Wednesday, June 11, 2008

Five Retirement Planning “Tax Tips” to Avoid… like the plague

1.IRA owned real estate + “sweat equity” = potential IRA disqualification

You’re at a party and are introduced to a “tax planner” who shares the following retirement “tax tip”. Purchase a run-down home (there are lots of them in today’s market) in your IRA. Fix it up, rent it and, when the market turns around, resell it. Right now “cash is king” and the liquidity in your IRA could purchase bargains that will generate big future returns. Like the idea? I did too until I thought about how this strategy could make your IRA implode.

If you, as the IRA owner, personally fix-up and/or manage the property (e.g. soliciting tenants, collecting rents, making repairs, etc.) you risk a possible tax evasion charge! Here’s why. The IRS could determine that the labor contributed by you is an assignment of income. They would argrue that the increase in value due to your labor is really income to you that you’ve “assigned” to the IRA by not charging for your services. So, if the IRS is in an ugly mood, they could claim you should have paid income and self-employment taxes on this value and that the value of your services should be treated as an IRA contribution, which might result in you having made “excess annual contributions” subject to additional income and penalty taxes.

Alternatively, the IRS could argue that your contribution of services is a “prohibited transaction” (as the IRA owner, you are a “disqualified person”) and the furnishing of services by a “disqualified person” can cause your whole IRA account to lose its tax exempt status. Or, if the IRS is in a more benevolent mind-set, they could argue that your IRA was running a home remodeling/rental business and all of the income is currently taxable as UBTI (Unrelated Business Taxable Income).

Don’t worry about all of the above legal “gobble-dee-gook” but to remember, if it sounds too good to be true… ask your tax advisor.

2. “Shifting” business income to your Roth IRA… to make it tax-free

Wouldn’t it be great if you could take an appreciated asset or business and transfer it into your Roth IRA so that the appreciation and income could later be withdrawn tax-free? If this sounds a bit like our prior discussion, then you’re a quick learner. Here’s the parable and, like above, it has a moral.

Some overly-sly taxpayers decided to have their Roth IRAs create a wholly-owned entity (typically an LLC). They then sold property to the LLC at a bargain price with the goal of sheltering future (and even existing) gains and income to the tax-exempt Roth. The IRS has attacked these transactions as disguised contributions, pushing the IRA owner above the annual contribution limits. The moral of our story? It’s OK to sell appreciating property to your Roth but make sure you have a qualified, independent appraisal and be prepared to defend it.

3. Naming a trust as your IRA beneficiary… when you want these funds to be fully accessible to your spouse

Assume you want your retirement benefits to go to your spouse. However, your attorney has just drafted this nifty revocable trust that your dieing (forgive the pun) to use. You notice that your trust creates a “Marital Trust” that your spouse has full access to upon your death. Furthermore, upon the death of your spouse the assets in this Marital Trust go to your kids. “Ahhh”, you think, “This is perfect! I’ll name my trust as the beneficiary of my retirement plans and have them go to my spouse via the Marital Trust it creates.” Sounds great and it works… but at a price.

If your IRA names a trust as its beneficiary, then your surviving spouse must start distributions the year after your death and your spouse must start taking these distributions over a predetermined number of years (the payout period is based upon a single life annuity table that references your spouse’s age). Now that might not sound too bad; however, the result would be better if you named your spouse directly as the beneficiary. If your spouse is the named beneficiary (not the trust), then he/she would not need to start taking IRA distributions until reaching age 70 1⁄2 and the required annual distribution amount uses a different table which allows for smaller annual required distributions. The moral of the story is that naming your trust as the beneficiary of your retirement benefits can make sense but it does have a potential tax cost.

4. Converting a traditional IRA to a Roth… when to doit and when you can’t

Converting a traditional IRA to a Roth before death can reduce estate taxes by removing the income taxes due on the Roth conversion from the taxable estate. (Of course, paying your investment advisor lots and lots of professional fees will also accomplish this goal… but most of us wouldn’t get excited about this “planning strategy”… so what’s the advantage of a Roth conversion?) The advantages are two-fold:

First, you want to consider a Roth Conversion if your estate is taxable. The savings in estate taxes (the estate taxes rate is currently 45%) compensates for the fact that you’re paying the income taxes now.

Second, your life will be simpler as you don’t have to take any distributions from your Roth plus your heirs will receive their distributions income tax-free. (The tax-free aspects of Roths will become more valuable if income tax rates increase… as is probable.)

When shouldn’t you convert to a Roth? Even if you have a taxable estate, you CANNOT convert an inherited IRA to a Roth! That means a nonspouse beneficiary cannot convert an inherited IRA. (There are special rules that allow a spouse to convert an IRA received from their husband our wife if your spouse did not previously inherit this IRA.)

The moral of this story? If you have a taxable estate, consider converting your traditional IRAs to a Roth. You can do this with any IRAs you have created or were inherited from your spouse. However, before making a Roth conversion, talk to your tax advisor as there are income limits that might prohibit your ability to make a Roth conversion.

5. Charitable Bequests from Retirement Assets…let the IRS partially fund your philanthropy

Upon your death, your estate donates $100,000 dollars to your favorite charity, the “Save the Nutria Foundation”. (Nutria are really big water rats that live in Texas swamps.) Your estate is comprised of an IRA worth $200,000 and other assets with a total value of $800,000. If your charitable donation is made from your traditional IRA, the charity will receive the income (tax-free) and your estate and it’s beneficiaries won’t be taxed on this IRA distribution. It’s a double win! In effect, the IRS has funded your donation by not charging you the income taxes that would be due from the IRA distribution. Furthermore, if your estate is large and taxable, you get an estate tax deduction for the full $100,000 contribution.

However, this doesn’t work with charitable bequests from Roth IRAs. Since Roth distributions are income tax-free, you lose the income tax benefit.

Bob Weins