Jouranl of Personal Finance Vol 14 Issue 1

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Journal of Personal Finance Techniques, Strategies and Research for Consumers, Educators and Professional Financial Consultants

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Volume 14, Issue 1

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Journal of Personal Finance

Volume 14, Issue 1 2015

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Journal of Personal Finance

CONTENTS

Editor’s Notes ........................................................................................................................................................................................8

Which Assets to Leave to Heirs and Related Issues...............................................................................................................9 Tom L. Potts, Ph.D., CFPÂŽ, Professor of Financial Planning, Baylor University William Reichenstein, Ph.D., CFA, Powers Professor of Investment Management, Baylor University ' $ & & & &

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Mitigating the Impact of Personal Income Taxes on Retirement Savings Distributions .....................................17 James S. Welch, Jr., Senior Application Developer for Dynaxys, LLC. = % &

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Volume 14, Issue 1

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Exploring the Antecedents of Financial Behavior for Asians and Non-Hispanic Whites: The Role of Financial Capability and Locus of Control ............................................................................................................................28 John E. Grable, Ph.D., CFPÂŽ, Athletic Association Endowed Professor of Family and Consumer Sciences, University of Georgia So-Hyun Joo, Ph.D., Professor, Division of Consumer Studies, Ewha Womans University, South Korea Jooyung Park, Ph.D., Professor in Consumersâ&#x20AC;&#x2122; Life Information, College of Human Ecology, Chungnam National University, South Korea B

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The Greatest Wealth is Health: Relationships between Health and Financial Behaviors ..................................38 Barbara Oâ&#x20AC;&#x2122;Neill, Ph.D., CFPÂŽ, CRPC, AFC, CHC, CFEd, CFCS, Extension Specialist in Financial Resource Management, Distinguished Professor, Rutgers Cooperative Extension

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Life and Death Tax Planning for Deferred Annuities ..............................................................................................48 Michael E. Kitces, MSFS, MTAX, CFPÂŽ, CLU, ChFC, RHU, REBC, CASL, Pinnacle Advisory Group, Columbia, MD # $ S % % 7

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Volume 14, Issue 1

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JOURNAL OF PERSONAL FINANCE VOLUME 14, ISSUE 1 2015 Co-Editors = X ! The American College # %

! Tomlinson Financial Planning, LLC

Editorial Board Benjamin F. Cummings, Ph.D., Saint Josephâ&#x20AC;&#x2122;s University Dale L. Domian, Ph.D., CFA, CFPâ&#x201E;˘, York University Michael S. Finke, Ph.D., CFPâ&#x201E;˘, RFCÂŽ Texas Tech Joseph W. Goetz, Ph.D., University of Georgia Michael A. Guillemette, Ph.D., University of Missouri Clinton Gudmunson, Ph.D., Iowa State University Sherman Hanna, Ph.D., The Ohio State University George W. Haynes, Ph.D., Montana State University Douglas A. Hershey, Ph.D., Oklahoma State University Karen Eilers Lahey, Ph.D., The University of Akron Douglas Lamdin, Ph.D., University of Maryland Baltimore County Jean M. Lown, Ph.D., Utah State University Angela C. Lyons, Ph.D., University of Illinois Carolyn McClanahan, MD, CFPâ&#x201E;˘, Life Planning Partners Yoko Mimura, Ph.D., California State University, Northridge Robert W. Moreschi, Ph.D., RFCÂŽ, Virginia Military Institute Ed Morrow, CLU, ChFC, RFCÂŽ, IARFC David Nanigian, Ph.D., The American College Barbara M. Oâ&#x20AC;&#x2122;Neill, Ph.D., CFPâ&#x201E;˘, CRPC, CHC, CFCS, AFCPE, Rutgers Rosilyn Overton, Ph.D., CFPâ&#x201E;˘, RFCÂŽ, New Jersey City University Alan Sumutka, CPA, Rider University Jing Jian Xioa, Ph.D., University of Rhode Island Rui Yao, Ph.D., CFPâ&#x201E;˘, University of Missouri Tansel Yilmazer, Ph.D., CFPâ&#x201E;˘, The Ohio State University Yoonkyung Yuh, Ewha Womans University Seoul, Korea

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EDITORSâ&#x20AC;&#x2122; NOTES

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Š2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

9

Which Assets to Leave to Heirs and Related Issues Tom L. Potts, Ph.D., CFPÂŽ, Professor of Finance, Baylor University William Reichenstein, Ph.D., CFA, Powers Professor of Investment Management, Baylor University and principal, Retiree Income, Inc.

Many retirees have funds in several savings vehicles including taxable accounts, taxdeferred accounts (TDAs) like a traditional IRA, and tax-exempt accounts (TEAs) like a Roth IRA. In this study, we address several questions. For simplicity, we assume the retiree is a widow, but the same considerations apply to a widower and a retired couple.

Assume the widow has funds in a tax-deferred account and a tax-exempt account. The

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combination of each, the widow should make sure she has taken the steps to ensure that they will be able to stretch distributions from the inherited IRAs over their remaining lifetime(s). Based on the work of Slott (2012), we explain what steps the widow should take now to make sure the IRAs can be stretched. In the next section, we explain how funds in TDAs are best viewed as partnerships with the government. This framework will prove useful when answering these questions.

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Journal of Personal Finance

Tax-Deferred Account Viewed as Partnership In this section, we explain why a TDA is best viewed as a partnership with the government. The government effectively â&#x20AC;&#x153;ownsâ&#x20AC;? t of this partnership, where t is the marginal tax rate when the funds are withdrawn in retirement. We begin by examining the after-tax future value of $1 market value in, respectively, a TDA and a TEA. To hold everything else constant, the underlying investment is the same in both the TDA and TEA as is the investment horizon of n years. The underlying asset can be stocks, bonds, or cash and the investment horizon can be any length of time. For now, assume the marginal tax rate in the year of withdrawal will be tn.

The TEA begins with $1 of after-tax funds. It grows at the r percent pretax rate of return for n years. At withdrawal, its market value is (1 + r)n dollars. Assuming the funds are withdrawn after 4 567

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The TDA begins with $1 of pretax funds. It grows at the r percent pretax rate of return for n years. At withdrawal, its market value is (1 + r)n dollars. Assuming the marginal tax rate in the year of withdrawal is tn, the after-tax value is (1 + r)n (1 â&#x20AC;&#x201C; tn) dollars.

Regardless of the underlying investment or length of investment horizon, the TDA buys (1 â&#x20AC;&#x201C; tn) as many goods and services as the same market-value investment in the TEA. Conceptually, the dollar in the TDA today can be separated into (1 â&#x20AC;&#x201C; tn) of the investorâ&#x20AC;&#x2122;s after-tax funds plus tn, which is the governmentâ&#x20AC;&#x2122;s share of the current principal. The purchasing power of a dollar in the TDA is the same as the purchasing power of (1 â&#x20AC;&#x201C; tn) dollar in a TEA. Thus, a TDA is like a partnership, where the government effectively owns tn of the partnership.

A related point is that, properly viewed, the after-tax value of the TDA grows effectively tax-free, just like funds in a TEA. For a given tax rate at withdrawal, tn, the after-tax value of the TDA grows at the pretax rate of return; that is, it grows effectively tax free. To repeat, a dollar of pretax funds in a TDA can be separated into (1- tn) dollar of the investorâ&#x20AC;&#x2122;s funds, while the government effectively owns the remaining tn of the TDA. From above, the after-tax value n years hence of the dollar in the TDA is (1 + r)n (1 â&#x20AC;&#x201C; tn). The after-tax value of the TDA grows from (1 â&#x20AC;&#x201C; tn) to (1 + r)n (1 â&#x20AC;&#x201C; tn), that is, it grows at the pretax rate of return.

Industry and academic researchers uniformly agree with this risk and return sharing analogy (e.g., Dammon, Spatt, and Zhang (2004), Horan (2005, 2007a, 2007b), Horvitz and Wilcox (2003), Reichenstein (2001, 2006a, 2006b, 2007a, 2007b, 2008a, 2008b, 2008c), Reichenstein, Horan, and Jennings (2012), Reichenstein and Jennings (2003), and Wilcox, Horvitz, and DiBartolomeo (2006)). In the following sections, we use this framework to address the questions addressed in this study.

Question 1: Should a Parent Leave the TDA or TEA to a Child?

To avoid the constant use of his or her, we assume the retired

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? @ conclusions are the same for a widow, widower, or married couple. For simplicity, assume the market values of the TDA and TEA are $100 each. Initially, we assume the widow will die shortly after the withdrawal and her son will withdraw and pay taxes on inherited funds this year. In a later section, we explain

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Q his lifetime. Initially, we assume the remaining funds earn a pretax return of 0%, but this is later relaxed. Withdrawals occur at the beginning of the year.

In Example 1.1, we assume the widow would pay a federal-plus-state marginal tax rate of 40% on TDA withdrawals, while her son would pay 15% on TDA withdrawals. She will spend $60 this year, which requires after-tax funds. In Strategy 1.1A, the widow withdraws $60 from the TEA to meet her spending needs, and her son inherits the rest. He inherits $40 of after-tax funds in the TEA plus $100 of pretax funds in the TDA. After paying taxes this year, his inheritance is worth $125 after taxes, [$40 TEA + $100(1- 0.15) TDA]. In Strategy 1.1B, she withdraws $100 from the TDA to meet her spending needs. Her son inherits the TEA, which is worth $100 after taxes. Clearly, Strategy 1.1A is better.

Someone is going to pay taxes on the TDA withdrawal. This account should be withdrawn by the son because of his lower marginal tax rate. In fact, the sonâ&#x20AC;&#x2122;s $25 advantage in Strategy 1.1A compared to Strategy 1.1B is due to the taxation of the $100 TDA at 15% instead of 40%. Finally, the analogy holds whether or not required minimum distributions apply. If RMDs are required, the widow should compare the marginal tax rate she would pay on additional TDA withdrawals beyond RMDs to the marginal tax

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Next, letâ&#x20AC;&#x2122;s reverse the tax rates. Now, the widow would pay a marginal tax rate of 15% on TDA withdrawals, while her son would pay 40% on TDA withdrawals. She will spend $85 this year. In Strategy 1.2A, the widow withdraws $100 from the TDA to meet her spending needs, and her son inherits the $100 in the TEA, which is worth $100 after taxes. In Strategy 1.2B, she withdraws $85 from the TEA and her son inherits the rest. After paying taxes this year, his inheritance is worth $75, [$15 TEA + $100(1- 0.40) TDA]. Strategy 1.2A is better. In fact, the sonâ&#x20AC;&#x2122;s $25 relative advantage in Strategy 1.2A is due to the taxation of the $100 TDA at 15% instead of 40%.

The better strategy in each case may appear obvious. But respected authorities often recommend that parents leave the TEA to their child(ren). For example, in the Wall Street Journal, Coombes (2014) writes, â&#x20AC;&#x153;A general rule is that Roth IRAs are good accounts to leave to loved ones.â&#x20AC;? In that article, one planner says, â&#x20AC;&#x153;The Roth IRA is pretty much the Cadillac of accounts for [children] to inherit.â&#x20AC;? The son would be better off inheriting $100 in a Roth TEA than $100 in a TDA, but this ignores the

Š2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

spending needs of the parent(s). To return to the partnership principle, the government owns t of the TDA, where t is the marginal tax rate of the withdrawal. The objective is to minimize the embedded tax liability, which requires the lower tax rate party to withdraw funds from the TDA. Since the parent may or may not have the lower tax rate, there is no general rule as to which account to leave to the child.

The same conclusion applies if we assume the underlying investment earns a pretax return of r. In Example 1.1, the sonâ&#x20AC;&#x2122;s ending after-tax value at the end of the year is $125(1+r) in Strategy 1.1A and $100(1+r) in Strategy 1.1B. The equivalent comparison applies in Example 1.2 and in the other examples related to Questions 1 through 3.

Question 2: If multiple children with different tax rates will inherit the funds, how should the widow allocate the remaining accounts?

For this question, assume the widow has two children, one with a marginal tax rate of 40% and the other with a marginal tax rate of 15%. Further assume that the widow wants to leave an equal after-tax amount to each child. How should she allocate the

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In Example 2, we assume the children will inherit $100 from a TDA and $100 from a Roth TEA. She wants to leave an equal after-tax amount to each child. Her daughter has the 40% tax rate and her son has a 15% tax rate. In Strategy 2A, the widow leaves the entire $100 in the TDA and $7.50 of the TEA to the son. The after-tax value of the sonâ&#x20AC;&#x2122;s inheritance would be $92.50, [$100(1 â&#x20AC;&#x201C; 0.15) + 7.50]. The daughter would inherit the remaining $92.50 in the TEA, which is also worth $92.50 after taxes. In Strategy 2B, the widow leaves half of each account to each child. In this case, the sonâ&#x20AC;&#x2122;s will still inherit $92.50 after taxes, [$50(1 â&#x20AC;&#x201C; 0.15) + $50], but the daughter will inherit only $80 after taxes, [$50(1 â&#x20AC;&#x201C; 0.40) + $50]. The combined after-tax inheritance is $12.50 more in Strategy 2A than in Strategy 2B. This $12.50 advantage is the tax savings from having the entire $100 (instead of $50) of the TDA taxed at the sonâ&#x20AC;&#x2122;s 15% rate instead of the daughterâ&#x20AC;&#x2122;s 40% tax rate.

Perhaps the widow wants to leave more after-tax funds to the

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4 leave the TDA plus $20 of the TEA to her son and the remainder to her daughter. He would inherit $105 after taxes, while the daughter would inherit $80 after taxes. This strategy would leave the daughter with the same after-tax inheritance as she would attain in Strategy 2B, but in this case the son gets the extra $12.50 in tax savings.1

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To return to the partnership principle, the government effectively owns t ! ? ! # !

parents should leave the TDA to child(ren) with lower tax rates.

This requires unequal distributions in terms of market values of accounts. For example, in Strategy 2A, the lower-tax rate son inherits $107.50 across accounts. But this strategy enhances the childrenâ&#x20AC;&#x2122;s combined after-tax inheritance â&#x20AC;&#x201C; and they buy goods and services with after-tax funds.

Question 3: When does it make sense for a parent to convert funds from a TDA to a TEA? Let us return to the setting where there is a widow and her bene

? ! " _ ! and TEA are $100 each. We also assume for now that the widow will die shortly after the withdrawal and her son will withdraw and pay taxes on inherited funds this year.

In Example 3.1, the widow has a marginal tax rate of 40%, while the son has a marginal tax rate of 15%. She will spend $60 this year. In Strategy 3.1A, she withdraws $60 from the TEA to meet her spending needs and leaves the rest for her son; that is, she does not convert the TDA to a Roth TEA. After paying taxes this year, the sonâ&#x20AC;&#x2122;s inheritance is worth $125 after taxes, [$40 TEA + $100(1- 0.15) TDA]. In Strategy 3.1B, she withdraws $60 from the TEA, but she also converts the TDA to a Roth TEA. She owes $40 in taxes on the converted TEA. At the end of the year, the son inherits the remaining $40 of after-tax funds from the original TEA plus $60 of funds converted to a TEA for a total of $100 after taxes. Clearly, Strategy 3.1A is better. The sonâ&#x20AC;&#x2122;s inherits $25 more after taxes in Strategy 3.1A, and this is due to the taxation of the TDA at 15% instead of 40%.

Since she has the higher tax rate, she should not convert the TDA to a Roth TEA. To use the partnership principle, the government owns t of the TDA, where t is the marginal tax rate at withdrawal.

The objective is to minimize the embedded tax liability. In this example, the widow should not convert the TDA, so the son will pay taxes on the TDA withdrawal.

In the same Wall Street Journal article, Coombes writes, â&#x20AC;&#x153;Some say if you donâ&#x20AC;&#x2122;t need the money for living expenses, it may make sense to convert all or part of a traditional retirement account to a Q

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_ sense for a person who does not need the fund for living expenses to convert a TDA to a TEA. In this example, we assume there are no inheritance taxes and taxes on TDA conversions are paid with funds from this TDA. 1Communicating

the rationale for unequal pretax distributions of the estate

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of several reasons that may call for unequal pretax distributions. Other reasons for unequal distributions may include special needs of one or more heirs and differences in types of assets to be inherited, where one child may inherit real estate !

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always equitable. Regardless of the reason involved in unequal distributions, it is best to discuss the estate distribution and property division while the parent is alive. This allows the parent to explain the rationale for the estate distribution.

In the example in this study, it should be easy to explain that the objective is to minimize taxes and thus maximize the after-tax value going to the heirs. This requires unequal pretax distributions, but it should be easy to explain that each pretax dollar is smaller than each after-tax dollar.  Â

12

Journal of Personal Finance

As we will show, the conversion of the TDA to a TEA would _

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ciary son. For example, if the widow would pay 15% on TDA withdrawals or conversions and the son would pay 40% then the widow should both withdraw and convert funds from the TDA. Suppose she will spend $51 this year. In Strategy 3.2A, she withdraws $60 from the TDA and converts the remaining $40 to a Roth TEA. The $60 withdrawal from the TDA would provide her after-tax spending needs of $51. Her son would inherit $134 after taxes, $100 from the original TEA plus the $34 of after-tax funds from the converted TDA after the widow paid $6 in taxes on the $40 conversion amount. In Strategy 3.2B, she withdraws $60 from the TDA to meet her spending needs, but she does not also convert the remaining $40 to a TEA. In this case, her son would inherit $124 after taxes, [$100 + $40(1 â&#x20AC;&#x201C; 0.40)]. The sonâ&#x20AC;&#x2122;s $10 advantage in Strategy 3.2A represents the tax savings by having the remaining $40 in the TDA taxed at the widowâ&#x20AC;&#x2122;s 15% tax rate instead of her sonâ&#x20AC;&#x2122;s 40% tax rate. Someone will pay taxes on the TDA withdrawal. The party with the lower tax rate â&#x20AC;&#x201C; in this example the widow â&#x20AC;&#x201C; should pay these taxes.

That same article concludes that the conversion decision depends, at least in part, on the length of the investment horizon. Coombes writes, â&#x20AC;&#x153;Withdrawing a lot of money in the years soon after a conversion extends the length of time it takes to reach the breakeven point â&#x20AC;&#x201C; or the point at which the hefty upfront tax bill you "

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al who said, â&#x20AC;&#x153;If you arenâ&#x20AC;&#x2122;t able to leave that [converted] money alone for at least 10 years after you convert it to a Roth, most of the time itâ&#x20AC;&#x2122;s just not going to work.â&#x20AC;? We will demonstrate that when taxes on TDA conversions are paid from these funds the length of the investment horizon has nothing to do with the conversion decision. Rather, the conversion decision depends only on the relative sizes of marginal tax rate in the conversion year (if the TDA is converted) versus the marginal tax rate if not converted and withdrawn later in retirement. (Later, we will show that the size of these two marginal tax rates is the key factor even if taxes on TDA withdrawals are paid with funds in a taxable account.)

Letâ&#x20AC;&#x2122;s compare the after-tax value of this TDA if converted this year and taxes paid at this yearâ&#x20AC;&#x2122;s tax rate, t0, from the converted funds to its after-tax value if not converted and withdrawn after n years at which time taxes are paid at tn. To hold everything else constant, the underlying investment must be the same. Without loss of generality, assume the pretax return is r. The investment horizon, n, can be any length of time. If converted this year, the $100 in the TDA becomes $100(1 â&#x20AC;&#x201C; t0) in the TEA. Its after-tax value when withdrawn n years hence is $100(1 â&#x20AC;&#x201C; t0)(1+r)n. If retained in the TDA and then withdrawn n years hence, the pretax value at withdrawal is $100(1+r)n and its after-tax value is $100(1+r)n(1 â&#x20AC;&#x201C; tn). Comparing the after-tax values clearly shows that the strategy to convert the TDA depends upon the comparison of the tax rate if converted this year, t0, to the tax rate if not converted but withdrawn in n years, tn. Therefore, a taxpayer â&#x20AC;&#x201C; whether retired or working â&#x20AC;&#x201C; should convert funds from a TDA to

a TEA this year if he has a lower marginal tax rate this year than he expects to have if not converted and withdrawn in retirement.

The length of the investment horizon does not matter. Furthermore, the underlying asset â&#x20AC;&#x201C;whether stocks, bonds, or cash â&#x20AC;&#x201C;does not matter. The key consideration is the marginal tax rates in the conversion year if funds are converted and withdrawal year in retirement if funds are not converted. Thus, a 20-year-old with a traditional IRA who has a low tax rate â&#x20AC;&#x201C; perhaps 0% if a student â&#x20AC;&#x201C; should consider converting this traditional IRA to a Roth IRA. He or she can maintain the same investment decision and still plan to withdraw funds for spending in retirement. It is simply a matter of comparing the tax rate in the conversion year to the expected tax rate in retirement.

We now show that if taxes on TDA conversions are paid from funds in a taxable account then the length of the investment horizon can matter. Suppose George has $100 in a TDA and $25 in a taxable account and the marginal tax rates this year and in the withdrawal year in retirement are 25% each. If he converts all TDA funds this year and pays taxes from the taxable account then he has $100 of after-tax funds growing tax free. In contrast, if he retains the funds in the TDA then, using the partnership principle, he effectively has $75 of his funds growing tax free, but the $25 in the taxable account grows at an after-tax rate of return. Thus, potentially there is an advantage to converting the TDA this year even if he would be in a lower tax bracket in retirement. To see how long it would take for the Roth conversion to make sense if he would be in 25% tax bracket in all years before retirement but have his tax rate fall to 15% in retirement, letâ&#x20AC;&#x2122;s compare the ! $ # ! " 4 ?

this year, pays taxes out of the taxable account, and the underlying investment is a bond earning 4% per year. His after-tax ending wealth is $100(1.04)n, that is, the $100 in the TEA grows tax free at 4%. If not converted but withdrawn n years hence when the tax rate is 15%, the after-tax value of the TDA plus taxable account is $100(1.04)n (1 â&#x20AC;&#x201C; 0.15) + $25(1.03)n, where 3% is the after-tax return on the bond held in the taxable account since the tax rate was 25% for all years before the withdrawal year. In this example, it would take 53 years before the Roth conversion this year would make sense despite the lower tax rate in retirement.2 In short, for reasonable investment horizons, the key factor remains the relative sizes of the two marginal tax rates.

The same logic applies to parent(s) deciding whether to convert funds from a TDA to a Roth TEA when the funds are intended for the children. Suppose a widow could withdraw additional funds beyond her spending needs each year that would be taxed at 25% rate. Eventually, her son who is living in an income-tax-free state would inherit these funds, which at the margin would be taxed at the 33% federal rate. Obamaâ&#x20AC;&#x2122;s 2015 budget calls for forcing

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motherâ&#x20AC;&#x2122;s death then he would be in the 33% federal tax bracket 2The

breakeven period would be even longer if the underlying asset was stock that was taxed at the 15% preferential tax rate.

Š2015, IARFC. All rights of reproduction in any form reserved.

Volume 14, Issue 1

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funds beyond her spending needs each year as long as they would be taxed at a lower marginal tax rate than her son would pay. In this example, the widow may be able to convert say $25,000 each year for decades without having the converted funds cause her income to rise above the top of the 25% tax bracket. In this case, the sonâ&#x20AC;&#x2122;s marginal tax rate when he withdraws the funds after his motherâ&#x20AC;&#x2122;s death may not exceed 25%.3 In the next section, we show how a parent can set up an IRA â&#x20AC;&#x201C; "

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stretch withdrawals over his or her life expectancy.

Stretching the IRA In the prior three sections, we generally assumed the funds would " "

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section, we relax this assumption and show the importance of "

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the work of Ed Slott (2012) to explain the steps a person must _

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person and not, say, the parentâ&#x20AC;&#x2122;s estate) can stretch distributions over his or her life expectancy.

For simplicity, but without loss of generality, assume the widow has $1 million in her traditional IRA and she wants to leave it

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? he can inherit the IRA and withdraw the funds over his life expectancy. For example, if his mother (the widow) died in 2014 after taking that yearâ&#x20AC;&#x2122;s RMD then in 2015 he would have _ QÂ&#x20AC; ?

% ! Â Â&#x201A;~5 QÂ&#x20AC; letâ&#x20AC;&#x2122;s assume he turned 40 that year. The life expectancy from the Single Life Expectancy Table (for inherited IRAs) is 43.6.

Thus in 2015, the sonâ&#x20AC;&#x2122;s RMD would be the December 31, 2014 closing balance divided by 43.6. His RMD for 2016 would be the December 31, 2015 closing balance divided by 42.6, one less than the prior yearâ&#x20AC;&#x2122;s life expectancy. His RMD for 2017 would be the December 31, 2016 closing balance divided by 41.6, and so on. In 2058, he would have to withdraw the remaining funds.

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Q withdrawn over a 44 year period. The RMDs are precisely that â&#x20AC;&#x201C; required minimum distributions. If the son wanted to withdraw a larger amount in any year then he could. Assuming the TDAâ&#x20AC;&#x2122;s December 31, 2014 closing balance was $1 million, the sonâ&#x20AC;&#x2122;s RMD would be $22,936, [$1,000,000/43.6]. A series of such withdrawals would not likely cause his marginal tax rate to rise substantially.

3 Coombes (2014b) discusses the implications if inherited IRAs must be with " "

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Slott is quoted as saying, â&#x20AC;&#x153;If thereâ&#x20AC;&#x2122;s no stretch IRA, it doesnâ&#x20AC;&#x2122;t pay for an older person to pay to convert a Roth. Why should someone 60, 70 years old, whoâ&#x20AC;&#x2122;s

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Mr. Slottâ&#x20AC;&#x2122;s advice is best when it comes to stretching an IRA and related themes, but his opinion on investment horizon is demonstrably wrong. The investment horizon is not a critical factor in the conversion decision. Rather, the conversion decision should be based on the comparison between the marginal tax rate in the conversion year and the marginal tax rate if not converted but withdrawn later.

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the son would be a , but not a ry. Since the estate has no life expectancy, the son would have " " !

! Â Â&#x201A;~5 through 2019. If he withdraws $200,000 from the TDA in 2015, this additional income would likely cause his marginal tax rate to jump substantially and it may also trigger a higher tax via the Alternative Minimum Tax . Worse yet, if he fails to withdraw anything from 2015 through 2018 then his RMD for 2019 would be the entire TDA balance. Even worse, if he failed to withdraw all funds then he would face 50% penalty tax on the remaining balance since the remaining balance would be the amount by which his distribution failed to match his RMD for that year. In this case, his marginal tax rate would likely jump dramatically. The net result is that the government would get a lot larger chunk of the TDA withdrawals. Using the partnership principle, the government would effectively own a lot larger portion of the TDA, while the son would effectively own a lot smaller portion of this TDA. Letâ&#x20AC;&#x2122;s return to the widow and her son. But now assume the wid "

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2015, the son would be 40 and his daughter would be 17. If the son does not need part or all of the $1 million IRA then he could disclaim part or all of it, in which case the daughter would inherit the disclaimed IRA. According to the Single Life Expectancy Table, her life expectancy is 66 years. So, she could enjoy 66 years of tax-deferred growth.

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! son disclaims the IRA, her granddaughter could enjoy up to 66 years of tax-deferred growth. Finally, suppose the widow had $1 million in a Roth IRA at her death instead of an IRA. In this case, the son or granddaughter would enjoy up to 5, 44, or 66 years of #$! 4 "

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Roth IRA. The ability to grow funds tax-deferred or tax-free for long periods is, indeed, a valuable option.

There are numerous exceptions to RMD rules affecting tax-deferred accounts including traditional IRAs and other TDAs and tax-exempt accounts like the Roth IRA and Roth 401(k). For an excellent discussion of these rules, we recommend Ed Slott (2012). He is the master of IRAs.