Roth

Which of These 9 Retirement Accounts Is Right for You?

Dr Penny Pincher — Wed, 24 Jan 2018 09:00:06 +0000

You might think that the simplest way to put away money for retirement would be to save or invest your money as you see fit — without reporting your contributions to anyone, and without following any special rules. The problem with following a freestyle retirement plan like this is taxes. You would pay full income taxes on the money that goes into your account, and you would pay capital gains taxes as your investment grows.

Fortunately, there are many retirement savings plans out there that can reduce your tax burden now and in the future, all while avoiding capital gains tax. And while there are many types of retirement accounts, you can — and should! — contribute to more than one. The 2018 contribution limit for traditional and Roth IRAs is $5,500 ($6,500 if you're age 50 or older). For 401(k) plans, the current contribution limit is $18,500 (plus an additional catch-up contribution of $6,000 if over age 50). (See also: Which Retirement Account Is Right for You?)

Here are some of the most popular tax-advantaged retirement plan options.

1. Traditional IRA

Contributions made to a traditional IRA are tax-deductible, which can reduce your current year income tax bill. However, you will have to pay income tax when you withdraw funds starting at age 59½. If your income is high now and you will be in a lower tax bracket after retirement, contributing to a traditional IRA may be a good move.

2. Roth IRA

Contributions to a Roth IRA are post-tax, so contributing to one of these accounts won't reduce your tax bill upfront. But when you withdraw the funds in the future, you won't have to pay income tax. A Roth IRA can be favorable if you are a young investor in a low tax bracket now. Also, if you are concerned that tax rates could go up in the future, contributing to a Roth IRA allows you to pay a known tax now versus a potentially higher tax in the future when you withdraw funds. (See also: 6 Reasons Every Millennial Needs a Roth IRA)

3. Traditional 401(k)

Employees can contribute wages to a 401(k) investment account as elective salary deferrals. The traditional 401(k) account works much like a traditional IRA where income can be contributed before taxes, but you will have to pay income tax on future withdrawals. Some employers provide matching contributions to 401(k) plans, and if you are not participating enough to obtain that match, you are leaving free money on the table. Keep in mind, however, that employer plans have fewer investment options than traditional IRAs, and that there may be limits on whether you can withdraw employer contributions early in, for example, a hardship distribution. (See also: 401K or IRA? You Need Both)

4. Roth 401(k)

The Roth 401(k) is an alternate 401(k) plan where employees can contribute after-tax funds. As with a Roth IRA, the Roth 401(k) allows you to pay a known tax today at your current tax bracket instead of an unknown tax rate in the future. A Roth 401(k) is also an attractive option to younger workers who are in a lower tax bracket now and who have a lot of time for funds to grow. If your employer offers matching funds, again, try to contribute at least the minimum required amount to receive the match. (See also: Things You Should Know About Your 401(k) Match)

5. SEP IRA

An SEP (Simplified Employee Pension) plan allows business owners — often the self-employed — to contribute to traditional IRAs on behalf of themselves and any employees they have. An SEP IRA has many of the same rules as a traditional IRA, but the employer is required to make all contributions to the SEP IRA, and employees can't make any.

An SEP IRA allows employers to adjust how much they contribute to an employee's account depending on the company's cash flow that year. Contributions cannot exceed the lesser of 25 percent of the employee's compensation, or $55,000, in 2018.

Money contributed to an SEP IRA is tax-deductible for the current year, and is subject to income tax when withdrawn in retirement. (See also: The SEP-IRA Is How the Self-Employed Do Retirement Like a BOSS)

6. SIMPLE IRA

A SIMPLE (Savings Incentive Match Plan for Employee) IRA is a retirement savings plan for businesses of any size, although it is still aimed at small businesses. A SIMPLE IRA allows employees to invest in their own accounts, in addition to receiving employer contributions of 1-3 percent of the employee's compensation. An employee may contribute up to $12,500 to a SIMPLE IRA in 2018.

Contributions made to a SIMPLE IRA (by both the employer and employee) are tax-deductible upfront and subject to income tax rates upon withdrawal.

7. 403(b) plans

A 403(b) plan, also known as a tax-sheltered annuity or TSA plan, is similar to a 401(k) — but is offered by public schools and 501(c)(3) tax-exempt organizations. Like 401(k) plans, 403(b) plans may be offered in either a traditional tax-advantaged or after-tax Roth version. (See also: 403(b) vs. 401(k): How Are They Different?)

8. Payroll deduction IRAs

Payroll deduction IRAs allow employees or even self-employed workers to automatically contribute to a traditional or Roth IRA through payroll deductions. The employees set up the account and then let the employer know how much they'd like to contribute from each paycheck. This is perhaps the simplest retirement program that a business can establish for its employees.

9. HSA "IRA"

A HSA (health savings account) is available to those who are enrolled in a high-deductible health plan (HDHP). An HSA allows you to contribute pretax funds into a savings or investment account, and you can withdraw funds tax-free at any time for qualified health expenses. Once you reach age 65, money left in an HSA basically acts like a traditional IRA — there is no restriction that the funds must be spent on health expenses, but they will be subject to income tax upon withdrawal. (See also: How an HSA Could Help Your Retirement)

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This article is from Dr Penny Pincher of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

The Inventor of the 401K Has Second Thoughts About Your Retirement Plan — Now What?

Tim Lemke — Mon, 13 Feb 2017 10:30:33 +0000

In the early 1980s, the 401K plan was introduced as a potential supplement to the pension plans offered by employers. Now, they are a staple of retirement planning, while pensions are available to fewer workers than ever before.

A 401K allows workers to set aside a certain amount of their salary and invest into a variety of mutual funds. Often, companies will match contributions up to a certain amount. These plans can be powerful vehicles for amassing great wealth in retirement, but the founders of these plans recently voiced concerns that the plans are inadequate for many people, and that they were never meant to replace pensions altogether.

For sure, 401K plans place more of the savings burden and risk onto the individual than pensions do. And many plans are lousy, with high fees and poor investment choices. So, what to do? Here's how to build that big retirement fund even when you're at the mercy of the 401K.

1. Save Up to the Match, Regardless

You may be annoyed that a 401K is all your employer has to offer, but if the company is offering to match contributions, you'd be a fool not to participate. Even if the plan has lousy mutual funds with high fees, free money is still free money. Most good companies offer at least 50 cents for every dollar you contribute up to a certain amount, and that can add up to a lot of dough over time.

2. Get an IRA

A 401K is not the only vehicle for saving for retirement. Individual retirement accounts, or IRAs, offer some good tax advantages and better flexibility than a 401K. There's no company match for an IRA, but you have the ability to invest in just about anything. That's why many investors will put money in a 401K up to the company match, then put any additional savings in IRAs. Most people can contribute $5,500 annually into an IRA. With a traditional IRA, any money you contribute is deducted from your taxable income. With a Roth IRA, your money is taxed right away but you don't have to pay tax on any gains when you withdraw the money at retirement.

3. Start Early and Have a Long Time Horizon

Despite the flaws of a 401K, it's still very possible to amass a large sum for retirement if you begin investing when you are young and keep it up for a long time. If you enter the workforce when you're 18 and keep saving and investing until retirement age, that means you'll have 45 years to allow your nest egg to grow. In fact, under this scenario, it's possible to retire a millionaire by putting aside less than a few hundred dollars per month.

4. Find the Low-Cost Funds

Even if your 401K plan isn't perfect, you owe it to yourself not to make matters worse by investing in bad funds. Many 401K plans offer mutual funds with high management fees and other expenses, but most also offer low-cost options, including basic S&P 500 Index funds. Find those funds with the lowest fees, so you get to keep more of your money. Look for funds with expense ratios below 0.5%, if possible.

5. Embrace the Power

When an employer offers a pension, it almost always contributes to a pension fund and then hopes that investment returns are enough to meet the obligations they have to employees. So in reality, the only significant difference between a pension and a 401K plan is who is in control. With a 401K plan, you have more control over how you invest. For some people, this is scary. But for others, it's just as scary to leave their financial future in the hands of others.

6. Make a Good 401K Part of Your Job Search

Think about the last time you searched for a job. When you applied and interviewed for positions, did you take the quality of the company's 401K plan into account? Chances are, this was far down the list of concerns, below salary, health benefits, and even vacation time. But imagine if more people turned down job offers because of a lousy 401K plan or a low company match. If more prospective employees voiced concerns about the quality of retirement plans during the hiring process, companies might be more likely to improve their plans.

7. Talk to Your Lawmakers

It's unlikely that the President or Congress can force companies to bring back pensions, but they are the ones who could change 401K plans to make them more attractive. Lawmakers could pass legislation that improves the tax benefits of plans or increases the amount investors are allowed to contribute. They could pressure companies to boost their matching contributions, and require more companies to offer plans to more employees. Lawmakers could also propose new kinds of savings plans managed by the government. At the very least, voicing your concerns about the quality of the 401K as a retirement option could start a conversation on Capitol Hill.

8. Join a Union, If You Can

Much of the erosion of defined benefit plans has coincided with the drop in influence of labor unions in America. According to the AFL-CIO, about 75% of union workers participate in defined benefit plans, compared to about 20% for nonunion workers. But far fewer people are part of unions these days.

This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

15 Retirement Terms Every New Investor Needs to Know

Damian Davila — Thu, 17 Nov 2016 11:00:14 +0000

Congratulations! By starting your retirement fund, you've taken one of the most important steps toward a comfortable retirement. But as a novice investor, you may feel a bit overwhelmed with all the available information, including contribution limits, early penalty fees, and Roth 401Ks. To help you make sense of it all, let's review 15 key terms you should know:

1. 401K

The 401K is the most popular qualified employer-sponsored retirement plan in the U.S. The two most common types of 401K plans are the traditional 401K, to which you contribute with pretax dollars, and the Roth 401K, which accepts contributions with after-tax dollars. Earnings in a traditional 401K grow on a tax-deferred basis (you'll pay taxes on the funds when you withdraw them during retirement) and those in a Roth 401K grow tax-free forever, since you've paid taxes upfront.

2. After-Tax Contributions

Only certain types of retirement accounts, such as Roth 401Ks and Roth IRAs, accept contributions with after-tax dollars. When you contribute to a retirement account with after-tax dollars, your retirement funds grow tax-free forever, since you've already paid Uncle Sam.

3. Catch-Up Contribution

Retirement investors who are 50 and older at the end of the calendar year can make extra annual "catch-up" contributions to qualifying retirement accounts. Catch-up contributions allow older savers to make up for lower contributions to their retirement accounts in earlier years. In 2016 and 2017, catch-up contributions of up to $6,000 (on top of traditional annual contribution limits) are allowed for 401Ks and up to $1,000 for IRAs.

4. Contribution Limits

Every year, the IRS sets a limit as to how much you can contribute to your retirement accounts. In 2016, you can contribute up to $5,500 ($6,500 if age 50 or over) to traditional and Roth IRAs and up to $18,000 ($24,000 if age 50 or over) to a traditional or Roth 401K. These annual contribution limits to retirement accounts remain unchanged for 2017. If you exceed your contribution limit, you'll receive a penalty fee from the IRS, unless you take out excess moneys by a certain date.

5. Early Distribution Penalty

To discourage retirement savers from withdrawing funds before retirement age, the IRS imposes an additional 10% penalty on distributions before age 59 ½ on certain retirement plans. Keep in mind that you're always liable for applicable income taxes whether you take a distribution from your retirement plan before or after age 59 ½. Under certain circumstances, you're allowed to withdraw money early from a retirement account without the penalty.

6. Fee

You've heard that there is no such thing as a free lunch and no retirement plan is exempt from this rule. There's always a cost for the employer or employee, or both. Always check the prospectus from any fund for its annual expense ratio and any other applicable fee. An annual expense ratio of 0.75% means that for every $1,000 in your retirement account, you're charged $7.50 in fees. And that's assuming that you don't trigger any other fees! (See also: Watch Out for These 5 Sneaky 401K Fees)

7. Index Fund

An index fund is a type of mutual fund that tracks of a basket of securities (generally a market index, such as the Standard & Poor's 500 or the Russell 2000). An index fund is a passively managed mutual fund that provides broad market exposure, low investment cost, and low portfolio turnover. Due to its low annual expense ratios, such as 0.16% for the Vanguard 500 Index Investor Shares [Nasdaq: VFINX], index funds have become a popular way to save for retirement. (See also: 3 Steps to Getting Started in the Stock Market With Index Funds)

8. IRA

Unlike a 401K, an individual retirement account (IRA) is held by custodians, including commercial banks and retail brokers. The financial institutions place the IRA funds in a variety of investments following the instructions of the plan holders. A traditional IRA accepts contributions with pretax dollars, and a Roth IRA accepts contributions with after-tax dollars. An advantage of using a Roth IRA is that it provides several exemptions to the early distribution penalty.

9. 401K Loan

Some retirement plans allow you to take a loan on a portion of your available balance — generally, 50% of your vested account balance, or up to $50,000, whichever is less. While the loan balance is generally due within five years, it becomes fully due within 60 days from separating from your employer. (See also: 5 Questions to Ask Before You Borrow From Your Retirement Account)

10. Mutual Fund

By pooling funds from several investors, money managers are able to invest in a wide variety of securities, ranging from money market instruments to equities. Investing in a mutual fund enables an individual retirement investor to gain access to a wide variety of investments that she wouldn't necessarily have access to on her own. Depending on its investment strategy, mutual funds can have a wide variety of fees. So, make sure to read the fine print. (See also: 4 Sneaky Investment Fees to Watch For)

11. Pretax Contribution

When you contribute to your employer-sponsored retirement account with pretax dollars, you're allowed to reduce your taxable income. For example, if you were to make $50,000 per year and contribute $5,000 to your 401K with pretax dollars, then you would only have to pay applicable income taxes on $45,000! You delay taxation until retirement age when you're more likely to be in a lower tax bracket.

12. Required Minimum Distribution (RMD)

You can't keep moneys in your retirement account forever. At age 70 ½, you generally have to start taking withdrawals from an IRA, SIMPLE IRA, SEP IRA, or 401K. An RMD is the minimum amount required by law that you have take out from your retirement account each year to avoid a penalty from the IRS. You can use of one of these requirement minimum distribution work sheets to calculate your RMD.

13. Rollover

When you separate from your employer, you generally have up to 60 days to transfer moneys in your previous retirement account to a new retirement account accepting those moneys. This process is known as a rollover. In a direct rollover, the process is automatic; in an indirect rollover, you receive a cash-out check from your previous employer to rollover the moneys to a new qualifying retirement account. (See also: A Simple Guide to Rolling Over All of Your 401Ks and IRAs)

14. Target-Date Fund

A target-date fund is a retirement investment fund that seeks to provide higher returns to young investors and gradually reduce risk exposure as they get closer to retirement age. Since the Pension Protection Act granted target-date funds the status of qualified default investment alternative in 2006, these type of funds have gained popularity. About half of 401K participants hold a target-date fund.

15. Vesting

In any retirement account, only money that is fully vested truly belongs to you. While all of your contributions and the matching contributions from your employer to your retirement account are always fully vested, some employer contributions, such as company stock, may follow a vesting schedule. In cliff vesting, you only become fully vested after a certain period of time. In graded vesting, you gradually gain ownership of those employer contributions.

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This article is from Damian Davila of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

7 Investment Accounts All 30-Somethings Should Have

Tim Lemke — Thu, 03 Mar 2016 10:30:34 +0000

You're in your 30s now. If you're finally looking to get settled in your financial life, you may want to consider ways to build wealth over the long term. But that checking account alone isn't gonna cut it. It's time to examine the options out there for someone in their 30s who finally has a little bit of money to invest.

Here are seven essential investment accounts all 30-somethings should have.

1. 401K, If Available to You

If you're employed full-time, your company may offer a retirement plan that gives you access to a number of mutual funds and other investments, plus the great tax advantages that come with it. Under a 401K, 403B, or similar plan, contributions are deducted from your pre-tax income, and most employers will match a certain percentage of what you put in. Now that fewer employers are offering pensions, the 401K has become the primary vehicle for saving for retirement. Pumping cash into this account while you're still relatively young gives your investments plenty of time to rise in value and give you a sizable nest egg. Even better, your investment is tax-deferred until you begin making withdrawals.

2. Traditional IRA

You don't necessarily need a traditional Individual Retirement Account if you have a 401K with an employer match. But if you have 401K from an old employer, it might make sense to roll it into an IRA, because you have a much broader choice of investments to choose from — many with lower fees. With an IRA, you can invest in practically anything, including individual stocks, mutual funds, bonds, and even commodities. Traditional IRAs are also great for people who are self-employed or otherwise don't have access to a 401K. Like a 401K, your contributions are deducted from your taxable income. You can open an IRA at most discount brokers such as Fidelity, TD Ameritrade, and E*TRADE.

3. Roth IRA

This account is a little bit like a 401K in reverse. The tax advantage is on the back end, when you can withdraw money upon retirement without paying tax on the earnings. That's because contributions to a Roth IRA come from earnings after tax, unlike 401Ks, which draw on pre-tax income. Under a Roth IRA, you can contribute up to $5,500 annually, and you can withdraw contributions (but not your gains) before retirement age without paying a penalty.

4. Taxable Brokerage Account

While your main focus should be investing in tax-advantaged accounts that are designed for retirement, it's good to have some investments available in this type of account due to the flexibility. You don't need to wait until retirement age to access funds in this account, for one thing. That means you can use it to boost your income now, through the sale of stock or the gain of dividends. If you hold on to investments in a taxable account for a long time (generally over a year), you'll pay only the long-term capital gains tax (mostly likely 15%) when you sell.

5. 529 College Savings Plan (If You Have Kids)

College is pricey, so nearly every state enables people to save for college by investing money for education in a tax-advantaged way. A 529 plan is similar to a Roth IRA, in that investments will grow tax-free until they're withdrawn, as long as they are spent on higher education. In many states, you also get a tax break from the contributions. It's possible to open a 529 for your child as soon as they have a social security number. Even if you don't have kids yet, you can designate a beneficiary now — such as a niece or nephew — and change it to your own child later. (See also: The 9 Best State 529 College Savings Plans)

6. High-Interest Savings Account

Everyone knows you need a basic bank account, but if you want to boost your savings, it's helpful to have a savings account with a higher-than-average interest rate. These days, interest rates are extremely low, but you can still find returns of above 1% in money market accounts and online banks. (See also: Best Online Checking Accounts)

7. Peer-to-Peer Lending Account

In addition to making it easier to invest in stocks, the Internet age has also made it possible for individuals to invest in other people's debt. There are thousands of people who have hopped onto sites such as Lending Club and Prosper and report consistently solid returns. These sites generally work in the same way as banks, except that those in need of money are borrowing from individuals, who are seeking to make money on the interest. In most cases, people can invest based on the risk level of each borrower; those who aren't as creditworthy promise a potentially higher return — but more risk — to the investor. Popular personal finance blogger Mr. Money Moustache has reported more than an 11% annualized return since 2012, and many others report similar gains. (See also: How to Make Money with Prosper)

How many of these accounts do you have?

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This article is from Tim Lemke of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

5 Important Things to Know About Your 401K and IRA in 2016

Shannah Game — Tue, 01 Dec 2015 14:00:24 +0000

We can all agree that investing in a 401K, IRA, or Roth, while being a scary proposition at times, is quite frankly the best use of our money for saving long term. Retirement might be a long way off for you, but it's important to stay on top of the changes that take place for these accounts each year. They could shift your overall direction of planning for your financial future.

Here is a list of what will and won't change for your 401K and IRA in 2016.

No Change

Before we look at what's new, let's look at what's staying the same.

1. Contribution Limits

"No change" usually implies something good is happening because it's consistent. In this case, no change for contribution limits means that you are limited to the same amount of money you could put away in 2015 for 2016. In 401K plans, that is $18,000 for people under the age of 50 — and in IRA and Roth plans, the contribution max will remain at $5,500 for those age 50 or younger.

This may not seem like a big deal, but over time the ability to put away less for your retirement means that you will need to earn more on your money that is already invested. According to Vanguard 401K data, only about 10% of participants put away the max every year. There's no escaping the truth that the more you put away, the better off you are going to be in the long run.

2. 401K/IRA Combo

Many people believe that you can only have a 401K or an IRA, but not both. That simply isn't true. In fact, having a separate IRA and a 401K can be a smart financial strategy. The downside of having both is that depending on your income, you may or may not be phased out of deducting your contributions to both plans.

In 2016, the income limitations will stay the same. If your adjusted gross income is between $61,000–$71,000 for single and head of household, or between $98,000–$118,000 for married couples, your deductible amount for contributions to your IRA will be phased out. If your income is lower, you will receive the full deduction. If your income is over those limits, you won't be able to deduct any portion of your contributions.

Change

And here are the details set to change — make sure you update your contributions to match.

3. Roth Income Threshold Limits Increase

Roth plans are very popular, especially with the Millennial demographic. They work in reverse of an IRA. Your contributions are made on an after-tax basis, but your distributions in retirement are tax-free. The objective is that you will be in a higher tax bracket when you retire, hence why you will ultimately save money on taxes that would've been due if you had an IRA. Roth plans have their own contribution income limits and are quite generous. In 2016, the contributions income threshold limits will increase by $1,000.

4. IRA for Non-Working Spouse

What about those spouses that don't work, but still want to contribute to an IRA? In 2016, IRA income limits will increase for spouses without retirement accounts by $1,000.

If your spouse contributes to a retirement account at work, but you don't work, you can set up your own IRA and contributions will be tax deductible up to $184,000 for couples filing jointly. Your contributions begin to phase out from $184,000–$194,000, and are completely phased out above that income level (meaning they wouldn't be tax deductible). You can always still contribute up to the IRA contribution max, but you just wouldn't receive the deduction.

5. Saver's Credit

The saver's credit is arguably one of the most overlooked tax credits. It rewards lower income individuals and families for saving for their retirement in any retirement plan. If you qualify for this credit, it is worth anywhere from 10%–50% of the contributed amount — up to $2,000 for individuals and $4,000 for couples. The credit is available to singles with an income under $30,750, and for couples, under $61,500.

Make sure your accountant is aware if you qualify for this credit so you can take advantage of this great benefit. Consider it the government's matching program for your retirement contributions.

How's your 401K doing?

This article is from Shannah Game of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Is This the End of the Back-Door Roth IRA Tax Loophole?

Brittany Lyte — Thu, 12 Mar 2015 13:00:08 +0000

One of America's most beloved tax-trimming strategies may soon be outlawed.

Deep inside President Barack Obama's proposed Fiscal Year 2016 budget is a measure — "Limit Roth conversions to pre-tax dollars" — that could put the kibosh on a practice used by high earners to dodge the income limits on Roth IRA contributions. The verbiage in the budget proposal is succinct, and therefore unclear. But experts say those six little words could stop high earners from contributing to their Roth by way of the back-door strategy.

What's the Big Deal With Back-Door Roths?

The Roth IRA offers account holders something very valuable: tax-free income in retirement. Since contributions to Roths are made using after-tax dollars, these accounts are not taxed as they grow, and no tax money is due when funds are withdrawn in retirement. The catch is that you can only directly contribute to a Roth IRA if your income is below a certain ceiling. For jointly filing married couples, that limit is $191,000. For single filers, it's $129,000. Folks with income beyond those barriers may instead contribute to a traditional IRA account.

But high earners (who value the benefits of these Roth accounts as much as the everyman) have a way of dodging the contribution limits that prevent them from enjoying these tax perks. Using the back-door strategy, high earners can make after-tax contributions to a traditional IRA account, for which there are no income restrictions, and then convert that account into a Roth. This method affords all the benefits of a Roth account with few of the limitations. And it's precisely this practice that Obama budget proposal wants to eradicate.

Uncertainty Around the Proposal

"It seems to me they're saying that was a good workaround, but we don't want you to do it anymore," IRA expert and CPA Ed Slott told Forbes.

But Slott says ending the back-door strategy is not so simple. One issue with Obama's loophole closure proposal is that it doesn't jibe with the Internal Revenue Service's new rules on after-tax rollovers, which actually make it easier to convert after-tax dollars into Roth IRA accounts.

"They didn't look at the practicality of how it butts heads with the rules that we're working with now," Slott says.

Now, it's important to keep in mind that the president's budget is more of a wishlist than a decree. It's bound to get rewritten, trimmed, and cut as the budget vetting process continues in Congress. But it's an important indicator of what the administration is thinking. And if you're a high earner enjoying the benefits of back-door Roths, it may signal an upcoming change in your retirement planning.

Do you think back-door Roths should be eradicated? Why or why not?

This article is from Brittany Lyte of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

Optimize Your IRA and 401(k)

Philip Brewer — Wed, 29 Jul 2009 20:00:11 +0000

Your IRA and 401(k) (or 403(b) if you work for a non-profit) are great tools for deferring taxes, and have other advantages as well. But because they're labeled "retirement" accounts, people are much too likely to put the wrong investments in them. Here's how to use them correctly.

Because of rules designed to discourage people from taking money out until they approach retirement age, people assume that they ought to put their "long-term" investments in their 401(k). But that's the wrong way to think about it.

The key difference in a 401(k) or IRA account is not that it's supposed to be for your retirement. The key difference is that money that goes into the account--and money earned in the account--is tax deferred. If you let the fact that the accounts are called "retirement" accounts influence what assets you hold in them, you're unlikely to make maximum use of their key feature--and that amounts to throwing money away.

Use that tax deferral!

There are two steps to optimizing your various retirement accounts. The first is to get some money into them, and the second is to put the right investments into the right accounts.

First of all, you probably want to put as a big chunk of your regular income into your 401(k), as you can.

I say "probably" because there are a few reasons why you might want to limit how much money you put in your 401(k):

Your income is very low. If your income is low enough that you're being taxed at 10% or less, there's a pretty good chance that you'd pay higher taxes when you take the money out of your 401(k) after retirement.
Your income is very high. Both the IRS and your company limit how much money you can tax defer if you have a very high income.
Your employer's plan is crappy. Some plans have high fees or poor choices of investments.
You want to save money outside the plan, such as because you want to use it before you're retirement age.

Of course, if your company still provides a corporate match, that plays into the decision as well. I've got a post on when NOT to put money in your 401(k) that talks about those issues in some detail. To what I'd say there I'd only add that federal income tax rates are currently at generational lows. That, combined with the current level of the deficit, suggests to me that future tax rates are likely to be higher than current tax rates--another reason why you might not want to put all your long-term savings in your 401(k).

Separate asset allocation from account selection

The allocation of assets among your various long-term goals is a completely different step from the selection of which account should hold which asset. Understanding this can add substantially to your wealth.

You probably have several long-term goals. Retirement (including early retirement) is one, but anything that requires years of saving qualifies as a long-term goal. (Examples: college savings for a young child, money to start a business, your dream home, a round-the-world cruise).

Investments for all your long-term goals can and should be managed together. All your assets support all your goals; you just confuse yourself if you start thinking that these stocks are for retirement while those other ones are to put a new roof on the house someday.

So, step one is to figure out your ideal asset allocation. This probably includes putting a large fraction of your investments in a broad-based, low-cost stock index fund, but may include investments in many other asset classes: mutual funds that invest in foreign stocks or dividend-paying stocks (or direct investments in such stocks), bonds, real estate, gold, silver, other commodities, etc.

Only after you've figured out how you want to invest your entire portfolio do you want to figure out which accounts should hold which investments.

Choosing compartments

The key to this step is to put income-earning investments in tax-deferred accounts.

Your asset allocation may include an investment in non-dividend paying stocks. They'd be part of a long-term investment strategy whose purpose is to produce growth over the next 20 or 30 years--but just because they're long-term does not mean that they should go in your 401(k)! Quite the reverse: a non-dividend paying stock that's a core holding in your portfolio should be in your regular brokerage account. If it does well you can go on holding it for years and years and won't have to pay any taxes until you sell--and when you do sell, you'll owe taxes at the low capital-gains rate.

Holding that investment in your retirement account would be crazy. First, since you already don't owe taxes while you're holding it, you'd get no benefit from the tax deferral. Second, when you withdraw money from a retirement account you have to pay taxes on it as regular income--losing the favorable tax treatment for capital gains.

(It doesn't work out any better if the investment does poorly--in your regular brokerage account you can use a capital loss to offset other gains before paying taxes, but losses in a retirement account are just losses.)

You don't want the compartment decision to drive your asset allocation--you already decided what investments you wanted to hold. But those assets should end up in compartments based on tax considerations. Interest-earning investments like bonds go in tax-deferred accounts. So do investments with frequent turnover--if you make trades in your regular brokerage account you have to pay taxes on your profits every year.

Dividends are a special case. Currently dividends are receiving favorable tax treatment, so you're probably better off keeping most dividend-paying stocks outside of your 401(k) at the moment. This is likely to change, though, so you'll have to monitor the situation.

If you have a good 401(k) plan with lots of low-cost fund choices, it should be easy to hit your target allocation with most of your interest-earning investments (and investments that you might trade actively) inside the plan.

Limitations

In an ideal world it would be straightforward to allocate things to the different categories: You'd put the things that earned interest into your 401(k) and IRA while keeping things that produced capital gains (and currently dividends as well) in regular accounts.

In the real world there are a bunch of constraints on that, the biggest being that many people, especially younger folks, have practically their whole wealth concentrated in their 401(k).

This happens almost automatically: You get a job, you direct enough money into your 401(k) to get the full corporate match (back when companies actually paid a corporate match), and then you spent most of your take-home pay. You can't hold your stock portfolio in your brokerage account (where you'd get the maximum tax advantage of the capital gains and dividend tax breaks) because you just don't have enough money outside the 401(k).

This and similar real-world considerations are going to limit your ability to get this exactly right--and that's to be expected. The important thing is to base your asset-allocation decisions on your best analysis of your goals and your expectations for the future. Below I've got a few tips for dealing with specific situations.

The main limitation on your ability to optimize your 401(k) plan has to do with the choices your employer offers within the plan. Happily, you can work around even a pretty mediocre plan's limitations, as long as you at least some of your long-term savings outside your 401(k).

First, take a close look at the investment choices you've got and compare them to your desired asset allocation. Maybe there's no bond fund, but there is a balanced investment fund that's half-and-half stocks and bonds. If you wanted 20% in bonds you could get that by putting 40% of your money into the balanced fund. (That would also put 20% of your money into stocks--which is fine, as long as your stock allocation is at least 20%, which it probably is.)

Second, where you really can't find the investments you need within the plan (no international fund, perhaps, or no gold fund) you have to cover that fraction of your asset allocation elsewhere--which is also fine, as long as you have some of your long-term investments outside the plan. If the investment is one that ought to be tax-deferred, see if you can't buy the appropriate asset within an IRA.

Generally, make hitting your asset allocation your number one priority. Maximum tax efficiency is a secondary consideration--but to the extent that you can keep your bond investments (and any investments where you make frequent trades) inside a tax-deferred plan, you'll come out ahead.

As a secondary matter, start saving some money outside your 401(k). As the sum grows, use it to invest for capital gains (and, for however long they remain tax-advantaged, dividends)--and simultaneously shift your 401(k) toward interest-earning investments that make maximum use of the 401(k)'s tax advantages.

For most people this will probably be a long-term problem: Unless you become quite wealthy, your 401(k) will always be larger than the amount of money you want to hold in bonds. But that's not a big problem. Just stick with your asset allocation and emphasize capital gains and dividends outside the 401(k).

Using a Roth

A Roth IRA is a special case. If you follow the rules (wait until your Roth is 5 years old and until you're 59-and-a-half), you can avoid paying any taxes on money earned in a Roth.

The upshot is that most of these issues don't really apply to a Roth. Just invest according to your asset allocation and don't worry about it.

Remember that tax rates always change (and everyone's individual tax situation is different), so be sure to check and understand how the rules will actually apply in your case.

Whatever mix of retirement accounts you end up using, don't let the fact that they're called "retirement" accounts distract you from the essential features that distinguish those accounts: the tax advantages. Taking maximum advantage of those features can add significantly to your wealth over the next few decades.

[Update 6 August 2009: This post was included in the Carnival of Personal Finance.]

This article is from Philip Brewer of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

3-6 months of living expenses?

Julie Rains — Thu, 05 Jul 2007 19:08:38 +0000

Personal-finance experts often recommend having 3-6 months' worth of living expenses saved and easily accessible. In his July 1, 2007 Getting Going column ("Popular Advice You Shouldn't Take"), Wall Street Journal columnist Jonathan Clements offers alternatives to a cash account (e.g., savings account or CD). He's got practical ideas that relate to how people really think, live, save, and invest.

Let's consider why experts make this recommendation so you can develop a personal-finance Plan B.

The primary reasons experts recommend cash reserves are 1) to pay for emergencies or unexpected, non-budgeted expenses such as medical bills or major home repairs 2) to pay regular expenses (e.g., your rent or mortgage, food) if you become unemployed, disabled, or lose income for some reason. They want you to avoid financial unpleasantness that may haunt you for years to come:

Bad: you have to pay for emergencies using credit cards with high interest rates; you have to sell your mutual funds, ETFs, or stocks, during a market downturn.

Worse: You have to pay tax penalties for withdrawing funds from your 401(k) or tax-deferred account.

Catastrophic: you have to declare bankruptcy; you lose your house to foreclosure.

Try to prevent or calmly, wisely deal with financial emergencies:

Don’t go a day without health insurance, especially now that the insured get discounts not typically available to the uninsured;

Get an estimate of costs ahead of medical bills and start setting aside money before the bills are due (In my experience, healthcare providers are slower than other vendors in forwarding bills as they often wait for insurance reimbursement before requesting payments from consumers);

Ask for a payment plan from vendors (When I was in my early 20’s, my dentist offered to let me pay a small portion monthly until my balance for extensive dental work was paid in full; my childhood dentist didn't believe in novacaine so I avoided dentists while in college);

Buy disability insurance;

Have your home inspected or do a home inspection yourself, figure out what items need to be replaced or fixed before they completely disintegrate, and start planning for major home repairs now;

See if your homeowner’s or renter’s insurance can cover unusual expenses.

Note that there are scenarios where losing your job wouldn’t be financially catastrophic:

You have a spouse/significant other who can cover regular expenses (which means, most likely, that you have purchased much less house or less car than you can afford by lenders’ standards or you have a high-earning spouse/significant other);

You can adjust your living situation easily (e.g., move in with your parents while looking for another job or recovering from an injury);

You work in a field and/or live in a market that makes finding a new job with pay comparable to your current one relatively easy (but if your company compensates you extremely well compared to its competitors, start socking away money now!)

In Popular Advice You Shouldn't Take, Mr. Clements suggests these alternatives to saving cash:

fund your 401(k) to receive company matches and tax benefits;

save some money in a conservative, taxable account;

open, fund, and, if necessary, access contributions to a Roth account (your contributions can be taken out without tax consequences although earnings generated from the investments can not be used without penalty; see this article on the Roth)

make a down payment on a home using funds you've saved by not having traditional cash reserves, and then

take out a HELOC (home equity line of credit), which should carry a lower interest rate than a credit card.

Please know that Mr. Clements and I do want you to set aside money now for future use; we just want you to consider investing your money rather than putting funds in accounts with low returns. When you can enjoy the fruits of not spending (buying a home, getting company-match dollars, growing your portfolio), you'll be motivated to keep on saving and investing.

(edited for placement of link to Mr. Clements' article)

This article is from Julie Rains of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread: