The New Laws Governing Roth IRA Coversions in 2010
The New Laws Governing Roth IRA Coversions in 2010
Jim Lange, JD/CPA is a nationally-recognized IRA and Roth IRA conversion expert and the best-selling author of Retire Secure! Pay Taxes Later. For more information on Jim Lange or if you are interested in hiring Jim as your next keynote speaker, visit http://www.retiresecure.com/speakertour.php.
The New Laws Governing Roth IRA Conversions
Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh based CPA, Attorney, and Retirement and Estate Planning expert. Jim is also the Author of Retire Secure Pay Taxes Later. To find out more about his book, his practice Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at www.paytaxeslater.com. Now get ready to talk smart money.
Hana Haatainen-Caye: Welcome to The Lange Money Hour: Where Smart Money Talks. We are talking smart money. Thank you so much for joining us tonight. I am Hana Haatainen-Caye H joining Jim Lange, nationally recognized IRA, 401k, and Roth IRA conversion expert. Jim is the Author of the best seller Retire Secure! with testimonials from Larry King, Charles Schwab, Jane Bryant Quinn, Ed Slott and 60 other financial professionals. Joining us tonight are our special guests, Steve Kohman, CPA, CSEP and Matt Schwartz, Esq. Steve is a key member of the Retire Secure! team at Jim Langes office specializing in income taxes and estate and Roth conversion planning. He and Jim as coauthors were awarded the CFP Board Article Award for The Roths Real Advantage published nearly a decade ago.
Jim Lange: Steve has a long background of Roth IRA conversion expertise in fact the book that you mentioned Retire Secure! has a lot of quantitative analysis and Steve did practically all of it. I go around the country giving talks to financial advisors regarding Roth IRA conversions and I am going to say maybe 1 or 2 out of the 1,000 if that has the degree of sophistication and the ability to do projections and to come up with excellent conclusions as Steve, so really we are talking about a really premier Roth IRA conversion expert.
Steve Kohman: Thanks, Jim, I am glad to be here to talk about the new Roth conversion law with you.
Hana Haatainen-Caye: Steve I wanted to start off by asking if you think the 2010 conversion law is making much of a difference?
Steve Kohman: Oh absolutely, I have seen so many clients and done so much planning and there were so many people who couldnt afford or excuse me couldnt convert to a Roth IRA in previous years that with this new law now can convert in 2010 and they are converting even larger amounts in 2010 then ever before. Lots of money is being converted which means a lot of money is going to go to the US treasury in the short term, but it means a lot of people are going to have some long term benefits in the long term.
Hana Haatainen-Caye: Jim what do you think about this, is the 2010 conversion law making much of a difference?
Jim Lange: Well, first of all, I have been a big Roth IRA conversion advocate for over a decade and its not because I am really into Roth IRAs it is because I and Steve run projections and we run numbers and we say ok lets take the status quo that is Mr. Status Quo doesnt make a Roth IRA conversion and we make reasonable assumptions about interest and what is going to happen in the future and we run those projections. Then we say well lets take example B where Mr. Roth does make a Roth IRA conversion, we run projections and it turns out in almost all cases that the person who makes Roth IRA conversions are much better off than people that dont. So we know this we have this published in peer reviewed journals and really the question for a lot of people is how much and when.
So, this is something that Steve and I have been doing for over 10 years. The thing that is really exciting now is that people regardless of their income are able to make Roth IRA conversions. So for example lets say that your income has consistently been $100,000 or more in the past, you werent allowed to make a Roth IRA conversion, so even though I have really been enjoying working in this area and we have run thousands of numbers it has been for people who have incomes of less then $100,000. Now with no income limitations and that is really big news, there is no income limitation for the people that make Roth IRA conversions. To me the flood gates are opening for high income tax payers and Steve and I are perfectly situated to help these people because we have been doing it already for 10 years.
To me the issue is for a lot of people how much to convert, when to convert, and coming up with a long term Roth IRA conversion plan and we talk about that in our workshops. While we are here, Steve, maybe I will ask you what kind of factors do you consider so I know we work together and I like to come up with a couple of ideas and a couple of starting points of how much somebody should convert or when they should convert, but ultimately you are really the person who runs the numbers and who does the quantitative analysis, what kind of factors do you take into account in your meetings when you develop a Roth IRA conversion plan?
Steve Kohman: Well there is quite a few factors to take into account. Some of which are objective factors and a lot of which are subjective factors. The objective factors are the things that you might first imagine when you think about Roth conversions, that being that when you do a Roth conversion you have to pay income tax on the amount you convert.
Jim Lange: Oh wait; let me interrupt you for one quick moment there. Youre making, lets say you make a Roth IRA conversion of $100,000 and to keep play simple lets assume we are talking about a 25% tax rate. The first question is where are you going to get the money to pay the tax on the $100,000 conversion? In other words you are going to owe the IRA $25,000 on this conversion, where do you recommend that people get the money to pay for that tax?
Steve Kohman: Well, if they have money outside of the IRA, outside of the tax deferred investment environment that is the best place to take the money to pay the tax. If you pay the tax from the IRA itself, lets say because all of your money is in the IRA or a retirement plan then it doesnt come out to be as beneficial to you because part of the long term benefit of a Roth IRA is that the tax money that you use to pay the conversion grows, but gets taxed every year on interest dividends and capital gains. This is another layer of tax that does not occur inside of a Roth IRA and so it is better to have money to pay the tax in your savings outside of the retirement plans.
Jim Lange: Thats right in fact didnt you run numbers that said if you take away the estate tax advantages and you take away the advantages of a minimum required distribution its actually basically a break even isnt it?
Steve Kohman: Yeah, as long as the funds are invested the same way in the Roth as they would have been in a traditional IRA it would always be the same in value no matter how long you go. Unfortunately, you do have required minimum distributions when you are 70 years old and what that does is it moves money from the tax deferred environment in an IRA into the taxable environment in what I call after tax funds where it is taxed on interest dividends and capital gains every year and over the long term your money just doesnt perform as well as if it were in a tax free account for the rest of your life like in a Roth IRA.
JimLange: So what you are basically saying then is if you have the after tax dollars then you should use those dollars to pay the tax on the conversion if you dont it still might be worthwhile, but it isnt quite as beneficial. Is that a fair summary?
Steve Kohman: Thats right, it still could have some advantages.
Jim Lange: I didnt mean to interrupt, but I think that that is an important point. Why dont you go on with a few more of your factors?
Steve Kohman: Ok, so one of the main factors then would be how much tax do you pay when you do the conversion is the amount of your conversion so large that you are going to be bumped up into a higher tax rate when you do the conversion or as you can now imagine with no income limit for Roth conversions people who are in the very top tax bracket can do a conversion and end up not paying anymore tax percentage wise by doing a conversion because they are already in the top tax bracket. So for those sorts of people that issue isnt such a concern for them and thats why 2010 and in the future years is going to be such a big boom to the wealthier people who are already in the top tax bracket and why this new law is a fantastic investment tool for many many people who never got to take advantage of it before.
Jim Lange: But, Steve, I know that you have run some numbers for some high income and high net worth clients and I think in some cases if they made too large a Roth IRA conversion and they didnt have a minimum required distribution later on and yet they were retired that sometimes they would be in a lower tax bracket and you havent told these people to convert everything you just told them to convert a certain amount but less then their entire Roth. Is that also right?
Steve Kohman: Oh yeah that is usually the case. Theres a condition I call over converting where maybe you convert so much to a Roth that you dont have any income the rest of your life because all you have is your social security income and maybe some pension income but it is not enough to use up your very low tax brackets in the future like the 0% tax bracket and the 15% tax bracket and if you pay 35% tax when you do the conversion it makes it hard to justify converting that much money.
Jim Lange: Yeah, in fact didnt you do an analysis where if somebody was paying taxes at 35% and then later they just went to 28% that it took them something like 14 years to break even. Does that sound right to you?
Steve Kohman: Yeah that sounds right and as a matter of fact just today I was working on the calculations spread sheet which shows the break even period if we are going from 35% tax on a conversion to 25% tax the rest of your life is a 17 year break even period. Taking that a step further it is not just your tax rate the rest of your life and this is one of the subjective factors to consider that is very important and that is your beneficiarys tax rate, your children perhaps or perhaps even your grandchildrens tax rate.
Jim Lange: Well, I think what you are referring to is if you use the old rule that you and I have developed which is lets assume that you have 3 types of money you have plain old after tax dollars savings money outside any type of retirement plan, then you have traditional IRAs and retirement plans, and then you have Roths. What we usually advocate subject to some exception is first spend your after tax dollars, then spend your IRA dollars, and only last should you spend your Roth dollars. So since particularly in your analysis you usually dont recommend people convert their entire IRA to a Roth people usually end up with that, that is some after tax, some IRA, and some Roth. If we are going to spend first the after tax dollars, then we are going to spend the IRA dollars it is very likely that you are going to die with Roth IRA dollars and what you are saying now, if I am understanding right, is if you are going to do this analysis correctly you have to take into account the tax bracket of your children and even perhaps your grandchildren. Is that right?
Steve Kohman: Thats right. As you know the benefit of the Roth occurs over a long period of time. The longer period of time there is the more of a benefit there is going to be and so when we are talking about 50 or 80 years we are talking about having your children inherit your money and maybe your grandchildren. So their tax situation, their financial situation, what state they live in are all relevant factors.
Jim Lange: Well, I like that. One of the things that I really like about Roth IRA conversions is it is true genuine multigenerational planning that doesnt cost you money. So for example if I say hey Steve I have the best Life Insurance policy in the world for you and boy all you are going to have to pay is $100,000 and your kids are going to get so much more money this is going to be wonderful, and that might even be true but ultimately it is still money out of your pocket. You are reducing your purchasing power and youre increasing your childrens or grandchildrens purchasing power. With a Roth IRA conversion you are actually increasing your purchasing power during your life time. So lets just talk about this. Everybody, we always talk about estate planning, the kids and the grandkids and we will get to that, but lets assume that you dont have kids or you have kids and you hate your kids and all you really care about is you or you and your wife, would you still make a Roth IRA conversion is it still as favorable? How would that play into it if you said hey look I educated those kids, I put braces on those kids I am done, if there is anything left over that is a bonus I am mainly interested in me. Would you still do a Roth conversion?
Steve Kohman: Well you certainly might benefit from a Roth conversion in many situations. We have many clients who are in that boat who maybe they dont have kids and they are thinking about the benefit during their own lives and then what is more important is the tax rates that they are going to face for the rest of their own lives and their future tax rates that they are going to face and how much tax they pay on the conversion and obviously if you are going to pay less tax on the conversion then you would pay in say 2011 or 2020 or for the rest of their lives then obviously a Roth conversion is a very good idea. If they pay slightly more tax on the conversion it is still probably a good idea and so we want to take a look at those future tax rates and as you know future tax rates could be higher for a lot of people and those factors come into play quite a bit but in answer to your question yes, could still make sense.
Jim Lange: Well didnt you do some analysis where if a guy " lets say he is 65 years old and he makes a $100,000 conversion. Now before he was in the 25% bracket, but now we are adding $100,000 to his income so now at least part of that Roth IRA conversion income in taxed at 28% and lets call him Mr. Roth and lets call the guy who didnt who has the exact same amount of money Mr. Status Quo. Didnt you run some analysis comparing Mr. Roth and Mr. Status Quo, what happens 20 years after you make the conversion?
Steve Kohman: Oh yes and thats right and it comes out to be quite a good advantage because if you dont convert that money it is going to be taxable income at some point in the future and the advantages of the Roth and moving money out of the taxable environment into the tax free environment is such an overwhelming tool and powerful tool for the Roth that it works out to their advantage in many cases.
Jim Lange: And wasnt that somewhere around $40,000 in 20 years that is if you converted $100,000 that they would be better off by $40,000?
Steve Kohman: Yeah, something along those lines, right.
Hana Haatainen-Caye: Ok thanks Steve, we are going to take a short break. We will be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back where we are talking smart money with
Jim Lange and Steve Kohman. We will also be speaking with Matt Schwartz in
a little bit. Steve can you tell us how you feel about the law to spread 2010 conversion income to 2011 and 2012?
Jim Lange: Before you say how you feel about it would you please describe how it works? That is probably something more of a concern.
Steve Kohman: Yeah sure I would be happy too. The new law says that if you do a Roth conversion in 2010 that income is required to be reported in 2011 and 2012 unless you make a special election on your 2010 tax return to allow you to tax it in 2010. Well that is totally different than all the other years. The rules on Roth conversions have always been taxed in the year you do the conversion. I think it is deceitful of the IRS to do it that way because as you may or may not know the tax rates are probably going to go up in 2011. For example it is commonly known that the 33% tax bracket will be a 36% tax bracket and the 35% tax bracket will be a 39.6% tax bracket. So the IRS is rubbing their grubby little hands together saying oh boy lets collect even more money lets make them pay tax at the higher rates.
Jim Lange: Wait Steve, can I ask you a quick question? When you say that the rates are going to be higher is that something that you think is going to happen just because of the general way the country is going or is that already on the books right now?
Steve Kohman: Its already on the books, it is part of the George Bush tax law
from 2001-2002 time frame and whats happening is they are going to sunset that law so the law right now is that those tax rates go up and under the Obama administration he doesnt want to tax people earning less than $250,000 so he is going to probably keep the 28% tax rate and the 25% tax rate where they are, but if he doesnt pass a new tax law even those rates are going to go up in 2011.
Jim Lange: So what you are saying is even forgetting any changes in the future even forgetting any of the needs that we have in terms of funding healthcare and the wars and everything else the existing tax rates are tax payers that we are talking about are going to have to pay more tax and then if there is additional taxes then presumably the Roth IRA conversion is going to be even more beneficial. Is that right?
Steve Kohman: Yeah, thats right.
Jim Lange: Alright why dont you go back to 2010 versus 2011 and 2012.
Steve Kohman: Well I like my clients to pay as little tax as they have to.
Jim Lange: Amen.
Steve Kohman: So we generally recommend that they pay the tax in tax year 2010 and not only is it an advantage because they are paying less tax in 2010 but if their Roth conversion plan is a multiyear plan where they are going to convert a certain amount every year up to a certain tax bracket for example, then they can do additional conversions in 2011 and 2012 while having an additional conversion in 2010 be taxed in that year. If they dont make the special election well then they are sort of missing the opportunity to do any conversion in 2010 at the lower tax rates.
Jim Lange: So you often end up with the ideal, based on running the numbers, is a series of Roth IRA conversions not a one time shot, but a series often trying to stay in lower tax brackets and if they are not careful about the election that can blow the strategy. Is that right?
Steve Kohman: Yes Jim, the conversion plans that we do for people are usually multiyear plans and even lifetime plans because the new rule is that anyone can do a Roth conversion in any year. Now that tax law may not permanently be the case the IRS might eventually say we cant do Roth conversions anymore because they are loosing out on future revenue, but for now they can always do conversions and for many people it makes sense to convert and pay a lower tax rate so that it is a multiyear conversion plan.
Jim Lange: So in other words you might say well you might have a long-term plan that converts say $500,000 but it might be prudent to say convert $100,000 a year for 5 years depending on the individual circumstances. Is that a possibility?
Steve Kohman: Yeah thats right. So the timing of the taxes paid is an
important issue and also the other subjective factors that consider include things like when is a taxpayer going to retire, is their income going to change in the future, maybe they are going to have lower tax rates by virtue of having less income because they retire or maybe a significant window of opportunity for some people to convert and pay less taxes so we have to look at the tax rates they are facing not only in 2010 but in 2011, 2012, and really for the rest of their life.
Jim Lange: So what you are really saying is that its good to have, if you will, a life time Roth IRA conversion plan of how much to convert and when to convert and it might be multiple year and it might be very long term. Is that right?
Steve Kohman: Thats right and of course it is very objective for me to
calculate their 2010 tax. I can do it with reasonable precision but for 2015 or 2020 I mean things get a lot less objective and a lot more subjective the further out in the future you go.
Jim Lange: Well thats true, but I think one of the things that you do that I think is very unique. You know I run around the country talking to all these advisors and I actually just did an 8 hour, how would you guys like to hear me for 8 hours talk about Roth IRA conversions and one of the problems with trying to help these guys run numbers something that you do is that they are not CPAs that know how to use a tax program. So you not only use a specialized software for Roth IRA conversions but you actually take out our 1040 software, if you will, lets call it super turbo charge turbo taxes - we obviously have a high end one and you actually put the numbers in and you can find out about, lets say, little surprises like phase out of itemized deductions or alternative minimum tax etc.
Steve Kohman: Oh yeah, there is a lot of surprises there. As a matter of fact I was doing one today where the tax payer was paying 35% tax even though they were in the 33% tax bracket and then for the next level of conversion they only paid 33% tax even though they were in the 35% tax bracket because of the alternative minimum on tax. So theres loss of credits, Altmin tax, and taxability of social security, and even the Medicare tax deducted from your future social security income these are all hidden little tricks, hidden little taxes that the IRS plays on you as a tax payer that you are not really aware of unless you use the tax software program and have somebody knowledgeable to figure it out.
Jim Lange: Well lets say you like to be a little bit of a do-it-yourselfer, it sounds like it is going to be very difficult to actually calculate what your effective tax bracket is because of all these items. Is that right?
Steve Kohman: Yeah it is very difficult and sometimes it leaves an opportunity on the table if you arent aware of all of those factors.
Jim Lange: And then sometimes I remember you telling people that they shouldnt convert when they thought that they were in the 15% bracket and you showed them, what bracket did you come up with some of the people that were in the 15% bracket to convert and it was the number was still less than $67,000 but what tax bracket were they in?
Steve Kohman: Typically if they get social security income and more and more of it gets taxed as your income goes up, these people in the 15% tax bracket were really paying 27% tax on the conversion and even there is a level where they would technically be in the 25% tax bracket paying like 45% tax on a Roth conversion amount. So it is very deceitful the way the tax laws are set up. I dont think that the IRS meant for it to be that deceitful but you just have to know what you are doing and know the tax implications of the taxes you pay on a Roth conversion.
Jim Lange: So let me ask you this. Does it make sense if you are a listener out
there and lets say that you have a CPA or maybe you do it on your own, does it make sense to hire a qualified professional to help do some of these projections to help you come up with a long term Roth IRA conversion plan?
Steve Kohman: Oh yeah, two heads are definitely better than one and using a consultant, in my opinion, is very important thing to do.
Jim Lange: Ok alright, I had another question about something that we like to do a lot and in fact I actually wrote an article back in 2002 about this and it is taking advantage of a particular portion of the law where you can, and the technical word is recharacterize but I like to think of it as undo a Roth IRA conversion. Can you tell us a little bit about how that works and why that might be an important buffer if you think that we are living in volatile times with investment rates of return and values of investments going up and down?
Steve Kohman: Oh absolutely. This has come into play quite a bit over the last year or two where people did a Roth conversion, for example they did a $100,000 Roth conversion, but the stock market dropped after they did the conversion and maybe their Roth IRA only ended up being worth $50,000. Well those poor people had to pay tax on $100,000 were it not for this undo rule which allowed them to undo their conversion and not pay any tax at all on the conversion and put it back into the traditional IRA where it should be. For some of those people they were then able to do a Roth conversion the next year and pay tax on only $50,000 or in some cases convert another $100,000 the next year, but in any case they save a lot of money in taxes.
Jim Lange: Alright, so lets say for discussions sake you do a Roth IRA conversion and lets say you do it in January or February of 2010 and so your fully expecting, and lets even say that it is going to be taxed as a 25% bracket and you are fully expecting to pay $25,000 in taxes or you even file a return next April and you do pay $25,000 in taxes and that $100,000 investment now goes to $50,000. So you are pretty upset because you pay tax on $100,000 and its only worth $50,000 you are saying you can recharacterize it or undo it.
Steve Kohman: Yeah you can undo it all the way up to the October 15th date after the year you do the conversion.
Jim Lange: Alright well that sounds like a great thing in the even that you are, lets say, on the fence of whether you should convert or not or whether the amount is if you actually end up converting what turns out to be a loser you can recharacterize that. Are there strategies that you can recharacterize that during the year that you convert or is it always better to wait until 2011 to recharacterize?
Steve Kohman: Well I guess there is no immediate rush to do it in the year you convert other then the fact that you have to wait 30 days to convert the same money, but typically people arent converting their entire IRA accounts so they could wait until after year end to recharacterize it to see if the investment comes back. Another advantage to doing a recharacterization is that as you eluded too, you may want to convert a higher amount if you are not certain of the amount to convert and then you can recharacterize a piece of the Roth conversion that you have done and you can use hindsight to determine #1 how well is the investment performed and #2 what are the real tax effects now that you are able to look backwards and see a real tax return, maybe some factors of your income werent completely known when you did the conversion earlier in the year. So it is a very useful tool and I always tell people who do conversions to take a look back say in June of the following year to see how the investment is performing.
Jim Lange: Ok and I guess what I will add to that is I sometimes, since it is very hard and very problematic to recharacterize a portion of one particular account it might make more sense to separate some IRAs into several accounts and perhaps recharacterize the one that does the worst. The other thing that I will mention is that sometimes what I like to do is to recharacterize during the year, so lets say it is 2010 and lets say you want to convert $100,000 and you convert it and it goes down to $50,000 but you still wanted to convert $100,000 in 2010 what I might like to do is recharacterize the first $100,000 and then make a Roth IRA conversion of $100,000 of a different IRA and that way for the same tax cost on $110,000 worth of income get a $100,000 Roth instead of a $50,000 Roth.
Steve Kohman: Yeah that is right. So there is a lot of strategies to be used with the recharacterization rule.
Hana Haatainen-Caye: Steve could you just summarize the new laws for 2010 and just wrap this up a little bit?
Steve Kohman: Yeah sure the new law for 2010 affects high income tax payers because they can do a conversion now. They are also the ones who have lots of after tax money typically to pay taxes on the conversion and they are the ones that maybe in the top tax bracket now and that top tax bracket is going to be going up higher, a lot higher in 2011 and in future years so really for those people 2010 is not only their first opportunity to do a Roth conversion its the best year to do a Roth conversion. So we highly recommend those sorts of tax payers, people who have a lot of money, who are now able to convert take a serious look at it and seek an advisor.
Hana Haatainen-Caye: Ok thank you Steve. You are listening to the Lange Money Hour. I am Hana Haatainen-Caye and invite you to stay tuned as Jim will be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back to the Lange Money Hour we are talking smart money. Jim has been speaking with Steve Kohman and we would like to now hear what Matt Schwartz has to add. Matt is an Estate Planning and an Estate Administration Attorney who devotes his practice to estate and retirement planning with a particular emphasis on IRA and Roth IRA planning opportunities. He has worked closely with Jim Lange over the past 7 years in implementing the Cascading Beneficiary Plan and many other estate planning strategies for our clients. Welcome Matt.
Jim Lange: I just want to add that Matt is a wonderful Estate Attorney, he gets along with clients beautifully and he and I complement each other very well because I like to talk about some of the big picture ideas which Matt understands completely and he will sometimes, by the way, correct me on that and then he works with the clients and just does a wonderful job of coordinating all the big picture ideas that Steve might come up with in terms of Roth IRA conversion or amounts and then clients just have a really terrific experience with him so I am really glad that he is on today. The other thing is technically he is just amazing and that is one of the reasons why I wanted him on today because we have a pretty technical topic today a very lawyerly topic and that is just an Estate Planning Attorney extraordinaire so maybe he can shed some light on some of the new tax laws.
Hana Haatainen-Caye: Ok first Matt though I would like to talk about what was the federal estate tax law in 2009?
Matt Schwartz: Thank you for the introduction Hana Haatainen-Caye. In 2009 the federal state tax exemption was $3,500,000 and there was a lifetime gift exemption which still exists today of $1,000,000 with a maximum federal estate tax rate of 45%. When clients were talking with me in 2009 and asked me what I thought would happen in 2010 myself like most of the estate planning community just thought that the 2009 law would be extended into 2010 because we didnt think we would want to create an incentive to kill people off at the end of 2010 when the law is supposed to revert back to $1,000,000 exemption or keep people alive so that their families didnt have to pay estate tax. Well we were surprised when Congress did not pass a patch at the end of the year to extend the federal estate tax exemption into 2010. So we actually have no estate tax right now at the beginning of 2010 and people can look at this in two ways. You can either be very aggressive in doing some planning or you can think that Congress is going to retroactively reenact the estate tax. If you are aggressive there is one option that is good and there is one option that is not so good. The not so good option is that you could die this year and if you die this year there is no federal estate tax. What do you think about that Jim?
Jim Lange: Well that is kind of interesting. So you can have a $1,000,000,000 and if you died last year with that $1,000,000,000 you have to pay roughly $400,000,000 in estate tax but if you died this year then theres no federal estate tax and can we count on that so alright I have $1,000,000,000 and I die and I leave it to my kids and my grand kids and they are Scott-free I dont have to worry about anything because I died during a time where there was no federal estate tax. Is that right?
Matt Schwartz: Well if Im Bill Gates heirs I am not thinking about killing off Bill Gates any time soon. There was a lot of comment in the estate planning community about whether the federal estate tax would be retroactively reinstated and whether that reinstatement would be constitutional and some commentators were suggesting to keep their offices open through New Years weekend to make very aggressive gifts and try to get as much out of peoples estates as possible but as more and more people have studied the topic the courts have time and time again retroactively reinstated tax laws. So it is everybodys full expectation that the law will be reinstated, we just dont know what the estate tax exemption will be and what the tax rate will be, but people are thinking that the exemption will be at least $3,500,000 and the maximum estate tax rate will be at least 45%.
Jim Lange: Alright so what you are saying then is, lets forget the $1,000,000,000 lets just assume that I have a taxable estate in 2009 dollars and I die, lets say between now and they make a tax law change. You are saying that they can make a tax law change and make it work backwards retroactive and thats not in violation of the constitution or a violation of due process or anything else?
Matt Schwartz: Well thats the main argument that people make, Jim, that it might be a violation of the due process clause, but theres been Supreme Court cases that have said as long as the tax advances at legitimate government interests and the government will argue that raising revenue is a legitimate government interest that the tax can be reinstated.
Jim Lange: And what about the generation skipping tax?
Matt Schwartz: Same deal. That tax can be reinstated as well.
Jim Lange: Alright, now I dont think that people are going to say well I am going to die now to avoid tax, but there is a proactive thing that some people could do which is to make significant gifts to their grandchildren. What do you think of that, lets say for wealthy tax payers who are interested in skipping a generation, does that make sense in general and does the current confusion in the federal estate tax give us an opportunity that we might not otherwise have or do you think it is a risk?
Matt Schwartz: Well there is certainly a risk to it if you werent thinking of making a large gift anyways or if you were in a situation where you projected that the estate tax exemption was going to rise enough that you wouldnt have had to pay gift tax or federal estate tax.
Jim Lange: Alright what about the ordinary guy, what if a guy doesnt have 5 or 6 million lets say he has $750,000, $1,000,000, $2,000,000, maybe even $3,000,000 does this concern him more and lets say he has the traditional he went to one of the downtown firms and he has one of the traditional AB wills. What is the impact for a guy like that with what is going on and what do you see as the best solution for somebody like that who is trying to plan their estate?
Matt Schwartz: The potential impact for a person like that is unwittingly their
spouse may end up not having any outright access to money, they may have had a will or trust written based on a federal estate tax formula and the way the formula works when there is no federal estate tax their spouse may have everything tied up in trust.
Jim Lange: So I think I call that the cruelest trap of all in the book Retire Secure! but the essence of it is that people who sometimes think they are leaving money to each other are actually leaving money into a trust where the surviving spouse doesnt have unlimited restrictions.
Matt Schwartz: And then what happens if that surviving spouse becomes incapacitated and her kids become trustees and there is not a great relationship between the kids and mom and maybe the kids dont want to pay a lot of money for support to put mom into a good nursing home and then the money is not there for moms purposes?
Jim Lange: So basically mom loses control when that wasnt really the intent. Is there something in peoples wills or that they can know if they have this kind of thing? Is there a language, in other words if there is a bunch of language that people dont understand is it possible that thats what is in their will because a lot people dont know what is in their will?
Matt Schwartz: That is true a lot of people, and we had a client in the other day he said Matt I believe you drafted this as well as you could but I am trusting you that that says what it says and we try to draft as clearly as possible. So if you have a lot of language in there about a maximum marital amount or a credit shutter amount or a federal estate tax formula you likely have one of these tax clause wills.
Jim Lange: Well I know one of the things that you like to do when you prepare a wills in our office is you actually write a letter in English describing what the will says, and we dont see very many of those types of letters from other Attorneys. Is that one component and could you comment on lets call it the volatility of the federal estate tax and how that plays in and what type of estate plan you would recommend for lets say actually most traditional families that are interested in providing for each other and then at the time of the second death to the kids maybe equally?
Matt Schwartz: Well with respect to your comment about the letter I found over time as I am trying to learn about technical topic it is always helpful to have a Cliff Notes version or a version that is easier to understand and that is one thing that I try to do for our clients. I think it is something that they are entitled to for the fees that they are paying. With respect to the volatility in the federal estate tax the exemption next year if there is no change goes down to $1,000,000. So if you have one of these tax clauses you can either have $3,500,000 going into a trust for your spouse or $1,000,000 and that makes one big difference. So when we do our drafting we tend to leave it up to the survivors to choose how much money they want to go outright to their spouse and the surviving spouse is making that choice and then how much money they want to go into a trust for their lifetime benefit and perhaps maybe the spouse doesnt need all the money based on their income needs and maybe they want to pass money directly to their children.
Jim Lange: And what about the grandchildren because I remember I think it was Ed Slott who said people dont like their kids they like their grandkids what if, now of course I am not saying you dont like your kids but what if you are interested in providing for your grandkids. Is that a possibility with the kind of plans that we do?
Matt Schwartz: Oh it absolutely is a possibility and often what we see is Jim, a lot of our clients have most of the assets in retirement plans as opposed to after tax money that just passes under somebodys will. And as both you and I well know the control of that money is determined by the beneficiary designation as far as where that money is going to go after someone dies. And so often those forms just say spouse primary children in equal shares so if there is an unusual order of death and one of the children predeceases the survivor of mom and dad and that deceased child had children those children could be left out of an inheritance because the way that designation is written the surviving child gets everything.
Jim Lange: And isnt it sometimes advantageous to have certain assets go to the children and certain assets go to the grandchildren. So lets say for discussion sake that either the first or the second death does it sometimes make sense for example for after tax dollars to go to the children and the Roth IRA conversion dollars to go into specially drafted trusts for the grandchildren?
Matt Schwartz: Absolutely, because the grandchildren have a much longer period of time to withdraw the Roth IRA dollars, which is going to maximize your tax free growth.
Jim Lange: So what you are saying is the type of flexible documents that you are doing will allow, lets say in the first case the surviving spouse and then maybe the second death the children to make strategic decisions on an asset by asset basis that will help maximize the value of the estate for the entire family?
Matt Schwartz: Yes, that is the flexibility of our plan.
Jim Lange: Alright now can you have just a regular plan the traditional plan and have somebody do that later or do you have to set everything up ahead of time?
Matt Schwartz: Well you really need to have it set up ahead of time. The great thing about the plan is you dont have to choose where the money is going, you dont have to choose exactly where the money is going to go at death. But you need to have the blueprint there, you need to have all the options set in stone.
Jim Lange: So basically the surviving spouse is going to be the boss. What are some of the choices that the surviving spouse might typically have in the documents that you typically prepare?
Matt Schwartz: Well one option is they can accept the money and traditional Estate Planners when there is the possibility of a taxable estate at the second death worry about that because maybe the spouse is going to get nervous and accept too much money which is going to cause the second estate to be taxable. And sometimes the response to that is that it is that familys money. They can choose to do what they want to feel secure.
Jim Lange: Alright so basically what you are saying is you like to make the surviving spouse the boss and if they are the boss then what are their choices in a typical what we call Langes Cascading Beneficiary Plan?
Matt Schwartz: First choice is to accept the money. The second choice which we only generally recommend for after tax assets, is the money can be held in trust for the surviving spouse for their health, maintenance, and support. The third choice is the spouse can say they dont want any of the money which would cause the money to pass to the children and they can do that with part of the money or all of the money. And the children could further say I dont want all of the money and they can pass it to well-designed trust for their children that they can control so many children find that to be attractive.
Jim Lange: And can they mix and match that is they might want some money outright, some money in trust, some money to kids, and some money to grandkids?
Matt Schwartz: Absolutely, its not an all or nothing choice.
Jim Lange: Well that sounds like it is a very flexible plan. Let me ask you this. What if you dont trust your spouse? Lets say that maybe your spouse has kids from her own marriage or has completely different values. Would it work for them or do you need one of these I call it Leave it to Beaver families where you have the husband and wife with the same kids and the same grandkids?
Matt Schwartz: Generally, its better in a Leave it to Beaver family, but if the second marriage the husband and wife are on board it can work in a second marriage context as well.
Hana Haatainen-Caye: We are going to take a short break. We will be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back. Steve do you have any closing comments for us?
Steve Kohman: I would just like to mention that a Roth IRA conversion can also save your family money by reducing estate taxes. And 2010 is a unique year with its lower tax rates then you will ever see in the future as far as we know. And developing a well designed Roth IRA conversion plan is extremely important to do this year in 2010.
Hana Haatainen-Caye: Ok thank you Steve. I just want to thank both of you and if you like to contact Matt Schwartz, Steve Kohman or Jim Lange you can call our office at 412-521-2732. This is Hana Haatainen-Caye and Jim Lange with the Lange Money Hour: Where Smart Money Talks. Please join us again on February 10th at 7 pm when Jim will be talking smart money. And dont forget to join us for Jims workshop on Saturday January 23rd at the Crown Plaza across from South Hills Village. This popular workshop on Roth IRA conversions is being offered at 3 different times throughout the day. Beginning at 9:30 am, 1:00 pm, and 4:00 pm. To reserve your spot please call 1-800-387-1129 or visit us at www.retiresecure.com again that is 800-387-1129 or www.retiresecure.com.
Jim Lange, JD/CPA is a nationally-known IRA, 401(k) and Roth IRA conversion expert. Jims best-selling book, Retire Secure! Pay Taxes Later is in its second edition and enjoys glowing testimonials from the industrys best including Ed Slott, Natalie Choate and Bob Keebler. For ordering information, please go to www.retiresecure.com. There you can obtain information on Jim Lange, Retire Secure!, and Jims keynote speaker availability. You can also access our treasure chest of radio show archives. Download the archives of The Lange Money Hour: Where Smart Money Talks.
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