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How to Rule Your Retirement Accounts
Robert Brokamp Dear Fellow Fools,
Motley Fool Advisor If you want to retire, you need to save and invest. And if you’re doing that,
you’re likely using some type of tax-advantaged retirement account. They have
boring names like 401(k), 403(b), and IRA, and - being creatures of Congress
Inside and the IRS - are subject to all kinds of quirky rules. But they’re still the best
Maximizing Your Savings...................... 2 way to build a nest egg for your future. As for those quirky rules, we’ll sort
them all out for you in this special report. Read on to make the most of your
Why We Love the Roth IRA................... 2 tax-advantaged savings.
Six Reasons to Roth ................................ 3 »» Maximizing Your Savings. When your 401(k) makes sense, and when
it doesn’t.
Uncle Sam Diversification..................... 4
»» Why We Love the Roth IRA. Get more flexibility and tax-free growth
Retirement Account Fast Facts............ 5
with the Roth IRA.
How Much Is Your 401(k) »» Six Reasons to Roth. Don’t know if a Roth is for you? Here are six sce-
Costing You?.............................................. 6
narios when the Roth makes sense.
Q&A: 401(k) or IRA?................................. 7 »» Uncle Sam Diversification. Learn the benefits of having retirement in-
Q&A: The Mechanics of come that is taxed at different rates.
Roth Conversions..................................... 8 »» Retirement Account Fast Facts. Here are several lesser-known rules —
and benefits — of tax-advantaged retirement accounts.
»» How Much Is Your 401(k) Costing You? Unfortunately, many employ-
er-sponsored retirement plans amount to no more than expensive ways to
invest in mediocre mutual funds.
»» Q&A: 401(k) or IRA? Generally, it’s better to transfer money in an old
401(k) to an IRA... but not always.
»» Q&A: The Mechanics of Roth Conversions. The nuts and bolts of turn-
ing traditional tax-deferred savings into Roth tax-free savings.
Maximizing Your Savings has been open for at least five tax-years, then everything in
it comes back to you free of any income taxes.
By David Braze
3. Invest in long-term, buy-and-hold vehicles like
Most financial experts tell us we should take full advan- stocks that pay little to no dividends or tax-managed
tage of tax-deferred retirement accounts such as 401(k)s stock funds within a regular, taxable account. Since you
and deductible traditional IRAs. That’s because both our won’t pay taxes on these investments until you sell, they
contributions and our earnings remain untaxed until we have a built-in tax-deferred benefit — as long as you hold
take them out many years later in retirement, which adds for many years. When ultimately cashed in, the gains will
significantly to the positive power of compounding and can be taxed at long-term capital gains rates, which are lower
result in a much larger nest egg. than ordinary income tax rates. If your other income puts
But while this advice is well-founded, you may want to you into a 25% or higher tax bracket, then the capital gains
keep some of your money out of your 401(k) or traditional rate is 15%. If that other income falls within the 10% or
IRA. Here are five steps to determining where to put your 15% bracket, the capital gains rate would be 5%. (Those
retirement savings to maximize your after-tax return. are the rates as of 2009, and will likely change in the future,
but it is expected that long-term capital gains will continue
1. You should always use your employer’s plan to get to be taxed at a lower rate than ordinary income.) Invest in
the maximum matching contribution. Let’s say your em- the same type of stocks within your 401(k) plan and when
ployer will match half of your contribution up to a maxi- withdrawn, those gains will be taxed at ordinary income
mum of 6% of your pay. That means if you put in 6% of tax rates instead. Note: For this to work, you really have to
your paycheck, your employer will match that by contribut- hold. It won’t work if you’re an active trader or invest in
ing 3%. Unless you know of a better way to get an immedi- high-turnover mutual funds that make frequent and signifi-
ate, risk-free 50% return on your money, then do all you cant capital gains distributions.
can to contribute 6% of your pay to your plan. After that
4. Use your retirement accounts to invest in high-
sit back, take a deep breath, and see where else you should
yielding vehicles like bonds and real estate investment
invest for retirement. Additional contributions to that plan
trusts. The payouts from these investments are taxed at or-
may not be the best choice.
dinary rates anyway, so shelter those payouts within your
While untaxed contributions and earnings may benefit plan for as long as possible.
you today, all the previously untaxed money in a retirement
5. Exercise the same investment discipline outside of
account will be taxed at the ordinary income tax rates in the
your employer’s plan as you would within it. One of the
year you take it. Income taxes are at historical lows today.
benefits of a plan like a 401(k) is that the money is taken out
What will those rates be like 10, 15, or 20 years from now
of your paycheck before you can spend it, and your contri-
when you’re retired? Personally, I think they have no place
butions automatically increase with every raise. If you can’t
else to go except up.
make that same level of commitment to your non-plan in-
Consider also that another tax Catch-22 may grab you. vestments, keep your money inside that plan to ensure you
When you are over age 70 1/2, you must take mandatory amass as many dollars for retirement as you can.
distributions from your tax-deferred retirement accounts. That means you must make your deposits to those invest-
(This may not be the case with your work plan if you’re ments each and every payday without fail, and your total
still working; check with your plan administrator.) Will deposits to those accounts must increase at the same time
those withdrawals push your taxable income above the and at the same rate as your pay does. And it means you
magic thresholds where 50% to 85% of your Social Secu- cannot, under any circumstances, make any withdrawal
rity income is also subject to income taxes? That situation from those investments before retirement. Fail to adhere to
happens to many retirees, and the result is a much higher that regimen, and you will neither equal nor beat the results
income tax bill than expected or even required. attainable within your tax-deferred retirement accounts.
2. Contribute to a Roth IRA. After you’ve taken advan-
tage of an employer match — or if you don’t receive one Why We Love the Roth IRA
in the first place — consider contributing to a Roth IRA if
By Robert Brokamp
possible (eligibility begins to phase out for single taxpayers
with adjusted gross incomes of $105,000 and married folks Want tax-free growth? Want more control over your re-
earning $166,000). Yes, that contribution will be taxed at tirement savings? Want to leave a bigger inheritance? If so,
today’s ordinary income tax rates, but the earnings grow you should consider contributing to or converting existing
tax-free. Plus, when you reach age 59 1/2 and if the Roth retirement savings to a Roth IRA.
2 Motley Fool Rule Your Retirement Special Report — July 2009 ruleyourretirement.fool.com
For Not-Yet Retirees: The biggest difference between IRA contained non-deductible contributions). But for many
a Roth and a traditional IRA is the tax treatment of con- people, that one-year tax bite is worth the subsequent years
tributions and withdrawals. With the Roth, contributions of tax-free growth. Here are the factors to consider:
aren’t tax-deductible, but withdrawals are tax-free (as long
»» Generally, convert only if you can pay the taxes
as you follow the rules). For the traditional IRA, contribu-
from sources other than the converted funds, espe-
tions might be deductible: investments grow tax-deferred,
cially if you’re younger than 59 1/2 and will have to
but withdrawals are taxed as ordinary income — the high-
pay a 10% penalty on the money you withdrew to
est rate possible.
pay the taxes.
To determine which will be best for you, start by deter-
»» If you’re close to retirement and you expect to drop a
mining if you’ll be able to deduct contributions to a tra-
couple of tax brackets, the conversion probably won’t
ditional IRA. If you’re covered by a retirement plan at
be worthwhile. This is also true if the conversion will
work and you earn more than $60,000 for single taxpay-
push you into a higher bracket than where you’ll be
ers ($80,000 for married taxpayers), you can’t deduct the
when you take money out of the Roth.
contribution. Contributing to the Roth is then a no-brainer,
assuming you’re eligible (see fact sheet). »» If you’re in a lower tax bracket now but RMDs at age
70 1/2 will push you into a higher bracket, converting
If you can deduct your contribution to the traditional
portions of your traditional IRA to a Roth over a few
IRA, you’ll have to do some calculations. The conventional
years (partial conversions are OK) might smooth out
wisdom is that a traditional IRA is better if your tax bracket
your taxes.
today is higher than what it will be in retirement. But if
you’re more than 10 years away from retirement, this is a »» If you expect to pay estate taxes, a conversion will
guessing game. Go with a Roth for all the other benefits. save your heirs money because the taxes you pay to-
day will reduce your estate, and assets in a Roth for
Another bonus for younger savers: Contributions to a
your heirs will be subject to estate taxes, but not in-
Roth IRA can be withdrawn anytime tax- and penalty-free,
come taxes.
even if you haven’t reached age 59 1/2 (but you will pay a
10% penalty on earnings you withdraw early). So if you’ll Want some help with all these numbers? Visit the calcu-
need the money before then, you can get it, but touch base lator at www.dinkytown.net/java/RothTransfer.html to see if
with the IRS. Finally, there are no required minimum distri- a conversion is right for you.
butions (RMDs) at age 70 1/2 from a Roth IRA, so you can
contribute beyond that age. Roth IRA Fact Sheet
Who can contribute? Anyone with earned income. Eli-
For Retirees: Since there are no RMDs from a Roth,
you can let your investments grow tax-free for as long as gibility begins to phase out for single taxpayers with an ad-
you don’t need the money. And unlike distributions from a justed gross income above $105,000 and married taxpayers
traditional IRA, non-taxable distributions from a Roth IRA above $166,000.
aren’t included in the calculation that determines whether Are contributions deductible? No.
your Social Security benefits will be taxed, which might How are withdrawals taxed? They’re tax-free, as long
mean double the tax savings. as you’re age 59 1/2 or older and the account has been open
For Heirs: The tax treatment of IRAs is the same for at least five years.
owners and beneficiaries. Anyone who inherits a tradi- Must I take money out at age 70 1/2? No.
tional IRA will have to pay ordinary income taxes on the
distributions. Not so with the Roth. The account will still Why is it called a “Roth”? Named after Delaware Sen.
maintain its tax-free status. And nothing says “I love you” William Roth Jr. (also known for leading investigations
like giving someone tax-free retirement savings. (Keep in into Pentagon overspending that uncovered the infamous
mind that all accounts, IRAs or otherwise, are subject to $9,600 wrench and $640 toilet seat).
estate tax if the combined value of a decedent’s assets ex- Why is it so good for colds? You’re thinking of “broth.”
ceeds the exclusion amount, which changes every year so
check with the IRS.)
Six Reasons to Roth
Should You Convert? We know you’re patriotic and love your country, but you
A traditional IRA can be converted into a Roth IRA by also don’t want to pay Uncle Sam any more than you have
anyone whose modified adjusted gross income is below to. Here’s one way to cut your future tax bill: Contribute to
$100,000. The converted amount will count as taxable the retirement account named after the late Delaware Sen.
ordinary income in the year of the conversion (unless the William V. Roth.
ruleyourretirement.fool.com Special Report — July 2009 Motley Fool Rule Your Retirement 3
Qualified withdrawals from Roth IRAs or 401(k)s are trib.html). If you’re not close to 70½, you’ll have to first
tax-free. That will reduce your tax bill in retirement, and estimate how much you’ll have at that age.
thus reduce the amount of income you need in retirement.
However, this is no free lunch: Contributions to a Roth ac- 5. You Will Defer Withdrawals
count are made with after-tax money — that is, they’re not Beyond Age 71
tax-deductible. Contrast that with contributions to a tradi- A study by Thomas Langdon, E. Vance Grange, and Mi-
tional employer-sponsored retirement account or tradition- chael Dalton titled “When Roth 401(k) and 403(b) Plans
al IRA, which are deductible (under most conditions), but Outshine Traditional Plans” found that if your marginal tax
withdrawals are taxed as ordinary income. So which is bet- rate is 25% both before and in retirement, “there is a slight
ter: a tax break today or a tax break tomorrow? Here are six advantage to using a traditional 401(k) or 403(b) plan” if
scenarios when contributing to a Roth makes sense. you intend to take minimum distributions beginning at age
70½. “But, all else being equal, if minimum distributions
1. You’re Young and in a Lower Tax Bracket are deferred for only one year, the Roth 401(k) or 403(b)
If you expect to be in a higher tax bracket when you retire, accumulation is superior.”
contributing to a Roth results in the most after-tax wealth.
If your tax rate drops from 25% to 20% in retirement, the
The payoff is bigger the farther you are from retirement.
authors found that the traditional accounts fare better — un-
2. You Have Large Traditional Accounts less you delay distributions until age 73. At that point, the
Roth looks better. The withdrawals might be delayed be-
If you’ve accumulated hundreds of thousands of dollars cause you’re working well into your 70s or because you’ve
in your tax-deferred accounts, it might be time to get some spent other assets in the earlier years of retirement.
“tax diversification” that will allow more flexibility with
managing your tax bill in retirement. 6. You Want to Leave More for Your Family
Large withdrawals from tax-deferred accounts can cause Finally, your heirs will inherit more after-tax money if
more of your Social Security to be taxed. This conundrum they inherit Roth assets.
was addressed by journalist Scott Burns and economist
Laurence Kotlikoff in their book The Coming Generational
Storm: “While Social Security benefits are tax-free if you
Uncle Sam Diversification
have little or no other income, the benefits become taxable By Robert Brokamp
as your income from other sources increases. Cross the reef Do you know what’s going to happen to the stock market
— the fixed threshold of $34,000 — and every $1,000 of next week? A month from now, will interest rates be higher
outside income will cause $500 of Social Security benefits or lower than they are today?
to be added to your taxable income. The burden gets stiffer
when your marginal tax rate in retirement is 25%. At that in- You might be willing to hazard some guesses, but chanc-
come level, there is a good chance that $850 of Social Secu- es are you don’t have definite answers to either of those
rity income will become taxable for each additional $1,000 questions — and you surely wouldn’t bet your entire retire-
of other income. That’s a marginal tax rate of 46.25% on ment on them.
each dollar taken from your retirement accounts.” This is why you have a well-diversified portfolio to safe-
guard against future bumps. But don’t limit yourself to just
3. You Think Taxes Will Rise Substantially asset diversification. Build a portfolio with plenty of tax
I have bad news for you. Taxes will definitely have to diversification by having assets in each of the three main
increase. The government spends more than it has, and it types of accounts: (1) taxable, where qualified dividends
will get worse as retiring baby boomers strain entitlement and long-term capital gains are taxed at 15% (as of 2009),
programs. Exactly how much taxes will increase is not and most everything else is taxed as ordinary income; (2)
known, but some experts believe taxes will be 30% to 50% tax-deferred (401(k)s and traditional IRAs), where with-
higher. If you agree, then building up a stockpile of Roth drawals are taxed as ordinary income; and (3) tax-free
assets is smart. (Roths), where qualified withdrawals are, well, tax-free.
4 Motley Fool Rule Your Retirement Special Report — July 2009 ruleyourretirement.fool.com
rate — or sell an investment at a loss to reduce your in- minimum distributions at age 70½. This allows those assets
come. You could even tap your Roth. more time to grow tax-free. While this certainly benefits the
More importantly, having control over your taxable in- account owner who doesn’t need the money at 70 but does
come allows you to protect more of your Social Security at 80, it’s also a nice bonus for the account owners’ heirs.
benefits from taxation. You don’t have to earn much for Here’s why:
Uncle Sam to taketh what he just gaveth, and the compu- The first reason, of course, is the larger inheritance due to
tation is a bit complicated. Start with your adjusted gross more years of tax-free growth. The second reason is that in-
income, then add one-half of all Social Security benefits herited Roth assets are also tax-free to the inheritor (though
and all unearned income received during the year (gener- they’re subject to estate taxes if the entire estate is over
ally, tax-exempt interest received from municipal bonds). the exempted amount). The potential to pass along a larger
If the computed total is greater than $25,000 (single) or amount of tax-free assets is a nice way to keep tax diversi-
$32,000 (married, filing jointly), then up to 50% of the So- fication in the family.
cial Security benefit will be taxed. If the amount is greater
Here’s to keeping your portfolios padded and protected
than $34,000 (single) or $44,000 (married, filing jointly),
from Uncle Sam!
then up to 85% of the Social Security benefit will be taxed.
These amounts aren’t adjusted for inflation, so more and
more retirees will actually be giving back their Social Secu- Retirement Account Fast Facts
rity benefits in the form of taxes. You may be able to shield By Robert Brokamp
part of your Social Security from taxation by relying on
income from a Roth IRA, which is exempt from the taxa- Tax-advantaged retirement accounts such as IRAs,
tion equation. 401(k)s, and 403(b)s are great ways to save for retire-
ment. However, like anything governed by the IRS, there
And then there’s Medicare. Starting in 2007, Medicare are plenty of rules, exceptions, and quirks. Here are some
beneficiaries earning more than certain income limits (which lesser-known facts about retirement accounts.
change annually) will pay higher premiums for Part B. Your
income calculation will be made by the Social Security Ad- Get the Money Before 59 1/2
ministration using information from your most recent tax If you tap a retirement account before age 59 1/2, you’ll
return, and will be based on your adjusted gross income plus pay a 10% penalty — but there are several exceptions:
any tax-exempt interest. If you’re near the thresholds, avoid
paying higher premiums by relying on your Roth accounts »» Contributions to a Roth IRA (not earnings) can be
for income. Distributions from Roth accounts will not be withdrawn any time, tax- and penalty-free.
part of the calculation, so having a chunk of your net worth »» You can make penalty-free withdrawals from your
in Roth accounts reduces the likelihood that your benefits last employer’s plan if you retire at age 55 or older.
from Uncle Sam will be reduced by your income.
»» Under rule 72(t), you can make substantially equal
If Taxes Increase periodic payments (SEPPs) at any age by agreeing to
take out a certain amount each year until you turn 59
No one can predict the future, but we, as investors, are
1/2 or for five years, whichever is longer.
willing to tilt our portfolios one way (stocks) or the other
(bonds) based on factors such as history, economics, or risk »» IRA assets used to pay for qualified higher education
tolerance. I, however, expect that with tax rates at multi- expenses — such as tuition, fees, books, and room
decade lows (the highest tax bracket is 35%, compared to and board — are exempt from the 10% penalty.
90% in the 1960s), large state and federal budget deficits, »» You can use your IRA to help put a roof over your
and the looming unfunded retirement of the baby boomers, head, as long as you’re considered a first-time buyer,
tax rates will likely increase in the coming years. which, according to the IRS, includes anyone who
This is yet another reason to have tax diversification in hasn’t owned a home in the past two years. There is
your portfolio. If current tax rates hold or move up only a $10,000 lifetime limit on what can be withdrawn
marginally, then Uncle Sam won’t be taking so much of penalty-free.
your taxable retirement assets. But if tax rates skyrocket,
you’ll be very glad you have sizable Roth accounts. Improve Investment Choices
The typical employer-sponsored retirement account of-
Increase Heirs’ After-Tax Inheritance fers so-so investment choices and charges too much for
One of the most underappreciated benefits of the Roth the privilege. Fortunately, you may not be stuck with those
IRA is that owners don’t have to begin taking required lousy and overpriced investments. Here are some options:
ruleyourretirement.fool.com Special Report — July 2009 Motley Fool Rule Your Retirement 5
»» If you no longer work at the company, transfer the Max Out a 457(b) and Another Plan
money to a low-cost IRA. If you’re a state or local government employee with a
»» Many retirement plans offer a brokerage window, 457(b) plan, you can max out that account and max out a
which allows employees to buy individual stocks, 403(b) or 401(k). How can you get access to more than one
exchange-traded funds, and other mutual funds. plan? Your employer might offer two choices, or you can
open up a solo 401(k) if you have a side business.
»» Some plans allow for in-service distributions, which
allow employees to transfer money to an IRA while Protect Assets via Retirement Accounts
still working for the company.
The money in your employer-sponsored retirement ac-
»» Your company may have a benefits committee, or at count most likely can’t be lost to bankruptcies or lawsuits.
least a group of folks who occasionally think about In most cases, the same goes for IRAs up to $1 million.
the retirement plan (typically, the human resources
folks and perhaps the CFO). You can agitate for bet- Have Uncle Sam Fund Your IRA
ter investment options, a brokerage option, or even a Getting a tax refund? Instruct the IRS to send it directly
completely different plan. to your existing IRA.
Invest in “Alternative Investments”
Retirement accounts are not limited to stocks, bonds, and How Much Is Your 401(k)
mutual funds. You may be able to use your retirement sav-
ings to invest in options, real estate, small businesses, and
Costing You?
collectibles; there’s even a 401(k) provider with a client By Robert Brokamp
who has invested in Babe Ruth memorabilia. The trick is It’s not news to longtime Rule Your Retirement readers
to find a custodian that will allow such investments. You’ll that employer-sponsored retirement plans — such as 401(k)
have to go beyond the usual brokerages and mutual fund s, 403(b)s, and the like — often aren’t the best places for
companies and find a company (often a bank) that special- your money. This article will help you find out exactly how
izes in such arrangements. much you’re paying to participate in your plan.
Use the Roth as an Estate Planning Tool 1. Look at the expense ratios of your
Let’s say you’re still working, but you’ve already saved mutual funds.
enough for retirement and would like to help your kids, The expense ratio is the percentage of your assets that are
grandkids, or favorite Rule Your Retirement editor. withdrawn by the mutual fund company to pay for manage-
One option is to contribute to a Roth IRA and name your ment and administrative costs. It should be found on your
relative(s) as beneficiaries. When you retire from this world plan’s website or other information made available by your
to the next, your heirs will receive that money income tax- employer. Ideally, you shouldn’t be paying more than 1.0%
free (although it may be subject to estate taxes). — 0.75% or lower is better.
There are a few reasons a Roth IRA is better than a tradi- Keep in mind that the expense ratio listed on a fund-in-
tional IRA for this purpose. You can’t contribute to a tradi- formation website, such as Morningstar.com, may not nec-
tional IRA past age 70, even if you’re still working. In fact, essarily be the expense ratio you’re paying. Extra adminis-
at that point, you must begin taking money out, which is trative costs may be added to the funds in your plan (which
known as a required minimum distribution (RMD). we’ll discuss in the next step).
The scenario is a bit different with a Roth; there’s no age Finally, we should note that the expense ratio for any mu-
limit and no RMDs. Plus, heirs must pay income taxes on tual fund — whether in your 401(k) or elsewhere —doesn’t
inherited traditional IRAs. capture all the costs you’re paying. The biggest missing ex-
pense is commissions the fund pays to buy and sell invest-
Pay Annual IRA Fees With Non-IRA Money ments, which are disclosed in the “statement of additional
Many IRA providers charge an annual account fee, which information.” As un-thrilling as it might be to read such
is automatically taken from your account assets. However, a document, you can get a rough idea of how much your
you can instead send a check to the custodian and leave fund is paying in commissions by looking at its “turnover,”
more money in the IRA to grow through the years. (Con- which tells how much of a fund is bought and sold over the
tact your provider for details.) Unfortunately, you can’t use course of a year. For example, a turnover of 80% means that
non-IRA money to pay other costs, such as commissions 80% of the fund’s investments have been sold (or “turned
and mutual fund expenses. over”) in the past year. The higher the turnover, the more
6 Motley Fool Rule Your Retirement Special Report — July 2009 ruleyourretirement.fool.com
the fund pays in commissions. Ideally, look for funds with amount of withdrawals from my 401(k) at that age?
turnovers less than 50%. Not only will this reduce com- Can I continue withdrawals if I have a part-time job or
missions, but many studies have found that low-turnover found my own company after I retire?
funds, as a group, outperform high-turnover funds. A: As far as the IRS is concerned, when you retire from
work in the year you reach age 55, you may make with-
2. Ask your human resources department
drawals from your 401(k) or 403(b) plan free of any penal-
Next, you’ll want to know how the administrative ex- ty. All that’s required will be for you to pay regular income
penses of your plan are paid. Your employer might be pick- taxes on those withdrawals in the year you take them. The
ing up the total tab — or it might be withdrawn from each only withdrawal restrictions you will encounter are those
employee’s account. This could be a fixed amount (e.g., required by the plan itself, so contact the administrator to
$300 for each participant) or a percentage of assets. learn the rules for your plan. You can continue to make
If you trust that the folks in your HR department will withdrawals even if you later take on a part-time job or start
give you reliable information, ask them how much the plan your own company, because you will be taking the money
costs and who pays the bill. They should be able to find out from the plan sponsored by a former employer, from whom
that information, and provide some documented proof. you retired at age 55 or older.
Generally, we recommend that money be transferred
3. Look at your Summary Annual Report from a 401(k) to a self-directed IRA as soon as possible.
If you want to investigate the plan expenses yourself, Why? Employer-sponsored retirement plans usually offer
request a copy of your plan’s Summary Annual Report, limited, mediocre investment choices — and charge too
Summary Plan Description, and/or Fee Arrangement — es- much for them, to boot. Chances are that you’d pay less
sentially, any plan documents your employer will give you. in fees and have many, many more investment options by
As you can scan the documents, you’ll learn all kinds of moving your money to a low-cost mutual fund family or
good stuff about your plan, and it might spell out explicitly discount brokerage.
whether you or your boss covers administrative costs.
There are also estate-planning benefits to having money
If not, then you might have to do a little math. Let’s look in an IRA vs. an employer-sponsored plan. When some-
at an example from Dave Loeper’s excellent book, Stop the one inherits a 401(k) from a person who wasn’t his or her
401(k) Rip-Off, based on his own (former) 401(k) plan. spouse, for example, the inheritor might be required to
In his Summary Annual Report, under the “Basic Fi- withdraw all the money from the account immediately, and
nancial Statement” section, Loeper learned that there were count the entire amount as ordinary income. That will lead
$11,304 in additional expenses. By dividing that amount to a hefty tax bill, and thus a lower after-tax inheritance.
by the total value of plan assets ($1,341,870), he calculated (Contact your plan sponsor to find out the rules for your
that his plan has an additional 0.84% in fees. After adding plan.) However, withdrawals from an inherited IRA can
that to the expense ratios of his funds, he discovered that he be spread out over the beneficiary’s lifetime. This provides
was paying 1.3% a year to be mostly in index-based invest- more flexibility, and permits most of the money in the ac-
ments. That’s way too high. count to continue growing on a tax-advantaged basis.
For someone in the age range of 55 to 59 1/2 years old,
4. Evaluate your investment choices however, there’s an extra wrinkle. While you can take mon-
Retirement plan providers don’t just get money from ey out of your employer-sponsored plan restriction-free if
you. They also receive money from mutual fund compa- you retire in or after the year you turn 55, you don’t have
nies to include their funds in your 401(k). These so-called such freedom with an IRA until you turn 59 1/2. The same
“revenue-sharing agreements” (a.k.a. bribes) might entice is true of SIMPLE IRAs and Simplified Employer Pen-
a plan provider to stock your 401(k) with funds that will sions, a.k.a. SEPs. If you want money from an IRA before
make the most for them, not for you. The solution is to that magic age, but you don’t want to pay the 10% penalty
match your investment choices up against a relevant index. on early withdrawals, you must take distributions that are a
If your funds consistently underperform, then you know part of a series of “substantially equal periodic payments”
you have sub-par choices. (SEPPs). The Internal Revenue Service allows three ways
to calculate your SEPPs.
Q&A: 401(k) or IRA? Once you’ve selected a method and resulting withdrawal
amount, you must take that much out of your IRA each year
By Robert Brokamp
for five years or until you turn 59 1/2, whichever is greater.
Q. I am planning my early retirement next year at In other words, if you transferred your money from an em-
age 55. Are there any restrictions on the frequency and ployer-sponsored plan to an IRA and began taking SEPPs at
ruleyourretirement.fool.com Special Report — July 2009 Motley Fool Rule Your Retirement 7
age 57, you would have to take that amount each year until conversion income will be split between 2011 and 2012 un-
you turned 62. So anyone between the ages of 55 and 59 1/2 less you elect to recognize all of it in 2010.
who wants to begin withdrawing money from an employer-
While the deadline for IRA contributions is April 15 of the
sponsored plan should weigh the benefits of transferring as-
following year, Roth conversions must be made by Dec. 31.
sets to an IRA vs. the reduced flexibility of SEPPs.
Please note: Contributions to a Roth IRA can be with-
Q&A: The Mechanics of drawn tax- and penalty-free at any time. But for earnings
to receive the same treatment, the account owner must be
Roth Conversions age 59 ½ and have had a Roth account for five tax years.
It’s a little different for converted Roths. Any of the con-
Q: I am considering converting the stocks in my tra- verted amount that is withdrawn before 59 ½ and within
ditional IRA to a Roth IRA, figuring that it’s better to five years of the conversion won’t be taxed, but will be sub-
do it now while my stocks are down. My concerns are ject to a 10% penalty. After age 59 ½, converted amounts
the taxes I would have to pay. Can I sell stocks in my and earnings can be withdrawn immediately. However, if
non-retirement brokerage account that are now worth you’re over age 70 ½, you must first withdraw your RMD
$5,000 less than what I paid and use the loss to offset the for the year from a traditional IRA before the conversion.
tax consequences of the Roth conversion? Once the funds have been converted to a Roth IRA, those
A: Not exactly, but read on. This can be an excellent strat- assets aren’t subject to RMDs.
egy during a down market. Since the value of the converted
amount gets added to your taxable income, it makes sense
to do it while stocks are down. If you want to lower your
tax bill, consider selling stocks in non-retirement accounts
at a loss, as long as you don’t buy back the same stock with-
in 30 days in any account, including retirement accounts.
(You can immediately buy a similar stock or fund.) How-
ever, the usual limits on the deductibility of capital losses
apply: They first offset capital gains, then ordinary income
up to $3,000. The amount added to your taxable income
due to a conversion falls under the latter.
Remember that you don’t have to convert everything at
once. Plus, in a conversion, you don’t have to sell anything.
You just move the holdings from your traditional IRA to
your Roth, so you don’t have to worry about commissions
or back-end loads on mutual funds.
You can’t convert in a year when your modified adjusted
gross income (AGI) exceeds $100,000; the limit is the same
for single tax filers and married folks filing jointly. You also
can’t convert if your tax status is married, filing separately.
Your AGI is the amount of money you made in a year, mi-
nus adjustments such as contributions to a 401(k) and ali-
mony payments, but before the standard deduction or item-
ized deduction and personal exemptions. If you file form
1040, it’s the last number on page 1. To get the “modified”
part, add back deductions for traditional IRA contributions,
foreign earned income and foreign housing, student loan
interest, as well as interest from series EE bonds used to
pay for qualified higher-education expenses, and excluded
employer-paid adoption expenses. However, the value of
the conversion is not counted against the $100,000 limit,
nor are required minimum distributions (RMDs).
In 2010, the income eligibility requirement goes away,
so anyone could initiate a Roth conversion, even those who
are married but file separately. If you convert in 2010, the
8 Motley Fool Rule Your Retirement Special Report — July 2009 ruleyourretirement.fool.com