IRAs make up the largest percentage of retirement assets for baby boomers and beyond. When’s the right time to take money out? What are the rules and penalties if you get it wrong?
Tune in this week to Make It Last to learn the ins and outs of IRAs.
Make It Last with Victor Medina is hosted by Victor J. Medina, an estate planning and elder law attorney and Certified Financial Planner™. For more information, visit Medina Law Group or Private Client Capital Group.
Click below to read the full transcript…
Announcer: Welcome to “Make It Last,” helping you keep your legal ducks in a row and your nest egg secure, with your host, Victor Medina, an estate planning and elder law attorney and certified financial planner.
Victor Medina: Hey, everybody. Welcome back to Make It Last. I’m your host, Victor Medina. I am an elder law attorney and certified financial planner.
Welcome back to a very exciting show. Today, we’re going to be talking all about IRAs. I’m going to touch upon something that I spoke on a couple episodes ago about assisted living and different kinds of long‑term care. It turns out that we had a reader feedback that wanted me to talk a little bit more about one kind of care, which we’ll get to very shortly.
I want to thank everybody for the outpouring of love that has come out since we’ve launched the show. A lot of people with some great feedback, telling us how well we’re doing and sharing the message, because the viewership or listenership of this is getting wider and wider and wider, and we just quickly wanted to say thank you to everybody for spreading the word.
If this is your first time joining us or if you like the show, realize that you can also go back and listen to prior shows by going to Make It Last Radio or looking online at iTunes or at Stitcher, and looking for the show, Make It Last.
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Now listen, a couple of shows ago, we talked about different kinds of care as you get older. One of the types of care that we talked about was care in your home.
We covered assisted living facility care. That’s what happens when you move into an assisted living facility or skilled nursing facility, but we also talk about care in your home.
A reader or a listener came back and said, “What about moving in, in like an in‑law suite together with your child?” I said, “That’s a really good question. Why don’t we handle that on the show?”
Here we are. We’re going to talk about that because it’s true. As you age, your ability to support and maintain your home can get more and more difficult.
Even staying within your home with care brought in could be too much if it turns out that you’ve got a big lawn to mow, or something else. Maintaining that home is difficult, so people think about moving in with their kid.
They’ll either build onto the existing home an in‑law suite, or maybe they will pool together some money, and then they’ll go buy a bigger home where they can all live. This could come at the suggestion of the adult’s child. It could be your suggestion.
At the same time, as helping you to be able to manage living in this space, to move to somewhere else with some help, the child or you could think that making such a move can help with care giving, or reduce costs.
I’ll share with you a real quick story. When we did the rehab on our house, we bought an older home and really redid the interior of it. When I brought it to the architect, the architect said, “What do you need to do in this home?”
I said, “Look, my wife and I, we are the oldest children in our family. My parents, they divorced and they remarried, and all four of them are still alive. My wife, she’s got two parents, and they’re still alive.”
I said, “The chances are that one or more of these parents are going to go ahead and move in with us. What we need is a spot for them to live.” The architect came back and had drawn out this in‑law suite. It had a bedroom, and a separate bathroom, and a kitchen, and a living room. It was sectioned off to the side of the house.
I stared at that for a little while, and I asked him, “What’s that over there?” He said, “This is the in‑law suite, see they’ve got the separate living inside of your living. Have you ever heard of that?”
I said, “I’ve have heard of that, but let me ask you, have you ever heard of the way a Puerto Rican family operates? Because we’re of Puerto Rican descent, so I’ve got to tell you a little bit about the enmeshment that happens by just culture and nature.”
I said to the architect, “I could build that kitchen, but the truth of the matter is that if I had one of my parents staying with us, they would still end up in my kitchen in their pajamas every morning. We don’t know boundaries, so we’re going to have to go away from that idea.” [laughs] We did, and I got an office back.
There’s no way I was going to build a separate kitchen because there’s no way that any of our parents are going to respect that boundary, nor would we want them, to be honest. We’ve got great relationships with them.
It does raise this issue. Depending on the dynamics of your family, living in such close proximity can be very challenging for a number of reasons. There’re some questions that you should answer before you commit to making such a big financial and emotional commitment.
First and foremost, do you want to live with your child? Because before you move in, it’s a good idea to have pretty in‑depth conversations with them about the roles and responsibilities, and even the finances.
For instance, are you going to be trading babysitting duties for watching your grandchildren, or helping to cook dinner? What kinds of responsibilities are there going to be? These children have run their nuclear family without you being there, and now that you’re there, how does that all shake out?
Are you going to pay rent? Are you going to pay room and board around it? Is your contribution towards the cost of this, and then you’re going to pass over the equity? How does that work? Do you put your name on the title? Do you have it owned in a trust, or through a company, all that kind of stuff?
Are you going to have access to the full home, or just certain parts of the home? From that perspective, you need to shake out how you’re going to be living in that environment. Can you have guests in? Are you going to be driving yourself?
Now, the second half of it is about this idea that there’s going to be some caregiving. You’re thinking that there might be some reduced costs. What is that going to look like, because caregiving can be an intense, physically and emotionally challenging job.
Whether or not your child is there to provide all of the caregiving, or to provide the nighttime caregiving, or something like that, this is an impact on them and their lives in a way that they may not be prepared for, they may not be skilled at. You’re going to have to walk through some of those issues ahead of time.
Once you start to commit to investing in real estate, either in building an in‑law suite or putting together money in a home, you should think through the next consequence steps from that, to see how it’s going to get shaken out.
The last thing that I want to submit to you is that this is going to be a solution for a very finite kind of care, because as you get older, you may not be able to be maintained in that home. As your care needs increase, you may need to, in fact, look at assisted living down the road.
If you have piled all of your eggs into this one basket, without planning the next consequence steps from that, it can be very eye‑opening, devastating to the plan, to not have thought through those issues.
I hope I have addressed the concept of an in‑law suite for you. We see a lot of this in our elder law practice, as we see people come in to us at certain different stages of the care need. Certainly it’s an option, right, but you want to think about whether or not it’s the right option for you.
That was our timely tip for today. When we come back from the break, we’re going to talk a little bit about IRAs. We’re going to spend the first segment introducing them, and then we’re going to spend the next segment talking about planning around them.
IRAs are a huge topic, so we’ll get as far as we can in that. Stick with us, when we come back from the break with Make It Last, where we help keep your legal ducks in a row, and your financial nest egg secure.
Victor: Everybody, welcome back. We’re going to talk now about IRAs. I told you before that we were going to go, in this segment, talking generally about it. Now, you may know a lot about IRAs. I don’t know where anybody is in their knowledge base on this.
I think it’s important to start at the beginning and ramp our way through thinking about IRAs, the basics, and then we’ll take the second segment, or the last segment of the show, and we’ll talk about planning.
Back in the past, people’s retirement was driven mostly by the idea that they would have a pension. That pension was a retirement benefit provided by the company, and then they might have Social Security.
Those were the two major ways for them to fund their retirement. Social Security is a government benefit, you pay into it, you get your certain amount of credits, and credit hours for quarters, then they tell you how much your benefit is. It goes up with any cost of living.
The more you make, and the more you contribute, the more you get out of Social Security. The pension was something called the defined benefit plan. The defined benefit plan is basically that the company was going to tell you how much they were going to give you. They had to fund that obligation.
Most of the time, it was a lifetime pension. They would pay that out. This defined benefit was their obligation to give you this defined benefit for the rest of your life.
Over time, in response to a very difficult financial situation of funding this defined benefit plans, what ended up happening is that companies migrated away from defined benefits and into defined contributions.
A 401(k), a 403(b), a 457, anything that’s in the umbrella of an IRA, like a SEP IRA, or a Solo 401(k), something like that, these are all defined contribution plans. The way that they work is essentially that you put money aside.
Under the IRS regulations, of all those numbers that I quoted for you, you are able to do two things with respect to taxes on those contributions. The first is, up to a certain limitation, you’re able to deduct the contributions into that account from your taxable wages.
If you put the maximum in there, say, it’s like $18,000, you could reduce your recorded wages down by $18,000, and pay tax on essentially what’s left. The first one was deductibility.
The second one was the deferment of the taxes that would be owed on the growth of those accounts. You would be able to take them, invest them. Over the history of that account, defer the taxes so that you didn’t have to owe that until sometime in the future.
As this became the norm for retirement, the pie chart of retirement funding changed. We got Social Security, smaller and smaller percentage of that is pension. In fact, for most people, though there are some Fortune 500 companies that are still offering pensions.
Most of those have a large base of unionized workers, like auto workers, and things like that. For the most part, pensions have gone away, and retirement is made up of Social Security and withdrawals from these defined contribution plans, or other savings they have.
Now we go through that, and we say, “Look, here we are with our retirement, and we need to take that money out.” That money is what we call qualified money. Non‑qualified money is money that you save after you pay taxes on that, and then you might invest that, but that’s non‑qualified money.
Qualified money is a little bit more valuable because of the way that it can grow tax deferred. That’s part of the reason why, first of all, the government limits the amount of money that you can set aside in that.
This account is not one that you can contribute to, and make up for any market losses, or anything like that if you’re not working, if you don’t have the ability to make those contributions because you’re working, you can’t add it to it.
The traditional IRA falls into this category of assets where you contribute them into a defined contribution plan. By the way, when I’m talking about traditional IRA, I am taking all those accounts with the numbers on, the 401(k)s, the 403(b)s because they are all capable of being rolled into a traditional IRA that you match.
The other ones with the numbers are all company sponsored. They have benefits because of the way that the company can match contributions, and the way that you can increase the amount that you are able to deduct off of your taxes.
Generally speaking, a traditional IRA covers all of these. There are couple of rules around that. Absence and special circumstances, you’re not allowed to touch that money before age 59.5, unless you’re willing to pay a 10 percent early withdrawal penalty.
The contributions that are tax deductible can grow tax deferred in the account, until one certain point in time, which is that by the time you turn 70.5, you need to start taking required minimum distributions or what people call RMDs.
Because while the government wants you to save for retirement and gives you incentives to do so, the IRS still wants its cut of this tax money after you’ve retired. Thus, is the creation of this required minimum distributions because you’re not allowed to essentially push that off to the future forever and ever and never pay taxes on it.
These are empty start when you’re 70.5, and it’s important to realize that if you don’t take out the required minimum distributions, you will pay an excise tax of 50 percent of what you needed to take out as a straight tax.
It’s important to know when it starts and it’s important to know that you have to take it out and do so before the end.
Last topic for this segment, which is we’re going to talk about the taxability of the withdrawals out of this account. It’s important to remember that every dollar of this required minimum distributions are 100 percent taxable as ordinary income. They show up like your wages showed up in your work‑life.
There’s a W2H. They go on that line item, that’s tax is to the highest of those brackets. If you go from 10 to 15, to 25, to 28, and so on and so forth, these are empty and gets added into that. It can shake people, because remember, you have invested this money for years, and years, and years.
Normally, if you took this after tax funds, and invested them, and you held these accounts for more than a year or so, you would pay capital gains. Capital gains is a lower rate, but coming out of the IRA account, it’s taxable as ordinary income.
It’s not only taxable as ordinary income to you, it’s also taxable as ordinary income for the rest of the existence of that account. What I mean is you might leave that behind to a spouse, you might leave that behind to children, but whenever those beneficiaries take that money out, it is taxable to them as ordinary income.
This brings together one of the most powerful tax planning strategies that you can ever employ which we call proactive income tax planning, which you get to hear about after the break because I’ve run out of time on this segment.
Stay tuned. When we come back, we’re going to talk about planning around these IRAs so that you have the most flexibility going forward and you minimize the amount of taxes. We’re going to hit as many topics as we can in the last segment. Stay tuned with us when we come back on Make It Last with Victor Medina.
Victor: Hey, welcome back to Make It Last. We’re in our last segment, talking about IRAs. We just left you talking about the taxability of that, and I promised to teach you the most powerful tax planning strategy around IRAs. It goes something like this. Most people when they are married have more flexibility in their ordinary income tax brackets than when they become single.
When they leave that asset behind to their children, their children are likely, because they’re working, in a higher tax bracket than the parents were in retirement.
If you take these two principles, if you take these two guideposts and say, “Look, I have a lot of power when I’m married to manage my tax brackets that are more generous, and my kids are in a higher tax bracket than I am in retirement,” you can employ the most powerful tax planning tool.
It cuts against all conventional wisdom. All conventional wisdom says that you should delay your RMDs, taking any money out of your IRA, until you turn 70.5, and then only take the minimum amount. I believe as a planner that that’s the worst planning that you can do, because you’re just going to give the government the highest amount of taxes that you possibly can.
Imagine this. The top of the 15 percent bracket is $75,000. That means that if you make $75,000 or less as a married couple, you’ll never pay more than 15 percent in ordinary income. That same 15 percent bracket caps out at half the amount when you’re single, only $37,000.
If you’re married and you have a $1 million IRA and you leave it behind to your spouse, if you are just taking the minimum out and that person’s getting older and happen to take more and more out as the RMDs increase, guess what? When they’re single, they’re going to pay more in taxes because there’s this big jump.
You go from 15 percent all the way up to 25 percent in the next bracket. That means 10 cents out of every single dollar goes to the government needlessly. What can you do about it?
Well, if you are in that retirement phase where you’re between your retirement and 70.5, what you need to do, and what we do for all of our clients in this situation is we calculate the maximum amount that they can take out in that 15 percent bracket every year, based on the US tax numbers, and we encourage them to take that money out.
Now, do they have to spend it? Of course, not. You can go and reinvest it. Can they convert it into a Roth IRA? Sure, they can. We haven’t really talked about Roths and their tax‑free nature. The idea here is that we are hitting this proactive income tax on an annual basis so that we chart the course of how much tax we’re going to pay by going in and triggering more distributions.
By the way, this isn’t just about the 15 percent bracket. This is still the case even if you’re in the 25 percent bracket, because the brackets are still adjusted downwards, the thresholds are downwards, when you turn single. Therefore, even if you’re in a higher percent bracket, we can calculate what the impact of the death of the first spouse is.
We can calculate that when that first spouse dies, there’s going to be more due in taxes than there was before. We want to make sure that we have accounted for that, because we don’t want the death of the one spouse to trigger less money in the remaining spouse’s pocket simply because they’re paying higher taxes.
That’s the case there, and it’s the same thing when we think about the inheritance taxes. When we go to inheritance taxes, we’re largely considering this idea that your kids pay higher taxes, so if you take it out at a lower tax bracket and leave it behind to them, then they won’t have to pay it at their higher rate.
It’s important that they have the chance to stretch out anything that’s left, and I’m going to talk about that in the last part about this. Realize that while most inheritances that you leave behind get a new basis, they get to eliminate all of the gains, that’s not the case in an IRA.
For instance, if you bought your home for $100,000 and it’s worth $400,000 now, when you die and you leave that home behind to your kids, they can sell it for $400,000 and pay nothing in tax. If you gave it to them during your lifetime and then they sold it, well, they didn’t get any basis adjustment. They’d have to pay capital gains on it.
It’s the same case on an investment account, but it’s different for an IRA. In an IRA, you cannot get a step up in basis. If you’re already going to pay taxes on this, maybe we want to think about moving it out of the account and investing it on something that would get a step up in basis. Now you may not be able to do this with all of the account.
In fact, if you have saved diligently, then you’re going to leave behind some measure of the account. When you do, it’s important that you leave it behind in a way where that individual can stretch out that account over their lifetime.
See, you’re allowed to leave behind an IRA as an inherited IRA where the individual that you’re leaving it to, most likely children, can stretch it out and only take out a certain amount.
When they inherit it, they can’t delay it to 70.5. The government doesn’t let you do that. They have to take some of that money out every year, but only a certain amount. If they’re able to continue to defer the taxes and continue to keep it invested, they can stretch that out. They can’t do it if you mess up the beneficiary designations.
The beneficiary designations control, your will does not control this account. In fact, if you set up the beneficiary designations because you thought you are all clever and say, “Well, I want it to go according to my will,” and that’s what you put on there, you’re going to cause a very bad tax event to happen.
Which is that, all of the money is going to end up coming out in one year and the taxes have to be paid over five years. It basically destroys the stretch out. We want to make sure that it’s left to a designated beneficiary, essentially an individual. In our office, when we do legal planning, we’re essentially leaving it behind in a trust, but it has to be a certain kind of trust.
This trust allows us to wrap the inheritance around divorce protection. We’re able to leave the IRA and make sure that no portion of the IRA can go in a divorce to somebody else or a creditor somewhere down the road. We’ve even, in prior shows, talked to you about the need for an IRA inheritance trust, a special kind of trust.
We’re making sure that we’re able to get both benefits. Being able to leave it behind in a protected fashion but also allow the designated beneficiary, your children, to essentially stretch that out over their lifetime. This is a very important step to make sure that your plan doesn’t blow up after you’re gone when it comes to these taxes.
Oh, my goodness. I just looked at the time and we are essentially out of time for this show. I didn’t even get to Roth IRAs, their power, how to do it, and how to do the conversion.
I also didn’t talk to you about asset location and strategies about where things should be and which kind of investments should be in which kind of account, where your bonds should be, where your stocks should be ‑‑ all important stuff.
I’m going to do this, I have written another book. That book is about finances and retirement, it’s called “Make It Last ‑‑ Ensuring Your Nest Egg Is Around As Long as You Are.” You can buy it at Amazon, but I’ll do this. I’m pretty sure that we run these ads for free books. If you go ahead on that and order the free book for the legal stuff, we’re going to go ahead and send you the financial book, too.
Inside of there is all the proactive income tax planning and all the asset location stuff, it’s all there. I would encourage you to go ahead and follow the link, order the free book, and we’ll send you the financial book. If you want us to talk to you about these IRAs and how to do that, you’re not really sure how to get it done the right way, you want to talk to an advisor, then go ahead and give us a call.
You can do that at Private Client Capital Group, follow the link, trigger the thing. Just contact us and we’ll sit down and have an absolutely free discussion on it, no obligation.
We’ll talk about how to protect those assets and make sure that they’re done the right way. Jeez, I’m exhausted. [laughs]
Thanks so much for listening today. This has been all about IRAs. In the future, we’ll talk about Roths, we’ll talk about asset location, we’ll talk about investment fees.
We’ll talk about all the stuff we haven’t gotten to yet. If you want to hear more of these shows, go ahead to iTunes or to Stitcher and look for Make It Last. Download the link and you’ll be able to go back to prior episodes and share it with a friend if you thought this was important. It would be really helpful to help us spread the word.
Victor: Other than that, thank you so much for listening to today on Make It Last, where we help keep your legal ducks in a row and your financial nest egg secure. Until next time, stay tuned. Bye‑bye.
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