To Roth, or Not to Roth: That is the Question

The Beatles’ George Harrison wrote these famous lyrics in “The Taxman” when he realized his earnings were pushing him into the 95% tax bracket in England:

Should 5% appear too small, be thankful I don’t take it all,
‘Cause I’m the taxman, yeah, I’m the taxman.

It may sound far-fetched today, but it was not too long ago, and I believe much higher taxes are coming sooner than any of us wish to believe. During the “Roaring 20’s” taxes were in the 25% range for top earners. Due to lower tax receipts at the onset of the Great Depression, our Congress increased the tax rate in 1932 to 63%, and then steadily pushed it up to 91% by 1963. It was still has high as 70% in 1980, before President Reagan slashed it down to 28%. With today’s top tax rate near 40%, and government budget deficits soaring, we are likely to experience a wave of new taxes and deduction limits.

Over the past 40 years as tax rates have fallen, it has been better to stash money into a retirement account during high tax years, and then withdraw the money at lower tax rates many years later. This 40 year trend is about to swing in the opposite direction, making the misunderstood Roth IRA your best tax friend.

What we don’t Understand, we Avoid
Most articles written about Roth IRAs are filled with complicated tax jargon – sometimes trying to be technically precise, but more often in an attempt to impress the reader. Either way, the information is too complicated and boring, making it virtually useless. While the actual tax rules are complicated, and include many deadlines, amounts, limits, and exceptions, the essence of the rules are very simple. What you need to know is…if, why and how a Roth IRA is to your advantage.

Why Me?
1. Age: The younger you are, the more a Roth is a great retirement tool for you.
2. Wealth: The more likely you are to leave some of your IRA to your heirs, the more a Roth is a great estate planning tool for you and your heirs.

Why Now?
1. Never before available to those earning over $100,000
2. Pay the tax at today’s lower rate
3. Advantageous IRS rules only available for 2010

Why Care?
1. Tax-free withdrawals
2. Lower estate tax
3. More spendable income
4. Lower tax on Social Security
5. No required withdrawals

What’s an IRA?
I imagine you have heard the term, but what is it? It actually stands for Individual Retirement Arrangement, of which there are several types, but the Individual Retirement Account is the most common since its creation in 1975. Money contributed to an IRA is tax deductible, it grows inside the IRA over the years with no taxes due on the increasing value, and then tax is due on each withdrawal. To avoid confusion, many people now use the term “Traditional IRA” to avoid confusion with a Roth IRA. I should note that 401(k), 403(b), SEP, Simple IRA, Profit Sharing Plan, etc., all work similarly to an IRA.

What’s A Roth?
Created in 1997, the Roth IRA works differently than a Traditional IRA when money is contributed or withdrawn. Money contributed to a Roth is not tax deductible, it still grows inside the Roth with no taxes due on the increasing value, but no tax is ever due on withdrawals. In the long-run, Roths are better than IRAs in generating more spendable income, because the taxes are paid early and then never again. This allows the power of compounding returns to work their long-run magic for younger savers and older, wealthier investors leaving money to their younger heirs.

What’s A Conversion?
Roths can be very beneficial, and since so many people already had money in IRAs and the like, the IRS created a process to convert IRAs into Roths if desired. Thus, a Roth Conversion allows you to convert some or all of your IRA into a Roth and pay the tax on the converted amount now, resulting in no future taxes.

A Break for the Wealthy…Really?
Yes, but only because Uncle Sam is desperate! Prior to 2010, the only people who could have a Roth were those making under $100,000 per year. Why? Because the government realized that Roths allow you to pay some tax now, versus lots more tax over the decades ahead, which is better for you and worse for them. Therefore, Congress initially decided to limit the number of people who could have a Roth in order to maximize the amount of taxes paid over the years. However, with our government’s budget out of control, Congress has decided to let you win in the long-run. They are willing to take less of your money if they can have some of it right now. Furthermore, a Roth Conversion makes even more sense with current tax rates being relatively low and likely moving much higher – you will be paying at today’s lower rates, and never again!

Beginning in 2010, two things change. First, everyone can now convert. Second, to sweeten the deal and entice more people to convert in 2010, you can elect to pay the tax due in 2011 and 2012. If you believe your tax rates will be higher in those years, you can still pay all the tax in 2010.

What’s A Recharacterization?
Sorry! I hate to bring up another term (especially this ominous sounding one), but it is important since it provides you an easy out and some great tax and investment planning opportunities. Put simply, a recharacterization reverses a conversion. Thus, if you convert your IRA to a Roth, and later need or want to move some or all of the money back to your IRA, you perform a recharacterization.

One useful strategy for recharacterization is if you convert and the Roth later drops in value. Unfortunately, you paid tax on the higher converted amount. Amazingly, the IRS allows you to pretend that you never converted. By recharacterizing your Roth back to an IRA, you get your taxes back. Then, if desired, you can again convert to a Roth, but at the lower value and pay less tax, keeping the difference. This is just one of many great strategies that use this tax provision to your advantage.

Conclusion
The IRA & Roth pool of required knowledge is deep and wide with new rules being added almost weekly. A great resource is www.irahelp.com. There are so many great planning opportunities, but an advisor must expertly apply the rules to benefit your personal situation.

1. 2010’s new Roth rules provide a unique planning opportunity that should not be ignored.
2. If your retirement account values are lower now than they were last year, then conversion or recharacterization strategies could improve your long-term results.
3. Roth Conversion or Recharacterization strategies involve investment, tax and estate planning considerations. It is important to work with an advisor that understands the interplay of these three areas and who will concisely analyze and simply explain to you how you would benefit.

The bottom line is…IRAs are tax deductible, then merely tax deferred, whereas Roths are not tax deductible, but tax-free for you and your heirs. Roth IRAs are a very powerful retirement and estate planning tool and 2010’s new tax rules are exciting. With increasing income tax rates on the horizon, it’s time to seriously consider a Roth Conversion.

NOTE: This material provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.

This Article appeared in the Jan/Feb 2010 issue of Westlake Malibu Magazine

Insuring Yourselves Before Disaster Strikes

There have always been risks, and Lloyd’s of London began insuring them in 1688. They’ll provide coverage for just about anything under the sun from body parts, to voices, natural disasters, and even kidnappings by aliens. Celebrity leg insurance is one of the more well-known policies, starting in 1940 with Betty Grable purchasing $1 million of coverage to our modern day David Beckham, with a reported $70 million policy.

Most people, however, lead much more normal lives and merely carry homeowners and auto policies. These types of insurance are package policies, meaning that they cover both damage to your property and your liability should you or members of your family injure or cause property damage to someone else. The next most common type of insurance for Southern California residents is earthquake. This insurance is easily available and regulated by the state of California. Another common form of insurance coverage is an umbrella policy. This coverage is often overlooked, because it requires that you maximize your home and auto coverage before it can be purchased. It is quite inexpensive, however, and I highly recommend that you talk to your insurance agent about its benefits.

Most people’s awareness and exposure to insurance ends right there. However, there is a nearly endless array of specialty policies available. Let’s look at a few that are typical for this local area and its demographics.

Wildfire

While insurance policies are known for the clever exclusions, fire is one of the most basic areas of coverage and included in most standard home, renter, business and auto policies. Where people come up short on their coverage is failing to account for code changes, your renovations or add-ons, or today’s higher building costs. It is also important to have coverage for the contents of your home at replacement value. For example, if your old computer is worth $100, your current policy might not cover the $1,000 to replace it, but merely cover the $100 current value. Also, make sure your policy covers your landscaping and the extra cost of living in an hotel and eating out while your house is being rebuilt. One of the areas not covered is the land value. If a neighborhood is ravaged by a fire and the property values drop because of the extensive damage, homeowners are not covered for this loss in value. To secure the highest reimbursement, it is a good idea to video-record your home and all its internal contents. Store this in your safe deposit box or remote office (not at a neighbor's) in case you need to prove your claim.

Mudslides

While most Americans only read about mudslides, we Californians need to seriously consider them. With homes often built on, or near, hillsides and the combination of wildfires and El Nino, we need to be mindful of the risk. The standard homeowners policy does not cover flood, mudslides and landslides. If you desire such insurance you generally must purchase it through the federal government’s FEMA program. Further, you can’t just pick up the phone and secure the coverage. It takes time to purchase, and there is usually a waiting period until the coverage begins – so plan ahead.

Vintage Wines

If your wine is covered solely by a traditional homeowners policy, you may be surprised by the meager coverage. Further, if your wine is stored away from your home, your coverage may be even more limited. To obtain full value coverage for fire, theft, earthquake, breakage, water damage, and more, you generally need a special policy. Many specialty policies even cover accidental dropage or unauthorized consumption.

Aviation

Owners and operators of an aircraft both share liability. It is generally the aircraft operator that obtains the insurance policy. Most owners require that the insurer have an “A” rating or better from A.M. Best. Further, the owner should review the policy, making certain that it covers their key areas of liability. A last important step for the owner is to make sure to periodically request a certificate of insurance to make certain insurance is in place and evidencing that the necessary protections are in place.

Bloodstock

High value horses have problems all their own and specialized insurance is available to cover their risks. The main risk is generally mortality – the animal dies due to accident, illness, or disease. However, theft and loss of use are also typical. Since many of these animals are transported around the world for shows, races, or breeding, transportation coverage is also common. Additional coverage can be purchased for stallion infertility, broodmare barrenness, and even the unborn foal.

Directors

Most businesses and non-profits have insurance that covers their risks, but many fail to provide adequate coverage to those who serve on their boards. While most companies do provide traditional Directors & Officers insurance, it may not be enough in today’s litigious world. Independent directors and board members should consider additional personal coverage designed specifically to protect their personal assets.

Fine Art

Collections can range from paintings to antique weapons to taxidermy. Specialty insurance can be obtained to cover your personal fine art or collectibles. Additional coverage is available for any portion of your collection that may be part of an exhibition or on loan to a museum. Many insurance companies are even happy to send a specialist to evaluate and suggest better ways to protect your fine art from theft, fire, water or light damage.

Kidnap and Ransom

The U.S. Department of Justice states that there are over 1 million cases of forcible entry of residences, almost 1.5 million stalking cases, over 50,000 carjackings, and between 3,000 and 5,000 cases of non-family-related abductions that take place annually. The average cost of a carjacking, stalking or home invasion is $38,000, yet ransom demands can run into the millions. Several insurance companies offer policies that address all of these threats. Kidnapping is a billion-dollar industry around the world, frequently run by well-trained teams. Some policies not only cover the ransom cost, but also provide an experienced response team to work with you for the safe return of your loved one. Americans traveling overseas, especially in eastern Europe and Latin America, are often preferred targets. Demands as high as $20 million are not uncommon, but ransom settlements are often 10-20% of the demand.

So while you may not be one of the 40,000 people who have purchased alien abduction insurance (you’ll need to pass a polygraph, have photographic evidence, and a witness to collect the money), I’m sure there are areas of risk exposure in your life for which you should consider additional or specialty coverage.

Robert J. Katch is the founder of Manchester Financial, an Investment Counsel/Wealth Management firm located in Westlake Village. For more information call 805 495 4405

This Article appeared in the Nov/Dec 2009 issue of Westlake Malibu Magazine.