JoeTaxpayer

I recently read a post “Why I love Roth IRAs” in which the author ignores much of the math going in and coming out. Now, I love Roths myself, but only when used to take most advantage of the tax rates involved. Let me explain. From my feature article earlier this year titled “Can you save too much, pre-tax?” we see that a couple with $447,500 in their 401(k) or Traditional, Pre-Tax IRA, can take withdrawals and remain in the 0% bracket. This is due to the combination of standard deductions and exemptions. The next $401,250 will support withdrawals at the 10% rate.
If you have a defined benefit pension (a traditional pension) the numbers certainly will shift, and you need to take this income into account. Pensions are getting more scarce and those who frequently changed jobs are likely to have never vested into any one plan.
So, now I’ll ask, what percent of retirees are likely to have saved this sum, a total $848,750 from the numbers above? I cite an article from AARP titled 2004-05 Boomers which offers a forecast. One chart in this report offers that for those born in 1956-65, their mean (this means average, important distinction from median, middle) wealth is forecast to be $839K. But reading on, we find that after subtracting non-retirement wealth and present value of Social Security benefits, we are looking at a retirement account balance of just $140K. It turns out the 4th quintile (this is the second 20% from the top) is forecast to have $906K, this scales to about $151K in retirement accounts. Even the top quintile (top 20%) will average $2028K total wealth, with maybe $350K-$400K in retirement accounts. So it’s only the upper portion of that group (in addition to those with fat traditional pensions) that need to consider the Roth while working. For the rest of us, we will likely be in the 10% or if fortunate, the 15% bracket upon retiring.
I’ll close with this thought - each family has their own set of numbers. This is why if you write in to a web site or magazine and ask “Is Roth good for me?”, it’s impossible to answer without knowing many details. We know more the closer you are to retirement, but only have a series of clues the further away you are. Another blog “The Finance Buff” offers a view similar to mine. I remain surprised at how many wave the Roth flag without some level of analysis. For those who have access to a Roth 401(k) and Roth IRA, it would be a shame to load those up and find that they missed out on the tax savings that pretax savings could have provided.

Joe

written by JOE \\ tags: 401(k), Finance, income, IRA, Retirement, retirement account, roth ira, saving, Savings, Social Security, tax, tax rates, traditional pension, wealth

I recently fielded this multi-part question;

First, is conversion from a traditional IRA to Roth IRA still OK when over 70 and taking RMDs (required minimum distributions)?

Ok? It’s fantastic!! I will first tell you that I believe that Roth’s value while working is slightly exaggerated. Your scenario above is ideal. I have an 80+ yr old client who is in the 15% bracket. Each year we convert just enough to ‘top off’ that bracket so the next hundred dollars would have been taxed at 25%.

Second, does the “conversion” count as part of RMD?

No, the conversion must take place after you calculate the RMD. Our RMD is based on 12/31/07 year end balance. We can do the Roth conversion any time during the year, but that RMD is fixed.

Third, is it possible to transfer stock directly from Traditional IRA to Roth IRA — using current valuation on day of transfer as the basis for amount of conversion?

Yes - you can convert stock, the broker will report that value based on the day of conversion. There is no wash sale selling in one IRA and buying in another, anyway.

Joe

written by JOE \\ tags: IRA, irs, required minimum distribution, roth conversion, roth ira, tax, traditional ira

There is a ‘rule of thumb’ out there that one should save 3-6 months salary (net, I assume) and from the near 16,000 Google returns on “emergency fund” “rule of thumb”, it would seem this is a hot topic among financial concerns. At Master Your Card, Kristy on Monday discussed the importance of the emergency fund, and while I agree with her that you shouldn’t put those funds into stocks, which may or may not be down at the very time you need the funds, I am concerned about the priority most attribute to the fund.

You see, most financial rules, are just that, generalizations that may apply to many/most of the readers of such advice. It’s easy, however, to offer examples where the rule(s) need some modification once the rest of the situation is understood.

For emergency funds, first, does your company have, and do they provide any matching contributions, to a 401(k)? If so, this is my highest priority. Some companies match as much as the first 6% of an employees’ salary deposited into their 401(k). On $50,000/yr, that’s $3,000 the company will match against your $3,000 deposit. In the 25% tax bracket, your net cost is only $2,250. Let me spell this out carefully - you are out of pocket $2,250, but now have $6000 in your 401(k)! Do you see why this is my top priority? Should you fund an emergency fund first, or take $2,250 and turn it into $6,000? If you lost your job, and had to take it out next year, you will likely drop to the 15% bracket, and after the 10% penalty for withdrawal, you still take out $4500. A side benefit, also subject to dispute, is that with $6,000 in the 401(k), you now have the ability to borrow $3000 back out, at 7-8%, and use that loan to knock down the high interest credit card debt. Yes, there are those who advise against the 401(k) loan, but in this scenario, it can be part of a kick start to both your retirement savings and debt reduction plan.

From a completely different perspective is an article on MSN titled “The $0 emergency fund“. I think that may be taking it a bit too far.
Joe

written by JOE \\ tags: 401(k), 401(k) loan, emergency fund, Retirement, Savings

Earlier this week, I talked a bit about the Social Security replacement rate, how much a single person could expect to receive at their normal retirement age. As we discuss trying to make up the difference to enjoy a post retirement income which replaces working income by close to 80% we run into the Social Security tax trap, the fact that for a single person, when half your benefit plus other taxable income exceeds $25,000, the benefits become taxable. So I updated the table a bit.

Now we can see the amount of (taxable) income we can have before we hit the range where SS benefits are taxable. We also can see the amount of money needed to generate that income (using the 4% withdrawal rate we’ve discussed in the past). Note: The column “$25K-1/2 Benefit” is increased by $8950, the sum of the standard deduction and exemption for a single person. Of course if you have high enough deductions to file schedule A this will increase further. So, getting back to the discussion of pretax and post tax savings, we are closing in on the gross numbers you can save, pretax, with little risk of either hitting a higher tax bracket at retirement or running into the range where Social Security benefits are taxable. In the next few weeks, I will offer more analysis, along with observation on this scenario for couples.

Joe

written by JOE \\ tags: Finance, Investing, money, Retirement, Savings, Social Security

I’ve had more frequent conversations recently regarding a number of financial topics. The pretax vs post tax IRA certainly tops the list along with the required income needed at retirement, both in absolute terms as well as replacement ratio. I thought this would be a good time to discuss how much of that retirement income is expected to come from Social Security. The primary insurance amount (the benefit (before rounding down to next lower whole dollar) a person would receive if he/she elects to begin receiving retirement benefits at his/her normal retirement age) is shown below for those with annual incomes ranging from $20K per year to $90K per year.

A few observations here: This reflects the benefit an individual would receive, and my comments for tax purposes also reflect one filing single. The way this is calculated, a lower wage earner receives a higher percent of his income at retirement than a higher earner. If we use 80% (not saying I agree or disagree, but 80% keeps popping up) as a target replacement income, the $55K earner will have half of this target covered by Social Security. In my next post, I’ll discuss the Social Security Tax trap, and tie the analysis back to the pretax vs post tax investing decision.
Joe

written by JOE \\ tags: Finance, Investing, Retirement, Social Security

The book “Last Chance Millionaire” by Douglas R. Andrew was interesting to me, if only for the lack of depth. It reminded me of the original “Twilight Zone” TV series in this regard - every episode could be summarized in about three sentences or one minute of action, and the remaining 24 minutes was filler.

Mr. Andrew spends the first 200 or so pages making the case that one should always have a mortgage, and it should be as large as possible. Now there’s a premise I’d not want to spend too much time debating, but I’d agree that there are better times to borrow and other times to pay down one’s debt. I am old enough to remember a 30 year fixed rate of 13.5% which, in the 25% bracket is still 10-1/8% after tax. At that rate, I prefer to pay down the mortgage and advise other to follow. With rates below 6%, someone in the 28% bracket has an after tax interest cost of 4.32%. There, I just saved you 200 pages.

He goes on to suggest investing in Indexed Universal Life Insurance. I am on record as being anti-variable annuities, but this product offers a few different twists. The withdrawals are first made against the principal within the account, so no taxes are due. Then with a bit of smoke and maybe a mirror or two, further withdrawals are taken as ‘loans’ against the account, which are then paid back on death.

I wanted to find out how the account grows in value and discovered a policy by Pacific Life called “Pacific indexed Accumulator II” which describes the annual crediting. One receives the return of the S&P index (no dividends) with a maximum of 12%, and minimum 0%. So the trade-off appears to be that you give up the dividend (The S&P currently yields about 2.1%) as well as accept a cap of 12% per year, in exchange for a guarantee of no annual losses. I’m still on the fence about borrowing to fund this, but the concept itself has a certain appeal. This chart from the prospectus does a good job illustrating the return you would have gotten over the past 20 years. I thank one of my regular readers for bringing this book and investment approach to my attention.

Joe

written by JOE \\ tags: douglas r. andrew, Finance, indexed universal life, Investing, last chance millionaire, money, Retirement, Savings

The June Kiplinger’s magazine ran an article, “Raiding your 401(k).*” It advises against borrowing from one’s 401(k) and cites a T. Rowe Price study suggesting that someone borrowing $10,000 for 5 years (at age 35) will be short $145,000 at retirement even after paying back the loan. At 10%, $10,000 would grow to $131,100 in 27 years, that’s just math. Maybe they think this guy will retire at 63, not 62. But he did not take a withdrawal, he took a loan. My 401(k) charges 6.5% for a loan, credited back to the account. This means a 3.5% hit to the return on that borrowed $10,000. The account will come up short about $900 for having had the loan outstanding. Still using the 10% return, the retiree may find he is short nearly $13,000 at age 62, certainly not $145,000. Someone at T Rowe hit the wrong key, and none of my friends at Kiplinger’s catch this?

Think about this, though, the story cannot just end there. I can make the case that what matters is where that $10,000 loan went. Did the person buy a plasma TV and sound system? Or did he pay off all his credit card debt (at 24%) and start fresh? I can add to this - perhaps he was paying $288/mo and would have done so for 5 years to pay off the cards, but now is able to pay only $196 to the 401(k) loan, and use the extra $92 as an addition monthly deposit to his account. He is in the 25% bracket, and deposits a full $123 (which is the gross amount that nets him the $92) to his 401(k) and it’s matched by his employer, dollar for dollar, so at the end of year 1 he has nearly $3000 more in his account which more than makes up for the $350 hit he has from the loan itself. By staying on this path, he’s actually ahead by over $150,000 at retirement time.

As with any example, your mileage may vary. There is just one point I’d like you to take from this post. In finance, there are few absolutes. For every person who uses their 401(k) loan wisely, there may be five who blow the money and run up their credit cards again. But just as I take issue with Dave Ramsey’s statement that ‘responsible use of a credit card does not exist’, I feel that there are wise ways to use loans, 401(k) or otherwise. While I admit that a short article appearing in a magazine cannot cover every possibility, the one missing (and most important question was ignored - what does the borrower do with the money?

Joe

*The article is not yet available on line. As soon as I am aware it’s accessible, I will link to it.

UPDATE - I made an error here. (I prefer to leave the error in tact, above, but add this footnote.) In fact, the article did state “assume contributions stop for the life of the loan, as usually occurs”. This would make the math work, although I still take issue with these assumptions. I plan to revisit this subject in a future post.

written by JOE \\ tags: 401(k), 401(k) loan, credit card, Finance, Inumeracy, kiplinger's magazine, Retirement, saving

Now that you’ve Taken a Breath, and are ready to roll over an IRA you inherited, there are a few important things you must know. Enough that I’ve written my May feature article, “Inheriting or Bequeathing an IRA” which you can read a day early. I believe the article highlights the importance of properly setting up one’s IRA with named beneficiaries on the account as well as the proper method for those inheriting so as to minimize the tax hit. For a deeper discussion, I recommend the book, “Parlay Your IRA into a Family Fortune” by Ed Slott

Joe

written by JOE \\ tags: beneficiary IRA, death, dying, Finance, inheritance, IRA, money, required minimum distribution, Retirement

There’s a recurring question regarding whether one should rollover a 401(k) from a previous employer to an IRA account (or to the new employer’s 401(k)) or leave it in the original account. One new variable that comes into play is the ability to convert one’s IRA to a Roth IRA, regardless of income, in 2010. How are the two related? When one converts from a regular IRA to a Roth, taxes (at your marginal rate) are due on a prorated basis on the pretax money within the IRA. For example, if you have a $100,000 balance, $20,000 of which is post tax deposits, 80% of any money converted is subject to tax. Now, this presents an interesting opportunity. Most 401(k) accounts will permit IRA money to be rolled back into the 401(k) regardless of the source. So in this example, you might consider rolling the $80,000 in pre tax money into the 401(k) before doing the conversion on the $20,000 post tax money. This two step will avoid any and all tax on that conversion. If you have a 401(k) account, you might consider leaving it for now, and converting it to an IRA only after that Roth conversion is made in 2010.

Joe

written by JOE \\ tags: Finance, Investing, IRA, Retirement, roth ira, saving

For my first post of this year I wrote an article titled, “Can you save too much, pre-tax?” This is a topic that comes up frequently as one decides whether to choose a Traditional (pre-tax) IRA vs a Roth IRA. I recently had some dialog with another blogger and it’s clear to me that the decision is not so clear cut. Ideally, one makes a deposit pre-tax and withdraws it at a lower rate some time later. But as Mark (the other blogger) reminds me, a Roth has many benefits that shouldn’t be ignored:

1. You can withdraw the original deposits at any time with no tax or penalty, as I suggested in my Roth magic post.
2. A Roth has no RMDs (required minimum distribution) requirement, which forces withdrawals when they may not be needed or wanted due to other considerations.
3. The accounts pass through one’s estate with less impact to estate tax as the funds are denser, and received by the beneficiary with no income tax upon withdrawal.

I think for any retiree there is likely an ideal mix, so they might draw funds from their pre-tax accounts (IRA and 401(k)) and use Roth withdrawals to avoid getting sent into the next bracket or be subject to the Social Security Tax Trap. The issue today is that we can’t know that mix two or three years out, let alone 20 or 30. What I do know, and I hope Mark agrees, is that this decision follows the shape of the Laffer Curve. I know with certainty that 100% of one’s savings in pre-tax accounts misses the benefits I share above. 100% in Roth accounts will miss the benefit of the zero bracket I discussed at length in my article cited and linked above. I don’t know the ideal mix, but I’d suggest this: The lower your savings rate, the more you’ll see the benefit of pre-tax savings, a diligent saver may be best served by leaning toward the Roth savings. A Wall Street Journal article titled “A Cool Million No Longer Buys You a Luxe Retirement” helps back up my position as it states that only the richest 2% of Americans have saved more than $1 million. One would need to be in this exclusive group to even begin worrying about higher taxes on the their retirement savings. I hope to get some feedback, as others’ opinions always help me to see a different side of the issue.

Joe

(update - are you feeling lucky? The Google search for “pretax vs post tax ira” (leave off the quotes) will lead right to this post. Could just be the choice of words? Or maybe I’m just lucky?)

written by JOE \\ tags: 401(k), Finance, marginal tax rate, money, Retirement, roth conversion, roth ira, Savings, Social Security, Taxes