Retirement Planning for IRA Owners and 401(k) Participants

IRA owners and 401(k) participants face a staggering array of options regarding their retirement plans. The Taxpayers Relief Act of 1997 significantly increases the ability of many retirement plan participants to accumulate wealth and reduce taxes. This article provides guidelines for IRA owners and 401(k) participants to optimize the benefits of their retirement plans.

Table of Contents

Always Make Contributions into a Matching Contributory Plan

If your employer offers a retirement plan where your contributions are partially or fully matched, then you should always contribute the maximum amount. Neither your nor your employer’s contribution will be currently taxed for federal income tax purposes. State and local taxation of retirement contributions vary. All taxes on dividends, interest, capital gains, and appreciation of the invested funds will be deferred until you begin making withdrawals from the retirement plan.

Normally, participants are provided a choice of investment vehicles. This choice will often include a family of mutual funds, such as Fidelity or Vanguard funds, and possibly the company’s own stock, if it is publicly traded. While choosing the type of investment is certainly important, it is not as important as the choice to make tax-deferred contributions.

Should You Make Non-Matching Contributions?

Most individuals who are employed can make non-matching, tax-deductible contributions to IRAs, 401(k)s, SEPs, Keoghs, SIMPLE plans, 403(b)s, 401(a)s, and defined contribution plans. For simplicity, this article refers to all of these plans as Supplemental Retirement Annuities (SRAs). After you have contributed the maximum amount that is subject to full or partial matching by your employer, I highly recommend making the maximum allowable additional tax-deductible, non-matching contribution that you can afford. Please keep in mind, however, that age 59½ is usually the earliest time you can access your SRA funds unless you retire or terminate services.

Investing in SRAs is better for long-term wealth accumulation than investing in the after-tax environment. For example, if you are in the 28 percent tax bracket, then you must earn $1.39 before taxes to accumulate $1.00 after taxes. After that dollar is invested, you then must pay income taxes on the interest, dividends, and capital gains which are earned on that dollar. To accumulate $1.00 in the before-tax or SRA environment, however, you only have to earn $1.00. In addition, the earnings and accumulations in your account will not be taxed until they are withdrawn. A graphic comparison of the accumulations in a taxable versus a tax-deferred environment is displayed in Exhibit One.


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Many clients ask if it would be better for them to make SRA contributions or to pay off their mortgage at a faster rate. Under most circumstances, making contributions to the SRA will be the preferred answer, if the goal is to attain the greatest accumulation of dollars in the future. There are two reasons for this recommendation. First, you have the opportunity to defer income taxes on retirement plan contributions and on your earnings and accumulations. Second, the mortgage interest expense can be deducted on your tax return.

In my opinion, the financial goal for the majority retirement of plan participants in their working years should be to accumulate as much wealth as possible in the tax-deferred environment. One situation where it may be wise to make earlier than required distributions from a tax deferred plan, however, is when there will be significant estate taxes, and the plan holds the only funds available to pay the estate taxes after the participant’s death. It may be wise to make earlier than required distributions, pay the income tax, and give the after-tax proceeds to your beneficiaries. This strategy will, in limited circumstances, be beneficial by not only reducing the amount of the estate, but also by providing the beneficiaries with funds to pay the estate taxes.

Another exception to the goal of accumulating money in the tax-deferred environment is to utilize funds for either a Roth IRA and/or a Roth IRA conversion which is discussed later in this article. Finally, methods of leveraging gifts with second-to-die life insurance policies, grantor retained annuity trusts, family limited partnerships, charitable remainder trusts, and other techniques may be appropriate for wealthy individuals.

Required Beginning Date

The Required Beginning Date (RBD) refers to that date when the participant must begin to receive annual distributions from his/her retirement accumulations (except from the Roth IRA, as discussed below). After 1996, the RBD is April 1st of the year following the later of the year in which the participant reaches age 70½ or retires. You cannot use the date you retire to determine the RBD for an IRA or for funds earned with previous employers. The minimum withdrawal amount is calculated based on the actuarial life expectancy of the participant and the participant’s named beneficiary. The older the participant, the larger the minimum distribution amount. Please note that pre-1987 funds in 403(b) plans are not subject to minimum distributions until age 75.

Taking Distributions from Your Retirement Plan

In general, it would be preferable for you to spend principal from your after-tax investments rather than taking taxable distributions from your IRA account.  A graphic comparison of the benefits of consuming after-tax savings before pre-tax accumulations follows. (See Exhibit Two.)  A more thorough explanation of the benefits of consuming after-tax savings before pre-tax accumulations follows.  (See Exhibit Two.)  A more thorough explanation of the benefits of consuming after-tax savings before retirement accumulations can be found in my article, Maximizing IRA Benefits, published in the September, 1997 issue of Financial Planning.   One possible exception to the general rule that it is wiser to spend non-IRA assets before IRA assets is when there are significant capital gains upon sale of after-tax assets.

If you retire before reaching age 70 1/2, you may find that your social security, other non-IRA income, and/or spending the principal of non-IRA assets produce enough funds for your living expenses.  If this is the situation, you should take the minimum required distribution based on the joint life expectancy of the named beneficiary and you.   The minimum distribution is calculated by utilizing actuarial life expectancy tables published by the Internal Revenue Service in Publication 590, which is likely to be revised this year.

Let us look at a Minimum Distribution Option (MDO) example for a regular IRA participant who has named his spouse as the beneficiary and has one million dollars in his IRA accounts. Assume that Mr. Wise is age 71 and his spouse is 65. According to the IRS tables, this gives him a life expectancy of 15.3 years and his spouse a life expectancy of 20 years. Their 22.8 year joint life expectancy is used to determine the MDO. Thus, the MDO for the first year is:

$43,859 ($1,000,000 ÷ 22.8).

There are two different methods of determining the life expectancies for both the participant and the primary beneficiary in future years: the recalculation method and the term certain method. Under the term certain method, on each anniversary of the RBD, you would subtract one year from your original life expectancy determination. Under the recalculation method, you recalculate your life expectancy each year. Note that as we age one additional year, our life expectancy decreases, but not by a full year. Using a higher life expectancy will result in a lower minimum required distribution.

There are four different methods available to determine the MDO in years subsequent to the first. This is because you may also choose to recalculate one life (usually the participant) and apply term certain to the other life (usually the beneficiary). For estate planning and family wealth preservation reasons beyond the scope of this article, the recalculation method for both spouses is usually not the wisest choice although it produces the smallest MDO amounts.

Minimum Required Distributions After Your Death

Assuming your heirs could afford to leave the funds in the tax-deferred environment after your death, it will usually be to their advantage to take out the smallest allowable distribution. If your spouse is the beneficiary, then upon your death, he or she could roll over your retirement account into the spouse’s own IRA. Your spouse could then use his or her own and a newly named beneficiary’s life expectancy to calculate the required minimum distribution. Note that either the recalculation method or the term certain method for the surviving spouse’s newly named beneficiary may be used. This scenario, however, is subject to the minimum incidental death benefit rules which limit the deemed life expectancy of the beneficiary (usually the children) to no more than ten years younger than the participant (usually the surviving spouse). Alternatively, if your spouse is older than you were when you died, then the spouse may be able to continue utilizing your distribution schedule.

The general rule for a non-spouse beneficiary is that the beneficiary must take distributions at least as rapidly as the deceased participant. If, however, certain conditions are met and the proper elections have been made, the beneficiary will be able to use his or her own age to determine the required minimum distribution. An advantage of naming a child (or even grandchild) as the beneficiary is that the child’s life expectancy is so long that the required distributions and the resulting income taxes can be deferred for many years.

Taxpayer Relief Act of 1997

In August of 1997, the President signed into law new tax legislation which includes profound changes that will have far-reaching implications for retirement and estate planning for retirement plan participants. For some, the legislation is almost too good to be true. The scope of the changes in the retirement plan area are so broad and so important that they are deserving of a separate article. I wrote such an article entitled “IRAs After the TRA ‘97–What Hath Congress Roth?,” which was published in the May 1998 issue of The Tax Adviser, the most prestigious CPA journal in the country. Here are some of the more important considerations.

First, the new legislation permanently eliminates both the excess distribution and excess accumulation taxes. Avoiding these taxes was the major reason that some financial planners had recommended withdrawing funds from retirement plans before age 70½. Since avoiding these two taxes is no longer necessary, there is little motivation to withdraw funds from your retirement plans before you need the money (except for the gifting strategy previously discussed).

Roth IRAs And Roth IRA Conversions

More importantly, the legislation created a new type of IRA called the Roth IRA. Starting in 1998, you can make a non-deductible contribution of $2,000 if you are single and have an adjusted gross income (AGI) of less than $95,000. Married taxpayers will be able to make combined contributions of $4,000 if their AGI is less than $150,000. The money will grow tax-free and withdrawals will be tax-free if the funds are held for five years and the IRA owner is age 59½ or older when distributions begin. In effect, the IRS is taxing the seed, not the harvest. All income and capital gains earned within the Roth IRA are never taxed. With regular IRAs, the income and capital gains are only tax-deferred. Another favorable feature is that Roth IRAs are not subject to the minimum distribution rules which apply to regular IRAs.

The following exhibit shows the accumulations in a deductible IRA versus a Roth IRA. Please note that we are presenting a 55-year-old in the 28 percent tax bracket who makes a $2,000 contribution which is invested at 10 percent. All amounts shown are measured in after-tax dollars. (See Exhibit Two.)


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Of even greater interest to regular IRA owners is the possibility of converting a portion of your existing retirement plan to a Roth IRA. Although you have to pay income tax on the amount converted, the account grows tax-free after the conversion. Furthermore, if you elect to make a Roth IRA conversion in 1998, then you have the opportunity of pro-rating the income tax over a four-year period. In other words, if you convert $200,000 in 1998, then you will incur additional taxable income of $50,000 per year for four years. If you convert $200,000 in 1999 or later, your taxable income for the year of conversion will increase by that amount.

To qualify for a Roth IRA conversion, your adjusted gross income must be less than $100,000. The Roth IRA conversion is something every participant in a retirement plan should seriously consider. A Roth IRA conversion runs contrary to the general principle that it is usually better to postpone the payment of any taxes. In most of the scenarios that we have analyzed, however, the retirement plan participant–and particularly, the participant’s heirs–will have more wealth in the long run if the participant makes the Roth IRA conversion on at least a portion of the total retirement plan accumulation. The huge income tax savings in the future more than offsets the current income tax bite.

Regular IRAs are eligible for the Roth IRA conversion. The general rule to determine whether your retirement plan is eligible for conversion, is that all retirement plans that can be rolled into a regular IRA can be converted to a Roth IRA. The following chart shows whether your assets will likely be eligible for the Roth IRA conversion. (See Exhibit Three.)





















*Employers can choose different options regarding “in-service” withdrawals from their Plans.



As an example, assume Mr. Wise is 55 years old and chooses to make a $100,000 Roth IRA conversion. Mr. Status Quo is in an identical financial position except that he chooses not to make a conversion. Assume both IRA owners have $100,000 of after-tax dollars, they are in the 28 percent tax bracket, and their rate of return is 10 percent. Exhibit Five shows the amount of after-tax dollars which both would accumulate.


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Now, begin with the previous example and look twenty years into the future. Assume each IRA owner dies at age 75, and they leave their IRAs and their savings account to their 45-year-old child. Assume the child makes annual distributions from the retirement account. The first distribution is $48,000 and the subsequent annual distributions are $48,000 increased by an assumed 4 percent rate of inflation. The following chart shows the after-tax balances in the funds. As you can see from Exhibit Six, the differences are staggering. This difference does not take into account the potential estate tax savings of making a Roth IRA conversion. Had that difference been considered, the results would be even more favorable for making the Roth IRA conversion.

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There are, however, several potential disadvantages to Roth IRAs and Roth IRA conversions. The major disadvantage for many individuals is funding the income tax burden caused by the conversion. Another potential disadvantage is the possibility that the participant’s tax rate may decrease after retirement. The Roth IRA conversion also will not be favorable if the intended beneficiary is a charity. Finally, future tax law changes could jeopardize the benefits and even make the conversion disadvantageous. Roth IRAs and Roth IRA conversions are a dynamic possibility that could significantly enhance wealth and reduce taxes. I recommend that you seek professional guidance to determine whether converting would be beneficial to you.

Your Retirement Account’s Beneficiary Designation

If retirement plans constitute the majority of assets in your estate, then the beneficiary designation of your retirement accounts (and not your Will) is the primary means to control the disposition of your wealth upon your death. Most SRA owners name their spouses as the primary beneficiary and their children as secondary or contingent beneficiaries to their retirement plans. Better options exist, however.

Spousal Beneficiary

I usually recommend naming your surviving spouse as the primary beneficiary of your retirement account. The advantages are: (1) the spouse is the most likely object of the participant’s affection, (2) the spouse does not have to pay any federal estate tax on the retirement account due to the unlimited marital deduction, (3) naming the spouse is likely to decrease the minimum required distribution while the participant is still alive, and (4) the amount in the retirement account can be distributed over a longer period of time once the participant dies.

The primary disadvantage of naming your spouse as the beneficiary of your retirement plan is the potential enormous estate tax due upon your spouse’s death if the marital assets exceed $625,000. If the only funds available to pay the estate tax are retirement assets, then the payment of estate tax will trigger income tax. The combined estate and income marginal tax rate could be 80 percent or higher.

Plan Benefits Trust Beneficiary

If the total marital estate is more than $625,000 (which, under the new law, increases in increments to $1 million in 2007), I often recommend creating a special trust called a Plan Benefits Trust (PBT). The PBT is designated as the secondary or contingent beneficiary to the retirement plan. The purpose of the PBT is to fund the unified credit shelter trust.

This PBT is created in addition to any trusts which you might establish in your Will. The terms of the PBT provide the surviving spouse with income for life and the ability to access principal for health, maintenance, and support. Upon the surviving spouse’s death, the remaining assets are distributed to whomever you choose, usually your children or special minor trusts depending on the age and maturity of your children. If the survivors make the proper election, then the income tax on the money in the PBT can be deferred. A sophisticated improvement to both the PBT and the B trust in A/B trust-type Wills is to allow discretion in the payment of income to the surviving spouse.

One of the main purposes of the PBT is to save $240,000 to $1 million in estate taxes for your children, while also protecting your surviving spouse. The PBT is especially beneficial to participants whose major asset is their retirement plan. Conventional thinking dictates that funding the unified credit shelter trust with retirement money is not ideal for many participants. The PBT utilizes pre-tax dollars to fund the unified credit shelter trust. Although not ideal, there often is not sufficient after-tax money to fund the trust. In most cases, funding the trust with pre-tax dollars is preferrable to not funding the trust.

The PBT is especially critical for individuals whose marital estates exceed $625,000 and need the retirement assets to fully fund their unified credit shelter trust. Since your Will usually does not control the disposition of your retirement plan, the PBT is necessary to utilize the unified credit shelter trust and to maximize the estate tax savings to your heirs upon the surviving spouse’s death.

Disclaimer Strategy

Naming a trust (i.e., the PBT) as the primary beneficiary of your retirement plan, however, is not the best choice in most circumstances. In most cases, I prefer to name the surviving spouse as the first beneficiary and the PBT as the contingent beneficiary. After the death of the first spouse, the surviving spouse could then choose either to inherit all of the retirement funds or disclaim $625,000 or less of the retirement funds into the PBT. [Note, however, that if your spouse is named as a joint annuitant of your TIAA/CREF account, then the disclaimer strategy will not work since the spouse cannot refuse an annuity benefit.] If your spouse is named as the first beneficiary, then your spouse will also have the option of rolling over the retirement funds into his or her own IRA.

Another advantage of naming the spouse as the primary beneficiary is that the spouse will not be burdened by a trust. In addition, there may be other funds which can be used to fund (either totally or partially) the $625,000 unified credit shelter amount which would make the PBT unnecessary. A final option is that the surviving spouse could keep a portion of the retirement account and disclaim the remaining portion into the PBT.

The advantage of the surviving spouse being able to disclaim the full interest of the retirement plan into the PBT results from the potential savings of $240,000 to $1 million in estate taxes for the children when the surviving spouse dies. The decision of whether the surviving spouse should inherit the retirement plan outright, or whether the family would be better served utilizing the PBT, often creates a tough choice. Many couples with long-term, trusting marriages where both spouses have the same children will prefer to let the surviving spouse make that decision after the first death when more relevant financial information is available. The mechanism to accomplish this goal is to name the surviving spouse as the primary beneficiary and the PBT as a contingent beneficiary. Disclaimer planning may not be appropriate for second marriages where each spouse has his or her own children.

Instead of making restrictive decisions when you do not know future circumstances, the disclaimer/trusts strategy allows your spouse to make these important decisions later with more defined and current information. When will more information be known? At the time of your death. In addition, your spouse will have nine months after your death to make a qualified disclaimer. This ability to disclaim the benefits of the retirement account creates an optimal estate plan. Disclaimers have long been an important part of estate administration. Recently, sophisticated planners have been using the disclaimer as part of the planning process before a death has occurred to achieve the optimal wealth transfer.

For tax and administrative reasons, the plan’s beneficiary designation should not refer to your estate, or even to a trust in your Will. The PBT should be a “stand-alone” document drafted in conjunction with your Will or living trust. In addition, the PBT must be submitted and approved by the investment company which controls your retirement assets.

If you prefer giving your surviving spouse options while retaining the possibilities of substantial estate tax savings, I recommend disclaimer-type Wills in addition to disclaimer-type retirement beneficiary designations. In both cases, everything is left primarily to the spouse, thereby allowing the surviving spouse to disclaim as much or as little as he or she likes into a trust for the spouse’s benefit. The drafter of the documents should provide for coordination of the PBT and the disclaimer trust under your Will. Under most circumstances, I recommend using an integrated fractional formula utilizing inter-textual language in both the Will and PBT to define the amount which will fund the trust. This is a fancy way of saying the combination of the Will and the PBT will carve out a total of $625,000 (or more as the unified credit amount increases) using a combination of pre-tax and after-tax dollars, depending on what is the most advantageous as decided by the surviving spouse after the first death.


Retirees have a wealth of options regarding their retirement plans. In most situations, the retirement plan participant and beneficiary will be best served by retaining as much money as possible in the tax-deferred environment (except for possibly taking premature distributions under a gifting strategy). Current retirement plan participants who have regular IRAs should consider converting a portion into Roth IRAs. The minimum distribution option will often be the wisest choice for the majority of the funds. Finally, retirement plan participants should also consider establishing a coordinated estate plan which incorporates disclaimer-type Wills and disclaimer-type retirement plan beneficiary designations.