HS352 Financial Decision for Retirement

1. HS352 Financial Decision for Retirement RONALD CHUNGPh.D., MBA, BBA, CCM, MFP Managing Partner of EQCCHonorary Associate, School of Business, Hong Kong Baptist University

2. Planning for Pension Distributions – Part I

3. Planning for Pension Distributions • Any strategy selected must account for the following factors: • The client’s needs and goals • The variety of distribution options that are available in your client’s particular situation • The implications of choosing one option over another from a tax perspective • The implications of choosing one option over another from a cashflow perspective • The implications of choosing one option over another from a death benefit and estate tax perspective • The ability to delay the receipt and taxation of a distribution by rolling the distribution over into an IRA or another tax-advantaged retirement plan

4. Rollovers • When a plan participant retires, changes jobs, or wants to change service providers (in the case of an IRA), in most cases a plan benefit can be rolled out of one plan and into another tax-deferred vehicle without any income tax consequences • Most distributions qualify as eligible rollover distributions with a few limited exceptions. The most common distributions that do not qualify are as follows: • Minimum required distributions • Hardship withdrawals from a 401(k) plan • Distributions of substantially equal periodic payments made • Over the participant’s remaining life (or life expectancy) • Over the joint lives (or life expectancies) of the participant and a beneficiary • Over a period of more than 10 years

5. Rollover • Rollover – a payment made to a participant from one type of tax-advantaged retirement plan that is subsequently deposited within 60 days into another tax-advantaged retirement plan • A distribution must be rolled over by the 60th day after the day it is received, or the entire distribution is subject to income tax

6. Direct Rollover • Rollovers are problematic because eligible rollover distributions from qualified plans are subject to 20% mandatory income tax withholding • Mandatory withholding is not required if the participant elects a direct rollover

7. Planning Considerations • For many retiring plan participants, the best strategic decision is to elect a direct rollover of the entire benefit into an IRA. The direct rollover bypasses the 20% withholding rules, and once the benefit is in the IRA, the participant has maximum investment and withdrawal flexibility. • There may also be several good reasons not to elect to roll over the entire distribution. • The portion of the benefit that represents after-tax contributions should not be rolled over in most cases. • Second, if the distribution includes the sponsoring company’s stock, then the participant needs to carefully evaluate whether the net unrealized appreciation rules make it advantageous to take the stock portion of the distribution into income.

8. Planning Considerations • A participant over age 55 (but not yet age 59 1/2) who needs funds might consider withdrawing the amount of the current need and rolling over the rest to avoid the 10 percent early withdrawal tax. • The ability to borrow from the employer’s plan, or specialized investment options like a guaranteed investment contract, may create an incentive to choose the new employer’s plan.

9. Rollovers by Beneficiaries • A spousal death beneficiary inheriting an IRA can leave the IRA account in the decedent’s name or roll the benefit into an IRA in his or her own name • Technically, the account can be retitled without even changing the IRA vehicle • Death beneficiaries other than the spouse (and QDRO distributees other than spouses and former spouses) are not allowed to rollover distributions from any type of plan

10. Waivers for the 60-Day Rollover Requirement • IRS may waive the 60-day rollover requirement when the failure to waive such requirement “would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.”

11. Lump-sum Distributions • Instead of taking periodic payments from a qualified plan, employees are frequently permitted to receive their retirement benefit in a lump-sum distribution • Unrealized appreciation • Whenever a recipient receives a lump-sum distribution from a qualified plan, he or she may elect to defer paying tax on the net unrealized appreciation (NUA) in qualifying employer securities • To qualify as a lump-sum distribution, the participant’s entire benefit (referred to as balance to the credit) must be distributed in one tax year on account of death, disability, termination of employment, or attainment of age 591/2.

12. Planning for Pension Distributions – Part II

13. Minimum-distribution Rules • The minimum-distribution rules contained in IRC Sec. 401(a)(9) are designed to limit the deferral of taxation on plan benefits.

14. Choosing a Distribution Option • Choosing the best distribution at retirement can be a rather complex decision that involves personal preferences, financial considerations, and an interplay between tax incentives and tax penalties. • Typical considerations include whether • The periodic distribution will be used to provide income necessary for sustaining the retiree or whether the distribution will supplement already adequate sources of retirement income • The client has properly coordinated distributions from several different qualified plans and IRAs • The retiree will have satisfactory diversification of his or her retirement resources after the distribution occurs • The client has complied with the rules for minimum distributions from a qualified plan

15. Qualified Plans • Every qualified retirement plan will specify when payments may be made and which benefit options are available. Each plan will also have a default option if the participant fails to make an election. • A qualified plan has a range of options with regard to the timing of payments. • When the participant terminates employment with a vested benefit of less than $5,000, the plan can provide that such small benefits will be cashed out in a lump sum – without giving the participant any choice in the timing or form of benefit. • involuntary cashout – when a participant terminates employment with a vested benefit of less than $5,000, the plan can provide that such small benefits will be cashed out in a lump sum

16. Qualified Plans • Most plans choose this involuntary cash-out option to simplify plan administration. A recipient of an involuntary cash-out retains the right to elect a direct rollover to an IRA or to receive the distribution directly. If the involuntary cashout is $1,000 or more and the participant fails to make an affirmative election, the plan administrator is required to roll the involuntary cashout directly to a designated IRA • When the benefit exceeds $5,000, participants must be given all the benefit options allowed under the plan as well as the right to defer receipt of payment until normal retirement age • Options for distributions may include: • Annuity payments • Installment payments • Lump-sum distributions

17. Qualified Plans • Life Annuity • A life annuity provides monthly payments to the participant for his or her lifetime. • Joint and Survivor Annuity • A joint and survivor annuity provides monthly payments to the participant during his or her lifetime and if, at the participant’s death, the beneficiary is still living, a specified percentage of the participant’s benefit continues to be paid to the beneficiary for the remainder of his or her lifetime. • Life Annuity with Guaranteed Payments. • A life annuity with guaranteed payments provides monthly benefit payments to the participant during his or her lifetime. Payments are made for the longer of the life of the participant or some specified period of time.

18. Qualified Plans • Annuity Certain • This annuity provides the beneficiary with a specified amount of monthly guaranteed payments after which time all payments stop (for example, payments for 20 years). • Lump-sum Distribution • The entire benefit is distributed at once in a single sum. • Installments • The installment option is similar to, but definitely different from, a term-certain annuity. • With installment payments, the participant will elect a payout length and, based on earnings assumptions, a payout amount will also be determined. Payments will be from the account, not an insurance carrier, and there are no guaranteed payments.

19. Value of the Benefit • To understand the value of the benefit provided by the plan, it is important to discuss defined-contribution plans and defined-benefit plans separately. In a defined-contribution plan, the benefit is always based on the value of the account balance. • In a defined-benefit plan, the value of each benefit is almost always the actuarial equivalent of a specified form of payment – most typically a single life annuity • actuarial equivalent – the value of different benefit options is altered to accommodate the uniqueness of the benefit form. This means that if, for example, the participant chooses a lump-sum benefit, the amount of the lump sum is based on the single sum value of a life annuity using the actuarial assumptions prescribed by the plan

20. Review P11.23-11.26

21. Working with Clients • Financial service professionals will work with a wide variety of clients, and each of their needs will be unique • The checklist in table 11-6 identifies some client issues • Generally the typical issues that need to be addressed can be divided into two client profiles • The first consists of those clients with limited resources whose primary goal is making their limited resources last throughout their retirement years. • The second group is made up of the clients who will not need all the pension assets during their own lifetime.

22. Working with Clients • Primary Concern: Funding Retirement Needs • For most of us, accruing adequate retirement resources is a daunting task. In many cases, the most significant asset is the company pension. • For this reason, it is imperative that the distribution decisions result in maximization of the family’s available after-tax dollars • Preretirement Distributions • The major concern for the individual who receives a pension distribution prior to retirement is ensuring that pension accumulations are used to finance retirement and are not spent beforehand. • In this regard, participants want to be sure to satisfy rollover rules so that inadvertent taxes do not have to be paid.

24. Example • Sonny Shortview, aged 40, is changing jobs. He will be receiving a much higher salary in his new job and he is feeling quite well of . Sonny has the opportunity to receive a pension distribution from his old company in the amount of $35,000. Even though he doesn’t really need the funds, the amount seems small enough to Sonny that he is considering paying taxes and using the after-tax proceeds for an auto upgrade. Sonny may change his mind when he learns that with a 10 percent rate of return, his $35,000 distribution will grow to $367,687 by the time he reaches age 65.

25. Working with Clients • Another difficult situation arises in the case of involuntary dismissal • In this case, the individual may need to tap into his or her pension. If the participant is younger than age 59 ½, he or she must pay the percent premature distribution excise tax unless one of the exceptions applies

26. Form of Retirement Distribution • Almost all individual account-type plans give the participant the option to receive a lump-sum distribution, which can be rolled into an IRA without tax consequences. • Defined-benefit plans may or may not have a lump-sum option, depending upon the terms of the plan. • If the lump sum is calculated with unfavorable assumptions, this option may not be advisable . One way to test the value of the lump sum is to compare the amount payable as a life annuity from the plan to the amount that would result from taking a lump sum, rolling it into an IRA, and then buying a life annuity at commercially available prices.

27. Tax Issues • With smaller distribution amounts from a qualified plan, the tax rate using special averaging treatment can look quite attractive • Once the rollover occurs, to maximize the benefit of tax deferral, amounts should be distributed only when needed, unless the minimum-distribution rules require a larger distribution

28. Tax Issues • Primary Objective: Maximizing the Estate • Clients with large pension benefits generally will not elect lump-sum averaging treatment.

29. Example • Oliver, aged 80, died (without a surviving spouse) with $2 million in his IRA account. Assume Oliver’s other assets are large enough that his pension is taxed at the highest marginal estate tax rate of 47 percent (the highest estate tax rate in 2005). Also assume that after Oliver’s death, the entire IRA is distributed to his beneficiary, who is in the 35 percent income tax bracket. Looking just at federal taxes, the benefit will be taxed as follows:

30. Refer to Estate Planning

31. Housing Issues

32. Housing Issue • Retirement often means adjusting to a new routine and reassessing one’s identity • Some clients cling to their home in retirement, the psychological attachment to the home sometimes outweighs the financial and tax wisdom • Planners need to understand the disposition of the family homestead • The decision of where to reside during the retirement years are personal choices

33. The job of planners • Although one’s house remains the same, the character of the neighborhood will be changed during retirement by the deaths and departures of friends. In addition, development in the local area will change the essence of community that once was so familiar • The house that was suitable for raising a family may not be suitable for retirement. Instead of being close to schools in the best school district, it might be more important to be close to medical care in a place with lower school taxes • The costs of heating, cooling, cleaning, and maintaining a house with empty rooms and a child-sized yard may be prohibitive • Even a mortgage-free house can be a financial drain that robs the retiree of income. Here’s why: besides the additional costs involved in maintaining a home, the equity from its sale could be used to provide needed retirement income

34. Tax Implications of Selling a home Your financial services practice: Illustrating the stream of income available from the sale of the home Clients need to understand the income that can be provided from any residual amount of money left after subtracting the purchase of the retirement residence from the sale of the preretirement residence. For this reason, it can be a lucrative opportunity to illustrate the projected installment payout, life annuity, or joint and survivor annuity available from freed-up assets. The number crunching will help some clients to make a more informed decision, even if they choose not to cash in on the “home asset”. For others, the income stream that can be provided by selling the home asset might mean the difference between just making ends meet and being able to enjoy retirement

35. Key definition • Downsizing – moving to a less expensive, more retirement friendly home and choosing to free up assets

36. Case of U.S. Code Sec. 121 provides that taxpayers of any age who sell their homes can exclude up to $250,000 of their gain ($500,000 for married taxpayers filing jointly). To qualify for the exclusion, the property must have been owned and used by the taxpayer as a principal residence for an aggregate of at least 2 years out of the 5 years ending on the date of sale. These are known as the ownership and use tests For married taxpayers, both spouses have to meet the 2-year use requirement – otherwise the available exclusion is $250,000 rather than $500,000. However, the couple can qualify for the higher $500,000 amount even if just one spouse owns the home. In certain situations, taxpayers may “tack on” periods of ownership and use for purposes of the exclusion. For example, a taxpayer whose spouse has died before the sale date can “tack on” the deceased spouse’s period of ownership and use prior to the taxpayer’s ownership and use. If a taxpayer receives a home pursuant to a divorce under Sec. 1041, the taxpayer can “tack on” the transferor’s period of ownership. Taxpayers who reside in nursing homes or similar institutions because they are incapable of self-care may treat their stay in such institutions as “use” of their principal residence for up to one year of the 2-year use requirement.

37. Other Related Issues Your financial services practice: Solving issues for clients with two or more homes If a client has more than one home, he or she is only entitled to exclude the gain from his or her main home. This is typically defined as the home he or she lives in most of the time. For example, if your client owns a house in the city and a beach house he or she uses during the summer months, the house in the city is the main home. For some clients the situation may be more complicated, however. For example, they own a house but they can live in another area while they rent a house. In this instance, the rented house is their main home. Also, the time factor may not be so clear cut. In this instance, factors used in determining a client’s main home include the place of employment, location of the other family member’s main home, the mailing address they use for bills and other correspondence, the address used for tax returns, drivers licenses, car registrations, voter registrations, and the location of the banks, recreational clubs, and religious organizations of which the client is a member.

38. Planning for the Client Who Moves • Client’s retirement decision either to remain in his or her current residence or to relocate to another • Reasons for changing residences: • Downsize • To avail themselves of living circumstances uniquely geared to the retired population • To relocate to an area where their dollars can be stretched further because the living costs are lower

39. Age-restricted Housing • Living in communities with other retirees • These housing communities can provide safety, companionship, special services, and have special recreation and leisure facilities, such as golf courses, craft rooms, swimming pools, game rooms, and libraries. There are activities to promote community life. Some contain amenities to make living almost self-contained, e.g. food stores, banks, hairdressers • Some retirees find this type of living sterile and depressing and prefer being in a broader community with a variety of ages • The legality of age-restricted housing, two exemptions from the nondiscrimination in housing rules may apply: • A community is allowed to restrict residents to age 62 or older: No residents can be younger than age 62 • To limited eligibility to age 55: Some individuals under age 55 are allowed as long as 80% of all residents are 55 or older and at least one resident in each living unit is aged 55 or older

40. Your financial services practice: Questions to ask when buying into age-restricted housing Advise your client to consider the following when looking to move to an age-restricted community: • Will views and open spaces be preserved? (In other words, what future construction is planned?) • What kind of additional construction can you do on your home? • How will you fit in? (How do residents feel about the community? What is the cultural atmosphere like?) • How does the governance structure work? (What kind of changes do the by-laws permit?) what voice do residents have in the community’s decision making powers?) • Is the community family friendly? (Will grandchildren enjoy visiting?) Also, check accessibility to shopping, recreation, and medical care. Double check the annual fees and look for hidden costs. Finally, investigate the security of the community and the reputation of the home builder.

41. Life-care Communities • Life-care communities are not simply retirement villages where people over a specified age reside; nor are they simply nursing homes where patients go for custodial and medical care. They are a combination of these two extremes • They attract those who are interested in living in a facility designed for older people and who want to enjoy recreational and social activities with their peers • The candidates for life care are looking for assistance in daily living that will be available if necessary and the ability to obtain nursing care at market or below market rate

42. How They Work – Life-care Contract • Common features of Life-care communities • Pay a one-time up-front fee that can range from modest to expensive depending on the quality of the community and the nature of the contract • The fee is refundable based on an agreed-upon schedule • Pay a monthly fee that can range from under $1,000 per month up to and over $5,000 per month • Client will get a life-lease contract (sometimes called a residential care agreement) that guarantees some level of living space, services, and lifetime health care • The residential accommodation may be a single-family dwelling or an apartment

43. How They Work – Life-care Contract • Services may include: • Some level of housekeeping, including linen service • Some level of meal preparation (taking one or more meals in a common dining hall) • Facilities for crafts, tennis, golf, and other types of recreation • Transportation to and from area shopping and events • Supervision of exercise and diet • Skilled-nursing care • Long-term care, including custodial care

44. How They Work – Life-care Contract • Lifetime health care: guarantee of space in a nursing home if it becomes necessary • One approach is to pay in advance for unlimited nursing home care at little or no increase in monthly payments (sometimes called an extensive contract) • Another approach is to cover nursing home care up to a specified amount with a per diem rate paid by your client for usage over and above the specified amount (sometimes called a modified contract) • A final approach is to cover only emergency and short-term nursing home care in the basic agreement and to provide long-term care on a per diem basis (sometimes called a fee-for-service contract)

45. How They Work – Life-care Contract • Additional concerns • Social interaction vs. less enthusiastic about group living • Having a meal in a common dining room vs. have its own kitchen • No scientific evidence exists to support the contention that retirees who live in life-care communities live longer, many gerontologists share this belief because of the support-group mentality associated with the communities, the high-quality medical care provided, and the quality of life associated with social interaction • Tax deductibility of medical costs associated with the life-care contract

46. Your financial services practice: Coordination of life-care community selection with long-term care insurance and medigap coverage Clients who are involved in a life-care community have definable needs for long-term care insurance and Medigap coverage. Astute planners will best serve these clients by coordinating the medical and long-term care coverage provided by the life-care community with that provided by insurance policies. For example, a life-care community that provides long-term care fro a specified period of time and then set a rate for usage beyond that time can be coordinated with a long-term care insurance contract’s waiting period and per diem allowance

47. How They Work – Life-care Contract • Hidden traps • Communities that have gone bankrupt have caused some retirees to lose the one-time up-front fee • Whether the long-term care costs are being self-insured or whether an outside carrier is involved • How the community sets its fees for services • Whether medical insurance on residents encourages overutilization of services • Communities may undercharge their early residents and must make up the difference from their most recent residents • If a married couple has an age disparity and the decision to enter the facility is to meet the needs of the older spouse. If the older spouse dies within a few years, the younger spouse may be left in an unsatisfactory living arrangement

48. Questions to Ask • Who manages the life-care community – owners or an outside profit agency? (third-party management is less desirable) • Is the community owned by a for-profit or nonprofit organization? • How long has the facility been in operation, and what is the organization’s financial condition? Specifically, what is the long-term debt? • How many units have been rented? • Does the facility have certifications from the state and leading organizations? • What is the profit of the resident population? • Is there a powerful and active residence committee that can influence management decisions? • What are the health care guarantees provided by the contract? • What about amortization of the one-time up-front fee? Are the one-time up-front fees of current residents being used to pay current costs? • How are fee increases determined, and what are they typically? • What is the refund policy for the one-time up-front fee? • What are the minimum and maximum age requirements? • Can the resident either insist upon or refuse nursing care?

49. Other Alternative Housing Options • Those who no longer want the responsibility of maintaining a home will choose to rent an apartment • Those who interested in owning may choose to buy a condominium or cooperative • There could be increases in monthly maintenance fees or special assessments in the near future • Cooperatives have restrictions on selling the property • Second home – retire into the vacation home and sell the primary home • House swapping – swap living units with a child

50. Relocation out of State • Reasons for relocation • Climate • Location of friends and relatives • Affection for the area itself • Considerations • Weigh the decision cautiously because it is not easily reversible • Consider the prospect of dying in the new state. If one spouse should die, will the other want to cope with another uprooting • Consider establishing domicile in a state with lower death taxes • Consider state income taxes • Consider property and transfer taxes • See if the state or local government provides specific tax breaks for the elderly • Consider looking for a replacement home that is equipped to meet the retiree’s needs • Domicile –the intended permanent home of the client. Important for state estate tax purposes, it is determined by such factors as where the person spends the majority of his or her time, where he or she is registered to vote, the state his or her driver’s license is from, and where his or her will is executed