May 2008 Issue

In This Issue...

• Getting the Money Out
• Should You Contribute to a Roth 401(k)?
• Asset Transfer by Nonspouse Beneficiaries Still Depends on Plan
• A 3-Step Asset Allocation Strategy
• Protecting Your Family: New and Old

Getting the Money Out

The tax laws regarding withdrawals from individual retirement accounts (IRAs) are complex. To avoid unnecessary penalties and to ensure you withdraw the funds efficiently, here are the basics:

Before Age 59 1/2

In addition to any income taxes that may be due, withdrawals before the age of 59 1/2 are subject to a 10% federal income tax penalty. However, the 10% penalty will not be assessed in the following situations:

• Distributions are made to beneficiaries after the IRA owner's death.
• Distributions are made to the IRA owner due to his/her disability.
• Distributions equal medical expenses paid in excess of 7.5% of adjusted gross income.*
• Distributions are made to certain unemployed IRA owners to pay health insurance premiums.*
• Distributions are made for up to the $10,000 lifetime limit for qualifying first-time homebuyer expenses.
• Distributions are made to pay qualified higher-education expenses for the IRA owner, his/her spouse, children, or grandchildren.*
• Distributions are made as a series of annual withdrawals in substantially equal amounts over the owner's life expectancy or the joint life expectancy of the owner and beneficiary.*

* While distributions are exempt from the 10% federal tax penalty, these types of Roth IRA withdrawals are subject to ordinary income taxes on any earnings. The other Roth IRA withdrawals are penalty free and income-tax free.

Between Ages 59 1/2 and 70 1/2

Between these ages, you can withdraw as much or as little as you like from traditional and Roth IRAs. Both contributions and earnings withdrawn from a traditional deductible IRA and earnings from a nondeductible IRA will be subject to ordinary income taxes. As long as the first contribution was made at least five years previously, Roth IRA distributions will not be subject to federal income taxes. Generally, you should postpone withdrawals as long as possible to continue tax-advantaged growth. However, in years when income is low, you may want to take distributions from a traditional IRA to take advantage of lower income tax rates. You may also want to convert all or part of a traditional IRA to a Roth IRA during low-income years. While you will have to pay income taxes on the conversion, future earnings will accumulate tax free as long as you make qualified distributions.

After Age 70 1/2

You are not required to take distributions from a Roth IRA after age 70 1/2. You must, however, take required minimum distributions (RMDs) from your traditional IRAs every year, or you will be assessed a 50% penalty on amounts that should have been withdrawn. You can always take out more than the RMD. Your RMD is calculated by taking the account balance as of the preceding year divided by the life expectancy factor from a uniform table. The table is based on joint life expectancies and assumes your beneficiary is 10 years younger than you. If your spouse is your sole beneficiary and is more than 10 years younger, you can use either the uniform table or a table based on the actual joint life expectancy of you and your spouse.

Your first RMD must be made by the required beginning date (RBD), which is April 1 of the year after your turn 70 1/2. However, if you take the distribution in the following year, you will then take both your first and second distributions in the same year. Evaluate your tax situation before doing that. Two distributions may increase your income so you are in a higher tax bracket, lose tax deductions or credits, or Social Security benefits become taxable. In those situations, you may be better off taking your first RMD in the year you turn 70 1/2.

After Death

Heirs must generally start taking distributions by December 31 of the year after your death. Distributions by heirs are based on who your beneficiary is and whether you died before or after the RBD:

• If the account has a designated beneficiary, which includes individuals and certain trusts, the account balance can be withdrawn over the beneficiary's life expectancy, based on a single life expectancy table. This calculation is used whether you die before or after your RBD.
• A spouse can treat an inherited IRA as his/her own, but the surviving spouse has to be the sole beneficiary. However, if a spouse and other beneficiaries inherit an IRA, the account can be split so the spouse solely owns his/her portion.
• If the account does not have a designated beneficiary, which includes your estate, charitable organizations, and certain trusts, and you die after your RBD, the balance is paid out over your remaining life expectancy. If you die before your RBD, then the balance must be paid out within five years of your death.

The decisions you make regarding IRA withdrawals have important consequences for your retirement and for your beneficiaries.

Should You Contribute to a Roth 401(k)?

Although Roth 401(k) plans became effective on January 1, 2006, they are just now starting to gain momentum. Originally, Roth 401(k)s were scheduled to expire after 2010, so companies were not willing to start a plan that would expire after a few years. However, the Pension Protection Act of 2006 made Roth 401(k)s permanent.

The Roth 401(k) is patterned after the Roth individual retirement account (IRA) - contributions are made from after-tax earnings that grow tax free, and qualified distributions are withdrawn tax free. Here are the basics, including how Roth 401(k)s differ from Roth IRAs:

• Eligibility - Employees eligible for their employer's 401(k) plan are also eligible for the Roth 401(k). There are no income limitations for contributions to a Roth 401(k). With a Roth IRA, single taxpayers with modified adjusted gross income (AGI) less than $101,000 and married taxpayers filing jointly with modified AGI less than $159,000 in 2008 can make contributions, regardless of their participation in a qualified retirement plan. Contributions are phased out for single taxpayers with modified AGI between $101,000 and $116,000 and for married taxpayers filing jointly with modified AGI between $159,000 and $169,000 in 2008.
• Contributions - The contribution limits for the Roth 401(k) are the same as for the regular 401(k) plan. In 2008, you can contribute a maximum of $15,500 plus a $5,000 catch-up contribution for those age 50 and over, if permitted by the plan. However, your employer may set lower limits to comply with nondiscrimination rules. Contributions can be split between a regular and Roth 401(k), as long as total contributions do not exceed the maximum. Funds contributed to each type must be held in separate accounts. Any matching contributions made by the employer must be held in the regular 401(k) account, so they will be taxable when withdrawn. In 2008, the contribution limits for a Roth IRA are $5,000 plus an additional $1,000 catch-up contribution for individuals age 50 and over. You can make contributions to both a Roth 401(k) and a Roth IRA, as long as you meet the income eligibility rules for the Roth IRA.
• Required distributions - With a Roth IRA, you are not required to take distributions during your lifetime. Thus, Roth IRAs are a good estate planning vehicle for individuals who want to leave tax-advantaged assets to beneficiaries, since beneficiaries can also withdraw qualified distributions without paying federal income taxes. With a Roth 401(k), annual distributions must be taken after age 70 1/2. However, funds in the Roth 401(k) can be rolled over to a Roth IRA, which would not require distributions.
• Conversions - Individuals under certain income levels can convert a regular IRA to a Roth IRA, as long as income taxes are paid on the amount that would have been taxable if withdrawn. Starting in 2010, all taxpayers, regardless of income level, can convert a regular IRA to a Roth IRA. There is no provision to convert a regular 401(k) to a Roth 401(k).

If your employer offers both a regular and Roth 401(k), which plan should you choose? Your decision will typically involve the same types of considerations as those made when deciding between a traditional deductible and Roth IRA. Two major factors include:

• Your current income tax bracket versus your expected income tax bracket during retirement. If you expect your income tax bracket to be higher during retirement, a Roth 401(k) will typically result in more retirement funds. Younger workers will often find themselves in this situation. On the other hand, if you expect your tax rate to decline after retirement, you will typically want to use a regular 401(k) plan. Workers who are nearing retirement age may find themselves in this situation. If you expect your tax bracket to be the same, both alternatives will typically provide the same balance.
• Whether you plan to leave assets to beneficiaries. If you are using your 401(k) plan as a vehicle to provide tax-advantaged assets to beneficiaries, you should consider the Roth 401(k). Once you retire, you can roll the balance in your Roth 401(k) to a Roth IRA, without any tax consequences. You then do not have to take any withdrawals during your life. When your beneficiaries inherit the Roth IRA after your death, they will have to take distributions over their expected life expectancies, but those distributions will be federal-income-tax free as long as the distributions are qualified.

Keep in mind that this does not have to be an either/or decision. You can split your contributions between the Roth and regular 401(k) plans.

Asset Transfer by Nonspouse Beneficiaries Still Depends on Plan

The Pension Protection Act of 2006 contained a provision allowing nonspouse beneficiaries to roll over funds from an employer pension plan to an inherited individual retirement account (IRA), starting in 2007. This was viewed as a significant development for nonspouse beneficiaries, who would be able to extend distributions from employer pension plans over their life expectancies rather than the typical five-year period imposed by most plans.

The Internal Revenue Service (IRS) then issued guidance indicating that the plan was not required to give nonspouse beneficiaries the ability to roll funds over to an inherited IRA. There is currently a bill in Congress to make these rollovers mandatory beginning in 2009, but until it is passed, it is still up to the plan to decide whether to allow rollovers by nonspouse beneficiaries.

If allowed by the plan, beneficiaries must ensure that the rollover is handled properly so that it is not considered a distribution. The rollover, which must be completed by the end of the year following the decedent's death, must be a direct trustee-to-trustee transfer to a properly titled inherited IRA that retains the decedent's name in the title. The funds cannot be transferred to an existing IRA belonging to the beneficiary. If the funds are issued to the beneficiary via check, it is considered a distribution, and those funds cannot be rolled over to an IRA. If a plan won't make a trustee-to-trustee transfer, a check can be made out to the inherited IRA and still meet the requirements.

Once funds are rolled over, the distribution rules that applied when the funds were in the employer's plan continue to apply, unless the beneficiary takes the first required distribution using his/her life expectancy by the end of the year following the decedent's death. If this is not done, the beneficiary must take distributions based on the plan's rules, which generally require the entire balance to be withdrawn in five years.

A 3-Step Asset Allocation Strategy

Perhaps the most important move you can make for your investments is to properly diversify your portfolio. By investing in a mix of stocks, bonds, and cash, you'll reduce the risk of a significant loss.

How you combine your diverse mix of investments is called your asset allocation. Asset allocation is a highly individual determination that's based on your risk tolerance, financial goals, and age. Asset allocation will spread out your investments among a mix of three types:

• Stocks - Stocks tend to be the riskiest investment. However, while they have the highest potential for loss, they also offer the greatest potential for gain.
• Bonds - Bonds tend to be less risky than stocks but more risky than cash equivalents.
• Cash - Cash equivalents, such as savings accounts, certificates of deposit, and money market accounts, typically offer the lowest risk and the lowest potential returns.

The benefits of allocating your assets among the three types of investments include:

• Proper asset allocation diversifies your portfolio among the three types of investments, reducing your risk.
• Allocating your assets between the three types allows you to tailor your portfolio to your specific goals.
• You can help manage the level of risk and volatility of your returns.

Considerations

To properly allocate your investments among stocks, bonds, and cash, consider this three-step approach to asset allocation:

Step 1: Be honest about your level of risk tolerance.

Some people think that investing in a relatively unknown start-up company with a great idea is a sound investment, while others prefer to stick with stable companies with household names. In other words, people's risk tolerances vary.

If you don't mind the more dramatic ups and downs associated with higher-risk investments, you may see higher return potential. But if you can't stand the thought of putting your hard-earned money in an untested company, you're probably better off sticking with relatively low-risk allocations, even though you may see more modest returns.

Step 2: Write down your financial goals.

What are the purposes of your investments? Are you saving to buy your first home? Planning to send your children to college? Looking to retire early? Whatever your financial goals are, knowing them will help you determine how to allocate your assets to help you meet them.

Step 3: Consider your time horizon for meeting those goals.

How much time do you have before you need your money for your goals? Is retirement a long-term goal, with 30 years to go? Or is it a short-term goal, with only five years to go? If you're just starting a career, do you have short-term goals, like buying a house, as well as intermediate-term goals, like sending your children to college?

There's no consensus on exactly how much of your portfolio should be in any of the three investment categories at any time. However, broadly speaking, the farther away in time you are from your financial goals, the more aggressively you can be invested.

Protecting Your Family: New and Old

According to the Census Bureau, blended families - families that include children from one or both spouse's previous marriages - now outnumber nuclear families. Yet, too many people in these blended families assume that their estate will be distributed to their spouse and children when they die. Without an estate plan, that assumption may be misguided.

No estate plan? Prepare for unintended consequences

Without an up-to-date estate plan, you could end up bequeathing part of your estate to an ex-spouse, disinheriting your own children, leaving less than you intended to your current spouse, or paying too much in estate taxes. Fortunately, there are a number of estate planning tools that can help avoid these unintended consequences.

• Disinherit your ex-spouse - To avoid accidentally bequeathing part of your estate to your ex-spouse, review how all assets are titled and check beneficiaries on all life insurance policies and retirement accounts. Update estate planning documents, removing your ex-spouse.
• Protect your own children - Consider a trust for the benefit of your children. Even if one or more of your children predeceases your ex-spouse, their inheritance can go to their children or be split up among the trust's other beneficiaries. Nothing has to go to your ex-spouse.
• Provide for your current spouse - If you leave your estate to your current spouse without explicitly providing for your own children, your estate could end up in the hands of your spouse's children when he/she dies, leaving your children out of the picture. A qualified terminable interest property (QTIP) trust can help prevent that from happening. A QTIP trust can pay income and part of the principal to your current spouse for the remainder of his/her life, and then transfer the remaining assets to your children when your spouse dies.
• Minimize estate taxes - If an insurance policy is set up properly, the proceeds are distributed free of both income and estate taxes. Another benefit is that the life insurance policy can be used to pay proceeds to specific beneficiaries you designate, including your current spouse and your own children.
• Protect your individual assets - If you're heading into marriage, a prenuptial agreement can detail what will happen to your individual assets in the event of divorce or death. Think carefully about holding property jointly. No matter what your estate planning documents state, property held in joint tenancy with rights of survivorship passes to the other owner.

Blending families is not an easy task. Making estate-planning decisions in a blended family environment can be complex, but it is a subject that should not be ignored.

Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

FR2008-0125-0044