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© 2005 Morningstar, Inc. All rights reserved.

Finding Gold in the CodeMining Tax Code Nuggets to MaximizeYour Clients’ Retirement Benefits

Natalie Choate

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A MorningstarAdvisor web seminar

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What We’ll Cover Today

×Roth IRAs--New Rules for 2005 and 2006

×Lump-Sum Distributions

×Pre-Age-59½ Distributions

×New Developments and Trends

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Roth IRAs--What’s good about Roth IRAs?

×Distributions are income tax-free

×Tax-free is better than tax-deferred

×No required distributions until owner’s death

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Roth IRAsBut what does it COST to get a Roth IRA?

×Pay income tax up-front, by converting traditional IRA to a Roth

×That’s too expensive or risky for many

×But it can be FREE: for example, when someone has business losses

×It can be CHEAP in a low-income year

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Roth IRAsWho is eligible to do a Roth IRA conversion?

× Income must be under $100,000, not counting the conversion itself

× Losses or temporary low income can make even the “rich” eligible

× New for 2005 and later: MRDs from IRAs do NOT count toward the $100,000 limit

× Status of MRDs from other plans, inherited IRAs unclear

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Roth IRAsBad Ideas: don’t do this!

× Give $3,000 to old poor person; he/she contributes to a Roth and leaves it to you

× Put your business in a Roth to make it tax-free (abusive tax shelter, says the IRS)

× Convert an inherited IRA to a Roth (inherited IRAs cannot be converted)

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Roth IRAsStarting in 2006: “Roth 401(k)s

× Any 401(k) plan can offer employees the option of making 401(k) contributions to a “designated Roth account” (DRAC), which is taxable now, tax-free later

× Unlike other Roth plans, there is no income test. All 401(k) plan members eligible.

× This will open up the “Roth decision” to vast numbers of new people--be prepared!

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Lump-Sum DistributionsDefinition

×Distribution of entire qualified plan balance in one taxable year of the recipient following the most recent “triggering event”

×Triggering events: death, reaching 591/2, separation from service

×Qualified plans only; not available for IRAs, 403(b)s, 457s, etc.

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Lump-Sum DistributionsThe Tricky Part: Where people go wrong

×Some plans must be aggregated for the “entire balance” test (e.g., all profit-sharing plans of the same employer)

×ALL means ALL. If $1 is left still inside the plan, it’s not an LSD

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Lump-Sum DistributionsBig benefit of LSD: NUA!

× If the LSD includes stock of the employer that sponsored the plan

× Employee pays tax currently only on plan’s cost basis in the stock; rest of the value is called “net unrealized appreciation” (NUA)

× NUA is not taxed until stock is sold; then it is taxed as long-term gain (maximum rate 15%)

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Lump-Sum DistributionsNUA continued

× Long-term gain rate applies to NUA regardless of holding period

× Employee can roll over the non-stock assets and still get the special deal for the NUA

× The NUA treatment is available to heirs, if the LSD occurs after the employee’s death

× Tragedy: Poorly advised employees sell stock inside plan, or roll it over to an IRA

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Lump-Sum DistributionsSecond good deal: special averaging

× Only for individuals born before 1936 (or their beneficiaries)

× The benefit: Special averaging tax (may be lower than regular tax); plus (for pre-1974 participation portion) 20% maximum tax

× Cannot roll over any part of LSD

× See form 4972 for details, requirements

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Pre-Age-59½ Distributions“Series of Substantially Equal Periodic Payments” (SOSEPP)

×All distributions before age 59½ subject to 10% penalty (PLUS income tax)

×There are 12 exceptions to the penalty!

×Best for planning purposes: SOSEPP

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Pre-Age-59½ SOSEPPThe requirements

×Equal regular payments (annual, monthly, or quarterly)

×Designated to liquidate the IRA over life expectancy of owner (or owner + beneficiary)

×Interest rate and life expectancy assumptions are supplied by IRS

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Pre-Age-59½ SOSEPPRev. Rul. 2002-62: the IRS methods

×RMD method: payments calculated like RMDs (fluctuate with account value)

×Amortization method: like a self-amortizing mortgage

×Annuitization method: annuitizes the IRA

×Variations, other methods, may be okay, but require IRS approval

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Pre-Age-59½ SOSEPPWhy this is much more flexible than it sounds

× The payments do not have to continue for life--only until age 59½ (but at least five years)

× The three methods have a variety of interest rate and life expectancy options

× Amortization and annuitization are “fixed” payments, but recent PLRs permit them to use recalculation if that is built into the design; or can switch to RMD method

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Pre-Age-59½ SOSEPPHow to implement

× Determine desired payments

× Work backward to size of IRA required to support desired payments

× Segregate an IRA of that size and use it for the SOSEPP

× Reserve other IRA funds for additional SOSEPP later

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Pre-Age-59½ SOSEPPHow to go wrong with a SOSEPP

×SOSEPP can be used for a qualified plan ONLY following termination of service

×Any modification of the SOSEPP (e.g., stopping payments or changing amount) prior to reaching age 59½ (or five years if longer) causes retroactive loss of exemption

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Pre-Age-59½ SOSEPPUses of the SOSEPP

× Finance estate-reducing gift program

× Finance life insurance purchase

× Diversify (for client overweighted in retirement plans)

× Start new business: mortgage home for startup cash, use SOSEPP to repay mortgage

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Pre-Age-59½ DistributionsOther exceptions to the penalty

×All plans: death benefits, total disability, deductible medical expenses, IRS levy, corrective distribution

×IRAs only: first-time homebuyer ($10K limit), higher education, health insurance for the unemployed

×QRPs only: early retirement at age 55 or older; ESOP dividends; QDRO distributions

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Growth Areas in Retirement PracticeNatalie’s Crystal Ball

× Charitable giving: irresistible bargain for wealthy clients who want to do good; halo effect

× Inherited plans: everybody (but you?) is completely clueless; big money at stake

× Rollers: When should I cash out my plan, roll to a different type of plan, or roll to a different plan of the same type? Help!

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© 2005 Morningstar, Inc. All rights reserved.

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For more information on the topics discussed here today, sign up for Natalie’s newsletter, Retiring with Natalie Choate, at MorningstarAdvisor.com and visit Natalie’s website ataxplan.com.

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