JLP-

Greetings!

Two countdowns, one problem: Nobody knows about them.

1. In 73 days, the 2010 Roth conversion opportunity will go into effect, allowing people earning over $100,000 to convert to a Roth IRA and enjoy tax breaks down the line.

2. In just 1 day, on October 15, we reach the deadline for Roth conversion take-backs: if you already switched to a Roth in 2008, you can undo the move (“recharacterize”) and convert your Roth IRA back to a traditional IRA, shrinking your overall tax bill and returning taxes paid with interest.

Schwab’s latest survey found that those most impacted by the 2010 change…

• don’t know about the 2010 Roth conversion rule changes (61 percent),

• are confused about the rules (26 percent find it more confusing than health reform),

• are not planning to convert (72 percent).

I kind of fell down on the job on this recharacterization stuff. For those of you who aren’t sure about recharacterization, it’s the process of reversing the conversion of a traditional IRA to a Roth IRA. I was going to explain the process in a post but I really can’t do a better job than was done in this article.

Silly me…..I have been reading your column and never thought to ask you a question!! I love reading your blog. I have been agonizing over what to do.

Here is the situation…..I am 50 years old, take home $68,000 a year (total of 2 jobs).

I did the Rave Ramsey Financial Peace University in January 2008. Paid off ALL debt ($8,000) but the house. I have $84,000 left on the mortgage which I plan to have paid off in about 3 years time. Yippii!!!!!! I will then be able to start building some real wealth…at least that is the plan.

I work 2 jobs to make up for my idiotic choices of the past. At my part time job I have a 4% match, which I do. At my full time job they give me 6% of my salary. I do not have to match it. I do contribute 15% at this time. Should I not be contributing and put my money (the 15%) in a Roth IRA. I have not yet started any kind of IRA. I have approx. $100,000 in my combined 403 and 401.

I plan on working both jobs till I am 67…….if only I knew what I know now at 18

Thank you,

Toni

She followed up with another email to say that she did have an emergency fund.

Since she didn’t ask any questions I’m going to assume that she wants our thoughts on her plan. A couple of things I noticed:

“I have $84,000 left on the mortgage which I plan to have paid off in about 3 years time. Yippii!!!!!! I will then be able to start building some real wealth…at least that is the plan.”

Although I see nothing wrong with paying off a mortgage early, one thing to keep in mind is that the decision implies an allocation choice. The additional money that you direct towards paying off your mortgage early is money that could be invested elsewhere (like saving for retirement). So, you have to ask yourself if paying off your mortgage early is really the best way to use your resources. I have written quite a bit on this topic in the past. You can find those posts listed under Mortgage in the directory.

“I work 2 jobs to make up for my idiotic choices of the past. At my part time job I have a 4% match, which I do. At my full time job they give me 6% of my salary. I do not have to match it. I do contribute 15% at this time. Should I not be contributing and put my money (the 15%) in a Roth IRA. I have not yet started any kind of IRA. I have approx. $100,000 in my combined 403 and 401.”

I think it’s awesome that you are working two jobs! No, it’s probably not fun but nothing says you have to do it forever.

I think a Roth IRA is a good choice because it gives you some “tax diversification.” You won’t get the tax deduction now, which means your current taxes will be higher. However, income from the Roth will not be taxable (assuming the money has been in there at least 5 years and you are over 59 1/2 when you begin taking withdrawals) AND it Roth income doesn’t count against you in deciding the taxability of Social Security. This is a nice benefit of the Roth that doesn’t get discussed too often. Also, remember that there are no required minimum distributions with a Roth IRA so you could let the money sit there and grow as long as you didn’t need it.

One advantage to working longer is that you can put off taking social security, which means you can expect a larger check when you do begin taking it.

If you would like me and AFM readers to comment on your retirement plan contributions, send me an email and I’ll be happy to take a look at it. There’s just not enough information to be able to tell you how much you could possibly have at retirement. I will say that you seem to be on the right track.

Hi JLP,

I found your blog thru real simple magazine. Props to you. Nice.

So here is my question, 44 years old, female, broke my whole life, no savings, wanna change. Came into 18K (my Dad died) and I don’t know what to do with it. It has been sitting getting like 2% since December 07. So if you can help or have a suggestion great, if not I understand.

Thanks,

DG

First things first. If you’re broke, you probably need an emergency fund. If you don’t have access to 3 months of expenses, you need to save towards that goal first. Just make sure that you treat your emergency fund as just that: an emergency fund.

After that…

I try to refrain from giving specific advice on this blog. That said, I would DEFINITELY put this money away for the long-run by opening a Roth IRA and depositing $4,000 per year for the next 4+ years. As far as where to open your Roth IRA, I would say either a discount broker like Scottrade or a mutual fund company like Vanguard (I’m NOT necessarily recommending these companies). The easiest route to go would be a fund company like Vanguard. Vanguard offers lots of low-cost index funds as well as exchange-traded funds. The simplest route to go would be to go with a target retirement fund. Since you’re 44 years old, I would considering looking at Vanguard’s Target Retirement Fund 2030 (other mutual fund familes have target date funds that are worth looking at).

I wouldn’t stop there.

Based on some simple math, I figured that your $18,000 lump sum will be worth somewhere in the neighborhood of $65,000 at retirement (assuming a 9% rate of return minus a 3% inflation rate). That’s hardly enough for a comfortable retirement. I would make saving for retirement a big priority. If you have access for a company-sponsored retirement plan, use it. If not, you should try to save at least $4,000 per year towards your retirement. Doing so could give you nearly $184,000 at retirement (again, adjusted for inflation). It’s not a lot but it’s better than nothing.

Good luck!

Here is an email I received from a relatively new reader:

Hi.

I’ve been following your blog for a few weeks now and really enjoy the no-nonsense advice you dole out to your readers. I have a question about some ongoing investments I’ve been making.

A friend of mine used to work for Primerica Financial Services and got me into VanKampen 5.75% front-end funds several years ago for both traditional and Roth IRAs. I made an initial investment of several thousand $ and have mostly neglected the accounts over the years, sporadically putting in a few hundred bucks here and there. Last year I vowed to myself to max out my Roth IRA and put in the full 4 grand. That was before I started becoming more financially savvy and looking into no-load funds, etc. Since then I’ve opened up a Vanguard account, put in a grand to get started with the Star fund in my Roth IRA and am contributing $150 monthly (about all I can afford at this point in time).

OK, my question is this – would you recommend that I rollover the VanKampen funds now or wait until early next year when (and if) I get dividends on the $ I put in and hopefully at least recoup the money I put in? At this point, I am down on some funds and up on others that have performed well as of late – but I would still be taking a bit of a hit. For example I bought $300 worth of 1 fund back in December, but as of today I have $291 because of its underperformance and 5.75% front-load. Also, they would be charging me $75 for the fund withdrawal. I’m not sure if it matters, but I have about $29K in those funds all told.

Any advice would be greatly appreciated. (btw, you can skip the disclaimers. I know the difference b/w the word of God and your word; I’m just looking for advice from an unbiased, educated source)

- Ralph in Chicago.

In a follow-up email with Ralph I found out that he was invested in the following funds:

Traditional IRA:

VanKampen Strategic Growth (ACEGX): $12K
VanKampen Equity Inc. (ACEIX): $4K
VanKampen Growth & Inc. (ACGIX): $4K
Total: $20K

Roth IRA:

VanKampen Strategic Growth (ACEGX): $1.6K
VanKampen Equity Inc (ACEIX): $2K
VanKampen Aggressive Growth (VAGAX): $0.7K
VanKampen Small Cap Growth (VASCX): $0.7K
VanKampen MidCap Growth (VGRAX): $1.5K
Total: $6.5K

If It Were My Money…

I wouldn’t worry about leaving VanKampen because you have already paid the loads. In other words, you won’t gain anything by staying with VanKampen and might actually gain something due to the fact that Vanguard’s fees are a fraction of VanKampen’s. I would move it to Vanguard and allocate it like this:

Traditional IRA:

Vanguard Total Market Index Fund (VTSMX): $17K
Vanguard Total International Stock Index Fund (VGTSX): $3K
Total: $20K

Roth IRA:

Vanguard Total International Stock Index Fund (VGTSX): $6.5K
Total: $6.5K

Overall Allocation Between the Two IRAs:

Vanguard Total Market Index Fund (VTSMX): $17K or 64%
Vanguard Total International Stock Index Fund (VGTSX): $9.5K or 36%
Total: $26.5K

The allocations are strange due to the $3,000 minimum for Vanguard funds. Your options open up as your account grows but this initial two-fund portfolio is sufficient. There’s no need to make it more complicated than it has to be. As an alternative, you could use Vanguard’s exchange-traded funds but they would require you to pay commissions for each purchase and each sale. Since you are going to be adding funds on a monthly basis, ETFs probably aren’t the best way to go.

I would contact Vanguard and ask them to help you begin the transfer process. It will most likely take several weeks as companies are notorious for dragging their feet on these kinds of things. I would avoid touching the money as you could be faced with tax consequences.

Those are my thoughts. Best of luck, Ralph.

I was reading this Marketwatch article recently:

Roth IRAs: Good for you or not?

In it they noted that, “A regular 401(k) beats a Roth for a majority of our stylized households, but both offer a significant improvement over fully taxed savings.”

I wasn’t surprised that fully taxed savings were worse, but I would have expected the regular and Roth IRAs to be neck and neck. The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

But the article suggests something different, and eventually my mathematical mind found a reason why their claim might be true. It depends on what percentage of your income you expect to be provided from your retirement assets and the fact that we have a progressive tax system. Here is a sort of maximal example.

Consider a couple that makes $80,000 and contributes 20% ($16,000) of their income into deductible 401(k) or IRA investments. That brings them just about down to one of the tax bracket boundaries, between the 15% and 25% bracket. Because it is their high-margin rate income that they put away, they saved 25% of $16,000 in tax, or $4,000 in federal tax.

Assume they retire next year (so we don’t have to think much about inflation or the tax code changing). The maximal case, would be having 100% of their income provided from accumulated retirement assets, although it would probably be less because of social security or pensions or the like. But if next year, we draw the same salary from their retirement assets ($80,000) it would in fact be taxed progressively: the first $15,650 at 10%; and then at 15% up to $63,700; and only the top $16,300 would be at the full 25% rate. Nearly 4/5 of their income would be taxed at a rate lower than the savings they got every year when they invested it even though they are in exactly the same bracket as before.

I believe this changes the naive Traditional/Roth comparison and it would tip in the favor of the Traditional (just as the article implies).

If you are the “typical” person, your Social Security income would account for 40% of your retirement income. In that case, starting from the scenario above, you’d be drawing $48,000 from your IRA. If we allocate the low-margin tax brackets to your Social Security, you’d still have $31,700 drawn from your retirement assets that would be taxed at the 15% and again only the top $16,300 would be taxed at the full 25% marginal rate. Nearly 2/3 of your income (provided by retirement assets) would be taxed at a lower rate than the rate you saved at when you made the contributions.

It seems that the practical advice to take from the analysis is this: if you are near a bracket boundary use Traditional IRA or 401(k) savings to reduce your savings just to the boundary. Further savings should be Roth savings. It makes sense to diversify in any event against tax changes that would adversely affect Traditional or Roth savings anyway since no one knows the future.

If you can’t save down to a boundary but could at least foresee where the boundary would land in retirement, you could split your Traditional/Roth savings to match that. In the example above where 40% of your retirement income is from Social Security, a reasonable person might make 2/3 of their savings Traditional and 1/3 of them Roth. You’re not really ahead or behind mathematically in this scenario, but you get “tax diversification” as well as the potential Roth advantages (no minimal distribution, etc.) on part of the money.

The only issue I have with Don’s thoughts is his computation:

The usual calculation goes like this: $4,000 pre-tax this year that earns 8% annually for 30 years would be worth $4,000* 1.08^30 = $40,250.63 and when you withdraw it you pay tax (say 25%) so you actually have $30,187.97 cash you could hold. The same money contributed in a Roth would start lower because you’d pay 25% tax up front, and then grow to the same $3,000* 1.08^30 = $30,187.97 tax-free cash at the end.

Is that really how people would contribute to a Roth? I would think most people would contribute $4,000 no matter if they used a Roth or a traditional IRA or 401(k). If they used the traditional IRA of 401(k), they would get the tax advantage up front. If they contributed to the Roth, they would take it on the chin and pay the taxes up front but still contribute the full amount to the Roth. NOTE: I’m going to run some calculations on my own and report back to you what I find.

This is a pretty complex topic because not only are we talking about the here and now, we are also trying to get a grip on the future. Adding to the complexity is the fact that there are benefits to the Roth that aren’t easily computable like the ability to NOT HAVE TO TAKE required minimum distributions and the ability to pass the Roth on to relatives, which gives them the opportunity for tax-free withdrawals. One other advantage to the Roth is the fact that distributions from the Roth DO NOT count towards the income threshold for computing taxes on Social Security.

My concern with the Roth are that the politicians may decide to tax withdrawals at some point in the future. Could it happen? Yes. Is it likely to happen? I have no idea. All I can say is that if times get tough and our politicians are looking for money to pay for their programs, and they see a bunch of tax sheltered assets sitting in Roth accounts, I wouldn’t put it past them to tax them “for the greater good.”

Anyway, there’s more on this topic to come. I’m working on a spreadsheet as I write this post. If I find out anything interesting, I’ll be sure and let you know.

Thanks to Don for his thoughts.

This is a topic I haven’t thought much about, because the answer has always seemed obvious. I am young and in a low tax bracket; I also intend for my income to rise over the course of my life, even through retirement. I also happen to believe Congress will eventually be forced to increase tax brackets accross the board if we’re going to keep piling on the entitlement promises(which it seems inevitable that we will). Because of all this I really don’t think my tax bracket will ever be lower than it currently is.

So because I qualify for a Roth IRA contribution and am offered a Roth 401k at work, my simple retirement solution has been to take advantage of as much tax-free savings as I can. Seems like the right call, no?

Well, I just read an article that has made me think seriously about other options for the first time. Protecting Your Retirement No Matter Who’s President. It’s short and to the point; I recommend checking it out.

The author advises taking a “three-pronged” approach to maximizing your investments (i.e. minimizing taxes).

“First, stash at least enough in your 401(k) to get the full employer match. Use the account to hold your portfolio’s bonds. The interest will be taxed as ordinary income anyway — and the 401(k) will allow you to defer the bill.

“Next, if you’re eligible, fund a Roth IRA. The Roth won’t give you an initial tax deduction, but all withdrawals should be tax-free.

“Finally, if you have additional money to save, buy stock-index funds or tax-managed stock funds in your taxable account. These funds should generate modest annual tax bills, and when you sell, the realized gain will be dunned at the capital-gains rate.

This advice is far from new, except for the last bit. Rather than going back and fully funding a 401k, the suggestion is to invest in regular old taxable accounts (albiet with tax-friendly index funds). I’d never considered that being taxed later at the capital gains rate might be more favorable than being taxed later at your future ordinary income rate.

But I have a Roth 401k, not a Traditional one. So I guess the question for me is, do I think being taxed later at the future capital gains rate will be better than being taxed now at my current income tax rate? The answer should tell me whether to continue to invest in my Roth 401k (after getting the match) or choose taxable index funds.

I think that for young people like me the decades of tax free growth combined with not being taxed at all on the withdrawals in retirement is a situation hard to beat. Then again, it’s also kind of reassuring to be able to justify having accessible, if taxable, investments in case I encounter a serious emergency or other investing opportunity before I hit 60.

Consider the author’s final quote:

What’s the advantage of all this? If income-tax rates rise, that could cut into the value of your 401(k) withdrawals. If capital-gains rates climb, it will hurt your taxable account. And if the income-tax system is ever replaced with a national sales tax, the Roth will lose its luster. In other words, you’ve spread your tax risk — and thus you should be in good shape, no matter what Congress does.

Geez. I hadn’t even though of that…

More from Meg at The World of Wealth

NOTE: It’s important to keep in mind that I am NOT a tax expert. So, if some of my thought processes don’t make sense here, that’s why.

So, here are some PROS and CONS (if I missed any, please let me know by leaving a comment) of the Roth 401(k):

PROS to the Roth 401(k):

1. Roth 401(k) offers the ability for tax-free income at retirement.

2. Roth 401(k) can be rolled into a Roth IRA. For those who make a lot of money, this could be an easy way to move money into a Roth IRA.

3. As of right now, income received from a Roth IRA during retirement does not count when figuring the taxation of Social Security benefits.

4. Unlike other accounts during retirement, there are no required minimum distributions with a Roth IRA.

5. Tax rates could be higher in the future, which would make tax-free income in the future, more valuable.

CONS to the Roth 401(k):

1. A Roth 401(k) is funded with after-tax money, which means higher tax bills now and could possibly subject you to the dreaded Alternative Minimum Tax. I did a quick calculation and figured that our tax bill for 2006 would have been around $2,000 higher had we gone with the Roth 401(k).

2. Along the lines with number 1, Roth 401(k) contributions will mean higher taxable income now. This could affect deductions.

3. There’s really no guarantee that lawmakers won’t change their minds and begin taxing Roth IRAs at some point in the future.

4. The employer match is put into a separate account, which will then be fully taxable at retirement. This is a wash since you don’t pay taxes or get a tax benefit from an employer match.

Those are the pros and cons that I can think of. I’m sure there are lots more that I just haven’t thought of. If I missed some, let me know and I’ll add them to the list.

For me, the jury is still out on whether this is a good deal for our family. I’m thinking about going half and half and trying it out.

JLP,

I am starting a new job with a small firm that offers a 401k through Principal Financial Group. The company matches dollar for dollar up to $5000 per year. There are 17 funds in the plan including lifetime funds and funds covering all the major asset classes. The problem is that the fees for the funds are exorbitant, averaging about 2.3% for the active funds and 1.6% for the two index funds. What’s more, the performance of the active funds is poor for the respective asset class across nearly all funds.

I read your post from April 3, 2007 about 401k fees (How Much is Your 401(k) Costing You?), as well as the comments, but I still wonder what to do here. Should I a) forget the 401k and invest in the IRA ($8000 max for wife and me), b) invest in the 401k up to the matching, then supplement with the IRA, or c) forget about the fees and invest in the 401k as much as I can afford.

My company is small, so I imagine they are getting a raw deal from 401k providers. I used to work for a different small firm that used a simple IRA through Fidelity that let me invest in anything I want via Fidelity. Maybe I’ll see if my new company could be persuaded to go that route.

Any advice or comments on this topic?

Thanks!

Those fees are high. My guess is that the fees are high because it is a small firm and they either went with an annuity or they are spreading the costs of the plan among the employees. Administration of a 401(k) plan is not cheap and providers would much rather service large plans than small plans. In any case, those fees are high and I think you should bring it up with your employer. Hopefully it’s not a political issue (like the boss’ brother is a broker or something like that). Be careful though. As the “new guy,” you don’t want to cause any problems.

Under these circumstances I would put in just enough to get the company match and use Roth IRAs for the rest. Even with the high fees, it is hard to walk away from free money. Even at 1.6% (wow, 1.6% for an INDEX fund!), I would stick with the index funds and use the Roth IRAs for diversification.

Good luck!

Filing Status: Married Filing Jointly & Qualifying Widow(er)

The phaseout based on your modified adjusted gross income (MAGI) is $150,000 – $160,000

Filing Status: Single, Head of Household, or Married Filing Separately

The phaseout, again based on your modified adjusted gross income (MAGI) is $95,000 – $110,000

If your MAGI is below the low end of the phaseout, you can make a full contribution. If your MAGI falls within the phaseout, your contribution will be reduced. If your MAGI is above the upper limit of the phaseout, you cannot contribute to a Roth. However, you can still contribute to a non-deductible Traditional IRA, which you might be able to convert to a Roth IRA in the future.

For 2007, the Roth IRA contribution phaseout is EXPECTED to be the following:

Filing Status: Married Filing Jointly & Qualifying Widow(er)

The phaseout based on your modified adjusted gross income (MAGI) is $156,000 – $166,000

Filing Status: Single, Head of Household, or Married Filing Separately

The phaseout, again based on your modified adjusted gross income (MAGI) is $99,000 – $114,000

It’s good to see them raise the phaseout threshhold. Personally, I think it is silly to have a phaseout in the first place since the MOST a person can contribute is $4,000 ($5,000 if over age 50).

The maximum contribution for 2006 is $4,000 (or $5,000 if you are 50 years old or older). These amounts remain unchanged for 2007.

Who Can Contribute?

According to Publication 590 from the IRS:

Generally, you can contribute to a Roth IRA if you have taxable compensation (defined later) and your modified AGI (defined later) is less than:

$160,000 for married filing jointly or qualifying widow(er),

$10,000 for married filing separately and you lived with your spouse at any time during the year, and

$110,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year.

There is a phaseout on Roth IRA contributions, based on your filing status and modified adjusted gross income (MAGI). The Roth IRA phaseout is:

For Married Filing Jointly or Qualifying Widow(er): $150,000 – $160,000

For Single Filers, Head of Household or Married Filing Separately: $95,000 – $110,000

If your modified adjusted gross income falls within the phaseout range you can still contribute to a Roth but at a reduced amount. The IRS website has a worksheet you can use to figure out your reduced contribution amount. There’s no direct link to the worksheet (although you can find it if you scroll down on this page) but it looks like this: