Do you think income taxes will go up or down in the next couple of years? Judging from the current presidential campaign rhetoric and the 2010 expiration of the tax reductions that were enacted between 2001 and 2006, taxes are undoubtedly headed higher. Also, unless Congress acts, the Roth IRA rollover income rule will be relaxed in 2010 so that high-income individuals can qualify. Expected tax hikes and the more liberal Roth IRA rule can be very good for your business.
Let’s see how.
Let me introduce you to Leon, age 58. Leon is his family’s primary breadwinner and very concerned about where his retirement money is invested. He learned a valuable lesson from the dot-com meltdown from 2000 to 2002 because a sizeable portion of his family’s savings and 401(k) assets were lost. It has taken the past six years to recover from these losses, and he’s especially concerned about what might happen in the current uncertain economic times. He views the credit, energy, and dollar problems as alarming and wants to move his retirement money out of harm’s way because he doesn’t have time to wait for a market recovery. Also, he expects income taxes to rise and would like to use this to his advantage. What can he do?
Leon has convinced his employer to modify their 401(k) plan to allow for in-service, non-hardship withdrawals. This is a simple procedure that will allow Leon and other employees to take their employer’s contributions and associated earnings out of the company’s 401(k) plan and put them into an IRA. Additionally, Leon and several of the other employees rolled over other qualified money into the employer’s 401(k) plan when they joined the company, which can also be moved to an IRA. There will be no tax implications for the rollover if they do a direct trustee-to-trustee transfer. Also, the plan, as modified, allows the employees to continue participating without interruption. So what are the advantages to Leon?
Leon makes more than $100,000 annually and does not currently qualify for a Roth IRA rollover; however, in 2010, when this restriction is scheduled to be temporarily removed, he will be able to convert his traditional IRA into a Roth IRA without penalty. If taxes go up as he expects at the end of 2010, he’ll pay the Roth IRA conversion taxes at a lower rate. He’ll get an additional break because only one-half the associated income taxes are due in 2011, with the remainder to be paid in 2012. Since he’ll have to leave the money in the Roth for five years following the conversion to avoid withdrawal penalties, he has decided to put the money in a seven-year bonus index-linked annuity. There are two reasons for this selection.
First, he has moved his retirement money out of the way of another market meltdown and gotten a bonus to boot. Granted, the market may do fine, but Leon cannot afford to take the risk that the market involves. In seven years, he plans to review his and the economy’s financial position and re-invest the money. Unless things change, he’ll consider a bonus index annuity at that time because the bonus will be tax-free and he’ll be immune to market gyrations.
Second, he has locked in the gain from his 401(k) because he has no downside exposure if he holds the annuity until maturity. The added advantage is that the Roth IRA principal and earnings withdrawn are tax-free. Plus, income from a Roth IRA will not increase the taxes on his Social Security. His Roth money can be used at any time after the fifth year following rollover. If not used during his or his spouse’s lifetime, it can be passed forward tax-free to his children and grandchildren at his death. The distributions of principal and earnings taken during their lifetime will be tax free, also.
At age 59½, Leon intends to take his employee contributions and earnings out of the 401(k) since the in-service, non-hardship provisions, and the IRS, allow him to do so without penalty and without being suspended from the plan. He’ll decide at that time where he wants to put it and also whether or not another Roth IRA is suitable. He can then be totally insulated from market losses that could easily ruin his retirement plans.
Leon, like a lot of 401(k) participants, is in the “red zone” right before retirement and, as a practical matter, cannot afford to suffer market losses. Many small-business people and professionals (doctors, lawyers, bankers, etc.) are in the same position. The investment choices inside their employers’ plans do not provide them the flexibility, selection, and protection they need during this phase of their working years; thus, they opted to take control of their investments outside of an employer’s plan and at the same time take advantage of the temporary changes in the Roth IRA and avoid forthcoming income tax hikes. Index-linked annuities are the perfect vehicle for the journey to this tax haven.
Dr. Shelby Smith is chief operations officer and SVP for BHC Marketing Ltd. He can be reached at ssmith@bhcmarketing.com.