Girding for a tax hike

The following is an edited transcript of a webcast, “What the New Tax Law Means for Clients and Advisers,” that was held Feb. 8. InvestmentNews deputy editor Evan Cooper and reporter Andrew Osterland moderated.
InvestmentNews: Let’s get an idea of what kinds of firms you have and what you do for your clients. So Larry, let’s start with you.

Mr. Soukup: Cambridge Financial Advisors is a comprehensive financial planning firm. We’re located in two mountain communities in Colorado, and our client base is primarily small-business owners and retirees. We prepare comprehensive plans for our clients and do investment implementation. We’re fee-only. We’re members of [the National Association of Professional Financial Advisors] and the Alliance of Cambridge Advisors [Inc.].

InvestmentNews: And you’re a certified public accountant and a certified financial planner, right?

Mr. Soukup: Correct.

InvestmentNews: OK. Loyd, tell us a little bit about you?

Mr. Stegent: We have two businesses: Cornelius Stegent & Price is a full-service accounting firm, and Stegent Equity Advisors is a registered investment advisory that provides investment advisory services for the clients of Cornelius Stegent & Price. My practice is predominantly individuals. I try to serve as a personal [chief financial officer] to my clients, helping manage their assets as well as their tax compliance and retirement-planning needs.

InvestmentNews: Mary Pat, tell us a little bit about you and your firm.

Ms. Wesche: I’m with Forum Financial Management. We’re an RIA transitioning to fee-only. And I serve primarily small to medium businesses and their owners — a lot of self-employed people — managing their investments, doing retirement projections, full-service wealth management. And I also have a separate CPA practice where we do some compliance work and a lot of tax planning for the same set of clients.

InvestmentNews: Do you do actual tax returns for clients?

Ms. Wesche: Yes.

InvestmentNews: And Loyd and Larry, do you do tax returns, too?

Mr. Stegent: Yes, we do.

Mr. Soukup: We do also.

InvestmentNews: Larry, let’s start with you and talk about what you think of as the key highlights of the new tax law.

Mr. Soukup: First of all, we’ve got a payroll tax decrease for 2011 — a 2% decrease for all workers and self-employed individuals, and I think that that’s a big item that we should be discussing with our clients and encouraging them to defer that into their 401(k) plans, especially if they’ve got an employer match. The second thing that I’d like to talk about in a little more detail later is 2010 Roth conversions. There were a lot of conversions that took place last year. There are still some decisions that relate to those in 2011 and I’d like to get back to those a little later in the program.

InvestmentNews: Loyd, tell us a little bit about what you think are the most important highlights of the new tax law.

Mr. Stegent: For me, the biggest issue with the new tax law is that for individuals, it essentially extends the status quo for two years. So we have two more years to do some planning with the lower tax brackets, and we know that if nothing else changes for 2012 or in 2013, we’re going to see a new 3.8% surtax on investment income. So I’m using these next two years to help my clients prepare for what we know is going to be a higher tax environment on their investment income and utilizing several strategies to do that, which include Roth conversions as well as asset positioning within client accounts.

InvestmentNews: Mary Pat, what are some of the highlights that you’re finding?

Ms. Wesche: I would agree with Loyd that we have a two-year window now where we know rates are going to be low, and I think we can use those two years to do Roth conversions, possibly accelerate income into 2011 and 2012. And also from an estate-planning standpoint, if you think your estate is going to be over $5 million, to really look at what kind of gifting can you do in the next two years to get out of the estate taxes that it looks like are going to be there.

InvestmentNews: OK. We’re going to go back and go into these things in a little more depth. Larry, let’s get into some of the issues that you wanted to discuss a little more fully, and see what advisers should be doing for their clients under the tax law this year.

Mr. Soukup: I think that financial planners and investment advisers need to have some tax discussions with clients to find out what’s going on in their lives from a tax standpoint and also to demonstrate that they’re on top of the tax laws and looking for ways to help clients reduce taxes and increase their assets.

We had a lot of Roth conversions in 2010, and under the tax law, the income from those conversions is spread evenly over 2011 and 2012 unless the taxpayer makes an election to recognize it all in 2010. And I think our clients who have converted have two decisions to make. One is whether to stick with the conversion or re-characterize back to a traditional IRA. And they have until Oct. 17 of this year to make that decision. And they also need to decide whether to go with this spread of income over 2011 and 2012 or make the election to recognize it all in [tax year] 2010.

Now, why would you recognize all of that income in 2010? You’d do so if your income was low for 2010 otherwise and you expected it to be higher in 2011 and 2012. We still have some small-business people who are struggling, other [clients] who are struggling, and it might be a good decision to recognize all of that conversion income in 2010.

Now I’m recommending that our clients who did convert to Roth [individual retirement accounts] extend their tax returns until that Oct. 17 date. That gives them more time to decide whether they want to spread that income out into 2011 and 2012, and if they do re-characterize back to the traditional IRA, then they don’t have to file an amended return to do that. They just do so on the extended 2010 tax return. So those are some considerations on that.

The alternative-minimum-tax patch came in as we all hoped it would. That’s good for Middle America. We found that a lot of clients who had never been subject to the AMT before were looking at an AMT tax bill, and the patch helped them with that. And that’s good through this year, too. And we may talk later about the depreciation deductions and the enhanced [Section] 179 deduction, but that’s really big for small business. So those are a few items that I just wanted to touch on at this point.

InvestmentNews: Loyd, let’s go to some of the ideas you wanted to go into in more depth.

Mr. Stegent: This new [investment income] tax that’s been implemented by the health care bill is going to be effective in 2013 regardless of what happens with the current rate structure. So even if we got another two-year extension, for example, under the current tax law, we know that our higher-income taxpayers are going to be subject to a 3.8% tax on their investment incomes. So the key over the next two years is going to be to try to reduce your clients’ adjusted gross income to either keep them below the $250,000 threshold or at least to minimize the impact of the income that’s going to be taxable.

Ways to reduce your investment income include municipal bonds, Section 529 plans — even if you’re not going to use those for college expenses, those are great ways to save money on a tax-deferred basis — variable annuities and [variable universal life], and cash value life insurance, depletion and intangible drilling cost, after-tax IRA contributions, gifting to family members and asset class selection by account type. If we have a minute, I could talk a little bit further about asset class selection by account type.

InvestmentNews: Sure. Before you do, a question came to mind. Let’s say a grandparent wants to do a 529 plan for a grandchild as a way to reduce investment income. Is the contribution considered a gift?

Mr. Stegent: It is considered a gift and it also gets the money outside of the grandparents’ estate for estate tax purposes, but the best thing about it is, the grandparents still control the money. And if for some reason they should need that money during their retirement, they can always cash out the 529 plan and use it for their own living expenditures. Now, there would be a 10% penalty on the earnings inside that 529 plan, but it doesn’t take too many years of tax-deferred growth to make up for the 10% penalty that you might incur when you pull the money out.

Mr. Soukup: One thing that might be a possibility for both reducing investment income and reducing [adjusted gross income] is a health savings account. We’re finding more and more of our clients have high-deductible health insurance plans and they’re eligible for an HSA.

That contribution reduces AGI, because it’s deductible and also the growth in there, if they don’t pay it out for expenses, reduces investment income. We’ve got for this year a contribution limit of $6,150 plus $1,000 catch-up if they’re over 50 years old. So it can add up over time.

Mr. Stegent: Larry, I agree completely. I use an HSA for my own personal insurance needs, but the problem I’m finding with my clients is that, number one, the employers are not offering HSA-qualified insurance products, and number two, a lot of my clients are retired and on Medicare, and so they’re not eligible for HSAs either. So for those who don’t have access to HSAs — and by the way, if you do have access to it, you should fully fund it, and you should never spend a dollar out of your HSA — because again, it’s just tax-deferred growth, so you never want to take money out of a tax-deferred account.

But going on to asset class selection by account type, there are a couple of key points here I want to make.

As a CPA, when I look at my clients’ accounts, I want to make sure that I’m repositioning accordingly.

For taxable accounts, you want to have your taxable accounts and municipal bonds, non-dividend-paying growth stocks and international stocks, and that’s due to the foreign-tax credits, because international stocks pay foreign taxes, but the dividends incur foreign taxes, and so if you have international stocks inside a tax-deferred account, your clients are going to lose the foreign-tax-credit benefit.

Your tax-deferred accounts should include the income-producing assets like bonds and preferred stocks and [real estate investment trusts] and high-dividend payers.

And this is especially important for clients who are at or near [required minimum distribution] age, because the key is that you want to keep as much growth out of your clients’ IRA as possible. Because if you think about how your clients’ assets are positioned, certainly you want to have your retired clients in some fixed income, and you want to have your retired clients diversify into some equities as well. But your clients’ RMD is computed every year based on the balance in the account, so the more the IRA grows, the greater that RMD is every year.

So rather than sticking growth assets inside the IRA, you stick the growth assets inside the Roth IRA first, and then second choice would be the taxable account because the more the IRA grows, the greater the RMD is going to be, and therefore, the larger the tax impact is going to be on those clients who have very large IRAs.

And this will be especially burdensome in a couple of years if their RMD is generating $150,000 to $200,000 of distribution and then most of these clients who have multimillion-dollar IRAs also have fairly large taxable accounts that are generating taxable interest and dividends as well.

So you add all this together and your clients’ investment income is going to be subject to the surtax, and so every little thing that you can do to reduce the impact of that is going to be appreciated by your client, and one of those key areas is to try to minimize the growth inside the IRA to minimize the RMD impact.

Ms. Wesche: I still like the high-dividend-paying stock in a taxable account with the current 15% dividend rate.

Mr. Stegent: As long as we have the 15% dividend rate, it’s great. But chances are, that’s going to go away, and so the point is, over the next two years, begin the process of transitioning those high-dividend-paying stocks out of the taxable account and into a Roth account or a tax-deferred account.

InvestmentNews: Mary Pat, do you have anything you’d like to add that you’re looking at specifically?

Ms. Wesche: We’re doing a lot of asset class work, with gifting and estate work — inflating people’s assets, trying to see if they’re going to be subject to estate tax and what kind of income they need. Can they gift that up to $5 million to children or whoever they want to gift to, to reduce or eliminate the estate tax? So we’re really looking at that pretty heavily. Again, you have to know what income you need. You can’t give too much. So we’re just doing a lot of planning with accelerating income into 2011 and 2012, and for businesses accelerating capital expenditures.

InvestmentNews: Do you think we’ll ultimately get any kind of AMT fix or are we just patching as we go forward?

Ms. Wesche: I think we’re patching. I think the problem is, it’s too expensive of a problem to really fix for good. It raises a lot of revenue.

Mr. Soukup: We need a fix on that, but historically, Congress has just done a patch, and it’s only done a patch when there’s been an outcry over the exposure of more and more Americans to the AMT.

Ms. Wesche: Probably 80% of my clients pay AMT. Really tough to avoid these days.

InvestmentNews: How have your clients reacted to the new tax law, and is there a sense of just resignation that the taxes will always be in flux? Larry, how have your clients reacted?

Mr. Soukup: Well, they were happy to see the extension of the Bush-era tax cuts. There is getting to be some sense that there needs to be tax reform at some point, especially with the budget deficit and the congressional commission that came out with its findings not long ago, and I think there’s a sense that the tax code is too complex and maybe favors the wealthy too much, and maybe the time is coming when Americans will embrace some type of tax reform.

InvestmentNews: Mary Pat, with the problems Illinois is having, how have your clients reacted?

Ms. Wesche: Nobody’s happy about the huge tax increase we had. Individuals went from 3% to 5% overnight. So they’re not happy about it. A lot of businesses are looking elsewhere. But a lot of states are higher than us in terms of taxes.

InvestmentNews: It sounds like Wisconsin is really targeting Illinois businesses.

Ms. Wesche: Yes. I’ve heard radio ads. They’re really coming after them.

InvestmentNews: What about low-tax Texas, Loyd?

Mr. Stegent: Of course, everyone’s happy that the laws have been extended for two years, but I don’t think anybody’s doing any cartwheels, because it is a limited window here. But what I suspect will eventually happen is, we will have a major reform of the tax laws, and that reform is going to result in a broadening of the tax base and an overall lowering of the tax brackets. But that lowering of the brackets is going to come with a lot of itemized deductions’ being eliminated or reduced substantially. So even though we’re going to be quoting lower tax brackets, in reality, we’ll all be paying more taxes. They’ll probably do away with the AMT at that point, but it’ll be because they’ve restructured the tax law so that they’ve made up for that revenue shortfall.

Ms. Wesche: They’ve talked about eliminating the home mortgage interest deduction, which amazes me in light of the housing market these days.

Mr. Stegent: Right. Yes, or limiting it to maybe $500,000 or $250,000. In other words, lowering the million-dollar mortgage limit dramatically.

InvestmentNews: Loyd, there’s a question from an attendee that’s apropos of a point you made: With the tax rate on qualified dividends at 15%, why not keep stocks paying those dividends in your taxable account, not in the IRA? Income coming out of the IRA will be taxed at a higher rate.

Mr. Stegent: Because we’re planning for 2013 and the assumption that that 15% rate is going to go away. So under current tax law, I agree having high-dividend-paying stocks in a taxable account makes sense, but when that starts being taxed at an ordinary rate plus a 3.8% surtax, then it’s much better to have that dividend-paying stock in a tax-deferred account.

InvestmentNews: Larry, let’s go back a little bit to the Roth and the Roth conversions. Is it more attractive to convert now?

Mr. Soukup: I think you have to take it on a case-by-case basis and look at the individual and what their income tax situation is now, what it’s likely to be in retirement. Do they have the funds available now to pay the tax on the conversion without dipping into qualified funds for that? I think it still makes sense. We don’t have the two-year spread for 2011 conversions that we had for 2010 conversions, but clients can still do staggered conversions. They could do some this year, some next year and so forth. And I think it still needs to be in our arsenal and looked at on a client-by-client basis.

Ms. Wesche: I think you can really be strategic with those and look at their tax bracket and take them maybe up to the maximum of their current tax bracket or look at years when they’re going to have lower income and plan around that. You really need to look long-term and see what their minimum distribution is going to be and how it’s going to affect taxes and Social Security, and kind of look at the whole package. And you’ll find, I think, surprisingly, a lot more people should convert than are actually converting.

Mr. Stegent: I agree completely — especially in conjunction with the additional taxes that are coming in 2013 on the 3.8%. What I’m doing is looking at my clients’ RMD and projecting out for the next five and 10 years and even beyond, what their expected RMD is going to be coming out of their IRA, assuming a reasonable growth rate on their IRA, and then applying the RMD tables to those distributions and then seeing exactly what that RMD amount is going to do to my clients’ taxable- income level. And for those clients whose IRAs are so large that their RMD is going to immediately kick them up into the $200,000, $250,000 AGI level, it makes all the sense in the world to start doing some dramatic Roth conversions now in 2011 and 2012. We did some last year in 2010 in order to get some money out of IRAs to reduce that RMD, and again, assuming that the client has the money in an after-tax account to pay the tax on that conversion, then it’s much better to do that now and get those RMD distributions down in 2013 and beyond, because otherwise, your clients are being set up to pay a dramatic income tax liability on their distributions from their IRAs.

Mr. Soukup: That’s a good point for retirees. I’d like to focus on small-business people for a second. With the enhanced Section 179 deduction — where you can deduct up to $500,000 of property purchases and the bonus depreciation, which is basically 100% of new acquisitions — small-business owners may find that their flow-through income from the business is very low, and that presents an opportunity for them to do Roth conversions at a low tax bracket. So we want to take a look at that, too.

InvestmentNews: Could you explain a little bit more what Section 179 is, exactly, and what it means?

Mr. Soukup: 179 is the Internal Revenue Code section that we’ve had for a long time that allows businesses to write off in the first year a certain level of acquisitions of machinery and equipment and other business assets. That limit was raised up to $500,000 of write-offs for 2010 and 2011. Additionally, we had another section, Section 168 (k), which is called the bonus depreciation section, where businesses from September of last year through the end of this year can buy new assets and deduct 100% of them. So you could actually — if you had enough asset acquisitions — you could create a net operating loss for the business, and that would create a real opportunity for some Roth conversions.

InvestmentNews: Larry, does that work with basically any investible business asset?

Mr. Soukup: That’s personal-property-type assets, although there are some limited real property assets that apply now, also. So it’s been a big boost to small business. The intent of Congress was to allow large tax deductions and reduce the income tax on small businesses so that they can expand and hire employees, and grow the economy.

InvestmentNews: It would seem, for some advisers, if their client is a small-business owner, much more of the tax opportunities lie in the business end of things than on the personal end. How would you suggest they talk to clients about this?

Ms. Wesche: I think it’s key just to have advisers talking to each other. If the CPA is outside of the wealth management firm, you really need to have everybody talking and looking at opportunities and seeing the whole picture.

InvestmentNews: It would seem, in this environment of relatively low returns on pretty much everything, that the ability to save money through taxes may be the biggest benefit that an adviser can bring to the table, in many cases.

Ms. Wesche: It’s huge, and people hate paying taxes, so if you can save them 35% of anything, they’re thrilled.

Mr. Stegent: I agree. The single largest expense any of us will ever have in our lifetimes is income taxes. So for advisers who have a tax background or for advisers who work closely with other tax advisers, you’re really doing your clients a service by taking income taxes into consideration in the moves that you’re making inside the clients’ portfolios.

Mr. Soukup: Most small-business people are structured as corporations or LLCs, and that net income of the business flows through to the personal tax return of the client. It really behooves the adviser to know what’s going on in that business. Midyear, how is the business doing? What’s the income of the business? Talk about the benefit plans. Do they have a 401(k) plan? Profit-sharing plan? What are the contributions going to be this year? Are there new asset acquisitions, and if so, can those be written off? What about health insurance? We’ve got a new health insurance credit for small employers that just came in last year with the health insurance reform bill. You really need to know what’s going on in the business if you’re going to be a well-rounded adviser to your client.

InvestmentNews: Larry, apropos of that, were any of the tax law changes — aside from the greater depreciation schedule — aimed at small businesses in particular?

Mr. Soukup: There are credits for hiring individuals who have been out of work for a while. And I just mentioned this health insurance credit for small employers. The employer can get up to a 35% tax credit for the premiums paid on a health insurance program for his employees. Now, this is truly for small business. You have to have fewer than 25 full-time-equivalent employees, and the average annual wages need to be less than $25,000 per employee.

Ms. Wesche: I’m having a real tough time [finding] anybody with their wages under that amount. It’s really a tough one to qualify for.

Mr. Soukup: Yes, and I’m finding that many small employers are just not offering a comprehensive health insurance program for the employees. They may be giving them a bonus to pay for their own high-deductible plan or something like that. But we’re not seeing much of this, either.

InvestmentNews: We had a question from one of the attendees: For those who have adjusted gross income that’s too great to make either a Roth IRA contribution or a deductible IRA contribution, should or can the client fund a non-deductible IRA, then convert to a Roth? If so, does the Internal Revenue Service have any plans to curtail the opportunity?

Mr. Stegent: I’ll take that, because that was one of my planning points. One of the ways to reduce adjusted gross income is for clients who are ineligible to make annual Roth contributions to go ahead and convert any existing IRA, because the strategy will only work if you don’t have any IRA to begin with. In other words, you’ve cleaned out your IRA. So you have a client who has $50,000 in an IRA for, say, the husband and $500,000 in an IRA for the wife. And you’re contemplating whether you should convert that. At least convert the husband’s smaller $50,000 IRA into a Roth, and now you’ve opened up the opportunity for the husband to be able to make non-deductible IRA contributions that are going to be after-tax, so then you can then immediately convert that into a Roth IRA, and that would be a tax-free conversion.

And now you’ve effectively found a loophole in the AGI limitation imposed on Roth IRAs. Now, whether or not the IRS is going to crack down on that, I have no way of knowing, but it’s not an abuse of the tax rules. It’s just taking advantage of the fact that you don’t have any assets inside a traditional IRA, and therefore, you’re able to now make that conversion on a tax-free basis.

Mr. Soukup: There’s another reason why you may want to make a contribution to a non-deductible IRA, regardless of whether you convert it, and that’s for asset protection purposes. At least here in Colorado, any money held in an IRA or a qualified-plan account is protected from judgment creditors, and I know some other states have the same provisions. And I think in our litigious society, we need to be at least cognizant of asset protection when we go about our tax planning.

InvestmentNews: In high-tax states like here in New York or in Illinois, what could you recommend? How much leeway do your clients have in escaping some of the tax burden in the state?

Ms. Wesche: One thing to look at with capital expenditures is, you have to see if the state has decoupled from the IRS for depreciation. I know in Illinois, they have. So you can take [Section] 179, and you’ll still get the state deduction for that. But if you take the bonus depreciation, you wind up not being able to take full advantage of that. It’s a timing thing within the state. So you really do need to know what your state laws are for depreciation and some of these other things.

Illinois is one of the states that doesn’t tax retirement income, so we’re having a great time with Roth conversions and not worrying about state taxes.

InvestmentNews: So once someone retires in Illinois, their income isn’t taxed by the state?

Ms. Wesche: Yes. They don’t tax the retirement portion of income. They still tax interest and dividends, but not pension, Social Security, those kind of things.

InvestmentNews: Another question from the attendees: Do you recommend that professionals such as lawyers, doctors and accountants incorporate? I guess the question is, is a C corporation better than an S or an LLC?

Ms. Wesche: Well, you still have liability protection, and I tend not to recommend C corporations too much, just because you have to work so much to get income to zero and bonus everything out at the end of the year before you get into the high tax bracket. Most of our service companies are LLCs.

Mr. Soukup: We see quite a few as S corporations, too. Now, I did want to mention there’s been some activity in this S corporation area from a payroll tax standpoint, where the IRS has come in and determined that the compensation being paid to the owner of the S corporation is too low, and too little payroll taxes are being paid, and they’ve assessed additional payroll taxes on that. In fact, the House passed a bill this last year that would cause professional-service S corporations to have all of their income up to the [Federal Insurance Contributions Act] limit taxed as earned income. So we need to watch that. There’s some case law developing in that area, and Congress is looking at that, and the old planning technique of telling S corporation owners to take a little salary out to reduce payroll taxes may not be viable for very long.

Mr. Stegent: Larry, the case that you may be referring to was actually one against the CPA that he lost against the IRS in Tax Court; he paid himself a $24,000 annual salary and took about $200,000 out as distributions, and that $200,000 would not be subject to payroll taxes, which would be the reason that you pay yourself a low salary.

Well, we as CPAs have always been taught that you could pretty much get away with paying yourself or recommending to your clients that they pay themselves a low but a reasonable salary in the neighborhood of $24,000 as long as you didn’t do something ridiculously low — like $1,000 — or claim no salary. Because it used to be that the IRS was going after just the unreasonably low salaries of zero or $1,000. But now they’ve raised the bar and they’re going after, at this point, $24,000-per-year salary.

Mr. Soukup: In a couple of ways, you’re working against yourself by paying too low a salary. One is that you’re probably reducing the ultimate Social Security benefit that you’ll receive, and then secondly, you’re reducing your ability to contribute to potentially a 401(k) or a profit sharing or a defined-benefit pension plan by having a low salary. So there are some offsetting factors there.

Ms. Wesche: Our advice has always been to pay yourself what you’d make on the outside, to maximize your contribution and avoid any additional scrutiny by the IRS.

InvestmentNews: Can you discuss the implications of the new tax law for owning real estate?

Mr. Soukup: The 1099 for landlords is part of a process that came into legislation last year by which there’s going to be required more 1099 reporting on transactions so that the IRS can track things better. Now, a landlord paying a provider, a repairman or something like that more than $600 has to issue a 1099 to that provider or be subject to penalties and a requirement for withholding tax from that payment.

And this has raised an outcry among many taxpayers and professional groups, and I think this is going to go away. But what I’m telling my clients right now is, it’s on the books. If you’re making payments out to someone for more than $600, have them fill out a W9 so that you have their employer ID number and are at least prepared to issue them a 1099 after Jan. 1 if this is still on the books.

So that’s that 1099 reporting, and also there’s expanded 1099 reporting that’s going to come into play next year if the law survives that long. There are bills in Congress to rescind this.

InvestmentNews: Is there anything else dealing with real estate as an investment that investors and advisers should be aware of that affects taxes under the new tax law?

Mr. Soukup: There are some provisions that would allow more-rapid depreciation and expensing of certain types of business real estate. Qualified retail property and qualified restaurant property are a couple that come to mind, and also some qualified leasehold improvements. So those bonus depreciation provisions and Section 179 provisions would help out in that area.

InvestmentNews: We had another small-business-related question: With tax rates always in limbo, a Roth 401(k) is a great tool for sole proprietors to create tax-free income later; what are your attitudes toward small businesses’ setting up a Roth 401(k)?

Mr. Stegent: If you can get money inside a Roth, that should be your first option — whether it be a Roth IRA or a Roth 401(k). There are not many opportunities within the tax code to have tax-free income, and the Roth IRA and the Roth 401(k) create that opportunity. So the Roth should be the first account that you fund. And it should be the last account you spend, because you do not have to take required minimum distributions out of your Roth IRA. So over your lifetime, if you’ve saved up enough assets that you’re able to live off of Social Security, pension and assets outside your IRA accounts, your Roth can grow for your entire lifetime. You never have to take a dollar out of it and then the best beneficiary to name for your Roth is going to be the youngest generation in your family — your grandchildren or your great-grandchildren — because after you pass away, whoever inherits the Roth is going to be required to take distributions out. So the younger that beneficiary is, then the slower those distributions will be, and therefore, he or she will be able to have a lifetime of Roth distributions that are tax-free. And the Roth IRA is going to continue to grow, because presumably, if a 10-year-old inherits a Roth IRA — assuming the account earns 10% per year over the lifetime of the 10-year-old — distributions for the first third of his or her life are going to be 1% to 2% of the Roth IRA.

So you can see that there’s going to be many, many years of compounding going into this Roth IRA at the early ages for your grandchildren or great-grandchildren.

InvestmentNews: For the small-business owner, is there a limit on how many different kinds of saving vehicles you can set up? Can you set up your own defined-benefit pension plan plus a 401(k) plus a Roth 401(k) — is there a limit? Are they mutually exclusive or what’s the limit of all this?

Ms. Wesche: They don’t really allow you to dip into all the baskets. So you do have to kind of pick and choose.

Mr. Soukup: You do have some flexibility. You can have a combination 401(k) and cash-balance pension plan, a combination 401(k) and profit-sharing plan. But they have to be coordinated so that you don’t double up on your contribution deductions.

InvestmentNews: And then can the individual proprietor — let’s say of an S corporation — do all this to have their own, plus the business’, savings plan? Is that OK?

Ms. Wesche: Generally not. Again, you have to look at plans, because I find my clients definitely want to maximize what they’re putting in their own account and minimize what they’re putting in employees’ accounts. So some things, it would be great for them, they look at as costing them too much for what they have to contribute for employees.

Mr. Soukup: I’d like to follow up on something Loyd was just talking about on the power of accumulation in Roth IRAs. With our small-business clients, we’re looking for opportunities for them to hire their children as employees, legitimate employees, that do some work, because once they have earned income — and that’s a requirement to make an IRA contribution — they can set up a Roth IRA. And if you’re talking about an 18-year-old contributing to a Roth IRA and the power of tax-deferred growth until they’re 60, 70, 80 years old, it’s incredible what that can grow to. So we need to look for those opportunities also.

InvestmentNews: There are a number of questions about life insurance; one in particular is about overfunding life insurance for maximum tax-free income and other uses of insurance to minimize taxes. What are your feelings about that?

Mr. Stegent: Under the ways to reduce investment income, I do include variable annuities, variable-universal-life and cash-value life insurance. I agree that those are very effective ways, if you overfund those policies, to reduce the taxable income and to reduce your AGI and avoid a lot of the tax on your investment income. So as long as you’re getting a cost-effective insurance product for your client, then I think it makes all the sense in the world. Where the problem sometimes comes in is in the price of the insurance products. Then it’s not such a nice trade-off if the client’s having to pay a large [mortality and expense risk charge] for the tax deferral.

InvestmentNews: And how do you compute whether it makes sense or not? How do you determine what’s too expensive or what isn’t?

Mr. Stegent: Since I’m a fee-only adviser, I use no-load products. Jefferson National [Life Insurance Co.] has a flat-fee variable annuity that I use. [The] Vanguard [Group Inc.] has low-cost variable annuities. So you really have to kind of look at the numbers on a case-by-case basis. There are even some good low-cost products on the commission side, so you just have to look at what the client’s being offered and determine whether or not the expense ratio or the M&E cost inside the product is going to justify the tax savings, or if it makes sense.

InvestmentNews: Larry, what’s your view on insurance?

Mr. Soukup: My philosophy has always been that if there’s a need for insurance, you should probably cover that need with term insurance and invest the rest. I find that many individuals and businesses are not maximizing their IRA and qualified-plan opportunities. One I wanted to point out is the simplified employee pension plan, the SEP. That can still be set up for 2010, and a contribution — and perhaps a very sizable contribution — can be made into it and deducted for 2010. It’s the only qualified plan that we can still do that at this point in terms of setting it up and making the contribution.

A lot of small businesses could have a 401(k) plan. I’m a big believer in 401(k) and perhaps coupled with the profit-sharing plan under some of the new testing provisions for profit sharing — new comparability, for example — it can come out very favorable for the business owner. So before I would really look too seriously at cash-value life insurance, especially if there’s a business situation, I would look at what qualified plans there are and how much money can be put away on a tax-deductible basis there.

InvestmentNews: Mary Pat, do you have anything you want to add on the insurance front?

Ms. Wesche: I’m just not a huge fan of using insurance for investment purposes. I think there’s a place for it if you really need survivor benefits or for estate-planning purposes. But I just don’t like it. I don’t think it’s a real efficient investment vehicle.

InvestmentNews: Another question was about the change to the law governing a charity direct contribution to an IRA; how did that change, specifically?

Ms. Wesche: That was a great change if you caught it in December or January for 2010; you could take money out of your IRA, and the check is cut payable to the charity, and it would basically be a huge savings for 2010. You don’t have to declare the income from the IRA distribution, which is really good if you’re in a Social Security taxable situation. You don’t get the deduction, but it reduces your required minimum distributions going forward. It’s kind of a win-win for everybody. I use it quite a bit.

InvestmentNews: But that’s not over — that still continues?

Ms. Wesche: 2011 is the last year.

InvestmentNews: So you can go directly from your IRA to a charity.

Ms. Wesche: Yes.

InvestmentNews: We had another question: What about purchasing illiquid assets for discounting purposes, then transferring that to a Roth?

Ms. Wesche: What kind of illiquid assets?

InvestmentNews: The questioner didn’t specify.

Ms. Wesche: Most of the custodians won’t touch anything that’s really illiquid for IRA purposes.

Mr. Soukup: If I could go back to the charity topic for just a second, we’ve been using donor-advised funds for some years now, and I think they’re a great vehicle. Essentially, you go to one of the big donor-advised fund providers like Fidelity [Investments] or Vanguard and they set up a fund. You make a contribution into that and take a current tax deduction for that — whether it be cash going in or appreciated securities going in — and then you over time designate the charities you want money to come out of that fund and go to.

And we really use it when people are in high-income years and we know they’re going to be in lower tax brackets later on and we know that they’re going to continue making gifts to charity. We can take some money off their higher tax brackets now by making contributions into the donor-advised funds, and then in some cases, they even can claim the standard deduction later on when they’re retired and they’re still directing money to come out of their donor-advised funds and go to the charities.

Ms. Wesche: That really works out best when you’ve got appreciated stock, which nobody had for the last couple of years. But I think we’re seeing a lot more interest in that again now.

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