy, not the federal tax system’s. Given the rate at which IRAs can grow over time, it will not be uncommon to see seven-figure IRAs as the major asset in many estates.

The federal tax system can extract a terrific bite out of such an IRA upon the death of an owner. For example, an IRA left by a decedent is subject first to the federal estate tax, which can be as high as 55% for larger estates. Then, the designated beneficiary, or the estate if no beneficiary is named, is taxed at ordinary income tax rates on every dollar withdrawn from the traditional IRA.

There are a number of planning steps that can be used to reduce some of the tax bite. Always name a beneficiary for each IRA. If the beneficiary is the spouse, two important benefits are realized.

First, a spouse who does not roll over the IRA and who is under age 59½ can draw from the IRA without the 10% penalty that otherwise applies, although income taxes must still be paid. Or the spouse can elect to roll over the IRA into his or her own name. Since this transfer qualifies for the unlimited marital estate tax deduction, there is no estate tax. Further, since the rollover is going directly into the spouse’s IRA, there will be no income tax paid until the money is distributed from the plan.

If the IRA is going to a non-spousal beneficiary, such as the decedent’s child, the beneficiary may elect to receive the IRA payments over his or her lifetime. This allows the IRA to possibly grow tax-deferred as a minimal amount is distributed each year. However, should the owner make the mistake of not naming a beneficiary, and if there is no spouse, the estate or heirs do not have the option of lifetime distributions.

Another solution is to spend the money while alive. It is counter-intuitive to think of spending dollars that represent taxable income if one has other less-taxed assets to spend first. However, keep in mind that by spending the IRA while alive, your estate will not be taxed twice at your death. Consider protecting other capital assets that will receive a step-up in basis at death. Even though these assets will be subject to estate taxation, they can be sold at the date of death and incur no income taxation. Such is not the case with an IRA.

Also consider giving your IRA to charity. If your estate plan calls for a sizable charitable bequest, make it out of an IRA. Your estate will receive a charitable deduction, reducing the value of the estate for death tax purposes. Since the charity does not pay income taxes, Uncle Sam misses out entirely.

Finally, when planning with a large IRA in your estate, by all means seek qualified tax advice. Laws are constantly changing, providing both opportunities for the informed and traps for the unwary.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

IRA Management (Part 1)

by Bruce Fenton

This isn’t your father’s retirement plan! No, tax law and company culture changes have shifted the responsibility for managing retirement accounts from the company’s shoulders to that of the employee. And judging by the size of the IRA accounts we see, the employees are doing a pretty good managing job!

It’s the very size of IRA accounts that raises planning problems, however. Where Dad’s IRA might have been for a few thousand, today it’s not uncommon for his children to have IRAs in six or seven figures.

The problems these larger IRAs pose are three-fold:

1. Managing the assets pre-retirement
2. Managing the assets after retirement, including dealing with complex required minimum distribution rules
3. Deciding what to do with an IRA for estate planning purposes.

This and my following column will speak to these issues.

Prior to retirement, the obvious objective is to manage the account to maximize growth and protect the principle. It is important not to trigger unintended taxation of the account. For example, it is not uncommon for an employee to change jobs every few years, each time leaving behind an orphan 401k plan. These orphaned plans should be consolidated into one IRA account through a trustee-to-custodian transfer.

Such a transfer will be considered a qualified rollover and not require mandatory withholding of 20% of the amount transferred—as would be the case if the employee withdrew the funds directly and then opened a new IRA account to accept the transfer.

Moreover, if an employee under age 55 attempts the do-it-yourself route and hangs on to the money more than 60 days, the rollover is disqualified and the owner will pay income taxes plus a 10% excise tax penalty for a premature withdrawal.

While you cannot borrow from an IRA as you can from many employer-sponsored retirement plans, you are allowed to roll the money over (take it out of the account and use it as you desire) for 60 days each year. Once per year per owner—but be sure it’s back not later than the 60th day!

By consolidating IRAs, the owner gains the advantage of ease of management. If set up in a brokerage account, then stocks, bonds, CDs, mutual funds, etc., may be combined in the IRA and the owner will see the entire account on one periodic statement.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.