The Best Retirement and Estate Plan for
by James Lange, CPA, Attorney
This report provides university faculty with critical information for pivotal decisions which have to be made while you are working, during your retirement, and for estate planning. The basic information was originally published in peer reviewed journals and the best-selling book, Retire Secure! For this report, we updated the analysis and developed specific recommendations for university faculty and their families. The recommendations are derived from a combination of theory, quantitative analysis, and my 30+ years of experience working with university personnel and their families. Over 500 of our clients are either current or retired faculty members and their spouses or surviving spouses.
While You Are Actively Employed
Always Make Contributions into a Matching Contributory Plan
|University faculty members face a staggering array of options regarding their retirement plans. The new tax law significantly increases the ability of many retirement plan participants to accumulate wealth and reduce taxes. This article provides guidelines for university faculty to optimize the benefits of their retirement plans.|
If your institution offers a retirement plan that either fully or partially matches your contributions, then you should contribute, at the very least, the amount that is eligible for a match. Both your contribution and the institution’s matching contribution are tax-deferred, which means no federal income taxes are collected on the contributions when the contributions are made or during the time they are invested. When you begin to withdraw money from your retirement plan, the withdrawals will be taxed.
State and local taxes on retirement contributions vary. In Pennsylvania, you do not get a tax break when you and the university contribute to your retirement plan. That is why your Pennsylvania taxable wages are almost always higher than your federal taxable wages. The good news is that when you retire and make withdrawals from your retirement plan, those distributions are not taxed if you stay in Pennsylvania.
Normally participants will be offered a choice of investment vehicles. TIAA-CREF is the most popular for university faculty members, but other funds, including a family of Vanguard funds, are frequently offered. While choosing the investment vehicle is certainly important, the critical action is to make the tax-deferred contributions.
TIAA-CREF participants are given a choice of investment funds, including two strong options with track records of more than 50 years. TIAA Traditional is the fixed income component that was conceived in 1918. Funded by TIAA-CREF’s bond-and-blue-chip-stock-heavy general account, it offers a guaranteed rate of return, plus dividends when available. The average annual return for 10 years through August 2013 has been 4.25%, which is exceptionally strong compared to most other guaranteed interest accounts available. The other long-standing option, CREF Stock Fund, boasts a 9.79% rate of return since its inception in 1952.
Later in this report we compare using your contribution (not the university’s contribution over which you have no control) to fund a Roth retirement plan vs. a traditional retirement plan. The traditional plan which the IRS refers to as a traditional 403(b) or a traditional 401(a) is similar to a traditional IRA. That is to say, you take a tax deduction for your contribution, it grows tax-deferred, and you pay taxes on both principal and the growth upon withdrawals. The Roth 403(b) or Roth 401(a) is analogous to a Roth IRA. With a Roth IRA, you don’t deduct the contribution—you pay tax on the contribution when you make it, but it grows tax-free and neither the growth (interest, dividends and capital appreciation) nor the principal are taxed upon withdrawal.
Should You Make Non-Matching Contributions?
Most institutions allow you to make non-matching, tax-deductible contributions called Supplemental Retirement Annuities (SRA) to TIAA-CREF or other investment vehicles. The SRA is conceptually similar to non-matched, fully deductible contributions to IRAs, 401(k)s, SEPs, Keoghs, SIMPLE plans, 403(b)s, 401(a)s, and defined contribution plans. For simplicity, I will refer to all of these plans as SRAs. After you have contributed the maximum level that is subject to full or partial matching by your employer, I highly recommend making additional tax-deductible, non-matched contributions – preferably the maximum allowed by law, but at least the amount that you can reasonably afford. Please keep in mind, however, that age 59½ is usually the earliest time that you will have access to your SRA funds unless you retire or terminate services. One benefit of Supplemental Retirement Annuities in TIAA-CREF is that many contracts follow a "59 ½ in Service" rule. This rule allows faculty who are still working after age 59 ½ to gain access to some of their retirement assets. This option can be extraordinarily useful for estate planning.
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, you must earn $1.39 before taxes in order to accumulate $1.00 after taxes. Then, after the dollar is invested, you 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 withdrawn. A graphic comparison of accumulations in an after-tax versus a tax-deferred environment follows. (See Exhibit One.)
Many clients ask if it is better for them to make contributions to an SRA or to pay off their mortgage at a faster rate. Under most circumstances, I think that making contributions to the SRA is the preferred answer if the goal is to accumulate the greatest number of dollars in the future. There are two reasons that I recommend making contributions to SRAs rather than paying off a mortgage: (1) you can defer income taxes on the retirement plan contributions and on your earnings and accumulations, and (2) the mortgage interest expense can be deducted on your tax return.
An exception to the goal of accumulating money in the tax-deferred environment is to use funds for either a Roth IRA contribution and/or a Roth IRA conversion which is discussed later in this article.
Upon Retirement—The Distribution Stage
If you are still working full time and not drawing on your portfolio, even if you are in your sixties or seventies or older, for our purposes you are still in the accumulation stage. If you are drawing on your portfolio and/or your retirement plan, then I would consider you in the distribution stage.
First, please consider the tax implications of what money you spend first. If you retire before reaching age 70½, you may find that your Social Security and other non-CREF income and even principal produce enough funds for your living expenses. If this is the situation, consider leaving your money in CREF (or rolling it into an IRA for investment reasons) and allow it to accumulate tax-deferred. In general, it is preferable to spend principal from your after-tax investments rather than taking taxable distributions from your CREF account. A graphic comparison of the benefits of consuming after-tax savings before pre-tax accumulations follows.
Upon retirement, you face an array of options. These options will vary from institution to institution and even contract to contract. For example, if you look at your TIAA-CREF statement, you will likely see that you have at least several contracts, sometimes ten or more, even if you worked at the same institution the entire time. Each contract has its own set of rules, which can create enormous complications. Fortunately, if you or your advisor takes the time to find out what the rules are for each contract, you can start to come up with the best plan for your retirement and estate.
One of the Great Mysteries of Life—How Do You Get Your Money Out of TIAA-CREF When You Retire?
1. Should You Annuitize?
The oldest option for TIAA-CREF participants is annuitizing. Annuitizing your retirement plan accumulations means surrendering all or a portion of your accumulated retirement account in exchange for receiving regular payments for life. When my Mom retired as a journalism professor, she had to annuitize her entire TIAA-CREF accumulations. Her only choice was annuitizing. Married participants who annuitize often choose to receive payments for the remainder of their and their spouses’ lives. Whether you should annuitize your retirement plan depends upon your circumstances. The biggest advantage to annuitizing is that you and your spouse will have a monthly stream of income that is guaranteed for life. There are cons, however. One problem with annuitizing is that your money is paid out to you at a set amount, on a regular schedule—and this may not be in tune with your needs, especially if you incur unexpected expenses. If you do need more than the annuity amount, you are just plain out of luck, and if you do not need the money in the short term, then annuitizing needlessly accelerates income taxes on your retirement accumulations. Finally, annuitizing TIAA-CREF funds will reduce funds available for a Roth IRA conversion.
|While choosing the type of investment is certainly important, the decision to make tax-deferred or Roth contributions is more important.|
Annuitizing is not an effective means of providing for your heirs. If you choose to annuitize, upon your death, any funds remaining in your retirement plan will vanish unless you have chosen the surviving spouse or guaranteed period option. Choosing either of these options, however, will reduce the total amount of your monthly annuity payments.
In essence, annuitizing is a gamble. Since the annuity is based on one’s life expectancy, you are gambling that you will outlive your actuarial life expectancy. If you have reason to believe that you will not survive your actuarial life expectancy, then annuitizing could be a mistake. If you and/or your spouse think, however, that you are going to substantially outlive your actuarial life expectancy, then annuitizing will provide an assured income stream for a long life. For most clients in reasonable health, I often recommend that they consider annuitizing a portion of their retirement accumulation. Annuitizing a portion, but not all of your retirement accumulation, is a method of diversifying your retirement assets.
Consider annuitizing sufficient funds that, in combination with Social Security and other income, will assure you and your spouse of at least enough money to pay for essential living costs.
In most cases, however, annuitizing all or most of your retirement plan is not recommended. Once you choose this option you are locked in and cannot change your method of distribution. Also, our analysis indicates that retirement plan participants and their beneficiaries will receive significantly more money if the participant chooses not to annuitize. In addition, not annuitizing will allow significant income-tax deferral for the beneficiaries after the death of the participant. To learn more about the potential benefits of leaving retirement accounts to beneficiaries, please refer to Chapter 13 in Retire Secure! (Wiley 2006 and 2009) on stretch IRAs. (To request a copy of my book, please contact our office).
One last issue to consider when thinking about annuitizing is interest rates. Some experts believe now (fall, 2013) is not a great time to annuitize because interest rates are down.
2. How to Withdraw CREF Accumulations
In addition to annuitizing, CREF participants have several options regarding their retirement accumulations:
- You can withdraw all of your accumulations which will trigger income taxes on the entire balance. This would not be wise, but it is an option.
- You can make a tax-free rollover to an IRA. If you meet other requirements, you could convert your CREF into a Roth IRA.
- You can have CREF systematically withdraw a specified amount from your account, on a monthly, quarterly, semi-annual, or annual basis. The amount of your withdrawal can be changed at any time and there is no limit as to the number of withdrawals you can request—in contrast to the fixed distributions from an annuity.
- If you are satisfied with CREF as an investment vehicle and don’t want to make any withdrawals until required, then you should consider the Minimum Distribution Option (MDO), provided it is offered through your employer’s retirement plan. The MDO assures that CREF will make only the minimum distributions required by federal tax law, starting at age 70½. Subject to potential contract restrictions contingent on your institution’s agreement with CREF, you can retain the right to exceed the minimum required distribution and make additional withdrawals whenever, and for whatever amounts, you desire. If you have not depleted your CREF account by the time of your death, then the money will go to your named beneficiary.
The MDO will work best for participants who want to retain all of their options. By retaining control of your retirement funds, you have the option to vary the amount of money that you withdraw each year. In addition, the MDO will often be the most effective way to provide for your heirs.
|Choosing the Minimum Distribution Option (MDO) will work best for participants who want to retain all of their options. In addition, choosing MDO will often be the most effective way of providing for your heirs.|
Finally, you could elect any combination of the above options. You could take out some money and pay the tax. You could annuitize part of your accumulation and elect the MDO on the remaining amounts. You could rollover part of your accumulations into an IRA and/or a Roth IRA. (Evaluating the advantages/timing of a Roth IRA conversion requires a fairly detailed analysis of an individual’s circumstances. For more information on Roth IRA conversions refer to my book, The Roth Revolution, or contact our office at 412-521-2732 for more information).
3. How to Withdraw TIAA Accumulations
Only some of the CREF options described above are also available with respect to TIAA accounts. The limitations upon retirement distributions from TIAA accounts are significant:
- The systematic withdrawal option is not available under TIAA accounts (option 3 above for CREF).
- Depending on the contract with your institution and TIAA, you may not be able to make large lump-sum TIAA withdrawals from your Group Retirement Annuities. Even if it is permitted, you may be assessed a 2.5 percent surrender charge, and the withdrawals can be made only within 120 days following termination of employment.
- You are not permitted to roll over your entire TIAA accumulation into an IRA and/or a Roth IRA.
- TIAA’S Minimum Distribution Option often limits your withdrawal to the IRS mandated minimum amount. You cannot, as you can with CREF, make withdrawals in excess of the minimum whenever and for as much as you like. So, it is quite possible that you could find yourself in a position where you want more money from your TIAA accumulations, but you will not be able to access the funds because of the severe limitations on your withdrawal options.
Although a detailed analysis is beyond the scope of this article, I think that the majority of long-term retirement assets belong in the stock market, whether it is through CREF, individually chosen stocks, mutual funds, index funds or managed funds. Visit www.tiaa-cref.org for information on specific TIAA and CREF investment funds. We also offer consultations through our office for both financial planning and estate planning. For more information contact our office at 412-521-2732.
For both investment reasons and TIAA’s distribution option limitations, I often recommend that clients consider changing their future allocations to more CREF and less TIAA. In cases where an even more aggressive approach is desired, consider the Transfer Payout Annuity (TPA) for a portion of your TIAA investment, particularly if your TIAA accumulation exceeds your CREF accumulation.
4. Transfer Payout Annuity for TIAA
Through the Transfer Payout Annuity (TPA), you may transfer a portion or all of your TIAA investment into CREF, or the TIAA Real Estate fund. It takes ten years, however, to completely transfer all of your funds. A critical planning point is that you can begin transferring TIAA funds to CREF funds before you retire. Many participants should consider initiating a TPA on a portion of their TIAA funds ten years or more before retirement. The TPA will allow more options at retirement, including the favorable terms of the Minimum Distribution Option discussed above.
|A critical planning point is that you can begin transferring TIAA funds to CREF funds before you retire.|
There is, however, a potential downside to starting the TPA. Remember that TIAA’s Traditional fund is an investment that historically has significantly outperformed its competitors, and it offers a guaranteed rate of return. By initiating the TPA, you may be shifting money from this excellent fund into a more volatile fund that will fluctuate with the stock market. In addition, TIAA shares, like fine wines, come in vintages. A unit of TIAA purchased in prior, high-interest rate years is more valuable than a current unit purchased in low-interest years. By electing the TPA, it is likely that you will liquidate some of your more valuable vintage TIAA shares; when you initiate the TPA, TIAA transfers a pro-rata portion of contributions from all years. You cannot elect to transfer only contributions made during the low-interest years.
For conservative investors who want added flexibility at retirement, consider transferring some TIAA funds to TIAA’s Real Estate fund. The Real Estate fund is a further method of diversification and is not tied directly to the stock market. The Real Estate fund essentially follows CREF’s flexible rules regarding distribution options.
Required Beginning Date for Distributions from a Retirement Account
The Required Beginning Date (RBD) refers to that date when the participant must begin to receive annual distributions from his/her retirement accumulations. The RBD for a 403(b), according to IRS rules, is on April 1, following the calendar in which the later of the following occurs: the participant reaches age 70 ½ or he or she retires. But, your own plan may require that you begin withdrawals at age 70½ even if you have not retired. Please note that pre-1987 funds in 403(b) plans are not subject to minimum distribution until age 75.
You cannot use the date you retire to determine the RBD for an IRA or for funds earned with previous employers. The minimum amount that must be withdrawn is calculated based on the actuarial life expectancy of the participant under IRS Life Expectancy Tables; the older the participant, the greater the minimum distribution.
Taking Distributions from Your Retirement Plan
If you would like to retain funds in the tax-deferred environment but do not want to incur a penalty, you should take the minimum required distribution. The minimum distribution rules are based on the joint life expectancy of an IRA owner or TIAA-CREF participant. A table of life expectancy rates for calculating minimum distributions is available online at http://www.irs.gov/publications/p590/ar02.html.
Minimum Required Distributions After Your Death
|With a Roth, the IRS is, in effect taxing the seed, not the harvest. Another favorable feature is that Roth IRAs are not subject to the minimum distribution rules that apply to regular IRAs.|
Assuming your heirs can afford to leave the funds in the tax-deferred environment after your death, it is generally to their advantage to limit distributions to the smallest allowable amount. Upon your death, if your spouse is the beneficiary, he or she can rollover your retirement account into his or her own IRA. Your spouse can then use the Uniform Life Table to calculate the required minimum distribution (RMD). Alternatively, if the surviving spouse is older than the spouse who died, the surviving spouse can continue to use the younger spouse’s distribution schedule. For a non-spouse beneficiary, the RMD is calculated according to the Single Life Table. An advantage of having a child (or even grandchild), as beneficiary is that the child’s longer life expectancy means required distributions are smaller, tax rates are potentially lower, and the money can remain and grow in the tax-deferred environment for many years.
Please note, however, there is pressure by Senate Democrats and President Obama to limit the tax deferral of inherited IRAs to five years. This idea was defeated 51-49 in the Senate in the summer of 2013, but we expect another fight in 2015, and we are extremely aware of the possibility of a major change in the law for inherited IRAs or retirement plans.
Roth IRAs and Roth IRA Conversions
For those who are eligible, contributing to a Roth IRA is a good idea. (For more information on Roth IRAs and Roth IRA conversions see my book, The Roth Revolution).
For 2013, you can make a non-deductible contribution of $5,500 (with an additional $1,000 catch-up contribution for those over age 50). The adjusted gross income (AGI) phase-out range for Roth IRA contributions are $178,000 - $188,000 for married filing jointly, and $112,000 - $127,000 for singles and heads of households. 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 that apply to regular IRAs.
What is even of greater interest to university faculty is the possibility of converting a portion of your existing retirement plan to a Roth designated retirement account. Even though you have to pay income tax on the amount converted, the account grows tax-free after the conversion. A Roth conversion is something every participant in a retirement plan should seriously consider. A Roth conversion runs contrary to the general principle that it is better to postpone paying taxes. In most of the scenarios that we analyze, however, the retirement plan participant, and particularly the participant’s heirs, will have more wealth in the long run if the participant makes a Roth conversion on at least a portion of the total retirement plan accumulation. That said, it is our recommendation that the decision to make a Roth conversion should only be made after running the numbers based on the individual’s particular circumstances. When appropriate, a Roth conversion can confer significant benefits on ones’ heirs.
The general rule is that all retirement plans that can be rolled into an IRA can be converted to a Roth IRA. The following chart shows whether you have assets which will likely be eligible for the Roth IRA conversion. (See Exhibit Three).
RETIREMENT PLAN CONVERSION ELIGIBILITY TO ROTH IRAs, PROBABLE RESULT *
|CREF OR VANGUARD RETIREMENT ANNUITIES OR GRAS:|
|SUPPLEMENTAL RETIREMENT ANNUITIES
(NO EMPLOYER MATCH):
|OTHER 403(B), OR 401(A), OR (K) FUNDS - EMPLOYER'S
AND MATCHED CONTRIBUTIONS:
|NON-EMPLOYER MATCHED PORTION:|
|*Employers can choose different options regarding "in-service" withdrawals from their Plans.|
Let’s consider an example. Assume Professor Wise is 55 years old and chooses to make a $100,000 Roth IRA conversion. Professor Status Quo is in an identical financial position except that he chooses not to make a conversion. Assume both professors have $100,000 of after-tax dollars, they are in the 28% tax bracket, and their rate of return is 10%. The following chart shows the after-tax dollars that both would accumulate. (See Exhibit Four).
Now, beginning with the previous example, let’s look twenty years into the future. Assume that both professors pass away at age 75 and they leave their IRAs and their savings account to their 45-year-old children. Assume each child takes 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% rate of inflation. The following chart shows the after-tax balances in the funds. As you can see, the differences are staggering. (See Exhibit Five). 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.
There are, however, several potential disadvantages to Roth IRAs and Roth IRA conversions. The major disadvantage for many faculty members is the problem of funding the income-tax burden on the conversion. For most people, I do not recommend making a Roth conversion unless they have sufficient money outside of their retirement account to pay the income tax due. Another potential disadvantage is the possibility that the participant’s tax rate will decrease after retirement, so going ahead with the conversion prior to retirement would cause them to pay higher taxes than if they had waited until after retirement. The philanthropists among you should also know that a Roth IRA conversion will not be favorable if your intended beneficiary is a charity. Finally, stock market volatility and future tax law changes could jeopardize the benefits and even make the conversion disadvantageous. While Roth IRAs and Roth IRA conversions are a dynamic possibility that can significantly enhance wealth and reduce taxes, they can also result in unfavorable outcomes. Since there are so many factors to evaluate, I recommend seeking professional guidance to see if you would benefit from such a conversion.
Your Retirement Account's Beneficiary
If assets in retirement plans constitute the bulk of your estate, the beneficiary designation of your retirement accounts (and not your will) is the primary means to control the disposition of your wealth at your death. Most university faculty will name their spouses as the primary beneficiary and their children as secondary or contingent beneficiaries to their retirement plans. Better options, however, exist.
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 because of the unlimited marital deduction, and (3) the amount in the retirement account can be distributed over a longer period of time once the participant dies.
|Most university faculty will name their spouses as the primary beneficiary and their children as secondary or contingent beneficiaries to their retirement plans. Better options, however, exist.|
It is critical to understand that the beneficiary designations of your IRA and/or retirement plan and not your will or living trust govern the disposition of your retirement assets at your death. It is also critical to understand that you can’t force someone to accept a bequest. That power, in essence, is what allows someone to “disclaim” a bequest at which point the bequest goes to the next person in line. When properly defined, a disclaimer strategy can provide your surviving spouse and your family with the ultimate flexibility to make decisions armed with the full knowledge of the family’s financial circumstances at the death of the IRA owner. Additionally, your spouse will have nine months after your death to make a qualified disclaimer. So, for example, with help from family and professionals, the surviving spouse could make an informed decision within nine months of the IRA owner's death. Those decisions could potentially:
- reduce estate-tax at the second death.
- allow a child or grandchild to keep money either outright, or in trust, that will have the benefit of tax-deferred (or in the case of the Roth IRA tax-free) growth for their whole lives subject to their small minimum required distributions.
- allow children (on an individual basis) to disclaim all or a part of their interest to their children, i.e., the IRA owner's grandchildren.
- encourage, or in some cases, force heirs to take advantage of the “stretch” IRA.
Ideally, there should be a well-coordinated estate plan that incorporates all your assets, but the described beneficiary designation will blend seamlessly with the vast majority of wills and living trusts. We have been using a disclaimer strategy for about 20 years. Our current work adapts these time-proven concepts to the new tax law. Using a combination of legal, income tax saving, and accounting principles, we have developed what we think is the ideal solution for naming beneficiaries to IRAs and/or retirement plans: Lange’s Cascading Beneficiary Plan™.If you would like more information about our comprehensive planning, please contact our office at 412-521-2732.
* Disclaimer planning probably is not appropriate for second marriages where each spouse has his or her own children.
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. Many university faculty members will benefit by beginning the transfer of a portion of their TIAA accounts to CREF accounts at least ten years before their planned retirement. Current retirement plan participants who have TIAA-CREF and Vanguard funds should also consider converting a portion of them into Roth designated retirement accounts. Annuitizing is a conservative strategy, but often an appropriate one for a portion of the retirement plan. The minimum distribution option will often be the wisest choice for the majority of the funds. Finally, university faculty should consider establishing a coordinated estate plan that would incorporate disclaimer-type wills and disclaimer-type retirement plan beneficiary designations.
We have a wealth of free information available electronically if you do not own copies of our two most recent books, Retire Secure! (Wiley, 2009) and The Roth Revolution (Morgan James, 2011). If you would like to receive our executive summary of Retire Secure! and/or The Roth Revolution e-book, please call our office at 412-521-2732.