Roth IRA Conversion Mistakes Can Be Costly

Roth IRAs have experienced a spike in popularity over the past decade. Between 2000 and 2009, the number of households owning Roth IRAs increased by an average of 6.3% per year, the fastest-growing rate of ownership among all types of IRAs.1

What distinguishes a Roth IRA from other types of IRAs — and what may be responsible for its rise in popularity — is its ability to provide a tax-free income in retirement and its exemption from required minimum distribution rules.

Although contributions to a Roth IRA are made with after-tax dollars (income eligibility limits apply), qualified distributions are free of federal income tax as long as all conditions are met and regardless of how much growth the account experiences (under current tax law).

One popular way to fund a Roth IRA is by transferring assets from a traditional IRA or an employer-sponsored retirement plan. This type of transaction, called a Roth IRA conversion, is simple in theory but can be complicated in practice. If you make any of these mistakes, you could lose some key advantages.

Paying the conversion taxes with funds from the account you are converting. When tax-deferred assets are converted to a Roth IRA, you must report them as income on your tax return for the year in which the conversion takes place and pay the taxes owed.

Unless you’re older than 59½, it’s generally not advisable to pay the income taxes using money from the account you are converting. Withdrawing money from a tax-deferred plan to pay the conversion taxes before age 59½ would be considered an early distribution and thus may be subject to a 10% early-withdrawal penalty. Consider paying the taxes from a non-tax-deferred account.

Even if you are older than 59½, it could take years before the conversion begins to pay off. If you use some of the tax-deferred assets you are converting to pay the income taxes, you are reducing the amount of money available to pursue potential investment returns.

Failing to consider a “recharacterization” if the account loses value. If the value of the converted assets declines after the conversion, you may be able to “undo” the conversion using a process called recharacterization. This enables you to amend your tax return and obtain a refund of the conversion taxes that you paid. The deadline to recharacterize is October 15 of the year after the year in which the original Roth IRA conversion took place.

You can reconvert the assets to a Roth IRA later at the presumably lower value (which may result in a smaller tax liability) as long as you wait 30 days after the recharacterization date or until the calendar year following the year in which you made the initial Roth IRA conversion, whichever is longer.

Violating the five-year rule. To qualify for a tax-free and penalty-free distribution of earnings and converted assets, Roth IRA distributions must meet the five-year holding requirement and take place after age 59½ or result from the owner’s death, disability, or a first-time home purchase ($10,000 lifetime maximum). The rules governing the five-year holding requirement for converted assets are complex. Before you take any specific action, be sure to consult with your Naperville tax professional.

1) Investment Company Institute, 2010

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

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Protecting What May Be Your Most Valuable Asset

If you are young and healthy, you might think your chances of becoming disabled are fairly slim. And you wouldn’t be alone in your belief: 64% of workers believe they have only a 2% (or less) risk of suffering a disability that could sideline them for three months or longer.1

But statistics tell a different story: 43% of 40-year-olds will suffer at least one long-term disability (90 days or longer) before age 65.2 Despite this risk, 38% of working Americans say they would be able to pay their living expenses for only three months or less if their incomes were interrupted; 65% would not be able to cover expenses for one year. These findings become all the more alarming when you consider that the average long-term disability lasts for two and a half years.3

If you wouldn’t think of going without insurance coverage for your home, health, or car, it doesn’t make much sense not to protect what may be your most valuable asset: your ability to earn an income.

A Policy That Can Protect

An individual disability income insurance policy can help replace a percentage of your salary, up to the policy limits, if you should suffer an illness or injury that makes it impossible for you to continue working. The benefits can continue until you recover or for a predetermined number of years, whichever comes first. If you pay the premiums yourself, the benefits usually are not taxable. Some policies will pay if you can’t perform your current occupation, whereas others will pay only if you cannot perform any type of job.

Many workers have some type of short-term group disability coverage through their employers. Group plans rarely cover as much as the 70% to 80% of income that individual policies typically offer, and the benefits from group plans are taxable to the extent that the employer pays the premiums.
Your Future Could Be at Stake

In the absence of an adequate, long-lasting source of disability income, you could be forced to use your retirement assets to pay living expenses and medical costs. If you have to withdraw assets fr

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om a tax-deferred retirement account, the withdrawals may be subject to a 10% federal income tax penalty if you are younger than 59½ (depending on the severity of the disability), as well as ordinary income taxes. Even worse, tapping your retirement assets could interfere with progress toward your retirement goals, creating the possibility that you might not be able to attain the retirement lifestyle you envisioned.

The appropriate disability income strategy may help reduce the financial consequences if you lose your income because of an illness or injury.

1, 3) Council for Disability Awareness, 2010
2) 2010 Field Guide, National Underwriter

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

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Help Keep Your Estate Out of Probate

If you’ve ever seen an estate go through probate, you know that it’s the legal equivalent of having a tooth pulled — an unpleasant procedure to be avoided whenever possible. And just like tooth decay, probate may not be entirely avoidable, but you may be able to reduce the risk through preventive care.

Probate is a costly and sometimes lengthy procedure wherein a court oversees the distribution of property to a decedent’s heirs. During probate, courts can freeze assets until the process is completed. Probate also risks a loss of privacy, because court records are open to the public. Perhaps the biggest drawback is the price tag — probate costs can eat up 4% to 5% of the total value of an estate, depending on its size, complexity, and the state in which probate occurs.1

One way to help shield assets from probate is by placing them in a trust. As you’ll see, trusts offer other benefits as well.

Meet the Key Players

Although trusts involve a complex web of tax rules and regulations, the concept behind them is fairly simple. The grantor places ownership of his or her assets in the trust, which holds the property for the benefit of the beneficiaries. The trust is typically overseen by a trustee who must distribute the assets based on instructions outlined in the trust. Even though a trust is a legal document, it enjoys a level of privacy not available with a will because it may never see the inside of a courtroom.

There are several types of trusts, but most fit into one of two categories.

Revocable trusts allow the grantor to modify the terms, add or remove assets, and even revoke the trust entirely during the grantor’s lifetime, after which the trust becomes irrevocable. This type of flexibility is popular for grantors who want to control how their assets are managed and distributed. Revocable trusts can be used to place limits and conditions on beneficiaries, help married couples segregate community assets from individual assets, and establish rules and guidelines for management of the trust assets during and after the grantor’s lifetime.

Irrevocable trusts don’t offer the same flexibility, but they excel when it comes to reducing exposure to creditor claims and estate taxes. The grantor is essentially required to surrender control of any assets that are placed in the trust. Transferring ownership of assets to the trust means they are no longer considered part of the grantor’s estate. Although the grantor can specify how the assets will be distributed, he or she is generally prohibited from benefiting from the trust assets once they are in the trust.

A properly structured trust can be a valuable estate conservation tool, but it is not something you should set up yourself. Before implementing any trust strategies, you should consider the counsel of an experienced estate planning professional.

1) 2010 Field Guide, National Underwriter

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

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The Federal Estate Tax Is Back and May Be Here to Stay

Despite the fact that 65% of taxpayers believe the federal estate tax is unfair, it’s back after a one-year repeal, and it could be here to stay.1

Some form of estate tax has been a part of the political landscape since 1797. Although it’s been repealed and reinstated many times, the federal estate tax appears to be as American as baseball and apple pie.

The 2010 Tax Relief Act reinstated the federal estate tax, imposing a 35% tax rate on estates that exceed the $5 million exemption through 2012. By taking specific steps, married couples may be able to pool their exemptions to shield up to $10 million. But these parameters — the most generous in decades — are temporary. After 2012, the federal estate tax is scheduled to revert to pre-2001 tax law levels, with a 55 percent top tax rate on estates valued at more than $1 million, unless lawmakers extend or modify the current law.

In addition to the federal estate tax, many states tax inheritances. Twenty-two states and the District of Columbia have estate or inheritance taxes that could apply to estate assets that are considerably lower than $5 million.2

A Matter of Trusts

If you are concerned that your estate may be subject to estate taxes, you might consider setting up a trust. When properly structured, an irrevocable trust may help you reduce or avoid the fees and estate taxes that may be imposed upon your death, control the distribution of your assets, and avoid probate. Trust assets are also protected from creditors.

A trust is a separate legal entity under which the grantor (or trustor) places assets in the trust, and a trustee administers the trust and eventually distributes assets to the beneficiaries according to the terms of the trust. Once property is placed in an irrevocable trust (which cannot be modified or terminated once set up), the assets are removed from the grantor’s taxable estate. Essentially, the grantor relinquishes ownership of the assets to the trust.

Irrevocable trusts can be used for specific purposes, such as to keep life insurance proceeds out of the taxable estate for the trust beneficiaries, and to benefit charitable groups.

An irrevocable life insurance trust can be used to replace assets in an estate left to charity (so beneficiaries will still receive an inheritance) and/or to keep life insurance proceeds out of the taxable estate. The grantor works with an attorney to set up the trust document, and the trustee uses money funded by the grantor to purchase a life insurance policy that is owned and controlled by the trust. When the insured individual dies, the life insurance proceeds are paid to the trust and distributed to the beneficiaries according to the terms of the trust. With this type of trust, the grantor cannot serve as the trustee, and the life insurance premiums must be paid by the trust.

The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable.

With a charitable remainder trust, you transfer assets to the trust and name a charitable group as the eventual beneficiary. This strategy preserves the appreciated value of the assets placed in the trust because they

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won’t be subject to capital gains tax. The assets are typically sold by the charitable group and placed in an investment portfolio that can provide you (or your designated income beneficiaries) with a specified income that can last for your lifetime or a specific period of time; this income is generally taxable. Upon your death (or the death of your designated income beneficiaries), the charitable organization receives the “remainder” assets. By gifting the assets to a charitable trust, you can preserve the full value of your gift to charity.

A charitable lead trust offers a way to donate income from your gift while retaining ownership of the assets. The grantor places assets into an irrevocable trust on behalf of a designated charitable organization, and any income generated from those assets goes to the charitable group for the duration of the trust period. Upon termination of the trust, the remaining assets pass to the grantor or to the chosen beneficiaries. This could help reduce, or in some cases even eliminate, estate taxes on appreciated assets that eventually go to the grantor’s heirs.

You should bear in mind that not all charitable organizations are able to use every possible gift, so it would be prudent to check first. The type of organization you select can also affect any tax benefits you might receive.

A properly structured trust may help shield your assets from estate taxes, but you must relinquish ownership of them to the trust. The use of trusts involves a complex web of tax rules and regulations. You should consider the counsel of an experienced estate planning professional and your legal and tax advisors before implementing such strategies.

1) Tax Foundation, 2009
2) American Family Business Foundation, 2011

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

Why You Want to Know How Much Your Business Is Worth

Business Valuation Can Be Valuable Even When No Sale Is Planned

If you have no plans to sell your business, an up-to-date valuation may seem like an unnecessary expense. But you might be surprised at how important the current value of your business can be to achieving your long-term goals. The current value of your business can affect how you approach everything from retirement to estate conservation and your succession strategy.
Your Retirement Lifestyle

The typical business owner has 50% to 70% of his or her net worth in the business.1 If you expect your business to help fund your retirement, a significant change in value might mean you need to adjust the amount of income you are investing for retirement. A shift in value might also affect the date at which you expect to retire, which could influence the timing of your decisions about the kinds of preparations you expect to make to get the business ready to sell or pass on.

Estate Conservation and Succession

It’s understandable if you would rather not spend too much time thinking about whether your business has lost value, but there could be an upside to knowing. If you are expecting to transfer ownership to the next generation, lower asset values may help you transfer a larger share of the business without tax consequences.

If your business has a buy-sell agreement that values the business too highly, a more reasonable valuation may help the survivors or successors take over without paying more than the business is actually worth.

If you discover that your business is responsible for more of your net worth than you realized, it could indicate that it’s time to diversify away from the business. It’s rarely a wise move to let your financial future hinge on the fate of a single asset — even if it is your own business.

Given the events of the past few years, you may be more inclined to focus on today’s problems than on what could happen years from now. But a precise valuation may provide you with valuable information that you didn’t realize you needed.

1) Financial Advisor, August 27, 2010

The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent Naperville business advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. © 2011 Emerald Connect, Inc.

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