We have recently been getting questions and concerns about retirement and retirement plans from our clients. Many of these have to do with taxes and the changing rules for distributions, and show various levels of misunderstanding.

“I would donate to charity, but I make too much and they will cut my deduction.”

This statement refers to the Pease limitation, named for deceased legislator Donald Pease, who originally pushed through the concept a couple of decades ago. The reincarnation of the limitation was part of the fiscal cliff tax package, the American Taxpayer Relief Act of 2012.

It is true that high income earners are subject to a reduction of certain itemized deductions. High income in this context is adjusted gross income (AGI) in 2015 of over $258,250 (for single filers), $309,900 (for married, joint-filing couples), $284,050 (for heads of households), and $156,000 (for those who are married but filing separately).

Indeed, in certain circumstances, a charitable donation will not result in the expected tax deduction, but in many cases, the limitation has no effect on the tax break from a donation.

The disconnect in taxpayer understanding stems from the fact that the act of making the donation is not the trigger. AGI is the trigger. The reduction is 3% of the amount of AGI greater than the thresholds listed above. A single taxpayer with an AGI of $358,250 is $100,000 above the threshold, so $3,000 of certain deductions is disallowed.

Charitable deductions are among those targeted, as are deductions for home mortgage interest, property taxes and state and local taxes. Some other deductions found on Schedule A are exempted, including medical expenses and gambling losses.

Say our single making $358,250 pays state taxes, property taxes and mortgage interest totaling $40,000 and is getting that as a deduction. She is considering a charitable gift of $10,000 as well. With the Pease limitation, she deducts $47,000 if she makes the donation ($40,000 plus $10,000 minus $3,000). If the Pease limitation did not exist, she would deduct $50,000. It sure appears to be a reduction, but it actually isn’t.

The choice isn’t Pease or no Pease. It is donation or no donation. If the single filer donates $10,000, she deducts $47,000. If she does not donate, she deducts $37,000 ($40,000 minus $3,000). The $10,000 donation results in a full $10,000 additional deduction, so there is no reduction of her deduction.

The $3,000 figure does not rise if she increases her donation or other deductible expenses. It rises only when her AGI increases. The limitation is really better described as a surtax. For a peek at the calculations determining the size of the surtax, I recommend Michael Kitces’ 2013 write-up of the topic on his blog, Nerd’s Eye View.

“I need to convert to a Roth IRA to avoid RMD.”

Based on experience, my guess is that somewhere between one-third and one-half of people who think this are probably dead wrong. 

To hear it from some, required minimum distributions (RMD) are an enormous problem. Now, it makes perfect sense to me that when clients do not need money from their retirement accounts, they can harbor some resentment at being forced to take distributions and pay taxes. Disliking the RMD rules is understandable. But we often have to keep people from throwing the baby out with the bathwater. 

In many cases, it can indeed make sense to distribute or convert some funds in retirement accounts so that the family can make full use of lower tax brackets. If the retirement accounts are large enough, the required minimum distribution can kick a household into substantially higher tax brackets. Since a taxpayer’s personal Roth IRAs are not subject to those distributions, converting can lessen the amount of the distributions from traditional IRAs and other retirement accounts.

For those who will not need their distributions for cash flow, Roth conversions have great appeal; they offer tax-free growth and no RMDs. 

But many people don’t look at the particulars of their situation and likely don’t need to convert. First, RMDs in retirement are not necessarily as large as people think they are. The first one that somebody will take at age 70 and a half is usually only about 3.7% of the IRA, depending on the applicable birthdates. When the person is age 85, it’s still under 7%.

Also, if somebody has so much money that they want to protect it from taxation, they are also likely leaning conservative in their investment approach. When that is the case, the growth of required minimum distributions is further muted. By the time a person is age 85, past the life expectancy of a male and close to the life expectancy of a female, a conservative portfolio is not likely to be kicking off massive RMDs after 15 years, particularly if the distributions were not large when the person started at age 70 and a half.

At its core, the conversion decision is dominated by relative tax brackets. It is the tax rate applied at conversion contrasted to the tax rate that would apply when distributions are finally made.

We see lots of couples who, in their rush to convert to avoid RMDs, plan to convert so much retirement money that they will kick themselves into a bracket they or their heirs would likely not have reached if the funds had not been converted. 

Granted, predicting the future marginal rate is often not easy, but sometimes it is. I saw one case in which a single man paid gobs of taxes on Roth conversions he’d made before he was 70 and a half, when he could have just paid tax on the relatively modest required distributions later. He was leaving everything to his church, a tax-free entity. He’s leaving a lot less to the church now because his fear of taxes prompted him to take action that actually cost him more in taxes.

“I’m hesitant to move my IRA because I can only do one rollover per year.”

This matter has come up a few times as we help clients decide whether to move retirement account money around. 

Last year, the IRS issued Announcement 2014-15, which states that beginning in 2015, for a rollover to be tax-free, no other rollover can have been made from any of the taxpayer’s other IRAs within the prior 365 days. 

It used to be you could use multiple IRA accounts to string together several 60-day periods. That was a way to get an interest-free loan of sorts from IRA funds. 

Now, after the tax court ruling in Bobrow v. Commissioner, 2014-15 basically makes the once per year restriction a per taxpayer issue, not the per account issue people thought it was. The IRS declared it would wait until 2015 to enforce this so that taxpayers and IRA custodians could adapt and the IRS could update Publication 590.

For us, the ruling is almost a non-event. Why? Technically, the ruling only applies to rollovers in which the clients receive a check payable to them and redeposit the funds to an IRA within 60 days. We rarely move assets in this way.

Instead, we use trustee-to-trustee transfers or “direct rollovers,” wherein an IRA custodian sends the money directly to another IRA without the taxpayer taking possession. The custodian of the original IRA may send the check to the client, but the check is payable to “XYZ Company FBO John Doe IRA,” not “John Doe.”

We do this for several reasons. There is no risk that the funds won’t get into the new IRA in time. The transfer is generally faster because the client need not cash the check then write a new one that must also clear. Also, no 1099-Rs are generated, so there is no chance we will need to explain to the IRS why line 15a is so much larger than 15b on the 1040. There won’t be any entry there at all to audit.

Neither the Bobrow case nor 2014-15 apply to “trustee-to-trustee transfers,” “direct transfers” or “direct rollovers.” There is no limit to the number of such transaction types that can occur in any one year. It is common for people to use the term “rollover” to refer to any transfer of retirement account assets. Misunderstanding this is, well, understandable. To try to reduce confusion among our clients and prospects, we are trying to only use the term “transfer” and not “rollover,” except in the few instances where the 60-day rule comes into play. 

Financial Planners Can Bring Clarity

Most of these misunderstandings or misapplications of the facts start when people hear something or only recall a headline, teaser or sound bite. A good financial planner can help them make better decisions for their families. People just don’t know what they don’t know. You know?

Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].