O.k. so now you want to retire. It’s time. You have worked long and hard to build your practice and 401-k retirement plan. But, just when you start looking at that walk away date, you are hit with a 30% decline in the value of your retirement account. You wonder, is the balance sufficient to provide for my lifestyle for the next thirty years or even longer given life expectancy increases? And, what about inflation, medical cost? You might wait, retire later and accumulate more in your 401-k, but unfortunately, that puts you in the realm of the unknown which may or not be a favorable solution either. Markets may decline again and the tax laws will surely change. With the economic pressure from all sides, your dreams for the golden-years would fade in the sunset. Can your retirement nest egg possibly endure another market decline?
Even worse, you just realized that you have a silent partner that owns approximately 40% of your 401-k plan, and that partner will take his share first. Also, your partner (a.k.a. the IRS tax code) is likely to decide, unilaterally, to take an even larger share in the not too distant future. You have risked your assets, taken a 30% market decline, and your IRS partner gets a free ride for 40% of the value.
How can you stop the bleeding? With the collective impact of market risk, the specter of higher income tax rates an avalanche of Roth IRA conversions by wealthier investors may be on the horizon.
Generally, provisions of your 401-k do not allow you to withdrawal before death, disability or termination of service. Moreover, withdrawing funds from your 401-k plan before age 59 ½ could inflict more damage in the form of a 10% tax penalty on the amount withdrawn. Eventually, all benefits of the 401-k will be taxed. Thus, waiting till 59 ½ to avoid penalties could have the detrimental effect of incurring interim tax increases.
There is a way, however, that you can unlock your retirement now, minimize taxes, grow the face value of your 401-k, and withdraw the compounded future value of your account tax-free at a time of your choosing.
The answer lies in a process with three critical steps. First, the 401-k plan assets must be “freed-up” by adding an “in-service, non-hardship (ISNH) distribution” election. The ISNH allows money to be withdrawn from a 401-k plan while still remaining as a participant. This is not a complicated change in the plan that demands bureaucratic approval. The plan administrator merely adds a provision to the plan document. The change is even simpler if you are in control as the owner employee. The ISNH distribution election is becoming more prevalent in 401-k plans as employers attempt to avoid as much fiduciary responsibility as possible.
Once the ISNH election is made, you are free to remove assets from your 401-k plan. However, by taking a distribution, you will have triggered a convoluted taxable event. A portion of the distribution could be taxed as ordinary income, a portion could possibly be tax free and the 10% early withdrawal penalty could apply if you are under age 59½. Conversely, a direct rollover of the assets to a traditional IRA avoids a taxable event altogether.
Once you have moved to the self directed traditional IRA, your next step is to transform the rollover assets to assets that will have a fair market discounted value for tax purposes. The fair market value carried on the IRA account is not necessarily the same as the net asset value/purchase price. The lack of marketability, liquidity and control are the factors in determining the discounted value of your IRA. If your IRA invests in a non-liquid REIT, for example, the value of the investment would be less than your purchase price until such time as the REIT or the underlying real estate can be sold. The same is true for certain ETF’s, and even fixed income securities with balloon maturities. Typically, appraisers value such illiquid assets in the area of 70 to 75% of acquisition costs, a substantial discount for potential taxation purposes.
Once the traditional IRA has invested the cash and the discounted value established, the third step is to convert the traditional IRA to a Roth IRA. This is a taxable event and taxes should be paid from funds other than 401-k distributions. By paying the taxes now, on the discounted valuation, you have limited your expense to the current tax rate, not the rate that may apply in the future. Best of all, you have paid the tax on a discounted value of perhaps 30% or more. If you believe taxes will increase, pay the tax now to preserve the future value of your retirement plan – this move is a no brainer.
Also, as of 2010, the tax law allows you to spread the tax equally over 2011 and 2012 at the tax rate in effect at the time of payment. The conversion from the traditional IRA to the Roth is a transfer of the assets in-kind (i.e. the assets with the discounted value will now be held in the Roth).
The Roth IRA has the advantages of being completely tax free for principal as well as all subsequent earnings and gains after a five year blackout period which begins at the date of conversion. The Roth is not subject to the required minimum distribution. Heirs receive Roth assets tax free.
The Delta Advisory Group, Inc. has created the three step Rescue Process. Team members at Delta Advisory Group, Inc. have collectively over 100 years experience and expertise in selecting a solid diversified portfolio that lends itself to discounted valuations while addressing client goals. Delta Advisory Group, Inc. works with the client’s CPA and retirement plan administrator to orchestrate each step in the process. For more information visit the Delta Advisory Group, Inc. at www.DeltaAdvisory.com or phone 1-800-333-3700.