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April 28, 2010

Estate Planning and Your Retirement Accounts

For many people, retirement accounts, including 401(k) plans and individual retirement accounts (IRAs), are their most significant assets. While you may think you'll need every bit of money in those accounts for your retirement, what would happen if you die at an early age? You should include these accounts in your estate plan so heirs inherit them with minimal estate- and income-tax effects. Some strategies to consider include:

Review your beneficiary designations. These assets are distributed based on beneficiary designations, not your will or other estate planning documents. Thus, you should name primary as well as contingent beneficiaries. Make sure you understand how your assets will be distributed if a primary beneficiary dies before you do. For instance, if your primary beneficiaries are your children and one child dies before you, do you want that child's share to go to your remaining children or to that child's children? Review your beneficiary designations after major life changes, such as marriage, divorce, or a child's birth.

Consider rolling your 401(k) plan assets over to an IRA. Now that 401(k) plans must allow nonspouse beneficiaries to withdraw funds over their life expectancy, there is not as much need to roll 401(k) plan assets over to an IRA. However, with IRAs, you will often have many more investment options for your plan assets. Also, you may want to roll the plan assets over to a Roth IRA, but will first need to roll over to a traditional IRA (see below).

Split an IRA when there are multiple beneficiaries. When there is more than one nonspouse beneficiary for an inherited IRA, distributions must be taken over the oldest beneficiary's life expectancy. By splitting the IRA into separate accounts, each beneficiary can take distributions over his/her life expectancy. You can split the account while you are alive, or your beneficiary can do so within nine months after your death. Separating the account is especially important when one of the beneficiaries is not an individual or qualifying trust, such as a charitable organization. If you die before required distributions begin at age 70 1/2, the entire balance must be paid out in five years. If you die after required distributions begin, the balance must be paid out over your remaining life expectancy. When the account is split, the individual beneficiary can take distributions over his/her life expectancy.

Make sure your spouse understands the rules for inheriting an IRA. Your spouse should be careful not to roll the balance over to a spousal IRA too quickly. Once the balance is rolled over, some planning opportunities are lost. For instance, spouses under age 59 1/2 can make withdrawals from the original IRA without paying the 10% federal income tax penalty. Once the account is rolled over, withdrawals before age 59 1/2 would result in a 10% federal income tax penalty. Also, spouses who are older than the original owner can delay distributions by retaining the IRA. The surviving spouse does not have to take distributions until the deceased spouse would have attained age 70 1/2, even if the surviving spouse is over that age. The spouse may want to disclaim a portion of the IRA, which must be done within nine months of the original owner's death. If the account is rolled over, that disclaimer can't be made. Thus, it is usually best for the surviving spouse to determine his/her financial needs before rolling over the IRA balance.

Consider rolling your traditional IRA balances over to a Roth IRA. Starting in 2010, all taxpayers can now convert from a traditional IRA to a Roth IRA, regardless of income levels. You must pay income taxes on the taxable amount of the conversion, but those taxes can be paid with funds outside the IRA. That preserves the IRA's value and reduces your taxable estate. Then, your heirs will receive qualified distributions free from income taxes, including all future appreciation on the balance.

• Teach your heirs the benefits of stretching out withdrawals from inherited IRAs. After an IRA is inherited, a traditional deductible IRA still retains its tax-deferred growth and a Roth IRA retains its tax-free growth. Your heirs should extend this growth for as long as possible. If the IRA has a designated beneficiary, which includes individuals and certain trusts, the balance can be paid out over the beneficiary's life expectancy. Spouses have additional options which can stretch payments out even longer. Your heirs can elect to take the entire balance immediately, paying any income taxes due. Make sure to stress to heirs the importance of taking withdrawals as slowly as possible.

April 24, 2010

Pay Yourself First

The advice sounds simple enough -- to force yourself to save regularly, treat those savings as a bill to yourself and pay that bill first every month. But when you're faced with a stack of bills that includes your mortgage payment, your car lease, and groceries to feed the kids, you're likely to skip paying yourself for at least another month. Unfortunately, those months can add up with little in the way of savings. If you're looking for ways to start paying yourself first, consider the following:

Reduce spending, diverting those reductions to savings. One way to accomplish this is to cut back on your spending, perhaps reducing your expenditures for dining out, traveling, clothing, or entertainment. But for many people, this feels too much like sacrifice, making it difficult to stick with this strategy. Another alternative is to find ways to spend less for the same items. For instance, get quotes for your car and home insurance from several companies, placing any premium reductions in savings. Or find ways to reduce your borrowing costs. Instead of paying higher interest rates on credit cards, consider paying those balances with a home-equity loan. Not only will the interest rate typically be lower, but the interest may be tax deductible if your balance is less than $100,000. Just make sure any reductions in your costs go directly to your savings.

Save all unexpected income. Immediately save any money from tax refunds, bonuses, cash gifts, and inheritances. Before you get used to any salary increases, put that raise into savings, possibly in your 401(k) plan.

Make saving automatic. Resolve to immediately set up an investment account that automatically deducts money from your bank account every month. Start out with small amounts that aren't even noticeable. As you get used to saving on a regular basis, increase the amount periodically. Another good alternative is to sign up for your company's 401(k) plan. Not only will the amount be automatically withdrawn from your paycheck, but you won't pay current income taxes on those contributions. (Keep in mind that any automatic investing plan, such as dollar cost averaging, does not assure a profit or protect against loss in declining markets. Because such a strategy involves periodic investment, consider your financial ability and willingness to continue purchases through periods of low price levels.)

April 5, 2010

Calculate Inflation With Your Retirement Planning

Inflation has been tame for so long that it's easy to forget how much it can affect your purchasing power over a long retirement. Over the past 10 years, inflation, as measured by the consumer price index, has averaged 2.5% (Source: Bureau of Labor Statistics, 2009). At 2.5% inflation, $1 is worth 78¢ after 10 years, 61¢ after 20 years, and 48¢ after 30 years. Thus, you need to look for strategies to lessen inflation's impact during retirement:

Use a conservative inflation rate when planning for retirement. You don't want to run out of money during retirement. So when calculating how much to accumulate by retirement age and how much to withdraw during retirement, use a conservative inflation rate. While inflation has averaged 2.5% over the past 10 years, it has averaged 3.9% over the past 30 years (Source: Bureau of Labor Statistics, 2009).

Determine how much of your retirement income is indexed for inflation. Social Security benefits are currently indexed for inflation, but most defined-benefit pension plans do not make adjustments for inflation. Thus, other income sources will have to fill an increasing income gap over time.

Invest in tax-advantaged retirement vehicles. Look into 401(k) plans, individual retirement accounts, and other retirement vehicles. While each has different rules for taxing contributions and earnings, all provide some tax-free or tax-deferred benefits. Since you aren't paying income taxes on earnings during the years, that typically means you'll have a larger balance at retirement.

Choose investments carefully. To avoid losing purchasing power, your after-tax rate of return should be higher than the inflation rate. Review your investments annually to make sure you aren't losing purchasing power.

Organizing Your Estate

Don't think you're finished with the estate-planning process once a will, trusts, and other estate planning documents are in place. From your heirs' point of view, it's just as important for you to organize paperwork and inform them of basic decisions. One way to approach this task in a systematic manner is to prepare a notebook including the following items:

Net worth statement. An up-to-date net worth statement is a good way to ensure heirs are aware of every asset and liability. Make sure to list all pertinent information for each item on the statement, including account numbers, contact names, and phone numbers. Identify where important documents are kept, including deeds, loan agreements, insurance policies, etc. You may also want to explain your rationale for your estate's distribution. You can go into specific detail, informing heirs how each asset will be distributed, or you can give a general overview of your estate plan. If you selected one heir as executor or trustee, explain why you chose that individual.

Individuals to contact. List names, addresses, and telephone numbers of individuals your heirs may need to contact, including employers, attorneys, accountants, insurance agents, investment managers, and financial planners.

Personal papers. Indicate where personal records are kept, including your birth certificate, marriage certificate, divorce or separation agreements, diplomas, military records, and naturalization records.

Safe deposit box. Indicate where the safe deposit box is located and what is contained in the box. Note where the key is kept and who has access to the box.

Disposition of personal items. Detail how you would like personal items distributed, including jewelry, photographs, personal collections, and furniture. Often, disputes over personal possessions are more apt to cause conflict among heirs than disputes over money, so explain your rationale for the distribution of personal items. After you have decided how to distribute your most valued possessions, come up with a method for heirs to distribute the remainder. It can be as simple as taking turns to select items or flipping a coin if more than one individual is interested in the item.

Last wishes. Indicate your preferences for funeral arrangements, including whether you want a religious or secular service, whether you want flowers or donations to a charity, whether you want to donate your organs or body to medical institutions, and where you would like to be buried. These are details your heirs may feel uncomfortable asking about, but will be grateful your wishes are known so they can be carried out. Also, list any friends or family you would like contacted after your death.

Your thoughts on these subjects can change over time, so review and update the information periodically. Keep it in a place where heirs can find it immediately after your death.

Investment Portfolio Losses

Capital gains on investments held for one year or less are short-term capital gains taxed at ordinary income tax rates. For investments held over one year, the maximum long-term capital gains tax rate in 2010 is 15% (0% for taxpayers in the 10% or 15% tax bracket). While the 15% rate is significantly below the maximum ordinary income tax rate of 35%, it still takes a significant chunk out of your investment portfolio.

To help minimize your capital gains tax bill, you should actively harvest any losses in your portfolio. Some strategies to consider include:

Recognize losses to at least offset $3,000 of ordinary income. Keep in mind the tax rules regarding gains and losses -- capital losses offset capital gains, and an excess of $3,000 of capital losses can be offset against ordinary income. If you are holding stocks with losses in your portfolio, you should probably take advantage of this tax rule.

If you still want to own the stock with the loss, you can sell the stock, recognize the tax loss, and then repurchase the stock. You just have to make sure to avoid the wash sale rules. These rules state that you must repurchase the shares at least 31 days before or after you sell your original shares to recognize the loss for tax purposes.

Consider recognizing all, or a substantial portion, of any losses in your portfolio. Realize that no one likes to sell investments at a loss. And since you can only offset an excess of $3,000 of capital losses against ordinary income, you might wonder why you should incur excess losses that can't be used currently, even though you can carry them forward to future years. There are a couple of advantages to this strategy.

First, it gives you an opportunity to totally reevaluate your portfolio. If you are convinced all your investments are good ones, you can sell them, recognize the tax loss, and then repurchase the stocks, being sure to avoid the wash sale rules. But it's probably more likely that you own some investments you wish you didn't.

Second, it gives you more flexibility when recognizing gains in the future. Until you use all your capital losses, you can recognize capital gains without worrying about paying taxes. Even if your losses are long term, you can use them to offset short-term capital gains.

Use stock losses to offset other capital gains. If you have capital gains from the sale of another type of asset, such as a business or real estate, stock losses can be used to offset those gains.

Don't gift stocks with losses. If you are planning a large charitable contribution, it makes sense to donate appreciated stock held for over a year. You deduct the fair market value as a charitable contribution, subject to limitations based on a percentage of your adjusted gross income, and avoid paying capital gains taxes on the gain. If the stock has a loss, however, you should first sell it and then send the cash to the charity. That way, you get the charitable deduction and recognize a tax loss on the sale.


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