An Open Letter of Retirement Planning Advice to President Obama

By Jeffery Levine, IRA Technical Expert  

Follow Me on Twitter: @IRAGuru4EdSlott

Mr. President,

As part of the campaign process for your bid to seek a second term in the White House, you recently released a copy of your 2011 tax return. Purely to satisfy my own curiosity, I decided to review the return, as well as the tax return of your challenger, Governor Romney.
 

First off, it should be noted that in 2011, you contributed over $172,000, or more than 20% of your AGI (adjusted gross income), to charities. This is certainly an excellent example for others to follow. In looking at your return, I also made several observations relating to retirement savings/planning – an area I focus in.

One of my first observations, since it’s right there on the first page of your return, was that you wisely maxed out your contributions to your self-employed retirement plan. In making such a significant contribution, you clearly see the value in accumulating funds on a tax-favored basis for your retirement. In reviewing your tax return, I noted several other ways that you could potentially improve your retirement plan, and I thought I would bring those to your attention.

It appears that in 2011, neither you nor the First Lady made traditional IRA or Roth IRA contributions. Although the latter is, surprisingly to many, not required to be reported on your tax return in any fashion, we can presume you did not make any Roth IRA contributions since you were over the income limit to do so. Married filers in 2011 were completely phased out of Roth contribution eligibility at $179,000. As your Presidential salary alone far exceeds this amount, Roth IRA contributions clearly are not in the cards for you at this time.

Many who look at your return might incorrectly assume that you and/or the First Lady would also be prohibited from making a contribution to a traditional IRA due to your high income and active participation in a company plan. In fact, this is one of the most common mistakes I see even the most seasoned CPAs making when this topic comes up for discussion at one of the CPA continuing education courses I frequently teach.

The fact of the matter is that there is no limit on income in order to make an IRA contribution, so as long as you have some sort of “compensation,” which in your case could be either your wages or your self-employment income, you are eligible to make a contribution to a traditional IRA.

So why the confusion? Simply put, your high income and active participation in a company plan prevents you from being able to deduct your IRA contribution, but that doesn’t stop you from making non-deductible IRA contributions. Although you will get no tax break for these contributions on their way into an IRA, the earnings on these contributions will grow on a tax-deferred basis and when you take distributions from your IRA in future years, the non-deductible contributions will be returned to you, pro-rata, tax-free.

So now that we know you were eligible to make a traditional IRA contribution, the question is, did you? Determining whether or not you and/or The First Lady made traditional IRA contributions gets a little trickier. Although one would normally expect to see a deduction for an IRA contribution on line 32 of Form 1040, we would not see such a deduction on your return regardless of whether or not you and/or The First Lady made a traditional IRA contribution, for the reasons outlined above.

With that said, it’s necessary to dig a little deeper to determine if any such contributions were made. Form 8606 (Nondeductible IRAs), or rather its absence, provides strong evidence to support the fact that you did not make any traditional IRA contributions in 2011. Non-deductible IRA contributions are reported on line 1 of this form. Furthermore, per the directions for “When and Where To File” on page 1 of the 2011 Instructions for Form 8606, you should “File Form 8606 with your 2011 Form 1040, 1040A, or 1040NR.” Since none is attached to your return, it seems safe to assume such form was not required, meaning that no non-deductible contributions were made to traditional IRAs for your and/or the First Lady.

So why do I make such a big deal over some IRA contributions? After all, what’s a few thousand dollars a year really going to amount to? Unfortunately, that is precisely the attitude too many of our fellow citizens have and it can put a serious dent in their chances for a successful retirement. I hope you don’t mind, but I took the liberty of running some numbers for you, just to make the point.

For instance, assuming you were to contribute the maximum amount to an IRA for you and the First Lady through the year in which you turn 65, even at a modest 6% rate of return, that put your combined additional IRA savings at more than a quarter million dollars. That’s hardly chunk change. If we used an 8% rate of return, more indicative of the S&P’s long-term rate of return, that amount would be even higher.

Of course, at 70 ½ you will have to start taking required minimum distributions from your IRA, whether you need the money or not. The First Lady will have to do the same with her IRA when she reaches 70 ½. Even factoring in the distributions you’ll both be forced to take upon turning 70 ½, if we assume you and the First Lady each live to 85, at the time Sasha and Malia inherit your IRAs they could still be worth close to $400,000. If they were to stretch that amount out over their respective life expectancies, that amount could balloon to a total of over $2 million. And again, all this simply from just making annual IRA contributions for the next 15 years or so.

Another planning strategy I would recommend considering is a Roth conversion. Although it’s possible you have made Roth conversions in previous years, it is safe to assume no such conversions were made in 2011. Roth IRA conversions are reported on the same form as non-deductible IRA contributions, Form 8606, so the absence of this form as part of your overall return also indicates no Roth conversions were made in 2011.

I’ll be the first to say that Roth conversions are not for everyone. In fact, many people are better off keeping their traditional IRAs intact and only paying the tax on distributions as they take them. We could go on and on forever discussing calculations and factors that weigh into making the appropriate decision, but at the heart of the matter, we can boil this down to three simple questions… when, where and what?

The “when” part of our three questions is short for “when will you need the money?” The longer you can wait to use the money, the more sense the Roth conversion makes. Now I certainly wouldn’t presume to tell you how to spend your own money or how much of it you’ll need, but generally speaking, Presidents and former Presidents don’t have too difficult of a time generating income.

Whether it be appearance or speaking fees, a tell-all memoir about your years in the White House or some other source of income, chances are you won’t ever need to touch your IRA money.

With that, we can move onto our next question, “where,” which is short for “where will you get the money to pay for the tax due on your conversion?” With very few exceptions, it does not pay to do a Roth conversion if you have to pay for the tax on the conversion out of IRA or Roth IRA funds. In other words, you generally want to pay for the tax with non-retirement savings.

I obviously am not privy to your precise breakdown of assets, but given the low rate of interest treasury bills are currently paying and the $16,640 of taxable U.S. governmental interest you reported on your return(4), you obviously have substantial non-retirement savings. Indeed, this is further confirmed by your required asset disclosures, which indicated you had between $1.6 million and $6.25 million of Treasury bills and at least another $500,000 in a checking account. Based on this information, it seems as though paying for the tax due on a Roth conversion would not be a problem for you.

The final question is, perhaps, the most interesting of the three. Here, our “what” is “what do you think your future tax rate will be.” For people that believe they will be in a lower tax bracket in later years, the Roth conversion may not make sense. On the other hand, for those that believe their tax rates will increase, a Roth conversion is often an excellent long-term planning tool.

Indeed, you are in a highly unique position here, as few, if any, have as much control over their future tax rates as you have. As a part of your own plan for a second term, you have proposed increasing the tax rates for married couples with incomes in excess of $250,000. In all likelihood, your income will exceed this threshold for the foreseeable future and therefore, if you are successful in implementing your plan, a Roth conversion now, in 2012, before rates increase, would make even more sense.

As noted above, a portion of your income is interest generated from your Federal Treasury holdings. Not only is this interest subject to ordinary income tax rates, which are currently as high as 35% (and scheduled to be as high as 39.6% next year), but it will also be subject to an additional tax next year. One of revenue raising provisions of the 2010 Health Care Acts, or so-called Obamacare, a name you’ve recently embraced, is a 3.8% surtax on net investment income for certain high income taxpayers. As a result, your taxable interest could be taxed as high as 43.4%, and that’s just for Federal income taxes. Using some of your taxable Treasury holdings to help pay for the tax on your Roth IRA conversion would not only provide you the means to create a tax-free retirement account, but would also reduce your exposure to the 3.8% surtax in future years.

Converting to a Roth IRA now would also offer significant estate planning benefits as well. Once you convert to a Roth IRA, you will no longer have any required minimum distributions during your lifetime. As such, any Roth IRA funds you and/or the First Lady have could be left alone to grow tax-free for the benefit of Sasha and Malia. Although once they inherit your Roth IRA(s) they would have to take required minimum distributions, those RMDs would be tax-free (assuming you had any Roth for at least 5 years) and could be stretched out over their longer life expectancy. If, at that time, you have grandchildren, you might even consider leaving all or a portion of your Roth IRA to your grandchildren, who would have an even longer life expectancy to stretch distributions over.

There are probably numerous other planning opportunities to consider, but as I am sure you can appreciate, it’s difficult to make such assessments from only a tax return. I hope you will take these recommendations under consideration and I wish you and the First Lady the best of luck in planning for your golden years.

Regards,

Jeffrey Levine, IRA Technical Consultant
Ed Slott and Company