At the end of the day, all retirement money is treated in one of three ways: taxable, tax-deferred or tax-free. Taxable income is taxed during the year in which it is received, but can also be tax-favored if from capital gains, dividends, Social Security, etc. Interest rates on tax-free municipal bonds are lower than their taxable counterparts; thus, taxes are implicit and municipals are in reality taxable. Tax-deferred earnings are not taxed as income now but will be in the future when withdrawn. If passed to the next generation, the deferred taxes will be paid by the beneficiary or the estate of the deceased. Tax-free income may have been taxed earlier but is not again taxed when withdrawn. The best example of tax-free income is the Roth IRA.

How much of a client’s retirement money should be in each of these categories? The correct answer is ‘it depends’ because the best strategy hinges on factors that cannot be predicted: changing tax rates, life expectancy, future income, allowable deductions and more. Since the future taxes and circumstances are uncertain, tax-liability diversification would appear to be prudent. The exact composition of the diversification will be a matter of personal preference, but it seems logical that tax diversification might be better than the risk of guessing wrong. Unfortunately, most retirees have little tax diversification. It is conspicuously absent among those with substantial assets, and this is interesting given that future taxes are expected to be higher to support current federal programs, re-finance entitlement programs and fuel the wealth redistribution trend. In fact, most of your clients and prospects – regardless of income or net worth – have no tax-free holdings and this presents an opportunity; especially with affluent families.

The tax-deferred annuities you have recommended are a great supplement to qualified retirement money, and many of your clients have this category covered. Likewise for the taxable bucket since investment/business income, rents and salary/wages, plus Social Security benefits are common. The empty bucket, even for the affluent, is the tax-free one. Municipal bonds do not fill this niche because of the implicit taxes. Also, tax-free municipal bond interest counts in the tax calculation for Social Security benefits.

The logical choice for tax-free income is the Roth IRA. Most employers have not added the Roth option to their 401(k), and many high-income families cannot qualify for Roth IRA contributions or conversions. In 2010 the Roth conversion income limit will be suspended, allowing higher income families to take advantage of tax diversification. You need to start preparing now for a noticeable increase in demand for Roth IRA conversion advice later in 2009 and throughout 2010.

The window of opportunity for Roth conversions in 2010 cannot be ignored. If a client’s adjusted gross income exceeds $100,000, they cannot now qualify for a Roth conversion but will in 2010. As icing on the cake, the taxes from a 2010 Roth conversion can be spread equally over 2011 and 2012. Unfortunately, many will miss the Roth opportunity because their retirement money is unnecessarily locked in a 401(k) and other employer-sponsored plan which prevent withdrawals prior to retirement. This impediment can easily be removed by adding an in-service, non-hardship withdrawal provision to the Plan (See BHC’s “Tapping Into Your 401(k) Before Retirement”). Once a qualified account is converted to a Roth, it will not be subject to income taxes nor required minimum distributions. Additionally, all money in the Roth IRA and future earnings will be tax-free to the owner, their spouse and to eventual beneficiaries. If you need help understanding Roth IRA conversions, you’ll want to take advantage of the training that BHC offers, including how to use index-linked annuities to secure a lifetime of guaranteed tax-free income. Start identifying your high income, high net worth clients and prospects today so you can start preparing them for Roth IRA changes in 2010.

Shelby J. Smith, Ph.D.
April 2009  

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