Lynn Brenner's Family Finance

Does a Roth IRA Conversion Really Make Sense?

That's the subject of my article in the March/April issue of AARP Magazine, titled 'Roth Mania!'

You can read that article here. 

The answer obviously depends on many variables, and I think that one of them doesn't get enough attention:

How soon will you have to spend the money you convert from a traditional IRA to a Roth IRA?

(Given my druthers and more space, I'd have devoted a couple of additional paragraphs of 'Roth Mania!' to that question alone.)

A Roth conversion has a price tag -- the income taxes you pay on the money you transfer from your traditional IRA into the new Roth IRA.

You won't come out ahead unless your new Roth IRA earns more than enough to cover that initial cost. That's going to take time -- and a decent investment return. Sure, a Roth IRA's earnings are tax-free. But even tax-free, an abysmal return is abysmal.

Some of the articles I've read quote financial advisers who suggest -- or at least imply -- that five years may be long enough.

I think that's much too optimistic. 

In 'Roth Mania!' I wrote that it's going to take at least ten years for your Roth IRA earnings to exceed the cost of the conversion, and I wish that the words at least had been italicized. 

If you believe that's overly cautious, consider the stock market's performance over the ten years that just ended. From the end of 1999 to the end of 2009, stocks traded on the New York Stock Exchange lost an average of 0.5% a year. It was the worst calendar decade for stocks in the past 200 years.

Many investors still haven't recovered from the shock. After all, in the previous decade --from 1989 through 1999 -- stocks earned an average 17.6% a year. And no matter how often we heard (and in my case, wrote) that those splendid annual returns were much higher than the long-term average, they grew to seem normal.

I'm not suggesting that this decade will be as bad as the last one. (God forbid!) I'm just pointing out that the market can deliver considerably less than its historic average annual return of about 10% to 11%.

When you calculate whether or not a Roth conversion is worthwhile, I wouldn't assume more than a 10% average annual investment return going forward -- and if you want to play it safe, figure on a more modest 6% to 8% return.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

Will Canceling a Credit Card Hurt My Credit Score?

Q: I dread the thought of credit card companies assessing an annual inactivity fee if you don't use their card. Over the years, I've accumulated several cards -- many from the 1970s when I was newly married. We wanted to establish credit, and card solicitations seemed to arrive in the mail daily.  I knew the billing dates for each card, so I could stagger the payments over the month, and sometimes get more than 30 days to pay a bill.  I always paid off all cards in full, and I still do.

If I choose to cancel a card because of a new annual fee, will that lower my credit rating?  I am divorced and retired now, and I'm concerned about my credit rating especially when I need to buy a new car. --BA via email

A: You handle your credit cards extremely well, but you're right to be concerned.

The cancellation of an unused card can hurt your credit score, whether the card is canceled by you or by the credit issuer. (In case you didn't know, the credit issuer has the right to cancel a card you don't use.)

Some credit issuers are indeed reintroducing inactivity fees on their cards. If yours are among them, you have three choices: 1) pay an inactivity fee for cards you don't use; 2) cancel those cards and risk hurting your credit score; or 3) avoid inactivity fees by using all your cards, thus increasing the risk of adding to your outstanding debt.

Talk about a stacked deck!

It isn't impossible to rid yourself of an unwanted card and emerge relatively unscathed, but it takes careful advance planning.

Let's start by explaining why canceling a card can hurt your credit score. (For those who don't know, this is a three-digit number ranging from 300 to 850 that lenders use to assess how good a credit risk you are. The lower your score, the harder it is for you to get a loan and the more you'll pay for it.)

Your credit score is based on your past use of credit. The most important factor in this history is whether or not you pay bills on time. That accounts for 35% of your score.

The second most important factor, accounting for 30% of your score, is how much of your available credit you actually use. Lenders call this your utilization ratio. If your total available credit is $5,000, for example, and your average outstanding balance is $1,250, you have a 25% ratio. If you have a $3,750 balance, you have a 75% ratio.

The more of your available credit you use -- the higher your ratio -- the worse it is for your credit score. A good ratio is 30% or less. If you're maxed out on your cards, you're considered a bad risk.

When you cancel an inactive card, you automatically increase your credit utilization ratio. Let's say you have five cards, but only use two. Your total available credit on the five cards is $10,000; your outstanding balance on the two you use is $2,500. Your ratio is therefore 25% ($2,500 divided by $10,000). But perhaps when you cancel the three cards you don't use, your total available credit limit drops to $5,000. Your ratio automatically jumps to 50% ($2,500 divided by $5,000).

And that's not the only damage. The length of your credit history -- how long you've had your oldest card, and the average age of all your lines of credit --  accounts for about 15% of your credit score. The longer your history, the better your score. You say you've had some of your credit cards since the 1970s. If you cancel cards you've had for 40 years and keep cards acquired more recently, you'll erase that long track record. A much shorter credit history means a lower credit score.

So what's the solution?

First, don't cancel any of your cards if you know you'll soon be looking for a car loan or a mortgage! That might lower your credit score, driving up the cost of borrowing.

For the time being, avoid inactivity fees -- and card cancellations by issuers -- by using all your cards. Make small purchases that you pay for in full every month. You're good at juggling cards, but for most people who have a lot of cards this advice isn't easy to follow. If you have 12 cards, making sure you use each one every month and pay all the balances on time can soon become a bookkeeping nightmare.

Second, after you get your car loan, plan your card cancellations very carefully to minimize the damage to your credit score. Think of yourself as David mapping out a campaign against Goliath.

Make a master list of the inception dates and credit limits on each of your cards, bearing in mind that the most important cards to keep are the oldest and those with the highest limits. 

Before you cancel a card, take steps to lower your utilization ratio. You can do that by temporarily reducing your average outstanding balance and/or by getting a higher credit limit on one of the cards you intend to keep. If you lower your ratio before canceling a card, the cancellation may only push it back up to where it was before.

Remember, too, that credit scores are constantly updated. So even if your score takes a dip after you cancel a card, it can recover before you need to apply for another loan.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

How Will I Be Taxed When I Sell Inherited Property? What's My Cost Basis?

Q: My parents deeded land to me and my siblings 10 years ago, keeping a life estate in the property reserved for themselves. Our last surviving parent died in November of 2009. We're trying to figure out how we will be taxed when we sell this land. I've had conflicting answers about what we should use as our cost basis. Some tax accountants have said we must use the original purchase price, and others say we can use the value of the property last November when our mother died. Which is correct? -- KF via email

A: Your cost basis is the market value of the property at the time of your mother's death last November.

In tax jargon, your cost basis for this property is 'stepped-up' to its market value.This means that if the land was worth $5 million last November -- why not use a nice fat hypothetical number? -- you can sell it for $5 million without incurring any capital gains tax.

By contrast, if you had to use the original purchase price as your cost basis, you'd owe a tax on the difference between your sale price and what your parents originally paid for the land. So if they'd bought it for $100,000 and you sold it for $5 million, your taxable profit would be $4.9 million.

Quite a difference, isn't it?

But as I'll explain in a moment, people who inherit assets from someone who dies in 2010 can't use the above example as a guide.   

That's because the rule in question is based on the relationship between two different taxes. One is the capital gains tax, which is the tax on your profit when you sell an asset that has appreciated in value since you acquired it. The other is the federal estate tax, which is the tax levied on assets that you bequeath to your survivors -- and as of January 1, we don't have a federal estate tax.

The longstanding rule is that heirs get a 'stepped-up' cost basis on assets that are subject to estate tax. This is true even if the estate in question is actually too small to owe any estate tax.

The practical result is that people have long enjoyed a stepped-up cost basis on most inherited capital assets. (I say 'most' because of course there are important exceptions. You never get a step-up on any asset that is inside a tax-deferred retirement account, for example.)

Because your mother kept a retained life estate in this property, 100% of its value is included in her taxable estate. Therefore you inherited it at its stepped-up cost basis. As I explained in an earlier post, even tax professionals sometimes get this wrong; that's why you've heard conflicting advice about it.

But Congress let the estate tax law expire on December 31, 2009.  Remember, you only get a step-up on inherited capital assets that are subject to estate tax. Because there is no federal estate tax at the moment, there's no step-up on inherited capital assets.

The good news for most people is that there is an exemption. "Each estate is entitled to a $1.3 million aggregate basis step-up, and a $3 million spousal step-up," says Bernard A. Krooks, a New York estate and elder law attorney.  

This means that a person who isn't married can still leave $1.3 million in assets that will qualify for the step-up. Someone who is married can leave $1.3 million of assets that get the step-up, plus an additional $3 million of assets to his or her spouse that will qualify for the step-up.

But the above exemptions don't apply to property in which the decedent had retained a life estate.  If your mother had died last week, you wouldn't get the step-up on your inheritance. The current situation is temporary, however. There's little doubt that the federal estate tax will be reinstated, probably later this year. When that happens the unlimited step-up will return.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

How To Divide an Inherited IRA Without Triggering Income Taxes: Don't Take a Check!

Q: My mother left an IRA on which she named her four children as beneficiaries, each of us to get 25% of the account. I have given the bank a copy of the death certificate.  I’ve talked to a lawyer, and he said that if my mother designated us as beneficiaries, and the bank has a death certificate, it can issue checks to the four of us.  My siblings are waiting on me for the go ahead to do this. But I guess I want to know what will happen before I do it. --CF, via email

A: That's a very wise policy! Here’s what will happen: If you take your inherited IRA in the form of checks from the bank, you and your siblings will owe income taxes on this money. Since each of your shares will be added to your 2010 taxable income, you might even be bumped into a higher tax bracket.

The lawyer you consulted may not know how IRAs are taxed. Unfortunately, the bank may not know either. Most banks know a lot more about how money goes into IRAs than about how it comes out.

To divide this account without triggering taxes, you and your three siblings should ask the bank to divide the IRA into four new IRAs … but not into new IRAs that list you as the owners! Your mother's name must remain on each of the new accounts as the deceased owner, with the name of each child on the account as its beneficiary. 

For example, if your Mom’s name was Joan Smith, each of the four new IRAs should be titled “Joan Smith IRA (deceased November 20, 2009) for the benefit of [insert name of one child].”

If necessary, insist on seeing a bank manager to make sure your mother’s name stays on the IRAs, says Barry C. Picker, a tax accountant and IRA expert.  Only a surviving spouse can transfer an inherited IRA into his or her own name. If any other beneficiary does that, the account stops being an IRA and is immediately taxable.  

If this is done right, each of you will have an inherited IRA that lists him or her as its sole beneficiary. At that point, if you wish, you can have your inherited IRA moved from your mother’s bank into your own bank – or to any other financial firm -- in a trustee to trustee transfer. (You open a new IRA at your own bank -- again making sure it's titled the right way, with your mother's name on it -- and the transfer is done by wire between the banks.)

As beneficiaries you must start taking minimum annual distributions from the account by December 31 of the year following your mother’s death; but the balance will continue to grow untaxed.

As the sole beneficiary on the account, you can take minimum distributions based on your own life expectancy, says Picker. This is one of the advantages of dividing the account correctly. If you keep an inherited IRA with four beneficiaries listed on it, the required minimum distributions must be based on the life expectancy of the oldest beneficiary.

Of course you can take more than the minimum distribution if you need it. But if you don't, why pay taxes on this money sooner than you have to?

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved