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.

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.

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.

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).

Note: This article focuses on choosing beneficiaries for your IRA. If you are the beneficiary of an inherited IRA, please see my article on inherited IRA rules.

When choosing beneficiaries for your IRA, there are really only two things you need to know:

1. Your will is not the proper place to name an IRA beneficiary, and
2. To the extent that it’s practical to do so, it can be advantageous to name your younger loved ones as the beneficiaries to your IRA.

Where to Name an IRA Beneficiary

When you open an IRA, the IRA custodian will ask you to fill out a beneficiary form. When you die, the person(s) listed on that form will inherit your IRA — even if somebody else is designated in your will as the recipient of your IRA.

So, when something changes in your life — new children, new grandchildren, divorce, etc. — it’s important to update your IRA beneficiaries accordingly. One of your children being left out (or an ex-spouse inheriting your IRA!) simply because you forgot to update a piece of paperwork would be a real shame.

Fortunately, updating your IRA beneficiaries is easy. With most brokerage firms, you can do it online. If you can’t, you should be able to get it done with a quick phone call.

Beneficiary Distributions: “Stretching” an IRA

When a non-spouse beneficiary inherits an IRA, she’s required to take distributions from the account over her remaining life expectancy. (More on that here.) The younger the beneficiary, the greater her remaining life expectancy and, therefore, the greater the ability for savings via tax deferral.

For example, if a 25-year-old inherits an IRA (from somebody other than his spouse), he’ll have to start taking distributions the following year (at age 26). At 26, according to the IRS life expectancy tables, his remaining life expectancy is 57.2 years. As such, he’ll be required to distribute the IRA over the next 57.2 years.

In contrast, if a 78-year-old inherits an IRA (from somebody other than his spouse), he’ll have to distribute the account over the next 10.8 years — a much shorter period due to his shorter remaining life expectancy.

In short, the longer a beneficiary’s remaining life expectancy, the smaller percentage of the IRA he has to withdraw each year, and the more he can take advantage of the power of tax deferral. As a result, to the extent practical, it often makes sense to choose your younger loved ones as the beneficiaries for your IRA.

Easy, Right?

As complicated as IRAs can be, choosing the beneficiary (or beneficiaries) for your IRA is fairly straightforward. Just remember to keep your beneficiary form up to date with your IRA custodian. And, if it’s reasonable to do so, consider leaving your IRA to your younger loved ones in order to maximize its value for your family.

Properly dealing with an inherited IRA can be tricky business. If you take the right steps, you can continue to delay taxation on the account for many years. But if you make a mistake, the entire account balance could be taxable immediately — thereby wasting a potentially huge sum of money on taxes.

When you inherit an IRA, the rules that apply to you depend on whether or not the deceased account owner was your spouse. We’ll cover spouse beneficiaries first, then non-spouse beneficiaries, then situations in which there are multiple beneficiaries.

Inherited IRA: Spouse Beneficiary

As a spouse beneficiary, you have two primary options:

1. Do a spousal rollover — rolling the account into your own IRA, or
2. Continue to own the account as a beneficiary.

Note: There’s no deadline on a spousal rollover. Should you want to, you can own the account as a beneficiary for several years, then elect to do a spousal rollover.

If you do a spousal rollover, from that point forward, it will be as if the IRA was yours to begin with. All the normal IRA rules will apply — whether Roth or traditional.

If you continue to own the account as a beneficiary, the rules will be mostly the same, with a few important exceptions.

No 10% Penalty
First, you can take distributions from the account without being subject to the 10% penalty, regardless of your age. So if you expect to need the money prior to age 59^1/2, this is a good reason not to go the spousal rollover route — at least not yet. (As mentioned above, there’s no deadline on a spousal rollover.)

Withdrawals from Inherited Roth IRA
Second, if the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax (though not the 10% penalty).

Spouse Beneficiary RMDs
Third, if the inherited account was a traditional IRA, you’ll have to start taking Required Minimum Distributions in the year in which the deceased account owner would have been required to take them, rather than the year in which you would ordinarily be required to take them. At that point, however, the distributions will be calculated the same as if it were your own account. (That is, each year, the RMD will be based on your own remaining life expectancy.)

Note: If the original owner (your spouse) was required to take an RMD in the year in which he died, but he had not yet taken it, you’re required to take it for him — calculated in the same way it would be if he were still alive.

Inherited IRA: Non-Spouse Beneficiary

When you inherit an IRA as a non-spouse beneficiary, the account works much like a typical IRA, with three important exceptions.

No 10% Penalty
Distributions from the account are not subject to the 10% penalty, regardless of your age. (This is the same as for a spouse beneficiary.)

Withdrawals from Inherited Roth IRA
If the inherited account was a Roth IRA, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax, though not the 10% penalty. (This is also the same as for a spouse beneficiary.)

Non-Spouse Beneficiary RMDs
Each year, beginning in the year after the death of the account owner, you’ll have to take a Required Minimum Distribution from the account. The idea is to distribute the balance of the account over your remaining life expectancy. The actual calculations are best explained with an example.

Imagine that your grandfather passes away in 2010, leaving you his entire IRA. If he was required to take an RMD in 2010 but he had not yet taken one, you’ll be required to take his RMD for him — calculated in the same way it would be if he were still alive.

Beginning in 2011, however, RMDs from the account will be based on your life expectancy. On your birthday in 2011, you turn 30 years old. According to the IRS Life Expectancy Tables, your remaining life expectancy at age 30 is 53.3 years. As a result, your RMD for 2011 will be equal to the account balance as of 12/31/2010, divided by 53.3.

For 2012, your RMD will be equal to the account balance at the end of 2011, divided by 52.3. In 2013, it’ll be the end of 2012 balance, divided by 51.3.

Important exception: If you want, you can elect to distribute the account over 5 years rather than over your remaining life expectancy. If you elect to do that, you can take the distributions however you’d like over those five years — for example, no distributions in years 1-3 and everything in year 4.

Successor Beneficiary RMDs
If the original non-spouse beneficiary dies before the account has been fully distributed, the new inheriting beneficiary is known as a successor beneficiary.

Successor beneficiaries are subject to the same rules as the original beneficiary, with one exception: The successor beneficiary must continue to take distributions each year as if they were the original beneficiary.

By way of illustration, in the example above, if you had died in 2013, leaving the entire IRA to your sister, she would be required to continue taking RMDs from the account according to the exact same schedule you had been taking them, regardless of her own age. So if you hadn’t yet taken your 2013 distribution, she’d have to take it. Her 2014 distribution would be exactly what yours would have been if you were still alive: the 12/31/2013 balance, divided by 50.3.

Tips for Non-Spouse Beneficiaries

1. When you retitle the account, be sure to include both your name and the name of the original owner.
2. Name new beneficiaries for the account ASAP.
3. If you decide to move the account to another custodian (to Vanguard from Edward Jones, for instance), do a direct transfer only. If you attempt to execute a regular rollover and you end up in possession of the funds, it will count as if you’d distributed the entire account.

Inherited IRA: Multiple Beneficiaries

If multiple beneficiaries inherit an IRA, they’re each treated as if they were non-spouse beneficiaries, and they each have to use the life expectancy of the oldest beneficiary when calculating RMDs. This is not a good thing, as it means less ability to “stretch” the IRA.

However, if the beneficiaries split the IRA into separate inherited IRAs by the end of the year following the year of the original owner’s death, then each beneficiary gets to treat his own inherited portion as if he were the sole beneficiary of an IRA of that size. This is a good thing, because it means that:

• A spouse beneficiary will be treated as a spouse beneficiary rather than as a non-spouse beneficiary (thereby allowing for more distribution options), and
• Each non-spouse beneficiary will get to use his or her own life expectancy for calculating RMDs.

To split an inherited IRA into separate inherited IRAs:

1. Create a separate account for each beneficiary, titled to include both the name of the deceased owner as well as the beneficiary.
2. Use direct, trustee-to-trustee transfers to move the assets from the original IRA to each of the separate inherited IRA accounts.
3. Change the SSN on each account to be that of the applicable beneficiary.

A Few Last Words

When you inherit an IRA, you absolutely must take the time to learn the applicable rules before you do anything. Don’t move the money at all until you understand what’s going on, because simple administrative mistakes (attempting a rollover rather than a trustee-to-trustee transfer, for instance) can be very costly.

Also, should you elect to get help with the decision — not a bad idea, in my opinion — don’t assume that somebody knows the specifics of inherited IRA rules just because he or she is a financial advisor. In these circumstances, I’d suggest looking for someone with CPA or CFP certification.