When in Doubt, Go With a Pro!

This week, Gail shows how important it is to get professional advice when making an IRA withdrawal or determining the tax rate on dividends. You'll probably have to pay a fee, but you'll often end up saving a bundle.


Hi, Gail

I'm 66 years old. This year I am surrendering a variable annuity (IRA) for $235,000 to purchase a house — not our first house. I make $32,000/yr. How can my wife and I minimize our taxes? I have already executed the surrender charge.


Sincerely, Daniel


Dear Daniel-

I wish you had met with an experienced financial advisor who could have explored alternatives to the plan of action you've outlined before you took matters into your own hands. Unfortunately, the path you have chosen is going to be VERY expensive.

First, it doesn't matter what you plan to use your IRA for. Assuming it is a traditional IRA composed of pre-tax contributions, EVERY CENT you withdraw will be subject to ordinary income tax.

If you withdraw the full $235,000, this amount, combined with your salary, will put you in the second-highest marginal income bracket (33 percent) this year — 2004. Assuming you don't have thousands of dollars worth of deductions, your federal income tax bill will be in the neighborhood of $69,000. In other words, approximately 25 percent of your IRA is going to go straight to the U.S. Treasury.

So instead of having $235,000 to purchase your new home, you'll have roughly $166,000.

Oh, did I mention you'll also have to subtract state income tax, too?

It makes no difference what this money is used for. If someone is under age 59 1/2, they can avoid a 10 percent early withdrawal penalty on a $10,000 IRA withdrawal provided the proceeds are being used toward the purchase of a "first-time" home. However, at your age you are no longer subject to this penalty, so it doesn't matter if you spend your IRA money on a boat, lottery tickets, or high-performance sports cars.

In addition, since you mention you are paying a surrender charge for this transaction, this means you are cashing in the annuity in which your IRA was invested ahead of schedule. Annuities, which are designed to be long-term investment vehicles, charge a fee if you cancel your contract before a certain number of years have passed. In general, this is seven years, though some have shorter waiting periods.

Daniel, if you KNEW you were going to withdraw the money from your IRA, you should have never tied it up in an annuity to begin with! Not only are taxes going to reduce your proceeds, so will the surrender charge, which generally runs from 1 percent to 7 percent, depending upon how soon you cash in your annuity.

Your situation is not complicated, but an hour spent with a financial planner might have saved you thousands of dollars. Frankly, with interest rates at 40-year lows, you would have been better off taking out a mortgage and just withdrawing a small amount from your IRA each year to help cover the payments.

IRAs are like genies: once the money's out of the account, it's tough to get it back in. However, there is one slim chance you can salvage some of this: as long as money withdrawn from an IRA is re-deposited within 60 days, the IRS forgets you ever make the withdrawal. But if you've passed this deadline, I'm afraid it's too late to return the money to your IRA. You cannot escape state and local income taxes on the full amount withdrawn.

Aside from losing more than 25 percent of your IRA to taxes and surrender charges, what also concerns me is that you are wiping out your retirement nest egg to buy your retirement "nest!" What happens if you and your wife have a medical or other type of emergency? I hope you have other savings you can use to bail yourself out. It would be doubly tragic if you were forced to sell your home to cover such expenses.

Even though the taxes on your IRA withdrawal won't be due until April 15, 2005, I strongly recommend you set aside that money — or a good portion of it — now so you have the funds available at that time. Don't make the mistake of spending the entire withdrawal and figure you'll worry about taxes a year from now. The time will go by faster than you expect.

Consider getting professional advice on any remaining assets you have. You can't afford to make another mistake like this one.

Best wishes-



Dear Gail-

I own shares — ADRs, actually— of British Petroleum. I know that dividends paid on US stock are only taxed at 15 percent. But does this same rule apply to dividends paid on foreign stock?Thanks,



Dear Bernie-

Absolutely! The Jobs and Growth Tax Relief Reconciliation Act passed last year reduced the tax on "qualified" dividends to a maximum of 15 percent. (For those in the two lowest income tax brackets— 10 percent and 15 percent — the rate is even lower: just 5 percent.)

To be eligible for this tax break, the dividends must be paid in either common or preferred stock. Interest paid on bonds and bank accounts is taxed at substantially higher ordinary income tax rates.

But as with most tax-related issues, it's not quite that simple.

What complicates things is that some "preferred" securities are called "stock," but are, in fact, debt instruments. When the issuing corporation files its annual tax return, it takes a tax deduction for the payments made to investors. The only reason it can do this is because the payments actually represent interest and not a portion of the corporation's profits, which is what true "dividends" are.

This is apparently a perfectly legitimate accounting approach (no "Enron" here!) and is fairly widespread. So if you are invested in individual "preferred" securities, you need to make sure you know whether what you own is a true equity or is a bond-in-stock-clothing. Your financial advisor should be able to tell you. If you bought the shares on your own, your best bet is to contact the shareholder services department of the company.

If you own preferred securities via a mutual fund, the fund does the homework for you: You should have received (or will soon) the annual 1099-DIV form from your mutual funds, spelling out how much of the income you received last year is eligible for the lower dividend tax rate.

But there's yet another hurdle you have to overcome: the "holding period." It's not enough that you owned shares of, say XYZ company when it paid out its dividend. You must own those shares for a certain length of time relative to the date the dividend was paid.

With common stock, you have to own the shares for 60 out of 120 days on either side of the "ex-dividend" date. (If you're not an owner of the shares before the ex-dividend date, you're not entitled to receive the dividend.) For preferred stock, the holding period is 90 out of 180 days.

These same rules apply to dividends paid on shares of stock of qualified foreign corporations.

In general, a foreign corporation is qualified as long as one of the following is true:

— The foreign stock trades on a US stock exchange. An "American Depositary Receipt" (ADR) is generally the form this takes; or

— The corporation which issued the stock is headquartered in a country with which the U.S. has a "comprehensive" tax treaty; or

— The company which issued the stock is incorporated in a U.S. possession.

More information on this topic can be found at the IRS website, www.irs.gov.

Thanks for the reminder, Bernie!



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