AFC Retirement & Investment Planning 2 — Questions and Answers
Question 1: A client is considering a Traditional IRA to Roth IRA conversion. What is the primary tax consequence?
- The conversion is tax-free before age 59 1/2
- The converted amount is added to taxable income in the year of conversion (Correct answer)
- There is a 10% penalty on all conversions
- The conversion reduces the tax bracket
Correct answer: The converted amount is added to taxable income in the year of conversion
The converted amount is treated as ordinary income in the year of conversion since money moves from tax-deferred to tax-free status.
Converting $50,000 adds $50,000 to taxable income, potentially pushing into a higher bracket. There is no 10% penalty on conversions. Strategic timing is key: convert in low-income years (between jobs, early retirement before Social Security). Consider partial conversions over multiple years to manage bracket impact.
Question 2: What is sequence of returns risk and why is it dangerous for retirees?
- Risk that returns will be lower than expected overall
- Risk that poor returns early in retirement permanently deplete a portfolio when combined with withdrawals (Correct answer)
- Risk of not diversifying across time periods
- Risk of inflation eroding income
Correct answer: Risk that poor returns early in retirement permanently deplete a portfolio when combined with withdrawals
Poor returns early in retirement, when the portfolio is largest and withdrawals compound losses, can permanently deplete savings.
A $1 million portfolio dropping 30% to $700,000 while withdrawing $40,000 leaves only $660,000, requiring a 52% gain to recover. Mitigation strategies include the bucket strategy (2-3 years in cash), reducing withdrawals during downturns, more conservative allocation in early retirement, and partial annuitization.
Question 3: A married couple is deciding when to claim Social Security. The higher earner's FRA benefit is $2,800/month. What strategy maximizes lifetime benefits?
- Both claim at 62
- Higher earner delays to 70 while lower earner claims earlier for household income (Correct answer)
- Both claim at FRA
- Lower earner delays to 70, higher earner claims at 62
Correct answer: Higher earner delays to 70 while lower earner claims earlier for household income
Delaying the higher earner's benefit to 70 maximizes both their retirement benefit and the survivor benefit.
The higher earner's benefit at 70 would be approximately $3,472/month. When either spouse dies, the survivor receives the higher benefit. Maximizing the higher earner's benefit locks in the larger survivor benefit for the surviving spouse's lifetime. The lower earner claiming earlier provides household income during the delay.
Question 4: What is the purpose of Required Minimum Distributions from Traditional retirement accounts?
- To ensure retirees spend savings during their lifetime
- To collect income taxes on previously tax-deferred contributions and earnings (Correct answer)
- To prevent accounts from exceeding balance thresholds
- To fund Social Security
Correct answer: To collect income taxes on previously tax-deferred contributions and earnings
RMDs ensure taxes are eventually collected on tax-deferred retirement savings.
RMDs begin at age 73 under SECURE 2.0. They are calculated by dividing the December 31 balance by an IRS life expectancy factor. Failure results in a 25% excise tax (reduced from 50%). RMDs can push retirees into higher brackets, increase Medicare premiums, and make Social Security more taxable. Roth IRAs have no RMDs.
Question 5: A 45-year-old client wants to withdraw $20,000 from their Roth IRA. They have $15,000 in contributions and $5,000 in earnings. How much is tax and penalty-free?
- Nothing
- $15,000 (contributions only) (Correct answer)
- $20,000 (full amount)
- $5,000 (earnings only)
Correct answer: $15,000 (contributions only)
Roth IRA contributions can always be withdrawn tax and penalty-free since they were made with after-tax dollars.
Roth withdrawals follow ordering: contributions first, then conversions, then earnings. Contributions are always tax and penalty-free at any age. The $5,000 in earnings does not meet qualified distribution requirements (must be 59 1/2+ AND 5-year holding period) and would trigger income tax plus 10% penalty unless an exception applies.
Question 6: What is the primary difference between a defined benefit plan and a defined contribution plan?
- Defined benefit plans are only for government employees
- Defined benefit plans guarantee specific retirement income; defined contribution plans specify contributions with no guaranteed outcome (Correct answer)
- Defined contribution plans always provide larger benefits
- Defined benefit plans require employee contributions
Correct answer: Defined benefit plans guarantee specific retirement income; defined contribution plans specify contributions with no guaranteed outcome
A defined benefit plan promises specific retirement income based on salary and service, while a defined contribution plan specifies contributions with the outcome depending on investment performance.
Defined benefit (pension) formula: years of service x percentage x final average salary. The employer bears investment risk. Defined contribution (401k/403b) specifies contribution amounts; final balance depends on investment performance. The employee bears the risk. The shift from DB to DC has transferred retirement risk to individuals, making financial counseling more critical.
AFC Retirement & Investment Planning 2
A client is considering a Traditional IRA to Roth IRA conversion.
What is the primary tax consequence?