roth ira

2010 Roth Conversion: Good Idea?

by J.J. on November 17, 2009

Over the next couple of weeks, six finalists will be auditioning for the opening of “staff writer” at Consumerism Commentary. Each will be providing two guest articles to share with readers. After the six writers have shared their guest articles, readers will have an opportunity to provide feedback before we select the staff writer.

This article is presented by J.J., a financial adviser and published financial author.

Roth IRA conversion rules are changing next year. Even if you make more than $100,000, you’ll be allowed to convert Traditional IRA money into after-tax Roth money. You can even spread the tax payments out over a few years to make it easier if you convert during 2010.

Does it make sense to do so?

We’ve touched on the 2010 Roth conversion rules before. Let’s dig deeper into why it may or may not make sense to convert.

Why convert?

The 2010 conversion rules may help some taxpayers. In general, the opportunity is more attractive if:

You think tax rates are headed higher
You’ve been making nondeductible IRA contributions
You have a high net worth or you want to leave more for your heirs
You want to diversify the tax status of your money, just like you diversify your investments

Higher tax rates

With higher tax rates in the future, you can get your tax payment out of the way now — at a lower rate. What might make tax rates higher in your retirement years? You could have higher earnings, lawmakers could raise tax rates overall, or both.

With all the talk of government bailouts and broken entitlement systems (like Social Security and Medicare) it’s easy to see why rates could go up. The government needs money, but the solution may not be as simple as an income tax rate increase. There are other ways they can drum up cash:

Consumption or value added taxes (VAT)
Change how much you and your employer pay for Social Security
Change limits on retirement plan contributions
“Forget” to change certain limits with inflation (IRA and retirement plan contributions, compensation recognized for Social Security and retirement plan calculations, etc)
Change the laws and make Roth distributions taxable (or potentially taxable, like Social Security benefits)
Other strategies I’m not smart enough to understand

If you’re betting on higher tax rates, make sure you understand how the bet can go wrong.

Nondeductible contributions

If you’ve been making nondeductible contributions, you’ve practically made Roth contributions anyway. In fact, you probably couldn’t deduct the contributions because you make too much money. For you, the conversion option is worth investigating because it would allow you to get the earnings out tax-free – as opposed to just the contributions.

Ideally, you’ve been making nondeductible contributions in recent years, and you have little or no earnings in the account after the recent market decline (sometimes there’s a silver lining). If so, the tax hit may be minimal. However, you should look at all your IRA accounts in aggregate to figure out how much it’ll cost.

Diversify, diversify, diversify

Diversification is another decent reason to consider converting. Most people have all (or a majority) of their retirement savings in Traditional pre-tax accounts. They’ll have to pay income tax as they spend that money. Since we don’t know what tax rates will do, it may make sense to hedge your bets.

If you have a choice of funds (pre-tax and post-tax) in retirement, you can choose whether or not to increase your tax bill in a given year. Suppose you do some consulting work and earn money – it may make sense to take a Roth distribution that year. On the other hand, you can take Traditional distributions when you have little or no taxable income.

Estate planning

If you’re fortunate enough to have an estate planning problem — or just more money than you need — then Roth money can come in handy. By converting, you pay taxes today so your heirs can take tax-free distributions (unless they change the rules and start taxing Roth distributions, of course). You also remove money from your estate when you pay the tax bill.

You’re required to take distributions from Traditional IRAs during your lifetime, starting after you reach age 70.5. The government wants you to generate some tax liability on all that money you’ve been protecting, so they force you to dribble it out over your remaining years. Roth IRAs do not have this requirement, so you can leave more for your heirs.

Proceed with caution

If the idea attracts you, don;t rush into anything. In the coming months, we’ll learn more about the complexities of the 2010 conversion rules, and how the landscape may change (for example, will tax rates increase in 2011 and 2012 — making it less attractive to spread the payments out?). Unless tax rates in your retirement years increase substantially, you probably won’t hit a home run by converting. However, you might come out ahead or just enjoy having more flexibility in retirement.

Remember that if you earn over $100,000, you’re already in a fairly high tax bracket (at today’s rates at least). A conversion won’t be cheap, and you should pay the taxes due from savings available to you outside of your retirement accounts.

Give your eyes a break and listen: a recent Consumerism Commentary podcast has more insight into the 2010 conversion rules.

Will you take advantage of the Roth conversion rules next year? Why or why not?

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Roth IRA Conversion

by Flexo on August 21, 2009

The option to convert a Traditional IRA to a Roth IRA has been around for a while. Here are the differences between a Traditional IRA and a Roth IRA for those new to these retirement accounts. As long as your modified adjusted gross income (MAGI) is under $100,000 you have qualified for this conversion. Contributions to the Traditional IRA is tax-deductible, which means that your tax bill is calculated after ignoring the amount you deposit into the IRA. You will pay those taxes after you retire and begin withdrawing these funds. If you have a higher tax rate now than you will in retirement, the Traditional IRA is a good choice.

On the other hand, the Roth IRA is not tax-deductible, so the deposits into this type of IRA are not exempted from your total income calculation for tax purposes. In effect, you use “after-tax money” to invest in a Roth IRA. This is a great choice for people who believe their tax rate now will be lower than it will be in retirement once they begin taking distributions.

There are two other benefits to the Roth IRA that often go unnoticed. The Roth IRA does not require distributions after age 70 1/2 like the Traditional IRA, offering more flexibility in retirement. The Roth IRA is better for estate planning; choosing a Roth IRA rather than a Traditional IRA for funds passed onto your heirs will allow them to avoid tax bills.

These benefits come with a drawback: if your MAGI is above $105,000 ($166,000 for those who are married filing jointly) your maximum allowed contribution begins to reduce and will completely phase out at $120,000 ($176,000 for married filing jointly). But there is now a law that will help you get around this for a short time.

In 2010, the $100,000 maximum for Roth IRA conversions will temporarily disappear. If you believe the Roth IRA is a better option for you but you have been prevented from investing in this type of account due to income limitations, now is your chance to make the change. Here is why this will be allowed: When you convert from a Traditional IRA you owe taxes on the amount of the conversion, and the government would really like that income.

If you must pay those taxes using funds from your IRA, the conversion might not be a good idea, but if you have cash saved for the tax bill you will be better off.

You can also convert accounts known as SEP IRAs and SIMPLE IRAs.

Here are some quality resources regarding Roth IRA conversions.

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4 Important Tips for Graduates Beginning a First Real Full-Time Job

by Flexo on June 29, 2009

in Career and Work

The summer following graduation is an interesting time for recently-former students. The newly-commenced young men and women, those not opting to pursue an additional number of years in an institution of higher learning, spend their time amongst activities such as attending backyard barbecues in celebration of their achievements, traveling to distant lands with newfound free time, and possibly beginning the first real job on their career path.

Not every job is the same, but for the most part there are a number of things in common.

You need to make a positive impression on people you are meeting for the first time.
How you perform on your first job sets the stage for your work ethic.
If you stay in the same career throughout your life, your initial salary will be your most important negotiation.

Here are more specific tips for making the most of your first job.

1. Look the part. As much as it is superficial and stupid, people will judge you by your appearance. You need to dress and carry yourself in a manner that is expected and accepted by the people who work in your field. What is acceptable varies. If you work in banking in New York City, it’s almost guaranteed you will be expected to show up in a suit every day. If you work in the graphic arts, more liberal clothing might be acceptable. Find out what your manager or supervisor wears and emulate.

If you have not been accumulating attire during college, you may find the need to buy a variety of clothing at the last minute. This is one reason it may make sense to accept a controllable level of debt. Attire is a start-up cost associated with accepting a first job, and if you are required to dress well, your salary should cover these costs before long.

2. Negotiate. Graduates may be experiencing a “sellers’ market” while starting new careers this summer. With stories of the difficulty of finding a great job in the right field, it may be tempting to jump at the first offer. It is true that times like this call for adjusted expectations, but the dance of negotiation is an important and expected part of every job offer.

Not every job has this flexibility. For example, if you start as a teacher in New York City, your salary and benefits are determined by the union contract and you have no room for negotiation. If your first job is with a cash-strapped non-profit organization, you may face resistance. But the first salary offer you receive is almost always lower than the company’s true ability to pay.

The best suggestion is to be prepared to support your desire for a higher salary by researching your peers’ compensation and by explaining well the skills you can bring to the table above other candidates. As you may not have much experience in your field when you start your first job, you may not have a list of accomplishments, so be creative while being honest.

Here are tips for dealing with a low salary offer. Remember to look at the total compensation, not just the salary. You may have more wiggle room if you ask for more vacation days or for quicker establishment of your retirement benefits.

3. Enroll in your company’s retirement plan. When I started at the company where I currently work, I qualified for the company’s 401(k) on the day I began. Although a portion of my company’s matching contributions wouldn’t vest (become officially mine) until I had been working there for three years, my first paycheck included a deduction for my 401(k) and a matching contribution from the company. While enrollment is often automatic, some companies don’t start helping you put aside money for retirement until you tell them how much you want taken out of your paycheck.

Young adults with their first job often do not think about retirement, an event likely to be more than forty years in the future. Not enrolling in a 401(k) with matching contributions is the same as throwing away money. I understand that people who are just establishing themselves at work and in life have expenses, and retirement savings cuts into income. But putting aside two or four percent of your income — or up to the maximum matched by your employer — should not be a stretch.

4. Open an IRA. Your 401(k) contributions are taken right from your paycheck, so you might not even notice your money is being transferred to your future self. It may be more painful to your wallet to open an IRA, but if there is no pain, there is no gain. So open an IRA at a low-cost brokerage like Vanguard. When I started my IRA, I didn’t have the $3,000 minimum, so I jumped right in with TIAA Cref. I suggest saving money periodically in a special bank account until you have the $3,000 necessary to open an account at Vanguard because I have encountered some problems with TIAA-Cref.

If you already have a 401(k), open a Roth IRA. These two types of accounts have different tax treatment, and it’s good to diversify. If your company does not offer a 401(k) or its non-profit cousin the 403(b), split your money between a Traditional and Roth IRAs, if you can, to get the same tax diversification.

Your career and the skills and tools you use to thrive in that career are your biggest assets, even though you won’t see them measured on any balance sheet. Protect, refine, and showcase your self and your skills when you can. If your career is important to you, go above and beyond the call of duty.

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Traditional vs. Roth IRA: An Introduction and Comparison

by Flexo on March 11, 2009

The Individual Retirement Account (IRA) allows anyone who earns income the opportunity to save for retirement, regardless of the plans offered by his or her employer. An IRA is not an investment in itself, it’s an account type. Within the IRA, you can keep your money for the future in money market funds, CDs, stocks, even gold. The government limits how much you’re allowed to invest in an IRA each year. Here are the contribution limits for 2009. In addition, the government also reduces these contribution limits for certain types of IRAs depending on your income. For individuals over the age of 50, the government raises the contribution limit to help “catch-up.”

Traditional and Roth IRAs

There are two main “flavors” of IRAs: traditional and Roth. Both types include the benefit of allowing money to grow tax-free while invested and untouched. That means that even while your account grows, you won’t have to pay taxes on capital gains or interest. That leaves more money in the account, with returns possibly compounding upon returns. A traditional IRA adds the benefit of tax-deductible contributions. In other words, if you contribute $5,000 to your traditional IRA, if you aren’t excluded by your level of income, you can deduct the $5,000 from the income you report on your tax return. You will pay tax, however, when you are retired and take a distribution from the account.

Contributions to a Roth IRA are not tax-deductible. The most common way of describing this is that you invest in Roth IRAs with “after-tax” money and traditional IRAs with “pre-tax” or “before-tax” money. When you take a distribution from your Roth IRA after you’ve retired, you will not pay tax on your capital gains, of which the plan is to have many.

You can withdraw money from an IRA at any time, but if you do so before age 59 1/2, you may face some penalties. First, with a traditional IRA, you will be taxed on your contribution and gains withdrawn, plus be subject to a 10% penalty in the form of a tax for “early withdrawal.”

Which IRA to choose?

In general, when deciding between a Roth IRA and traditional IRA, the choices comes down to your tax bracket. If you think you have a lower tax rate now than you will when you retire, the Roth IRA will keep you from paying tax on your contributions when you withdraw after age 59 1/2. If you think you will have a lower tax rate in retirement, take the deduction in a traditional IRA now and pay the tax on contributions when you withdraw after 59 1/2. Sounds simple, right? There are a lot of variables to consider. For example, will this country’s tax rates be much higher by the time you retire?

More importantly, will the government decide to change the tax advantaged status of these accounts, and will that change affect current investors, before you reach retirement? Many people hedge their bets on the future tax rates by investing a portion of their maximum allowed contribution in a traditional IRA and the remaining portion in a Roth IRA.

There are numerous nuances to consider as well. If your income is too high to qualify for a Roth IRA right now, you can contribute to a non-deductible traditional IRA and “recharacterize” the IRA as a “Roth IRA” by paying taxes next year, regardless of your income level in 2010. There are certain circumstances in which you can withdraw your money from a Roth IRA without paying the 10% penalty. Using your Roth IRA to pay for your first house is one of the qualifying cases. Furthermore, you can re-contribute to a Roth IRA if you withdraw your contributions.

If you’re self-employed, even if only as a side job to complement your main career, you can also contribute to a SEP IRA as your own employer. This greatly increases the amount you can save for retirement.

Setting up your initial IRA

I find it important to look for low-cost investments for IRAs. Since they are tax-advantaged — you don’t pay taxes on gains and interest while your money stays with the IRA — you can freely trade without having to report your income to the government, leaving more money working for you. For the last few years, I have been using Vanguard exclusively for my IRAs. They have low cost index funds and solid money market funds available. The account opening process is straightforward, and once your initial account is active, it takes only a few clicks to contribute, transfer money from one fund to another, and create automatic investment plans.

Another popular company for IRAs is Fidelity.

This is only n introduction to Individual Retirement Accounts. Please feel free to share any tips you have or experiences you’ve had with IRAs.

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Traditional and Roth IRA Contribution Limits for 2009

by Flexo on January 1, 2009

The total contribution limit for IRAs is not changing in 2009. Just like 2008, the maximum you can contribute to your IRAs across both Traditional and Roth types is $5,000. Anyone who becomes 50 years old this year has a higher maximum of $6,000. Keep in mind that this maximum is across IRA types, so if you’re 49 years old and have already invested $4,000 in a Roth IRA, you can only add $1,000, whether the amount is invested in a Traditional IRA, Roth IRA, or split between the two.

The phase-out ranges for Roth IRAs change this year. If your modified adjusted gross income (MAGI), a specific calculation on the 1040 tax form, is above $105,000 for single filers or above $166,000 for those who are married filing jointly, your maximum allowable Roth IRA contribution begins to reduce to zero. If your MAGI is above $120,000 (single) or $176,000 (married filing jointly), you do not qualify for Roth IRA contributions.

If you haven’t contributed to your 2008 IRA, don’t panic. You have until your tax filing deadline to fund your 2008 IRA. I haven’t contributed to my 2008 Roth IRA yet. I need to calculate my MAGI first in order to determine my maximum contribution amount.

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The New Emergency Fund: Five Components of an Emergency Plan

by Flexo on January 29, 2008

in Best Of, Saving

In an world of overly simplified platitudes and one-size-fits-all “advice,” there is little repeated more in personal finance than the importance of the emergency fund. Typical popular financial advice prescribes a high-yield savings account in which one can store three to six months’ worth of expenses. Suze Orman suggests aiming for eight months’ expenses in a savings account. David Bach believes four months is a good starting point for an emergency fund.

Advice for a fat emergency fund sounds good when high-yield savings accounts are actually providing high yields. When interest rates are low, it can be financially detrimental to leave so much cash uninvested. It may be worthwhile to diversify. Rather than having just an “Emergency Fund,” like a “subaccount” at ING Direct with its own name, this can be only one component of a larger scheme. To encompass all that could be included, perhaps “Emergency Plan” is a better term than “Emergency Fund.”

I am not talking about a box that you keep in the trunk of your car that contains a gas mask, a gallon of water, a hand-crank radio, and a can opener, like one of my coworkers. While that might be helpful for the Y2K bug when airplanes fall out of the sky in midflight, this “Emergency Plan” refers to finances only. There are five components.

1. Mattress cash stash. Obviously not hidden beneath your mattress, having some cash in the house — hidden in a weird place that a burglar would not think to look — gives you access to fast cash if you need to leave right away without any time to stop at a cash machine. Also, if the ATM network is down for some reason, you won’t have any trouble trying to access some money. It would be impossible to predict how much you would need before you could access the banking system in a catastrophic event, so I think the guideline here is just to be reasonable. Maybe keep a couple hundred dollars in cash around the house.

Of course, in the worst situation imaginable, money itself would lose all value and society would be reduced to a system of bartering for what you need. Even gold, which some people claim has intrinsic value that paper money does not (it doesn’t), could be worthless. Don’t bother keeping bars of gold around. The idea is to prepare within reason. Keep this amount as low as possible; money sitting around loses value relative to the things you would need to trade it for thanks to inflation of the money supply.

liquid 2. Liquid account. Unless the banking system fails, you should be able to access your next level of emergency fund within 24 hours. With interest rates decreasing every week, it might make sense to seek out better paying liquid investments like money market funds. All of the cash I have earmarked for emergencies, about $10,000 right now, is held at ING Direct, currently one of the lowest of the “high-yield” savings accounts.

It wouldn’t hurt to add layers to this level. This year, I will change my Emergency Plan to leave cash in the amount of expenses for one month or less at ING Direct while increasing my savings at a money market fund that beats inflation like the Vanguard Prime Money Market Fund, currently earning a 4.55% yield. Between my mattress stash and liquid accounts, I want to be able to cover three months’ worth of my current expenses. That’s a little lower than what’s recommended by the gurus, but I chose this amount because the chance of losing both of my sources of income at the same time is low and I believe I could find a new job quickly if necessary.

Bankrate discusses using certificates of deposit or bond funds for this portion of liquid savings, but they are not liquid enough. The interest premium offered over high-yield savings accounts and money market funds, usually small, won’t outweigh the chance of paying an interest penalty for early withdrawal before maturity.

3. Investments. With investments, we’re starting to get into the territory of the money you’d be better of not touching, even in an emergency. The Roth IRA is the first stop if you need to tap your investments in an emergency. You can withdraw your contributions (not your earnings) without penalty, taxes, or fees (depending on your broker). Once the emergency condition has subsided, you can still contribute the money you withdrew back into your Roth IRA.

If you don’t have a Roth IRA, you may have to turn to taxable investments. This isn’t a great option, but still better than the next. If you have to sell when you’re investments are down, you’re not doing yourself a favor down the road. You may get some tax benefits in this case, but you’ll have to determine whether it’s worthwhile. If you sell your investments while they’re higher than they were when purchased, you will owe taxes, which could be just as troubling in the short term if you’re still in an emergency condition. Either way, you’ll also contend with transaction fees.

Stay away from granting yourself a loan from your 401(k). If you lose your job during this emergency, your 401(k) loan will become due immediately. That’s an unaccessible level of risk, at least for me.

cheerful credit 4. Credit. This is a slippery slope. Some recommend using a home equity line of credit as an emergency fund but having a HELOC in the first place means having an interest expense every month. The purpose of a HELOC goes beyond emergency funds, and therefore shouldn’t be the only part of an Emergency Plan.

Credit cards should be avoided in most cases. They could be used most effectively when you know that the emergency condition will subside before your credit bill comes due. Interest charged for credit card accounts is usually way too high for effective emergency use. If you have a special promotion with your credit card, like 0% APR on purchases or cash advances, then taking advantage of these deals could pay off. It requires extra special attention to make sure you don’t fall into any of the credit card traps. If you end up owing back interest due to a late payment, even in an emergency situation, you could be paying for this emergency longer than you would otherwise.

5. Friends and family. While I originally thought this fifth component is outside of one’s control, if you’ve done a good job of taking care of the universe around you, the universe will return the favor when you’re in need. If you’ve made a habit of helping those in need when you were able, when you’re in need, perhaps someone will be there to look out for you. Perhaps this will be in the form of your roommate or friend lending money to you at a very low rate or a gift from your parents. Either way, it’s best not to rely on help from the universe, as there are no guarantees. When you save cash in a money market fund, it’s guaranteed to be there when you need it. Friends and family can provide powerful assistance, but if you don’t need it, don’t take it.

Here’s a secret. There are actually six components.

6. Reduce your expenses. One thing you can do to make your Emergency Fund last longer, or save more for next time, is reduce your expenses temporarily. Make some sacrifices, like the Expensive Coffee-Relate Drink, cable television, or weekly dining engagements. Desperate times call for desperate measures. Feel free to indulge again once you find a new job or otherwise increase your cash flow to normal conditions.

What is your Emergency Plan? Do you consider yourself covered with cash in a savings account, or do you take a more complete approach?

Image credits: tanakawho, ChicagoEye

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The Mole on Lump Sum vs. Dollar Cost Averaging

by Flexo on January 16, 2008

Recently, I asked whether I should fund my Roth IRA in one lump sum or dollar cost average throughout the year. It’s unlikely that I’ll qualify to fund a Roth IRA this year, so now this question is moot. Regardless, Money Magazine’s “The Mole,” an anonymous financial adviser insider, tackled this question (though with an investment of $600,000 rather than $5,000).

Funding each year’s Roth IRA completely once a year is actually just a slower for of lump sum investing; if you had $150,000 ready to invest when you first started your career — an estimate I based on 30 years of a $5,000 full investment though as we know the maximum contribution changes — then investing the entire sum at the beginning would have returned much more than $5,000 each year.

The Mole’s point is that your asset allocation in your investment should match the risk level you’re willing to take, and over the long term, lump sum investing presents higher returns.

Most of us, however, don’t view our lives mathematically. For example, if you had put this $600,000 in the market in March of 2000, it would have taken nearly a 50 percent hit two and a half years later. And if you were like most investors, the pain of this loss would have compelled you to sell long before the recovery began. Had you not sold, you would likely have seen your global set of index funds delivering some pretty decent returns over the total period.

Psychology tends to get in the way of sound financial decisions.

Of course, if you don’t have the lump sum available, then you have no choice but to dollar cost average.

Investing $600K: Lump sum vs. little by little [Money Magazine]

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2008 Roth IRA: Lump Sum or Dollar Cost Average?

by Flexo on December 22, 2007