The 9 Steps to Financial Freedom (25 page)

Q. Does this mean I can have a traditional IRA and a Roth IRA?

A. Yes, as long as between the two IRAs you have not in one year contributed more than the $5,000 annual cap for IRAs (or $6,000 if you are fifty or older).

Q. Are there income limitations to who can have a Roth IRA?

A. Only if you want to contribute directly to a Roth IRA; anyone can contribute to a traditional IRA and then convert to a Roth. To make a direct investment in a Roth IRA, the maximum adjusted gross income limitations are as follows: for those filing an individual return, $125,000; for joint returns, $183,000.

Q. Is there an income limit to be able to convert a traditional IRA to a Roth IRA?

A. No.

Q. When do I owe the taxes on the money that I have converted into my Roth IRA from a traditional IRA?

A. You owe all the tax in the year of the conversion.

Q. What if I converted my traditional IRA to a Roth at the time the market was really high? Since then, the market has taken a tumble. I now owe a lot of taxes on an IRA that in reality is worth a lot less. Is there anything that I can do?

A. Yes. You have until October 15 of the year after the conversion to “recharacterize” the account back into a traditional IRA. You can then convert it back again to a Roth IRA as long as you wait until the later of 1) the year after the year of the original conversion, or 2) more than thirty days after the date of the recharacterization. (Please note that I said the
later
of the two.) Just be sure that your income allows you to be eligible still to do a conversion at this later time. For instance, let’s say that you have a traditional IRA worth $100,000 and you converted it to a Roth. Six months later in the same year, the market has gone down and now that $100,000 is only worth $78,000. Since you converted your traditional IRA when the value was worth $100,000, if you do not do anything, you will owe income taxes on $100,000. What you could do is recharacterize back to a traditional IRA, then reconvert back (30 days later or the next calendar year, whichever one is longer) to the Roth with hopefully a lower conversion value. This is something that you should always keep in mind. It could save you lots of money, but make sure you check with a tax professional before doing anything, since these laws can change.

IRA Guidelines

A few thoughts to keep in mind. Are you eligible for a company retirement plan like a 401(k) and do you also qualify to
fund a Roth IRA? If so, it can be confusing as to whether you should fund your 401(k) plan or the Roth IRA first. It would be best to fund both to the maximum if you can. But if money is tight and it is an either/or situation, then this is what I would do. If you have a 401(k) plan where your employer matches your contribution, meaning that for every dollar you put into your retirement plan at work, they put money in for you as well to match in full or in part, I would first fund my retirement plan at work up to the point of the match. Now, if you don’t get a company match on your 401(k), I would make my first priority the Roth IRA before investing in the 401(k). If you have been investing in a nondeductible IRA, you, too, should definitely consider switching to a Roth IRA; for most people it makes the nontax-deductible IRA obsolete. If you are not covered by a company retirement plan, and can really use the tax write-off right now from a traditional IRA deposit, but you are a spender and not a saver and—realistically—will fritter away the tax savings from a traditional IRA instead of investing them each year, then you might want to lean more toward the Roth IRA as a savings against future taxes that you would have owed with a traditional IRA. In other words, pass up the current tax savings for the future big picture. If you are very young, just starting out in your career, and in a low tax bracket, by all means look into a Roth IRA, which can jump-start your retirement savings by a lot, even if you switch tactics later. Let’s say that from ages twenty-one to thirty you invested $5,000 a year into a Roth IRA averaging an annual return of 6 percent every year and then you never deposited another cent into that account and just let it grow; at age sixty, you’d have more than $400,000 that you could access totally tax-free. Big difference, if you think that all it would have saved you in taxes in a traditional IRA (if you are in a 15 percent tax bracket) would be about $750 a year, or $7,500 over ten
years. As you can see, it makes no sense to have to pay taxes on $400,000 later on in life (when you might be in a very high tax bracket) just to have saved $7,500 over ten years early in your career. By the way, if your tax bracket changes and you want the deduction of a regular IRA, you can make that change anytime you want. Rather than making a deposit into your Roth IRA that year, switch to a traditional IRA.

Benefits of Withdrawal of a Roth IRA vs. a Traditional IRA

With a traditional IRA, upon your death your spouse is the only one allowed to take over your account as if it were his or hers. Thus surviving spouses (if withdrawals had not already started) can continue to use the tax deferral strategies until they really need to live off the money, or until age seventy and a half when withdrawals have to start. However, if you are currently not married, then your named beneficiary for these funds will have to start taking withdrawals that year and continue them over his or her entire life expectancy. But what usually happens is that the beneficiaries wipe the account clean over a short period of time. This often results in a significant tax bill for your beneficiaries. This can be avoided with a Roth IRA. In this case, your beneficiaries would also get the money tax-free. No doubt this will make you the most loved relative in the family.

Comparison of the Traditional IRA and the Roth IRA

Another possible advantage of the Roth IRA is that you do not have to start withdrawing money at age seventy and a half. With a traditional IRA, you have to start making withdrawals by April 1 of the year after you turn seventy and a half. Because of this, a Roth IRA could also help you tax-wise down the road. When you have to start taking money out of your traditional
IRA—even if you don’t need it—these add to your tax bracket, which affects the bottom line all the way around. One last factor is that if you really need help saving money, if you tend to sneak into your future piggy bank when you want money available to spend on today’s eventually useless treasures, gear yourself toward a traditional IRA where it is harder to get at the money without sustaining penalties before age fifty-nine and a half.

What’s the Difference between a 401(k) and an IRA?

Well, you can invest a lot more in a 401(k). In 2012, the general limit for an IRA contribution is $5,000, while the 401(k) limit is $17,000. And if you are at least fifty years old, your IRA limit for 2012 is $6,000 and your 401(k) contribution limit is $22,500. This is a big reason to push for a 401(k). Even with a SIMPLE (see
this page
) you can possibly put away $6,000 more a year than you can with an IRA.

Maximizing the Impact of a Roth or Traditional IRA

Most people wait to contribute to their IRA until they file their taxes in April of the year after—a mistake that adds up. For the tax year 2012, you have the right to put up to $5,000 in your IRA in January 2012 if you are under fifty years old. But most people will wait until April 2013 to do so. This is an incredible waste of money. If you possibly can, I urge you to put that money away at the beginning of the year rather than at the tax deadline.

If you invested your $5,000 in January 2012 and that money sat there averaging a 6 percent return, by the time April 15, 2013, came around, you would have an extra $393 in the account compared to if you waited until April 2013 to make your 2012 contribution.

If you don’t have $5,000 at the beginning of the year, and so can’t make the investment all at once, start putting $416 (or whatever you can) each month into your IRA. You will still come out ahead than if you had waited to do it in one lump sum on April 15.

If you’re self-employed and are not incorporated, you also have excellent options for funding your retirement. You can open up what is known as a SEP, a Keogh, or a SIMPLE. All three of these are great ways to plan ahead. In order to qualify for these three retirement accounts, your earnings must be reported on Form 1099-misc. or be earned as fees for services you’ve provided. (Company employees, on the other hand, are usually provided with W2s to report the money they’ve earned.)

If you have people working for you, after a certain period of time you’ll have to fund the SEP, Keogh, or SIMPLE plan for them as well.

Simplified Employee Pension Plan (SEP)

You can open a
SEP
, or
simplified employee pension plan
, and put away up to 25 percent of your income or $49,000—whichever is less—per year in payments for yourself. SEP-IRAs can be set up at banks, mutual funds companies, brokerage firms, discount brokerage firms—almost anywhere you’d like to invest (read Step 6 and decide). If you have employees who have worked for you for three out of the past five years, you will have to put money in their SEPs as well, to the tune of the lesser of 25 percent or $49,000. Please keep in mind that these figures change yearly, so check with a tax professional to find out the current limits. The above figures are for the year 2011.

Keogh

A
Keogh plan
(named after Senator Eugene Keogh, who came up with the idea) can also be used to fund a retirement for the self-employed. Keoghs are more complicated than SEPs but used to allow you to set aside more money than you could with a SEP. That is no longer true. The amounts are the same as with a SEP. You must also fund a Keogh for anyone who has worked for you for at least one year. And you must contribute the same percentage for those who work for you as you do for yourself.

Keoghs are divided into two types of plans. The first is known as a
money purchase plan
, and the second is known as a
profit-sharing plan
. With both, you can invest the money just about wherever you like. However, due to the new, more generous limitations for SEPs, there is currently no reason to set up either type of Keogh, since a SEP plan is easier to administer.

SIMPLE

SIMPLE, or
Saving Incentive Plan for Employees
, lets you put up to $11,500 a year (for 2011) into a plan for yourself.
The limit is $16,500 if you are over fifty years old. There is no percentage limitation for a SIMPLE, as there is for a SEP or Keogh. If you have any employees who have worked for you and have made at least $5,000 in compensation over the past two years and are projected to do so again, they, too, are eligible for a SIMPLE.

As a self-employed person with employees who are eligible, you are required to follow one of two contribution formulas for your employees: either the matching contribution formula or the 2 percent formula. Under the matching contribution formula, you must match dollar for dollar what the employee elects to put into it, from 1 percent up to 3 percent of their compensation. You get to decide. However, if you choose the lower match, you cannot do that for more than two out of any five years. With the other formula—the 2 percent contribution formula—you simply decide that you are going to contribute 2 percent of the employees’ compensation.

Note that all contributions are considered vested the second they are made. This means that they belong to your employee even if he or she leaves your employ the very week after you made the match.

One thing to know, particularly if paperwork makes you crazy, is that there’s more paperwork involved with a Keogh than with a SEP or a SIMPLE (for which the paperwork requirements are almost nil). With a Keogh, from the moment you have more than $100,000 in the account you have to file what’s called a 5500ez form at tax time. Not all that bad, but it’s still paperwork, and paperwork that’s not required
with a SEP or a SIMPLE. If you don’t have employees, or if you do and you don’t mind contributing the same percentage of their income for them as you contribute of yours for yourself, the SEP is the way to go. If you have employees whom you do not want to contribute a lot of money for, or if your income is so low that you can put more away with a SIMPLE plan, then go with it. If you’re self-employed, you must take advantage of one of these options. Whichever way you go, you cannot lose.

Employed, self-employed—it doesn’t matter. When it comes to money, time is probably the most important factor in the growth process. The more time you give to your money and the more time it has to grow are the two key ingredients to attracting and creating large sums. The amount you will have accumulated when retirement comes will determine what kind of lifestyle you will then be able to afford.

If you’re forty-five, and start putting $100 a month into an account that averages a 6 percent return, you’ll have $46,400 by age sixty-five.