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"There was a time when a fool and his money were soon parted, but now it happens to everybody."
-Adlai E. Stevenson (1900-65), presidential candidate and U.S. representative to the United Nations
Let me tell you about Ann, a woman with a nest egg consisting mainly of her 403(b), a tax-deferred retirement account for employees of nonprofit entities such as schools and hospitals. A widow, she was retired from her job of 30 years as a New York City schoolteacher. Ann's sole wish at the end of her life was to leave her entire savings to her two children: Jessica and Tom.
When Ann died suddenly in 2000, just two years into her retirement, Jessica and Tom came to me for advice. They explained how they'd been brought up in a modest, middle-class home where the emphasis was on living within one's means and always saving for a rainy day. They were amazed that although their mom, being a teacher after all, was clearly not a rich woman, she had, during 30 years of disciplined saving, accumulated more than $800,000 in her retirement account!
As Jessica and Tom both had good jobs with decent incomes, I suggested that they try to delay receiving that money since any distributions taken now would be subject to income tax, and they were both in high brackets. I explained that by "stretching" the distributions from their mom's 403(b) over their own lifetimes (Jessica was 40, and Tom was 36), the $800,000 could compound tax-free into an even bigger fortune as I'm sure Mom would have liked.
That was the good news.
However, as I learned more about the arrangements their mother had made-or, rather, had not made-I then had to give them the bad news: They wouldn't be able to take advantage of this option.
From Bad to Worse
Although Ann had never lived like a wealthy woman, according to our tax system, her combined estate of $1.2 million (her house, some minor savings, and other personal property, plus the $800,000 retirement plan) was large enough to be subject to estate tax.
Furthermore, as in all high-tax states (she was a New Yorker), her retirement plan distributions were subject to estate and income taxes on both the federal and state levels, as well as a city income tax!
Once I revived Jessica and Tom, I had to give them even more bad news.
As the estate tax exemption was only $675,000 (today it's $1 million) and their mother's estate was worth $1.2 million, they would have to pay a combined federal and New York State estate tax of $207,000, or almost 40 percent, on the $525,000 balance ($1.2 million - $675,000 = $525,000) of the inheritance. Neither Jessica nor Tom was in a position to shell out such a hefty amount, so Ann's retirement account itself would have to be tapped since there were few other liquid assets in the estate besides the account.
But it got worse.
Once the money was withdrawn from their mom's retirement account to pay the estate taxes, the withdrawal itself would be hit with federal, state, and city income taxes of another $80,000!
Then came the worst news of all.
Under the best payout option offered by their mom's 403(b) plan, they would have to empty the account within five years, even if they didn't need the cash.
Thus, there would be no lifetime stretch option, no 40-plus years of additional tax-free compounding-which, even at a modest rate of interest, might conceivably have grown the account as high as $10 million.
Instead, their mom's retirement account, which represented a lifetime of sacrifice and saving, would be reduced by a snowball effect of taxation on taxation to less than $150,000 for each child.
Moral: Ignorance is not always bliss.
If Ann had known enough to roll her 403(b) over into an IRA when she retired, and had protected her account with sufficient life insurance, this terrible tax trap could easily have been avoided-and Jessica and Tom could have parlayed Mom's retirement account into $10 million for both of them-maybe even more.
Worst Rollover Attempt Ever
Horror stories occurring to average people just like you abound. Here's another:
In a notorious 1993-98 tax case, a Mr. Albert Lemishow decided to take advantage of the IRS rule that allows you to withdraw funds from one retirement account and roll them over into another within 60 days without incurring taxes and penalties. His purpose was to use the cash to buy some shares of stock, and roll over the stock in what he thought would be a tax-free transaction.
Unfortunately, Mr. Lemishow missed the fine print.
He took the following distributions from his Keogh self-employment plan and IRA accounts to buy the stock:
Type of Account Amount
Keogh $250,651 Keogh 50,130 IRA 13,939 Keogh 153,828 IRA 6,377 IRA 5,489 ---------- Total Distributions $480,414
Federal tax was withheld on the $50,130 and $153,828 Keogh withdrawals, but for some reason was ignored on the $250,651 Keogh. The combined tax withholding was $43,297. Therefore the net amount of the Keogh and IRA distributions was $437,117.
Since Mr. Lemishow withdrew the funds on December 14, 1993, he had until February 12, 1994, to complete the rollover within the required 60 days.
In the meantime, Mr. Lemishow completed a subscription to buy $450,000 worth of the stock he had his eye on. However, he was only able to buy $377,895 worth of that stock, which, on February 11, 1994, he deposited into a new IRA. He did not roll any of the other cash into the IRA.
When he filed his 1993 federal tax return, Mr. Lemishow reported no taxable Keogh or IRA distributions and claimed credit for the $43,297 tax withheld. However, the IRS assessed, and the tax court held, that all of the Keogh and IRA distributions were taxable, and disallowed any tax-free treatment on the stock that was rolled over to the IRA.
As a result, Mr. Lemishow got hit with a staggering tax bill of $170,968 plus penalties and interest that effectively wiped out his pension!
Why? Here's what was in the fine print.
When withdrawing cash from an IRA or other plan for the purpose of rolling it over to another IRA, only the same property (i.e., cash) can be rolled over tax-free. If a different property (in this case, stock) is rolled over, the distribution is taxable, as well as subject to early withdrawal and other applicable penalties (see Chapter 3).
There are almost as many variations to these two horror stories as there are run-on sentences in the tax code. But the common denominator among them is this: The number of such stories is growing because of two unprecedented events in our nation's history that are converging: the passing away of the World War II generation and the retirement of that generation's offspring, the so-called baby boomers.
The convergence of these two events is fostering the greatest transfer of wealth our planet has ever seen as all the people of the WWII generation, who've spent their lives saving, bequeath their savings to their children, the baby boomers, who are just now beginning to retire in record numbers and starting to take distributions from their own retirement accounts.
This is resulting in two scenarios:
Many pre-retirees of the baby boom generation who are inheriting money from their parents are suddenly finding themselves well fixed (perhaps even wealthy) and are running up against some hard, costly estate taxes not taken into account by their parents, and they're going into shock ("How did this happen? My folks saved 40 years, and you say it's all gone? How is that possible? How is that fair?").
Simultaneously, retiring baby boomers are leaving their jobs with the biggest check they've ever had (and biggest asset they own)-their retirement savings-and thus potentially opening themselves up to a big financial problem.
Having been so busy chasing investment returns all their working lives, they've probably neglected the distribution part of the equation, and thus risk losing a whopping amount of what they've saved to the taxman.
As this greatest transfer of wealth in human history reaches its apex in the coming years, there will be an explosion of excessive taxation that will reach epidemic proportions (especially given the population affected), an explosion that will give millions of ill-prepared and underprotected American savers like yourself the financial shock of their lives.
The fallout from this "retirement savings time bomb" will continue to affect you, your children, the economy, and society for years and years to come.
How much at risk are YOU personally?
Turn the page and see.
"A good scare is worth more to a [person] than good advice."
-Ed Howe (1853-1937), American editor and novelist
Genius or Idiot-The IRS Doesn't Discriminate
I have a client who's a genius. It's true. He's one of the most brilliant research scientists in the world. His IQ is somewhere up there in the high triple digits. Unfortunately, none of his remarkable gray matter renders him immune from making the same boneheaded mistakes the rest of us make where our retirement savings are concerned. In fact, his smarts may even make things worse for him.
After soliciting my advice on his retirement account, he proceeded not to listen to me as I tried to persuade him that a decision he was considering would put his entire savings at risk. He's apparently such a genius that he only needs to listen to himself. I have no idea why he even asked me for advice since it's clear that all he wanted was an accomplice.
The Wiz, I'll call him, had a substantial IRA; it was created when he left a former job where he had a 401(k) and rolled the money over. Now he was working for a new company and was participating in its 401(k) plan. When he read in the newspapers about a new tax law that would allow him to roll his IRA back into his new 401(k), he called to ask if this was true. I said it was but asked why on earth he would consider such a move since its long-term consequences could spell disaster for him and his family.
"Simple," he said. "My 401(k) investments are doing better than my IRA investments."
"Then change your IRA investments," I said, sounding like Henny Youngman.
I explained that, first of all, an IRA offered literally thousands of investment choices whereas his 401(k) offered only eleven. Second, I knew from past meetings with him that he wanted to leave his retirement savings to his children since his wife had sufficient assets of her own and didn't want his retirement money. For most people, especially this family, the IRA is the best vehicle for this because you can leave an IRA to anyone you wish-while creating the opportunity to build a powerful pile of cash in the bargain.
Under federal law, however, the Wiz had to leave his 401(k) to his spouse, unless she signed a waiver in favor of the children, which she had yet to do because he, being a research scientist, felt compelled to do more research on the subject before she took pen to paper. This meant that if he dropped dead suddenly, the children would be out of luck.
But let's say Mrs. Wiz has signed a waiver. That just opens up another can of worms. You see, a typical 401(k) does not allow taking distributions over an extended period of time, as is permitted with an IRA. On the contrary, the beneficiary-in this case the Wiz's children-would have to take the entire payout from the 401(k) within one year after their father's death and pay all the deferred tax on the account in one fell swoop. As a result, they would suddenly find themselves owing a fortune in taxes that they likely wouldn't be able to pay, which means that the IRS would reach into their father's retirement savings to collect. Presto, there goes their bequest (or most of it anyway) and Dad's legacy in the blink of an eye.
On the other hand, if the Wiz spends his time doing scientific research instead of analyzing tax law and leaves his IRA alone rather than rolling it over into his new company's 401(k), his children will inherit everything immediately upon his death-and be able to keep the inheritance growing tax-deferred for another 40 years into their own dotage if they so desire.
You tell me which strategy is better.
My recommendations fell on deaf ears, however. Focusing on the Small Picture rather than the Big Picture-i.e., current returns rather than savings protection-the Wiz bulldogged ahead and rolled his IRA money over into his new 401(k), setting up a scenario for disaster.
Shortly afterward an event occurred that neither of us would have predicted, whose repercussions added even more fuel to the fire of his bad decision. The nightly news broke the scandalous story of the financial failure of Enron, America's seventh largest corporation. Although the Wiz did not work for Enron, his company, like so many others, was scorched by the Enron effect as stock prices plummeted. So, on top of what he'd done to put his retirement savings at risk on his own, fate had stepped in to take away a substantial amount of the value of his new 401(k) as well.
I'll bet that the return on his old IRA looks pretty good to him about now.
Unfortunately, his is not an isolated case. When it comes to cashing in on our errors, the IRS doesn't discriminate. Genius or idiot, we're all in the same boat.
Most people don't-or, worse, won't-see the forest for the trees when it comes to things financial. For example, I've found that they'll devote more time going over their supermarket receipts to make sure they haven't been overcharged than they'll spend keeping their life savings from becoming a windfall for Uncle Sam. As a matter of fact, I've actually had clients cancel their estate planning appointments with me to hit a sale at their local Price Club wholesaler. Believe me, they'll have to score some mighty big bargains there, plus rob several banks, to make up the percentage of their life savings they'll lose to taxes if they don't get smart.
That's what seeing the Big Picture is all about, and I've spent the better part of the past 15 years pointing it out.
Excerpted from The Retirement Savings Time Bomb . . . and How to Defuse It by Ed Slott Copyright © 2003 by Ed Slott. Excerpted by permission.
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Posted January 2, 2010
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