Originally Aired: January 13, 2010
Topic: The Lange Philosophy with guests Matt Schwartz & Steve Kohman, CPA, CSEP, CSRP
The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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- Introduction of Steve Kohman
- Roth IRA Conversions Have Exploded Since Law Changed in 2010
- Use After-Tax Dollars to Pay Taxes on Roth Conversion
- How Much Traditional IRA Should You Convert to a Roth?
- Consider Future Tax Rates Before Doing a Roth Conversion
- Introduction of Matt Schwartz
- Series of Roth IRA Conversions Better Than One Large Amount
- Law Allows Roth Conversions to Be ‘Undone’ in Later Years
- There Is No Federal Estate Tax for 2010
- Lack of Estate Tax Could Leave Surviving Spouses No Access to Money
- Roth IRA Dollars Can Grow Tax-Free for Many Years
Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.
Hana Haatainen-Caye: Welcome to The Lange Money Hour, Where Smart Money Talks. We are talking smart money. Thank you so much for joining us tonight. I’m Hana Haatainen-Caye joining Jim Lange, nationally-recognized IRA, 401(k) and Roth IRA conversion expert. Jim is the author of the bestseller Retire Secure!, with testimonials from Larry King, Charles Schwab, Jane Bryant Quinn, Ed Slott and 60 other financial professionals. Joining us tonight are special guests Steve Kohman and Matt Schwartz. Steve is a key member of the Retire Secure! team at Jim Lange’s office, specializing in income taxes and estate and Roth conversion planning. He and Jim as co-authors were awarded the CFP Board article award for The Roth’s Real Advantage, published nearly a decade ago.
Jim Lange: And Steve has a long background of Roth IRA conversion expertise. In fact, the book that you mentioned, Retire Secure!, has a lot of quantitative analysis, and Steve did practically all of it, and I go around the country giving talks to financial advisors regarding Roth IRA conversions, and I’m going to say maybe one or two out of a thousand, if that, has the degree of sophistication and the ability to do projections and come up with excellent conclusions as Steve. So, really, we’re talking about a really premier Roth IRA conversion expert.
Steve Kohman: Thanks, Jim. I’m glad to be here to talk about the new Roth conversion law with you.
Hana Haatainen-Caye: Steve, I wanted to start off by asking you if you think the 2010 conversion law is making much of a difference.
Steve Kohman: Oh, absolutely. I’ve seen so many clients and done so much planning, and there were so many people who couldn’t convert to a Roth IRA in previous years that with this new law, now can convert in 2010, and they’re converting even larger amounts in 2010 than ever before. Lots of money is being converted, which means a lot of money is going to go to the U.S. Treasury in the short term, but it means a lot of people are going to have some long-term benefits in the long term.
Hana Haatainen-Caye: And Jim, what do you think about this? Is the 2010 conversion law making much of a difference?
Jim Lange: Well, first of all, I’ve been a big Roth IRA conversion advocate for over a decade, and it’s not because I’m “really into IRAs,” it’s because I and Steve run projections and we run numbers and we say, “OK, let’s take the status quo.” That is, Mr. Status Quo doesn’t make a Roth IRA conversion, and we make reasonable assumptions about interests and what’s going to happen in the future, and we run those projections. And then, we say, “Well, let’s take example B where Mr. Roth does make a Roth IRA conversion.” We run projections and it turns out, in almost all cases, that the person who makes Roth IRA conversions is much better off than people who don’t. So we know this. We have this published in peer-review journals, and really, the question for a lot of people is how much and when?
So this is something that Steve and I have been doing for over 10 years. The thing that is really exciting now is that people, regardless of their income, are able to make Roth IRA conversions. So, for example, let’s say that your income has consistently been $100,000 or more in the past, you weren’t allowed to make a Roth IRA conversion. So even though I’ve really been enjoying working in this area, and we’ve run thousands of numbers, it’s been for people who have incomes of less than $100,000. Now, with no income limitations — and that’s the really big news — there’s no income limitation for the people who make Roth IRA conversions. To me, the floodgates are opening for high-income taxpayers, and Steve and I are perfectly situated to help these people because we’ve been doing it already for 10 years. You know, to me, the issue is for a lot of people, how much to convert, when to convert, and coming up with a long-term Roth IRA conversion plan, and we talk about that at our workshops, but while we’re here, Steve, maybe I’ll ask you what kind of factors do you consider? So I know we work together and I like to come up with a couple ideas and a couple starting points of how much somebody should convert or when they should convert. But ultimately, you’re really the person who runs the numbers and who does the quantitative analysis. What kind of factors do you take into account in your meetings when you develop a Roth IRA conversion plan?
Steve Kohman: Well, there’s quite a few factors to take into account, some of which are objective factors, and a lot of which are subjective factors. The objective factors are the things you might first imagine when you think about Roth conversions, that being that when you do a Roth conversion, you have to pay income tax on the amount you convert.
Jim Lange: Wait, let me interrupt you for one quick moment there. Let’s say you make a Roth IRA conversion of $100,000, and to keep life simple, let’s assume that we’re talking about a 25 percent tax rate. The first question is, where are you going to get the money to pay the tax on the $100,000 conversion? In other words, you’re going to owe the IRS $25,000 on this conversion. Where do you recommend that people get the money to pay for that tax?
Steve Kohman: Well, if they have money outside of the IRA, outside of the tax-deferred investment environment, that’s the best place to take the money to pay the tax. If you pay the tax from the IRA itself, let’s say because all your money is in the IRA or a retirement plan, then it doesn’t come out to be as beneficial to you because part of the long-term benefit of a Roth IRA is that the tax money you use to pay the conversion grows but gets taxed every year on interest, dividends and capital gains. This is another layer of tax that does not occur inside a Roth IRA. And so it’s better to have money to pay the tax in your savings outside of the retirement plans.
Jim Lange: That’s right. In fact, didn’t you run numbers that said if you take away the estate-tax advantages and you take away the advantages of a minimum required distribution, it’s actually basically a breakeven, isn’t it?
Steve Kohman: Yeah, as long as the funds are invested the same way in the Roth as they would’ve been in a traditional IRA. It would always be the same in value no matter how long you go. Unfortunately, you do have required minimum distributions when you’re 70½ years old, and what that does is it moves money from the tax-deferred environment in an IRA into the taxable environment in what I’ll call after-tax funds, where it’s taxed on interests, dividends and capital gains every year, and, over the long term, your money just doesn’t perform as well as if it were in a tax-free account the rest of your life like in a Roth IRA.
Jim Lange: So what you’re basically saying then is if you have the after-tax dollars, then you should use those dollars to pay the tax on the conversion, and if you don’t, it still might be worthwhile, but it isn’t quite as beneficial. Is that a fair summary?
Steve Kohman: That’s right. It still could have some advantages.
Jim Lange: All right. I didn’t mean to interrupt, but I think that that’s an important point. Why don’t you go on with a few more of your factors?
Steve Kohman: OK. So one of the main factors then would be how much tax do you pay when you do the conversion? Is the amount of your conversion so large that you’re going to be bumped up into a higher tax rate when you do the conversion? Or, as you can now imagine, with no income limit for Roth conversions, people who are in the very top tax bracket can do a conversion and end up not paying any more tax percentage-wise by doing a conversion because they’re already in the top tax bracket. So for those sorts of people, that issue isn’t such a concern for them, and that’s why 2010, and in the future years, is going to be such a big boon to the wealthier people who are already in the top tax bracket and why this new law is a fantastic investment tool for many, many people who never got to take advantage of it before.
Jim Lange: But Steve, I know that you have run some numbers for some high-income and high net-worth clients, and I think, in some cases, if they made too large a Roth IRA conversion, and they didn’t have a minimum required distribution later on and yet they were retired, that sometimes they would be in a lower tax bracket, and you haven’t told these people to convert everything. You just told them to convert a certain amount, but less than their entire Roth. Is that also right?
Steve Kohman: Oh, yeah. That’s usually the case. There’s a condition I call overconverting where maybe you convert so much to a Roth, but you don’t have any income the rest of your life because all you have is your Social Security income and maybe some pension income, but it’s not enough to use up your very low tax brackets in the future, like zero percent tax bracket and the 15 percent tax bracket, and if you pay 35 percent tax when you do the conversion, it makes it hard to justify converting that much money.
Jim Lange: Yeah. In fact, didn’t you do an analysis where if somebody was paying taxes at 35 percent, and then later they just went to 28 percent, that it took them something like 14 years to break even? Does that sound right to you?
Steve Kohman: Yeah, that sounds right. As a matter of fact, just today, I was working on the calculation spreadsheet which shows the breakeven period, if we’re going from 35 percent tax on the conversion to 25 percent tax the rest of your life, is a 17-year breakeven period. But taking that a step further, it’s not just your tax rate the rest of your life, and this is one of the subjective factors to consider that’s very important, and that is your beneficiary’s tax rate, your children perhaps, or perhaps even your grandchildren’s tax rate.
Jim Lange: Well, I think what you’re referring to is if you use the old rule that you and I have developed, which is, let’s assume that you have three types of money: you have plain old after-tax dollars, savings, money outside any type of retirement plan; then you have traditional IRAs and retirement plans; and then you have Roths. What we usually advocate, subject to some exception, is first spend your after-tax dollars, then spend your IRA dollars, and only last should you spend your Roth dollars. So since, particularly in your analysis, you usually don’t recommend people converting their entire IRA to a Roth, people usually end up with that. That is, some after-tax, some IRA and some Roth. If we’re going to spend first the after-tax dollars, then we’re going to spend the IRA dollars, it’s very likely that you’re going to die with Roth IRA dollars, and what you’re saying now, if I’m understanding right, is if you’re really going to do this analysis correctly, you have to take into account the tax bracket of your children, and even, perhaps, your grandchildren. Is that right?
Steve Kohman: That’s right. As you know, the benefit of the Roth occurs over a long period of time. The longer period of time there is, the more of a benefit there is going to be. And so when we’re talking about 50 or 80 years, we’re talking about having your children inherit your money, and maybe your grandchildren. So their tax situation, their financial situation, what state they live in, are all relevant factors.
Jim Lange: Well, I like that, and one of the things that I really like about Roth IRA conversions is it is true, genuine multigeneration planning that doesn’t cost you money. So, for example, if I say, “Hey, Steve, I have the best life-insurance policy in the world for you, and boy, all you’re going to have to pay is $100,000 and your kids are going to get so much more money. This is going to be wonderful!” And that might even be true, but ultimately, it’s still money out of your pocket. You are reducing your purchasing power, and you’re increasing your children’s or grandchildren’s purchasing power. With a Roth IRA conversion, you’re actually increasing your purchasing power during your lifetime. So let’s just talk about this. We always talk about estate planning and the kids and the grandkids, and we’ll get to that, but let’s assume that you don’t have kids, or you have kids and you hate your kids, and all you really care about is you, or you and your wife. Would you still make a Roth IRA conversion? Is it still as favorable? How would that play into it if you said, “Hey, look, I educated those kids. I put braces on those kids. I’m done. If there’s anything left over, that’s a bonus, but I’m mainly interested in me.” Would you still do a Roth conversion?
Steve Kohman: Well, you certainly might benefit from a Roth conversion in many situations. We have many clients who are in that boat who, maybe they don’t have kids, and they’re thinking about the benefit during their own lives, and then, what is more important is the tax rates that they’re going to face for the rest of their own lives and the future tax rates they’re going to face and how much tax they pay on the conversion, and obviously, if you’re going to pay less tax on the conversion than you would pay, say, in 2011 or 2020 or for the rest of their lives, then obviously a Roth conversion’s a very good idea. If they pay slightly more tax on the conversion, it’s still probably a good idea. And so, we want to take a look at those future tax rates, and, as you know, future tax rates could be higher for a lot of people, and those factors come into play quite a bit. But to answer your question, yes, it could still make sense.
Jim Lange: Well, didn’t you do some analysis where if a guy, let’s say he’s 65 years old and he makes a $100,000 conversion. Now, before, he was in the 25 percent bracket, but now, we’re adding $100,000 to his income. So now, at least part of that Roth IRA conversion income is taxed at 28 percent. Let’s call him Mr. Roth, and let’s call the guy who didn’t, who has the exact same amount of money, Mr. Status Quo. Didn’t you run some analysis comparing Mr. Roth and Mr. Status Quo? What happens 20 years after you make the conversion?
Steve Kohman: Oh yes, that’s right, and it comes out to be quite a good advantage because if you don’t convert, that money is going to be taxable income at some point in the future, and the advantages of the Roth and moving out of the taxable environment into the tax-free environment is such an overwhelming and powerful tool for the Roth that it works out to their advantage in many cases, yes.
Jim Lange: And wasn’t that somewhere around $40,000 in 20 years? That is, if you converted $100,000 that they would be better off by $40,000?
Steve Kohman: Yeah, something along those lines, right.
Hana Haatainen-Caye: OK, thanks Steve. We’re going to take a short break. We’ll be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back, where we’re talking smart money with Jim Lange and Steve Kohman. We’ll also be speaking with Matt Schwartz in a little bit. Steve, can you tell us how you feel about the law to spread 2010 conversion income to 2011 and 2012?
Jim Lange: And before you say how you feel about it, would you please describe how it works?
Steve Kohman: Yeah, sure, I’d be happy to. The new law says that if you do a Roth conversion in 2010, that income is required to be reported in 2011 and 2012 unless you make a special election on your 2010 tax return to allow you to tax it in 2010. Well, that’s totally different than all the other years. The rules on Roth conversions have always been taxed in the year you do the conversion. And I think it’s deceitful of the IRS to do it that way because, as you may or may not know, the tax rates are probably going to go up in 2011. For example, it’s commonly known that the 33 percent tax bracket will be a 36 percent tax bracket, and the 35 percent tax bracket will be a 39.6 percent tax bracket. So the IRS is rubbing their grubby little hands together saying, “Oh boy, let’s collect even more money! Let’s make them pay tax at the higher rates!”
Jim Lange: Wait, Steve, can I ask you a quick question? When you say that the rates are going to be higher, is that something that you think is going to happen just because of the general way the country’s going, or is that already on the books right now?
Steve Kohman: It’s already on the books. It was part of the George Bush tax law from the 2001-2002 timeframe, and what’s happening is, they’re going to sunset that law. So the law right now is that those tax rates go up, and, under the Obama administration, he doesn’t want to tax people earning less than $250,000. So he’s going to probably keep the 28 percent tax rate and the 25 percent tax rate where they are, but if he doesn’t pass a new tax law, even those rates are going to go up in 2011.
Jim Lange: So what you’re saying is, even forgetting any changes in the future, even forgetting any of the needs that we have in terms of funding health care and the wars and everything else, the existing tax rates and the taxpayers that we’re talking about are going to have to pay more tax, and then, if there’s additional taxes, then, presumably, the Roth IRA conversion’s going to be even more beneficial. Is that right?
Steve Kohman: Yeah, that’s right.
Jim Lange: All right. Why don’t you go back to 2010 versus 2011 and 2012?
Steve Kohman: Well, I like my clients to pay as little tax as they have to.
Jim Lange: Amen!
Steve Kohman: So we generally recommend they pay the tax in tax year 2010, and not only is it an advantage because they’re paying less tax in 2010, but if their Roth conversion plan is a multiyear plan where they’re going to convert a certain amount every year up to a certain tax bracket, for example, then they can do additional conversions in 2011 and ’12 while having an additional conversion in 2010 be taxed in that year. If they don’t make the special election, well, then, they’re sort of missing the opportunity to do any conversion in 2010 at the lower tax rates.
Jim Lange: So you often end up with the ideal, based on running the numbers, is a series of Roth IRA conversions, not a one-time shot, but a series, often trying to stay in lower tax brackets, and if they’re not careful about the election, that can blow the strategies. Is that right?
Steve Kohman: Yes, Jim. The conversion plans we do for people are usually multiyear plans, and even lifetime plans because the new rule is that anyone can do a Roth conversion in any year. Now, that tax law may not permanently be the case. The IRS might eventually say we can’t do Roth conversions anymore because they’re losing out on future revenue. But for now, they can always do conversions, and, for many people, it makes sense to convert and pay a lower tax rate, so it’s a multiyear conversion plan.
Jim Lange: So in other words, you might have a long-term plan to convert, say, $500,000, but it might be prudent to convert $100,000 a year for five years, depending on individual circumstances. Is that a possibility?
Steve Kohman: Yeah, that’s right. And so, the timing of the taxes paid is an important issue, and also, the other subjective factors to consider include things like when is a taxpayer going to retire? Is their income going to change in the future? Maybe they’re going to have lower tax rates by virtue of having less income because they retire. There may be a significant window of opportunity for some people to convert and pay less taxes. So we have to look at the tax rates they’re facing, not only in 2010, but in 2011, ’12 and really for the rest of their lives.
Jim Lange: So what you’re really saying is that it’s good to have, if you will, a lifetime Roth IRA conversion plan of how much to convert and when to convert, and it might be multiple year and it might be very long-term. Is that right?
Steve Kohman: That’s right, and, of course, it’s very objective for me to calculate their 2010 tax. I can do it with reasonable precision, but for 2015 or 2020, I mean, things get a lot less objective and a lot more subjective the further out in the future you go.
Jim Lange: Well, that’s true, but I think one of the things that you do that I think is very unique, and, you know, I run around the country talking to all these advisors, and I actually just did an eight-hour … how would you guys like to hear me for eight hours talking about Roth IRA conversions? And one of the problems with trying to help these guys run numbers, something that you do, is that they’re not CPAs that know how to use the tax program. So you not only use specialized software for Roth IRA conversions but you actually take out our 1040 software, if you will, let’s call it Super Turbocharged Turbo Taxes. We obviously have a high-end one, and you actually put the numbers in, and you can find out about, let’s say, little surprises like phase out of itemized deductions, or alternative minimum tax, et cetera.
Steve Kohman: Oh yeah, there’s a lot of surprises there. As a matter of fact, I was doing one today where a taxpayer was paying 35 percent tax even though they were in the 33 percent tax bracket, and then, for the next level of conversion, they only paid 33 percent tax even though they were in the 35 percent tax bracket because of the alternative minimum tax. So there’s loss of credits, alt-min tax and taxability of Social Security, and even the Medicare tax deducted from your future Social Security income. These are all hidden little tricks, hidden little taxes, that the IRS plays on you as a taxpayer that you’re not really aware of unless you use the tax software program and have somebody knowledgeable to figure it out.
Jim Lange: Well, let’s say you like to be a little bit of a do-it-yourselfer. It sounds like it’s going to be very difficult to actually calculate what your effective tax bracket is because of all these items. Is that right?
Steve Kohman: Yeah, it is very difficult, and sometimes, it leaves an opportunity on the table if you aren’t aware of all those factors.
Jim Lange: And then sometimes I remember you telling people that they shouldn’t convert when they thought that they were in the 15 percent bracket, and you showed them … what bracket did you come up with with some of the people that were in the 15 percent bracket to convert? And the number was still less than $67,000, but what tax bracket were they in?
Steve Kohman: Yeah, typically, if they get Social Security income, and more and more of it gets taxed as your income goes up, these people in the 15 percent “tax bracket” were really paying 27 percent tax on the conversion, and even there’s a level where they would technically be in the 25 percent tax bracket paying, like, 45 percent tax on a Roth conversion amount. So it’s very deceitful the way the tax laws are set up. I don’t think that the IRS meant for it to be that deceitful, but you just have to know what you’re doing and know the tax implications of the taxes you pay on a Roth conversion.
Jim Lange: So let me ask you this: Does it make sense if you’re a listener out there, and let’s say that you have a CPA, or maybe you do it on your own, does it make sense to hire a qualified professional to help do some of these projections to help you come up with a long-term Roth IRA conversion plan?
Steve Kohman: Oh, yeah. Two heads are definitely better than one, and using a consultant, in my opinion, is a very important thing to do.
Jim Lange: OK, all right. I had another question about something that we like to do a lot. In fact, I actually wrote an article back in 2002 about this, and it is taking advantage of a particular portion of the law where you can — and the technical word is recharacterize — but I like to think of it as undo, a Roth IRA conversion. Can you tell us a little bit about how that works and why that might be an important buffer if you think that we’re living in volatile times with investment rates of return and values of investments going up and down?
Steve Kohman: Oh, absolutely. This has come into play quite a bit over the last year or two where people did a Roth conversion, for example, let’s say they did a $100,000 Roth conversion, but the stock market dropped after they did the conversion, and maybe their Roth IRA only ended up being worth $50,000. Well, those poor people had to pay tax on $100,000 were it not for this undo rule, which allowed them to undo their conversion and not pay any tax at all on the conversion and put it back in the traditional IRA where it should be. For some of those people, they were then able to do a Roth conversion the next year and pay tax on only $50,000, or, in some cases, convert another $100,000 the next year. But in any case, they save a lot of money in taxes.
Jim Lange: All right. So, let’s say, for discussion’s sake, you do a Roth IRA conversion, and let’s say you do it in January or February of 2010, and let’s even say that it’s going to be taxed at the 25 percent bracket, and you’re fully expecting to pay $25,000 in taxes, or you even file the return next April and you do pay $25,000 in taxes, and that $100,000 investment now goes to $50,000. So you’re pretty upset because you paid tax on $100,000 and it’s only worth $50,000. You’re saying you can recharacterize or undo it.
Steve Kohman: Yeah, you can undo it all the way up to the October 15th date after the year you do the conversion.
Jim Lange: All right, well, that sounds like a great thing in the event that you’re, let’s say, on the fence of whether you should convert or not, or whether the amount is if you actually end up converting what turns out to be a loser, and you can recharacterize that.
Steve Kohman: Mmm-hmm.
Jim Lange: All right, and are there strategies that you can recharacterize that during the year that you convert, or is it always better to wait until 2011 to recharacterize?
Steve Kohman: Well, I guess there’s no immediate rush to do it in the year you convert, other than the fact that you have to wait 30 days to convert the same money, but, typically, people aren’t converting their entire IRA accounts. So they could wait until after yearend to recharacterize it to see if the investment comes back. But another advantage to doing a recharacterization is that, as you alluded to, you may want to convert a higher amount if you’re not certain of the amount to convert, and then you can recharacterize a piece of the Roth conversion that you’ve done, and you can use hindsight to determine Number 1, how well has the investment performed, and Number 2, what are the real tax effects now that you’re able to look backwards and see your real tax return? Maybe some factors of your income weren’t completely known when you did the conversion early in the year. And so it’s a very useful tool, and I always tell people who do conversions to take a look back, say, in June of the following year to see how the investment is performing.
Jim Lange: OK. And I guess what I’ll add to that is, since it’s very hard and very problematic to recharacterize a portion of one particular account, it might make more sense to separate some IRAs into several accounts, and, perhaps, recharacterize the one that does the worst. The other thing that I will mention is, sometimes, what I like to do is to recharacterize during the year. So let’s say it’s 2010, and let’s say you want to convert $100,000 and you convert it and it goes down to $50,000, but you still wanted to convert $100,000 in 2010. What I might like to do is recharacterize the first $100,000, and then make a Roth IRA conversion of $100,000 of a different IRA, and that way, for the same tax cost on $110,000 worth of income, get a $100,000 Roth instead of a $50,000 Roth.
Steve Kohman: Yeah, that’s right. So there’s a lot of strategies to be used with the recharacterization rule.
Hana Haatainen-Caye: Steve, could you just summarize the new laws for 2010 and just wrap this up a little bit?
Steve Kohman: Yeah, sure. The new law for 2010 affects high-income taxpayers because they can do a conversion now. They’re also the ones who have lots of after-tax money, typically, to pay taxes on the conversion, and they’re the ones that may be in the top tax bracket now, and that top tax bracket’s going to be going up a lot higher in 2011 and in future years. So really, for those people, 2010 is not only their first opportunity to do a Roth conversion, it’s the best year to do a Roth conversion. So we highly recommend those sorts of taxpayers, people who have a lot of money who are now able to convert, take a serious look at it and seek an advisor.
Hana Haatainen-Caye: OK, thank you, Steve. You’re listening to the Lange Money Hour. I’m Hana Haatainen-Caye and invite you to stay tuned as Jim will be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back to the Lange Money Hour. We’re talking smart money. Jim has been speaking with Steve Kohman, and we’d like to now hear what Matt Schwartz has to add. Matt is an estate-planning and estate-administration attorney who devotes his practice to estate and retirement planning with a particular emphasis on IRA and Roth IRA planning opportunities. He has worked closely with Jim Lange over the past seven years in implementing the Cascading Beneficiary Plan and many other estate-planning strategies for our clients. Welcome, Matt.
Jim Lange: And I just want to add that Matt is a wonderful estate attorney. He gets along with clients beautifully, and he and I complement each other very well because I like to talk about some of the big picture ideas, which Matt understands completely, and he will sometimes, by the way, correct me on that, and then he works with the clients and just does a wonderful job of coordinating all the big-picture ideas that Steve might come up with in terms of Roth IRA conversions or amounts, and then clients just have a really terrific experience with him. So I’m really glad that he’s on today, and the other thing is, technically, he’s just amazing, and that was one of the reasons why I wanted him on today because we have a pretty technical topic today, a very lawyerly topic, and Matt is just an estate-planning attorney extraordinaire, so maybe he can shed some light on some of the new tax laws.
Hana Haatainen-Caye: OK. First, Matt, though, I’d like to talk about what was the federal estate-tax law in 2009?
Matt Schwartz: Thank you for the introduction, Hana. In 2009, the federal estate-tax exemption was $3½ million, and there was a lifetime gift exemption, which still exists today, of $1 million with the maximum federal estate-tax rate of 45 percent. When clients were talking with me in 2009 and asked me what I thought would happen in 2010, myself, like most of the estate-planning community, just thought that the 2009 law would be extended into 2010 because we didn’t think we wanted to create an incentive to kill people off at the end of 2010 when the law’s supposed to revert back to a $1 million exemption, or keep people alive so that their families didn’t have to pay estate tax. Well, we were surprised when Congress did not pass a patch at the end of the year to extend the federal estate-tax exemption into 2010. So we actually have no estate tax right now at the beginning of 2010, and people can look at this two ways: you can either be very aggressive in doing some planning, or you can think that Congress is going to retroactively re-enact the estate tax, and if you’re aggressive, there’s one option that’s good and there’s one option that’s not so good. The not-so-good option is you could die this year, and if you die this year, there’s no federal estate tax. What do you think about that, Jim?
Jim Lange: Well, that’s kind of interesting. So you can have a billion dollars, and if you died last year with that billion, you’d have to pay roughly $400,000,000 in estate tax, but if you die this year, then there’s no federal estate tax, and can we count on that? So, all right, I have a billion dollars, I die, I leave it to my kids and my grandkids, and they’re scot-free. I don’t have to worry about anything because I died during a time when there’s no federal estate tax. Is that right?
Matt Schwartz: Well, if I’m Bill Gates’ heirs, I’m not thinking about killing off Bill Gates any time soon. There was a lot of comment in the estate-planning community about whether the federal estate tax would be retroactively reinstated and whether that reinstatement would be constitutional, and some commentators were suggesting to keep their offices open through New Year’s weekend to make very aggressive gifts and try to get as much out of people’s estates as possible. But as more and more people have studied the topic, the courts have time and time again retroactively reinstated tax laws. So it is everybody’s full expectation that the law will be reinstated, and we just don’t know what the estate-tax exemption will be and what the tax rate will be. But people are thinking the exemption will be at least $3½ million and the maximum estate tax rate will be at least 45 percent.
Jim Lange: All right, so, what you’re saying then is … let’s forget the billion. Let’s just assume that I have a taxable estate in 2009 dollars, and I die, let’s say, between now and they make a tax-law change. You’re saying that they can make a tax-law change and make it work backwards, retroactive, and that’s not a violation of the Constitution or a violation of due process or anything else?
Matt Schwartz: Well, that’s the main argument people make, Jim, that it might be a violation of the due-process clause, but there’s been Supreme Court cases that have said as long as the tax advances a legitimate government interest, and the government will argue that raising revenue is a legitimate government interest, that the tax can be reinstated.
Jim Lange: And what about the generation-skipping tax?
Matt Schwartz: Same deal, that that tax can be reinstated as well.
Jim Lange: All right, now, I don’t think that people are going to say, “Well, I’m going to die now to avoid tax.” But there is a proactive thing that some people could do, which is to make significant gifts to their grandchildren. What do you think of that, let’s say, for wealthy taxpayers who are interested in skipping a generation, does that make sense in general, and does the current confusion in the federal estate tax give us an opportunity that we might not otherwise have? Or do you think it’s a risk?
Matt Schwartz: Well, there is certainly a risk to it if you weren’t thinking of making a large gift anyways, or if you were in a situation where you projected that the estate-tax exemption was going to rise enough that you wouldn’t have had to pay gift tax or federal estate tax.
Jim Lange: All right. What about the ordinary guy? What if a guy doesn’t have $5 or $6 million? Let’s say he has, you know, $750,000, a million, two million, maybe even three million, and let’s say he has the traditional, he went to one of the downtown firms and he has one of the traditional A/B wills. What’s the impact for a guy like that with what is going on, and what do you see as the best solution for somebody like that who is trying to plan their estate?
Matt Schwartz: The potential impact for a person like that is, unwittingly, their spouse may end up not having any outright access to money. They may have had a will or trust written based on a federal estate-tax formula, and the way the formula works when there’s no federal estate tax, their spouse may have everything tied up in trust.
Jim Lange: So, you know, I think I call that “the cruelest trap of all” in the book Retire Secure!, but the essence of it is is that people who sometimes think they’re leaving money to each other are actually leaving money into a trust where the surviving spouse doesn’t have unlimited restrictions.
Matt Schwartz: And then, what happens if that surviving spouse becomes incapacitated and her kids become trustees, and there’s not a great relationship between the kids and Mom, and maybe the kids don’t want to pay a lot of money for support to put Mom into a good nursing home, and then the money’s not there for Mom’s purposes.
Jim Lange: So, basically, Mom loses control when that wasn’t really the intent. Is there something in people’s wills that they can know if they have this kind of thing? Is there language, in other words, if there’s a bunch of language that people don’t understand, is it possible that that’s what’s in their will? Because a lot of people don’t know what’s in their will.
Matt Schwartz: That is true. A lot of people, we had a client in the other day who said, “Matt, I believe you drafted this as well as you could, but I’m trusting you that that says what it says.” And we try to draft as clearly as possible. So if you have a lot of language in there about a maximum marital amount or a credit-shelter amount or a federal estate-tax formula, you likely have one of these tax-clause wills.
Jim Lange: Well, I know one of the things that you like to do when you prepare wills in our office is you actually write a letter describing what the will says, and we don’t see very many of those types of letters from other attorneys. Is that one component, and could you comment on, let’s call it, the volatility of the federal estate tax and how that plays in and what type of estate plan you would recommend for, let’s say, actually most traditional families that are interested in providing for each other, and then, at the time of the second death, to the kids maybe equally?
Matt Schwartz: Well, with respect to your comment about the letter, I found, over time, as I’m trying to learn about technical topics, it’s always helpful to have a CliffsNotes version, or a version that’s easier to understand, and that’s one thing I try to do for our clients. I think it’s something they’re entitled to for the fees they’re paying. With respect to the volatility in the federal estate tax, the exemption next year, if there’s no change, goes down to a million dollars. So if you have one of these tax clauses, you could either have $3½ million going into a trust for your spouse or a million dollars, and that makes one big difference. So when we do our drafting, we tend to leave it up to the survivors to choose how much money they want to go outright to their spouse, and the surviving spouse is making that choice, and then how much money they want to go into a trust for their lifetime benefit, and perhaps maybe the spouse doesn’t need all the money based on their income needs and maybe they want to pass money directly to their children.
Jim Lange: And what about the grandchildren? Because I remember, I think it was Ed Slott who said, “People don’t like their kids. They like their grandkids.” Now, of course, I’m not saying you don’t like your kids, but what if you are interested in providing for your grandkids? Is that a possibility with the kind of plans that we do?
Matt Schwartz: Oh, it absolutely is a possibility, and often what we see is, Jim, a lot of our clients have most of their assets in retirement plans as opposed to after-tax money that just passes under somebody’s will, and as you and I well know, the control of that money is determined by the beneficiary designation as far as where that money’s going to go after someone dies. And so, often, those forms just say, “Spouse primary, children in equal shares,” so if there’s an unusual order of death and one of the children predeceased the survivor of Mom and Dad and that deceased child had children, those children could be left out of an inheritance because the way that designation is written, the surviving child gets everything.
Jim Lange: And isn’t it sometimes advantageous to have certain assets go to the children and certain assets go to the grandchildren? So, let’s say, for discussion’s sake, either at the first or even at the second death, does it sometimes make sense, for example, for after-tax dollars to go to the children and the Roth IRA conversion dollars to go into specially drafted trusts for the grandchildren?
Matt Schwartz: Absolutely, because the grandchildren have a much longer period of time to withdraw the Roth IRA dollars, which is going to maximize your tax-free growth.
Jim Lange: So what you’re saying is, the type of flexible documents that you’re doing will allow in, let’s say, the first case, the surviving spouse, and then maybe at the second death, the children, to make strategic decisions on an asset-by-asset basis that will help maximize the value of the estate for the entire family.
Matt Schwartz: Yes, that’s the flexibility of our plan.
Jim Lange: All right. Now, can you have just a regular plan, the traditional plan, and have somebody do that later, or do you have to set everything up ahead of time?
Matt Schwartz: Well, you really need to have it set up ahead of time. The great thing about the plan is, you don’t have to choose exactly where the money’s going to go at death, but you need to have the blueprint there. You need to have all the options set in stone.
Jim Lange: So, basically, the surviving spouse is going to be the boss, and what are some of the choices that the surviving spouse might typically have in the documents that you typically prepare?
Matt Schwartz: Well, one option is they can accept the money, and traditional estate planners, when there’s the possibility of a taxable estate at the second death, worry about that because maybe the spouse is going to get nervous and accept too much money, which is going to cause the second estate to be taxable, and sometimes the response to that is it’s that family’s money. They can choose to do what they want to feel secure.
Jim Lange: All right, so basically, what you’re saying is, you like to make the surviving spouse the boss, and if they are the boss, then what are their choices in a typical, what we call Lange’s Cascading Beneficiary Plan?
Matt Schwartz: First choice is to accept the money. The second choice, which we only generally recommend for after-tax assets, is the money could be held in trust for the surviving spouse for their health maintenance and support. The third choice is, the spouse can say they don’t want any of the money, which would cause the money to pass to the children, and they could do that with part of the money or all of the money. And the children could further say, “I don’t want all the money,” and they could pass it to a well-designed trust for their children that they can control. So, many children find that to be attractive.
Jim Lange: And can they mix and match? That is, they might want some money outright, some money in trust, some money to kids and some money to grandkids.
Matt Schwartz: Absolutely. It’s not an all-or-nothing choice.
Jim Lange: Well, that sounds like it’s a very flexible plan. Let me ask you this: What if you don’t trust your spouse? Let’s say that maybe your spouse has kids from her own marriage, or has completely different values. Would it work for them, or do you need one of these, I call it, “Leave It to Beaver” families, where you have the husband and wife with the same kids and the same grandkids?
Matt Schwartz: Generally, it’s better in a “Leave It to Beaver” family, but if the second marriage, the husband and wife are onboard, it can work in a second-marriage context as well.
Jim Lange: OK.
Hana Haatainen-Caye: We’re going to take a short break. We’ll be right back to talk more smart money.
Hana Haatainen-Caye: Welcome back. Steve, do you have any closing comments for us?
Steve Kohman: I’d just like to mention that a Roth IRA conversion can also save your family money by reducing estate taxes, and 2010 is a unique year with its lower tax rates than you’ll ever see in the future as far as we know, and developing a well-designed Roth IRA conversion plan is extremely important to do this year in 2010.
Hana Haatainen-Caye: OK, thank you, Steve. And I just want to thank both of you, and if you’d like to contact Matt Schwartz, Steve Kohman or Jim Lange, you can call our office at (412) 521-2732. This is Hana Haatainen-Caye and Jim Lange with The Lange Money Hour, Where Smart Money Talks. Please join us again on February 10th at 7 p.m. when Jim will be talking smart money, and don’t forget to join us for Jim’s workshop on Saturday, January 23rd, at the Crowne Plaza across from South Hills Village. This popular workshop on Roth IRA conversions is being offered at three different times throughout the day, beginning at 9:30 a.m., 1 p.m. and 4 p.m. To reserve your spot, please call (800) 387-1129, or visit us at www.retiresecure.com.