Get With The Plan: June 7, 2009

Jim and Devon have two teenage children, a mortgage, upcoming college bills and their own retirement to worry about.

But high on their list of goals is helping Devon’s parents, 76 and 71, who recently lost their home to arson and are living in an unheated RV.

“We are looking to have them set up in a new place before winter,” said Devon, 47. “They are living on my father’s Social Security money only.”

Jim and Devon have a retirement nest egg — $109,393 in 401(k) plans and $337,561 in IRAs — and they’re wondering if tapping those funds to help Devon’s parents is a viable option.

At age 62, Jim, 47, expects an annual pension of $90,000, and at age 60, Devon will receive an annual pension of $8,400.

The couple have saved $31,800 for college for their two children, ages 18 and 13, and their oldest starts school in September, with expected bills of $2,875 per month. They’ve also set aside $12,000 in a money market fund, $12,000 in checking and $4,000 in savings.

To help the couple weigh their hefty short-term goals, The Star-Ledger enlisted the help of Doug Buchan, a certified financial planner with Tilson Financial Group in Watchung.

“Let’s take the goals one at a time,” he said. “From a retirement standpoint, Jim and Devon are in very good shape.”

After running several retirement projections, given their anticipated retirement expenses, their pension income and Social Security income, Buchan found the couple will have the vast majority of income they need for retirement.

Because the couple have significant cash outlays in the next few years, proper funding of these goals is critical, he said.

First, despite the urge to do so, liquidating their IRA to help Devon’s parents should be avoided, he said.

“That money will be hit hard in two ways, and they will end up giving away more than half to Uncle Sam,” Buchan said.

Initially, the $357,000 will be penalized at 10 percent, since Devon is not yet 59½ years old.

Additionally, they’d pay ordinary income tax of the full $357,000. This full distribution would place them in the highest tax bracket, and that would leave somewhere between 50 percent and 60 percent of this money due to the IRS.

There are better alternatives, Buchan said. Given the value of their home and their current mortgage balance, it appears they may have some room to take out a home-equity line of credit (HELOC), he said, depending on their credit strength. As long as they qualify, Buchan said rates on HELOCs are at historic lows, so it’s a great time to borrow. Plus, this borrowed money is tax deductible.

If more money is needed above and beyond the HELOC, a second option to consider would be a 72(t) distribution from the IRA, although there are drawbacks, too. Buchan said Rule 72(t) is an IRS rule that allows for penalty-free withdrawals from an IRA account.

The rule requires that, in order for the IRA owner to take penalty-free withdrawals, he or she must take “substantially equal periodic payments” for the greater of five years or until age 59½.

There are three different methods to calculate the required distribution. In Devon’s case, she would have to take distributions of roughly $15,000 per year until age 59½.

If she modifies these payments, the 10 percent penalty would be imposed on all past payments, plus interest.

“Although this avoids the 10 percent penalty, it does not avoid the ordinary income tax that will be owed on the annual payments,” Buchan said.

Buchan noted this strategy is not for everyone and should generally be avoided if possible. It will greatly increase the chance of an investor exhausting retirement funds before exhausting their life expectancy.

“Given their situation of significant pension income relative to their projected expenses — which helps create a solid retirement projection — their strong desire to help Devon’s parents, and their limited taxable assets, this strategy may be appropriate,” Buchan said.