Wednesday, February 23, 2005
By Jonathan Clements, The Wall Street Journal
It's never too late for revenge.
If you are a working stiff, the April 15 tax-filing deadline makes one thing painfully clear: You are pretty much tax toast. Sure, you can take advantage of tax-deferred accounts and make the most of available credits and deductions. But if you have a healthy income, you are basically at Uncle Sam's mercy.
All that changes once you quit the work force. Suddenly, you have a heap of control over your annual income -- and the chance to have a little fun at the taxman's expense. Here's how to make the most of your no-earnings years.
Crying uncle. With any luck, you will retire with a hunk of money in both your retirement accounts and your taxable accounts. But unloading these investments will trigger vastly different tax bills.
If you have a Roth individual retirement account, or if you hold bonds and money-market funds in a taxable account, selling will cost little or nothing in taxes. Dumping winning stocks in your taxable accounts will be a tad more painful, with your long-term capital gains dunned at a maximum 15 percent.
The big hit, however, will be levied on your 401(k) and regular IRA. Withdrawals are taxed as ordinary income, which can mean paying as much as 35 percent to Uncle Sam. Indeed, if you aren't careful, you could get hosed on taxes during retirement, just like you were during your working years.
What to do? Pittsburgh estate-planning attorney and accountant James Lange says the best strategy is to spend down your taxable accounts first, while leaving your retirement accounts to grow tax-deferred for as long as possible. But there is an intriguing exception to this rule.
Let's say you retire at age 62. At some point in the next eight years, you will want to start taking your monthly Social Security benefit. Up to 85 percent of that money could be taxable. Similarly, after age 70 1/2, you will have to begin minimum distributions from your retirement accounts, and that will also boost your taxable income. Put it together, and it looks like Uncle Sam has you on the ropes.
You will, however, have a little time before you start Social Security and before required minimum distributions kick in. During those years, the stocks and bonds in your taxable accounts will generate dividends and interest, and you may also receive a company pension. But beyond that, how much taxable income you have is at your discretion.
Manipulating income. Want to turn this to your advantage? Suppose that, once you are in your 70s, you will likely be taxed at 25 percent or more, thanks to Social Security and required retirement-account distributions.
To soften that blow, you might tap your IRA and 401(k) even earlier. My advice: While in your 60s, withdraw enough from your retirement accounts each year so that _ when these sums are combined with your other income _ you get to the top of the 15 percent federal income-tax bracket, but no further. That will allow you to shrink your IRA and 401(k), reducing the amount that might get dunned at 25 percent later on.
If you are married filing jointly and take the standard deduction, you could have gross income of as much as $75,800 in 2005 and still be in the 15 percent bracket. Meanwhile, if you are single, the figure would be $37,900. If you are age 65 or older, both amounts would be modestly higher, because you qualify for a larger standard deduction.
You could, of course, spend these withdrawals. But if you don't need the cash, you might instead convert small chunks of your IRA to a Roth IRA each year. Once the money is in a Roth, it will grow tax-free and it won't be governed by the minimum-distribution rules that affect 401(k)s and regular IRAs.
Indeed, if you want to make your kids happy, you will leave your Roth untouched and instead bequeath the account to them. Your children would be subject to minimum-distribution rules. Still, they could spread their Roth withdrawals over their lifetime, giving them years of tax-free growth. "The Roth is the best asset you can inherit," Mr. Lange argues.
A Roth conversion makes most sense if you can pay the resulting tax bill with taxable-account money. If you have to dip into your IRA to pay the conversion tax, you can still come out ahead, Mr. Lange says. But the case isn't as strong, so you should probably convert only if you are anxious to avoid minimum-distribution rules during your lifetime or, alternatively, if you are sure that whoever empties the Roth _ whether it's you or your heirs _ will be in a higher tax bracket than you are today.
As you gauge how much income to generate in your 60s, don't forget about Social Security. As a rule, you should take reduced Social Security benefits at age 62 if you don't expect to live beyond your early 80s. Meanwhile, those with a better family health history might delay benefits until their full Social Security retirement age, thereby garnering a larger monthly check.
If you were the family's main breadwinner, also factor in your spouse's life expectancy. The reason: If your spouse outlives you, his or her survivor's benefit will hinge on the size of your monthly check.
How does this figure into the strategy described above? Starting Social Security will potentially boost your taxable income. At that juncture, you might want to curtail your annual IRA withdrawal so you don't push yourself into the 25 percent bracket.
First published on February 23, 2005.
Question:What if you could have a Roth account that had higher annual contributions and no income limits?
Answer:If you have a 401(k), you can! (Keep reading.)
Dear Friends,
Remember the hoopla and excitement when the Roth IRA was introduced in 1997? The thought of being able to put money into an account where the growth would forever escape federal tax had everyone salivating. Even non-financial publications ran stories about how much money you’d end up with after years of tax-free compounding. The government was doing something that actually encouraged us to save — it seemed too good to be true!
“Indeed,” sniffed the doomsayers, who started predicting that the tax-free status of Roth withdrawals would be repealed almost before the ink had dried on the legislation creating the new IRA.
Huh. Here it is 8 years later and the Roth IRA is still alive and well. According to the Investment Company Institute, Americans have squirreled away about $120 billion in Roth IRAs so far. Of course, the doomsayers are still claiming they’ll be proven right… one of these days.
To be fair, there are a few drawbacks to the Roth IRA. First, the amount you can contribute is limited by the IRA rules. Thankfully, the annual contribution has been increasing ever since passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, or 2001 Tax Act. As a result, this year you can contribute up to $4,000 to an IRA, plus another $500 as a “catch-up” contribution if you’re age 50 or more. (Next year the base contribution stays the same, but the catch-up amount increases to $1,000.)
In addition, even though contributions to a Roth IRA can only be made with after-tax dollars — meaning you don’t get any tax deduction at the time you make your contribution — not everyone is eligible for one of these accounts. There are income limits.
If you’re single, you can only contribute to a Roth IRA if your modified adjusted gross income (MAGI) doesn’t exceed $95,000. Between $95,000 and $110,000 you can make a partial contribution. Once your income is over $110,000, you’re no longer eligible.
If you’re married and file [jointly], the magic number is $150,000. If your MAGI is higher than this but below $160,000, each spouse can make a partial contribution. If it’s more than $160,000, neither spouse can contribute to a Roth.
By the way, if you’re married and file separately, you lose your eligibility for a Roth IRA when your MAGI exceeds $10,000. (That’s “ten thousand dollars.” I did not leave out a zero. Please contact the IRS, not me, if you have a problem with this!)
Last but not least, these are the same income brackets we were given eight years ago when the Roth was introduced. Unlike the traditional IRA, the Roth IRA income limits are not adjusted for inflation.
So in a way I suppose the doomsayers are right: Congress won’t have to do anything to eliminate the Roth IRA; as salaries increase due to inflation, this will ensure that fewer and fewer Americans are eligible for it.
Just when you’re ready to throw up your hands and write off politicians as idiots who, on the one hand, chastise us for not being better savers while on the other they eliminate the incentives for doing so, the clouds part and a brilliant ray of sunshine bursts through the gloom. I won’t claim to have read the entire 2001 Tax Act, but there’s a gem inside it that is in danger of being overlooked:
The Roth 401(k)
As you may know, although this massive piece of legislation was passed in 2001, many of its provisions are phased in — and out — over several years. The lower tax rates for qualified dividends and capital gains are one example. These disappear at the end of 2008.
Starting January 2006, the Tax Act gives 401(k) plans the ability to offer participants a “Roth” option. Like its IRA cousin, contributions would be made from after-tax dollars, so you wouldn’t get a tax deduction for contributing to this part of your 401(k). But this might not be a big deal. It all depends on what you expect your tax bracket to be in retirement compared to what it is today.
Lori Lucas, Director of Participant Research at the benefits consulting firm Hewitt Associates points out that “if you’re a younger worker just starting in your career and expect to be in a higher tax bracket when you retire, you’d be better off paying the taxes now.” By biting the bullet sooner rather than later, you eliminate the tax on all of the growth your contributions will earn over your working life and ensure you have a source of tax-free income for your later years.
But it doesn’t have to be an “all or nothing” proposition. If you aren’t sure what income tax brackets will look like in the future (who is?), you can simply hedge your bet and put, say, half of your 401(k) contribution into the Roth side of your plan.
The most important thing, according to Martin Nissenbaum, National Director of Personal Income Tax Planning for Ernst and Young, is that you activate your Roth account. That’s because, like the Roth IRA, in order for earnings on your Roth 401(k) to come out tax-free, a key condition is that the account must be at least five years old. “The five-year clock starts running the day you make your first contribution,” says Nissenbaum.
Even if you’re not certain you should participate, he recommends making a minimal contribution in order to establish the opening date. You can always decide later whether to fully participate or not.
Aside from the tax-free growth and five-year rule, there are some distinct differences between a Roth 401(k) and a Roth IRA. First of all, the contribution amounts are governed by the 401(k) rules, meaning next year you could put as much as $15,000 into the Roth portion of your company retirement plan. Tack on another $5,000 if you’re at least age 50. That’s potentially $20,000 that can grow federally tax-free.
Perhaps best of all, there are no income restrictions on who can put money into the Roth part of their 401(k) plan. Anyone eligible to contribute to the 401(k) can choose to direct his/her money into either the traditional or the Roth accounts. For this reason, Hewett’s Lucas predicts “people above the Roth IRA limits could find it very attractive.”
According to Nissenbaum, any profit-sharing or matching contributions your company makes would be unaffected. These would continue to go into the regular (pre-tax) side of your 401(k). To reduce confusion, Hewitt is recommending that 401(k)s offer the same investments in both regular and Roth accounts.
The rules that govern getting your money out of a Roth 401(k) will be similar to those for your regular 401(k) plan — not a Roth IRA. For instance, you couldn’t withdraw money from your Roth 401(k) to use toward the purchase of a first-time home. A “hardship” withdrawal would only be possible if your 401(k) plan had a provision for this.
When you leave your company or retire, the Roth portion of your 401(k) could be rolled over to a Roth IRA where it would continue to grow tax-free.
But before you get all excited about a Roth 401(k), ask yourself if you’ve heard anything about this from your company human resources department. Chances are you haven’t. That’s because most companies don’t plan to offer these accounts. At least not right away.
A survey of major employers by Hewitt Associates found that only 6 percent are “very likely” to add a Roth option to their existing 401(k) plans next year. According to Lucas, a number of companies are concerned that it could actually reduce employee participation rates by making the plan seem more complicated.
But both she and Nissenbaum agree that a significant factor is the lack of demand from employees. In other words, H.R. folks are just like the rest of us: busy. However, when there are a lot of people clamoring for something, that’s the issue that usually gets their attention.
The point is if you and your fellow employees want a Roth 401(k) on January 1, you’ve got to ask for it. Be a pest. Badger your H.R. department with emails. Circulate a petition. Buttonhole the CEO in the elevator.
This isn’t something that can be turned on overnight. The 401(k) plan document has to be amended, employees have to be educated about the new option, they have to be given time to enroll, etc. It takes months.
By delaying the implementation of this account, a company isn’t “just pushing off the Roth 401(k),” says Nissenbaum. “It’s delaying the start of the five-year clock.”
It’s more critical than that. Your company might completely miss the opportunity to offer a Roth 401(k) at all. Unless Congress acts to change things, the Roth 401(k) is slated to “sunset” at the end of 2010 along with the rest of the provisions of the 2001 Tax Act.
From my perspective, if a Roth 401(k) makes sense for you, the fact that there is such a narrow window of opportunity makes a stronger argument for contributing as much as you can to these accounts as soon as possible. Even if you’re not allowed to add new money after 2010, whatever you’ve contributed up to that point could continue to grow tax-free in this account.
Hope this helps,
Roth IRA is the surest route to retirement-savings success-MarketWatch
BILL DONOGHUE Pay taxes now, spend more later Commentary: Roth IRA is the surest route to retirement-savings success By Bill Donoghue, MarketWatch
Last update: 7:08 p.m. EST Dec. 11, 2007
SEATTLE (MarketWatch)
Over your lifetime the bulk of your retirement savings should represent investment profits, not contributions. But it's just not working out that way for millions of investors. You will never retire on the money you save for retirement; you will retire on the money you make on the money you save for retirement.
To do so, Roth IRAs are the better choice over 401(k)s or IRAs because the future profits are tax-free (after you settle up your past liability on taxes and hold for five years) and you have better investment choices than what your employer and financial advisers probably suggest.
If you are a successful, then when you retire your profits will comprise the bulk of your retirement savings account. Keep that clearly in mind.
It's better to earn future profits tax-free than to tax-defer your investment principal and profits. Tax-deferred accounts only inflate the balances so the managers can charge fees on higher asset balances. Tax-deferral does little for you.
Make or break
To make money on your retirement investments, get as much as you can into a Roth IRA as soon as you can. All of your profits will be free from income taxes after you hold them in your Roth IRA at least five years.
Otherwise, by all means invest in a 401(k) or a traditional IRA - it's the only way you can deduct 100% of your losses. You have to wonder why your adviser, banker or employer encourages you to invest more in a 401(k) and then provides you only mediocre funds unlikely to earn competitive long-term returns. See related story on Roth IRAs vs. traditional IRAs. which includes the largest 500 U.S. companies, has averaged a gain of only about 2.5% annualized before taxes since 2000. Millions of 401(k) investors who could not "stay the course"lost money in that time. In fact, mutual-fund managers (who directly or indirectly manage most of this money) cost investors as much as $6 trillion from 2000 to 2002 alone.
Why? Fund managers promised you in their prospectuses they would take no action to protect investors from a down market.They refused to go to cash. They refused to sell securities short. In fact they put that in writing. You can bet they weren't foolish enough to do that with their own money. Of course, in a Roth IRA, which is by definition self-directed (you manage the money), you could make much better choices on your own. You could invest in a fund that sells securities short. You could invest in so-called inverse funds and profit during down markets. You could invest in leveraged inverse funds that earn a multiple of the downward trend in the market. Only three mutual-fund families allow you to take such actions: Rydex Investments; ProFunds and Direxion Funds. You also could have shifted your assets to cash to protect your assets. Any investor could have done that but few did because of the "wise" encouragement to "stay the course." You could have saved money by investing not in load mutual funds or no-load mutual funds, but exchange-traded funds (ETFs) that have much lower management fees. Your financial advisers could have done all these things for you; but, many did not. The mutual-fund industry still supports "staying the course" at all costs and has added, with the encouragement of regulators, punitive surrender charges and minimum holding periods.
The two biggest benefits of Roth IRAs
(1) You make your own investment decisions in Roth IRAs, instead of leaving it to those who deliberately lost you money for you.
(2) You can avoid income taxes on future profits and deduct any investment losses.
Those over 70 1/2 years of age can do Roth IRA conversions at will; so can those who earn less than $100,000 taxable income in the year of conversion and those expecting lower income.
The huge layoffs that are expected as we restructure our economy may affect you. Well over 150,000 are expected to be laid off on Wall Street and in the auto industry alone. Those who lose jobs may find it beneficial to pay income taxes on their IRA rollovers from 401(k) plans while they can qualify.
All of the cash to pay your tax bill is residing in your 401(k) or IRA. You cannot avoid the taxes in your lifetime; why not settle them once and forever on this money right now? I would caution you that the creditor protection on Roth IRAs is not as strong as for IRAs.
Of course, the current law anticipates allowing many more investors to do Roth IRA conversions after 2009 and spread the conversion over three years to ease the tax burden. Ask your tax adviser for details. Boost for the U.S. Treasury.
There is more than $4 trillion in deferred income taxes and at least $12 trillion in tax-deferred investment accounts. That would be enough to make a large down payment toward the Social Security shortfall or running the federal government for a full year.
America needs to collect its income tax receivables to protect our economy from the weakening dollar, the sub prime mortgage crisis and the threat of $200 a barrel oil. Delay this decision and much of the balances will be potentially lost to a bear market. That's just the taxes. The principal may well have to be protected from the risk of a down market and I can guarantee that, for now at least, mutual funds will not change their prospectuses. You must take action to manage your own money.
Settle your income taxes on your savings as soon as you can and enjoy a chance at tax-free profits.
Bill Donoghue is editor of The Proactive Fund Investor, a weekly newsletter published by MarketWatch.
