© 2005 Morningstar, Inc. All rights reserved. Finding Gold in the Code Mining Tax Code Nuggets to Maximize Your Clients’ Retirement Benefits Natalie Choate Sponsored by: A MorningstarAdvisor web seminar

2 What We’ll Cover Today × Roth IRAs--New Rules for 2005 and 2006 × Lump-Sum Distributions × Pre-Age-59½ Distributions × New Developments and Trends

3 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

4 Roth IRAs But 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

5 Roth IRAs Who 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

6 Roth IRAs Bad 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)

7 Roth IRAs Starting 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!

8 Lump-Sum Distributions Definition × 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.

9 Lump-Sum Distributions The 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

10 Lump-Sum Distributions Big 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%)

11 Lump-Sum Distributions NUA 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

12 Lump-Sum Distributions Second 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

13 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

14 Pre-Age-59½ SOSEPP The 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

15 Pre-Age-59½ SOSEPP Rev. Rul : 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

16 Pre-Age-59½ SOSEPP Why 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

17 Pre-Age-59½ SOSEPP How 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

18 Pre-Age-59½ SOSEPP How 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

19 Pre-Age-59½ SOSEPP Uses 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

20 Pre-Age-59½ Distributions Other 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

21 Growth Areas in Retirement Practice Natalie’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!

© 2005 Morningstar, Inc. All rights reserved. Question and Answer Natalie will now answer your questions. 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. Sponsored by: