401k and IRA

Conventional investment wisdom says that when choosing between tax-deferred accounts [like a traditional 401(k) or IRA] or tax-free accounts [like a Roth IRA or Roth 401(k)], it’s primarily a question of how you expect your tax bracket in retirement to compare to your current tax bracket:

• If you expect your retirement tax bracket to be higher, go for the Roth.
• If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
• If you have no idea, do some of both.

I recently received a related question from a reader about choosing between a regular 401(k) or a Roth 401(k):

I can contribute approximately $1,000 each month to my 401(k). The plan allows me to make either Roth or regular contributions.

I’m in the 25% tax bracket, so the $1,000 deduction I’d get every month from making regular 401(k) contributions would give me an extra $250 to contribute. Would that extra $250 monthly investment, compounded from now until I retire, be enough to overcome a higher tax bracket in retirement?

Good question. The short answer is, “No, because that’s already factored into the normal advice.”

How About an Example?

Annie invests $500 in a traditional 401(k) and $500 in a Roth 401(k). Each investment goes into the same fund. When Annie retires:

• The Roth contributions will come out tax-free, but
• The traditional 401(k) contributions will be taxable as ordinary income.

In other words, the $500 Annie invests in her Roth 401(k) will end up being worth more than the $500 she puts in her traditional 401(k) unless her tax rate during retirement is zero percent.

Takeaway: You have to invest more in a tax-deferred account than in a Roth account in order to have the same amount left after taxes.

For example, if you expect to be in the 25% tax bracket in retirement, you have to invest $1,333 ($1,000 ÷ 0.75) in the tax-deferred account each month for it to be as valuable as investing $1,000 in a Roth.

What Role Does an Employer Match Play?

In a follow-up email, the reader asked about how an employer match factors into the decision. For the most part, it doesn’t. Any employer contributions will be made to a “traditional” 401(k) account, regardless of whether the employee makes Roth or regular contributions.

Is Conventional Wisdom Right This Time?

When people say that the question of Roth vs. traditional is primarily about how your current tax bracket compares to your future tax bracket, they’re right. Again:

• If you expect your retirement tax bracket to be higher, go for the Roth.
• If you expect your retirement tax bracket to be lower*, go for the traditional IRA/401(k).
• If you have no idea, do some of both.

Just remember that when investing via tax-deferred accounts, you have to contribute more money.

*This is obviously not a scientific survey, but my correspondence with investors indicates that the majority of retirees are in a lower tax bracket in retirement than they were in for most of their careers.

March 14, 2011 14 comments

Some investors are fortunate enough to have 401(k) plans run by low-cost administrators, offering low-cost investment options. For most investors though, the situation is quite different:

• The typical 401(k) plan charges administrative fees ranging from 0.5% to 1% per year, and
• The investment options are often limited to actively managed mutual funds with expense ratios of 1% or more per year.

At a grand total cost of 2% or so per year, investing via a 401(k) plan is not cheap. In contrast, with an IRA, there are no admin fees at all (at most brokerage firms), and you have access to super-low-cost index funds and ETFs with expense ratios of 0.20% per year or less.

So does it make sense to forgo 401(k) contributions in favor of maxing out an IRA?

Not necessarily.

Get that 401(k) Match!

Before contributing to an IRA, be sure to contribute enough to your 401(k) to get any match that your employer offers. In nearly all circumstances, a dollar-for-dollar match (or even a 50-cents-on-the-dollar match) outweighs any other drawbacks such as high admin costs, fund expenses, or a tax-preference for a Roth.

Important note: If you’ve read that your employer offers, for example, a 4% match, that probably does not mean that they contribute 4 cents for every $1 you contribute. It usually means that they contribute $1 for every $1 you contribute, up to 4% of your compensation. This is a big difference! If you contribute 4% of your compensation, they immediately double it.

An immediate, risk-free, 100% return is impossible to beat.

I Got My Match. Now What?

After getting the maximum 401(k) match, the best approach is typically to:

1. Max out your Roth IRA,
2. Then, if you still have more to invest, go back and max out your 401(k).

By following this approach, you get your employer match, you take advantage of the lower costs available via an IRA, and you tax-diversify your investments by spreading them out among both pre-tax accounts (your 401(k)) and after-tax accounts (your Roth).

Exceptions

Naturally, in certain situations, it makes sense to do things differently.

For example, if you earn enough to make you ineligible for Roth contributions, it likely makes sense to replace that step by making (non-deductible) contributions to a traditional IRA, with the intention of converting them to a Roth at some point.

Alternatively, there are some situations in which it makes sense to max out your 401(k) completely before making any Roth contributions. For example, if you’re:

• Getting close to retirement and you’re currently in a much higher tax bracket than you expect to be in during retirement, or
• Not very close to retirement, but you still think you’re in a higher tax bracket than you expect to be in during retirement and your 401(k) has low admin costs and fund expenses,

…then the benefit of decreasing your taxable income now — via larger 401(k) contributions — would likely outweigh the associated costs.

November 1, 2010 8 comments

The whole point of an IRA (Roth or otherwise) is to save for retirement. Unfortunately, things don’t always go as planned, and you may find yourself needing to withdraw money from your Roth IRA before age 59½.

The most important thing to know is this: Contributions (that is, the money that you put into your Roth) can come out at any time, free of taxes and penalties.

Distributions of Earnings

When it comes to distributions of earnings, however, things get a bit more complicated. That’s why I prepared this handy flowchart (and the following explanations) to help you determine whether or not distributions of earnings will be subject to income taxes and/or penalties.

Please note, this flowchart only applies to earnings when your Roth does not include any amounts converted from a traditional IRA or other retirement plan. If your Roth does include such amounts, please see “Distributions After a Roth Conversion” below.

Qualifying Reasons for Distributions

The following are the “qualifying reasons for distributions” referenced in the first step of the flowchart:

• You have reached age 59½.
• The distribution was made to your beneficiary after your death.
• You are disabled.
• You use the distribution to pay certain qualified first-time homebuyer amounts.

5-Year Rule

Any earnings distribution prior to the first day of the fifth year after your first Roth was established will be taxed as ordinary income, at whatever your tax rate is at the time.

Example: You open a Roth IRA on May 18, 2009. The 5-Year Rule will be satisfied as of January 1, 2014.

Other Exceptions to 10% Penalty

Even if your distribution is not for a “qualifying reason,” you may be able to escape the 10% penalty (but not ordinary income taxes) if any of the following situations apply:

• You have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
• You are paying medical insurance premiums after losing your job.
• The distributions are not more than your qualified higher education expenses.
• The distribution is due to an IRS levy of the qualified plan.
• The distribution is a qualified reservist distribution.
• The distribution is a qualified disaster recovery assistance distribution.
• The distribution is a qualified recovery assistance distribution.

All Roth IRAs Are Viewed as One

When applying each of the above rules, the IRS views all of your Roth IRAs together as one big Roth IRA. For example, once you’ve met the 5-Year Rule for one of your Roth IRAs, you’ve met it for all of them. Also, distributions from a Roth will not count as distributions of earnings until you’ve withdrawn an amount greater than the total of all of your contributions to all of your Roth IRAs.

Example: In 2005, you contribute $2,000 to a Roth. In 2006, you open a Roth with a different brokerage firm, and contribute $3,000 to it. By 2007, each Roth has grown to $5,000. You could withdraw $5,000 from either (but not both) of the two Roth IRAs without having to pay taxes or penalties because your total contributions were $5,000 and because the IRS considers them to be one Roth IRA.

Distributions After a Roth Conversion

If, you’ve converted money from a traditional IRA to a Roth IRA, things get slightly trickier.

Any distributions of converted amounts (assuming they were taxable at the date of the conversion) will be subject to the 10% penalty (though they’ll be free from ordinary income taxes) if the distribution occurs prior to the first day of the fifth year after the date of the conversion. If, however, the distribution was for a “qualifying reason” or you meet one of the “other exceptions” above, the distribution will be free from penalty.

If the conversion included amounts that were not taxable (because they came from a nondeductible IRA), those amounts will not be subject to the 10% penalty even if they are withdrawn from the Roth prior to the first day of the fifth year after the date of the conversion.

Order of Distributions

According to IRS Publication 590, distributions are assumed to occur in the following order:

1. Regular contributions.
2. Conversion and rollover contributions, on a first-in-first-out basis (generally, total conversions and rollovers from the earliest year first). Take these conversion and rollover contributions into account as follows:
   • Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
   • Nontaxable portion.
3. Earnings on contributions.

Example: During 2009, you contribute $5,000 to a Roth IRA. You also convert $20,000 from a traditional IRA into your Roth IRA. Of that $20,000, $13,000 was taxable upon the conversion, and $7,000 was not because it came from nondeductible IRA contributions.

In 2010, you withdraw $8,000 from your Roth. The first $5,000 is free from tax and penalty because it’s a return of your contributions. The next $3,000 is assumed to come from the taxable portion of your converted amount. As a result, it will be free from income tax, but it will be subject to the 10% penalty because the distribution occurred prior to the first day of the fifth year after the date of the conversion.

In 2011, you withdraw another $15,000 from your Roth. The first $10,000 will be the remainder of the taxable portion of the conversion (and will again be free from income tax but subject to the 10% penalty). The remaining $5,000 will be considered to have come from the nontaxable portion of the conversion, and it will be free from both tax and penalty.

Phew!

Admittedly, things can get a bit tricky. Hopefully this helped to clear things up.

October 7, 2010 33 comments

I’ve recently gotten a few questions about the deadline for a Roth IRA conversion. The answer is that it depends on what, exactly, you want to know the deadline for.

The shortest answer is that, for any given year, the deadline for a Roth IRA conversion is December 31 of that year. (Note: This is different from IRA contributions, which can be made up until April 15 of the following year.)

There are a few other Roth conversion-related deadlines you may want to know about, though.

Income Limits Are Gone for Good

As of 2010, the income limits for Roth IRA conversions disappeared. They are not scheduled to come back. In other words, no matter your income level, Roth conversions are not “do it in 2010 or miss your chance.”

Why 2010 Is Special

December 31, 2010 is the deadline, however, for the special option to delay payment of the tax on a Roth conversion. That is, for 2010 Roth conversions, if you choose to do so, you can claim 50% of the converted amount as income in 2011 and the other 50% in 2012.

Beginning in 2011, Roth conversions will go back to working like normal — if you convert in a given year, you’ll have to claim the converted amount as income in that same year.

Roth Conversion Recharacterization Deadline

In case you’ve never run across the term before: A “Roth conversion recharacterization” is basically a do-over. If you convert an amount from a traditional IRA to a Roth IRA, you’re allowed to undo the whole thing as long as you don’t wait too long.

To do so, you’ll have to:

1. Notify the custodian(s) of your traditional IRA and your Roth IRA of your intention to recharacterize the conversion,
2. Transfer the amount in question from the Roth IRA back to the traditional IRA, and
3. If you’ve already filed your tax return for the year of the conversion, you’ll have to amend that return.

The deadline for recharacterizing a Roth IRA conversion is October 15 of the year following the conversion.

Just Because You Can…

One last point: Just because you can convert your IRA to a Roth IRA doesn’t mean you should convert it.

July 26, 2010 7 comments

From time to time, people ask me what I think about mutual funds run by American Funds. My answer is that it depends on the circumstances.

In my experience, if you’re considering using American Funds, you’re likely in one of two situations:

1. A commission-paid financial advisor is pitching you an American Funds portfolio, or
2. American Funds is one of the investment options in your 401(k).

American Funds in your IRA

If somebody is currently attempting to sell you an American Funds portfolio for your IRA or taxable account, I’d suggest politely declining. I’d also suggest finding another advisor — one not paid on commission.

American Funds aren’t the worst thing you could put your money into, but the reality is that there are better, less expensive options available. There’s really no need to pay a sales load or an expense ratio of almost 1% per year.

Expense ratios are an excellent predictor of future performance. In fact, some studies show that they’re the best predictor. In other words, one of the most reliable ways to improve the performance of your portfolio is to reduce the costs you’re paying for your investments. (Makes sense, right?)

High-cost fund companies (and the salespeople pushing their products) will go to great lengths to obscure the common sense importance of costs. Rather than focus on costs, they promote the performance of whichever of their funds have performed best lately — all the while ignoring the fact that past performance is basically worthless as a predictor of long-term future performance.

American Funds in your 401k

While I’d suggest against using American Funds in your IRA or taxable account, it’s actually quite likely that, if American Funds are available in your 401(k), they’re going to be one of your best options.

Why the big difference? Two reasons:

1. In a retirement plan at work, you’ll often get access to American Funds products without paying a sales load, and
2. It’s likely that the other options in your 401(k) aren’t any better.

My advice for choosing funds in your 401(k) is to determine the asset allocation you want for your portfolio, then research the available investment options to determine the lowest-cost way to implement that asset allocation. For many investors, that will mean using some American Funds products in their 401(k).

July 7, 2010 11 comments