2013 retirement account updates – IRS contribution limits increase for IRAs and 401ks!

IRS contribution limits for 401ks/403b plans will increase to $17,500 in 2013 (up from $17,000 in 2012).   The 50+ age group can contribute an additional ‘catch up’ amount that will remain at $5,500 for 2013.

Additionally, Roth IRA contributions will increase from $5,000 in 2012 to $5,500 for 2013 for those under 50, and $6,500 in 2013 for those 50+.

For those boss ballers making six figures (nice work!), the Roth IRA contribution phase-out range is Adjusted Gross Income (AGI) of $112,000 to $127,000 for single tax filers, and $178,000 – $188,000 for married filers.  This basically means you can’t make ANY Roth IRA contributions if your income is at or above those levels.  If you’re close, check with your accountant, or crunch your AGI numbers in a program like Turbo Tax come January/February to determine if you can make any contributions for tax year 2012.

Keep stashing as much cash as you can in those tax-advantaged retirement vehicles!

Details: http://www.irs.gov/uac/2013-Pension-Plan-Limitations

Ramit Sethi will teach you to be rich – 4 links to wealth: negotiate, automate, cut costs & earn more

Ramit Sethi is my favorite financial blogger and advice-giver for the ‘basics’ (which can still be complicated) of personal finance: spending, saving and earning income.  He recently railed against those who worry about things that they can’t control, yet fail to do the simple steps that will really matter.

His quoted question below to these people (and everyone else who needs to take control of their money) have 4 excellent starting points (links) for personal financial freedom.  Check out each of these and apply them to your financial life.

“Have you negotiated? Automated? Earned more? Taken the 30-day challenge to save $1,000?”


Ramit stresses the importance of negotiating all things financial, from credit card interest rates, getting out of bank fees, to your next salary raise.


The best way to save is to automate the process so that no active effort is required on your part.  This can be anything from setting up direct deposits on your paycheck (most employers allow you to split the check into multiple accounts, the better to target your savings goals), having 401k deductions come out of your check, or using Vanguard (or whoever your mutual fund provider is) to invest money from your bank account on a regular schedule.  (If you already have a Vanguard account, go here.  If you need to set up a Roth IRA or other financial account, go here.)

Earn More

Expenses are only half of the financial coin of savings.  Earning a healthy salary is also a big help along the road to wealth.  Here’s a few ideas on how to make more money:

Get an education (academic or vocational, formal or informal) that increases the worth of what you know, and your ability to apply that knowledge and make money (or other benefits) from it.

Ask for a raise at work.

Start your own business on the side, or find a part-time or freelance job that you can do in your spare time.  (Make it something you enjoy and that energizes you, otherwise it’ll be hard to force yourself to do it given your other work/life commitments.)

Save Money – Enter Ramit’s ’30 day challenge’

Ramit put together a fantastically useful list of 30 tips (described in each of the links below) to save money.  These aren’t the typical ‘stop buying lattes’ ideas generated on so many financial blogs.  Instead, they’re likely to save you big bucks without taking away the things that you really enjoy in life.

While I’ve copied Ramit’s entire list below (with his links for the details of each tip), his original post can be found here.

Full list of Ramit Sethi’s tips from iwillteachyoutoberich.com
Tip #1: Pack lunches for the rest of the week
Tip #2: Turn your thermostat down 3 degrees
Tip #3: Sell something on eBay today
Tip #4: Involve your friends in your savings challenge
Tip #5: Optimize your cellphone bill
Tip #6: Use gas prices to become your own hedge fund
Tip #7: Create a “No Spending” day once a week
Tip #8: Implement the A La Carte Method
Tip #9: Only buy new things when replacing something old
Tip #10: Use the free rewards from your credit card, car insurance, and workplace
Tip #11: Never pay full retail price for clothes or eyeglasses again
Tip #12: How I’m saving $2,000+ on eating out in 2009
Tip #13: How to negotiate your car insurance
Tip #14: Use self-persuasion to share how much you’ve saved so far
Tip #15: Forget going to a bar — ask people over for dinner
Tip #16: Cancel any large purchase this month
Tip #17: Buy generic for the stuff you don’t care about
Tip #18: No Christmas gifts this year
Tip #19: Save Money, Eat Well and Look Hot in Less Than an Hour
Tip #20: Change the date of Christmas
Tip #21: Save thousands by pre-paying your debt
Tip #22: Analyze your progress in the 30 Day Challenge (plus, see how I’m doing)
Tip #23: Go cash only for 15 to 30 days
Tip #24: Cut your commute expenses by 40%
Tip #25: Earn more money using your God-given skills
Tip #26: Gardender? Cleaning lady? DIY instead
Tip #27: Use barriers to prevent yourself from spending money
Tip #28: Use price-protection guarantees to always get the lowest price (travel, retail)
Tip #29: Stop being a loser and spend money to save money
Tip #30: How I’m saving $25,000+ in 2009


Two new FANTASTIC retirement calculators

Financial awesomeness

I just discovered two really excellent and easy-to-use/understand retirement calculators from Vanguard (who else?) These are both essential tools for planning for retirement.  They will help you determine if you’re going to run out of money in retirement, how much to save for retirement, and how to retire earlier.
#1 Retirement nest egg

The first one computes the likelihood that your portfolio will last in retirement given your spending amounts, how much you start with, and what your asset allocation is.

This is a great tool for determining how much you’ll need in retirement, and if your current nest egg will get you through retirement.  You can even include information about any company matching you might receive

It also gives you a feel for the safety of different asset allocations.

#2 Extra savings

The second calculator shows you how much more money you’ll have in retirement if you increase your current contributions by 1 to 2%.  You can also use it to simulate how much you’ll have if you increased your contributions beyond that, or with whatever other variables you want to look at.

Asset allocation rules of thumb

“Asset allocation”, or the percentage of your assets (usually just financial ones) that you put into different types of things (stocks, bonds, cash, real estate), has been shown to determine a very large portion of a person’s return.  It is also the key determinate in how much volatility your portfolio undergoes.

[UPDATE 12-21-2010: HERE is a very good, quick (5 minute or less), easy-to-use questionnaire from the good people at Vanguard that can be used to estimate your personal asset allocation.  It might be a bit conservative for my taste (too heavily weighted towards bonds instead of stocks), but it’s an excellent starting point to get a ballpark stock-to-bond split.]

While there many ways to arrive at a recommended asset allocation, it often helps to have some simple rules of thumb.  The general idea is that the older you are or the sooner you need the money, the safer your investments should be.  So while a 100% stock retirement portfolio would be great (in my opinion) for a 30 year-old with 30+ years until retirement, it would generally NOT be advisable for a middle-income retiree.

The following rules of thumb that I will discuss assume that the asset allocation is for RETIREMENT, and that the average person won’t be tapping into it until they’re between 60 and 70 years old.

120 minus your age

To simplify between all the different types of assets, people often just make the distinction between stocks and bonds.  For people that own homes and keep some petty cash in their savings or checking accounts, I think just talking about stocks and bonds works well for most people.  One such stock-to-bond ratio rule of thumb is this:  from 120, subtract your age.  The remaining number should be in stocks.  For example, if you’re 60, this rule would tell you to put 60% (= 120 – 60) of your assets into stocks, and the rest (40%) into bonds.

This rule is definitely simple, and reasonably useful.  (It used to be 100 minus your age, but that was when people didn’t live as long.)  My criticisms of it is that may tend to put too much of one’s assets into bonds, especially prior to age 60.  Historically, stocks have out-performed bonds in almost every 30 year period.  Of course, this is no guarantee that they will continue to do so, but it suggests a high probability.

In general, if you have more than 5 – 10 years to go before you need some money, it could be in the stock market.  Thus, I tend to recommend that people who still have 10-20 years to go before retirement put all of their money into stocks.  This assumes that most people will have some fixed income anyway (like social security.)  It also assumes that the person will only be using a small portion of their retirement funds per year (like 4 – 5% of the total account balance.)

Some alternatives

Since I prefer a slightly more aggressive rule of thumb than the above, I came up with the following asset allocation formula: Put 2 times the difference between your age minus 50 into bonds.  I.e.: % in bonds = 2*[Your age – 50]

So, if you’re 50 or under, you put nothing in bonds.  At 60, you’ll have 20% in bonds (= 2*[60 – 50]), and 80% in stocks.  At 70, you’ll have 40% in bonds, 60% in stocks, and so on.  This has the virtue of keeping a 100% stock portfolio until you’re 10 – 20 years out from retirement.  It also ‘catches up’ to the more conservative allocation by increasing the percentage of bonds in your portfolio by 2% per year after age 50.

Another option might be to just use a fixed allocation like 60-40 or 75-25 stocks to bonds.  You might choose to gradually switch from 100% stocks to this fixed allocation over a period of, say, 10 years, like from 50 to 60, or starting 10 – 20 years prior to your target retirement date.

Lastly, you could adjust my 2*[age – 50] formula above to take your target retirement age into account: use % of bonds = 2*[ Age – (Target retirement age – 15) ].  If you’re going to retire at 65, this works out to just 2*[Age – 50] (since 65 – 15 = 50.)  But, if you’re going to retire earlier or later, your recommended asset allocation will adjust accordingly.


Asset allocation is important.  Within each asset class, always diversify as much as you can.  Pick stock and bond index funds with low expense ratios that sample the entire market.  (Large cap and small cap, domestic and international for stocks.)

In general, I like 100% stocks as an allocation for retirement portfolios that still have 10 – 20 years until you start tapping them.  Then, gradually switch to something more conservation using one of the above rules of thumb, or something more exact like a financial advisor or William Bernstein’s “The Intelligent Asset Allocator”.

Reverse Mortgages: Tap your home as a last resort for retirement

Ideally, a person would finance their retirement through a combination of fixed income (social security or pensions), individual retirement accounts (401k, IRA) and, if necessary, supplementary income from working, or even family support.  However, as many retirees saw in the recent stock market downturn of 2008 & 2009, things don’t always work out this way.  Fortunately, other options exist that provide retirees with ways to close the income gap (other than ‘starving’, an unpopular method.)

Home, sweet home

Most Americans have at least 50% of their wealth in their primary residences.  Wouldn’t it be nice if, after working hard to pay down that mortgage, there was a way to use the value of your home as income? The simplest way is to ‘down-size’ by selling your home and moving to a less-expensive one, investing the difference to pad your retirement funds.  While this may be great for a purely financial point of view, the obvious downside is the hassle and the emotional or practical undesirability of moving.

Home equity lines of credit (HELOC) are a way to use your home equity without selling your home.  A private bank will loan you the money as an interest-bearing loan taken from your home’s equity (the difference between the house’s worth and the mortgage principal you owe.)  You can then use that money for pretty much whatever you want, paying back the loan according to its terms.  One drawback is that you can unwittingly take out too much, then have to either pay it back at an inconvenient time, go without income, or lose your home if you default on the HELOC.  Additionally, your lender could freeze or reduce your line of credit if your home value declines.  For the financially savvy (you!) there’s another way to get at that home equity in a less-risky fashion.

Enter the reverse mortgage

If you’re at least 62 years old, reverse mortgages, called Home Equity Conversion Mortgages (HECM) when sponsored by the Federal Housing Authority (FHA), allow you take either a lump sum, a line of credit, or fixed payments for a specified term or for as long as you live in your house.  This last payment option, called ‘tenure’, seems the safest and most attractive from a retirement income perspective since your payments come monthly, keeping you from spending the lump sum too fast.  However, all the HECM options keep you from losing your house as long as you stay in it.  The loan is also ‘non-recourse’ which means the bank can only collect what is received from the sale of the home, and not any other parts of your estate, even if the loan is more than the value of your house when it’s sold.

From the FHA HECM site:

A borrower cannot be forced to sell the home to pay off the mortgage, even if the mortgage balance grows to exceed the value of the property. A HECM loan need not be repaid until the borrower moves, sells, or dies. When the loan must be paid, if it exceeds the value of the property, the borrower (or the heirs) will owe no more than the value of the property, if they sell the property to repay the loan.”

Wait as long as you can, and take note of high fees

The positive from the fixed payment reverse mortgage option is that you receive constant income for life that can supplement social security and your (cracked?) retirement nest egg.  The more equity you have built up in your home, and the older you are, the higher this reverse mortgage income will be.  This is one reason why you should wait as long as possible before taking out such a reverse mortgage.  Another is that you want to be sure you actually need to take out the loan.  Reverse mortgages come with very expensive upfront fees, about 6-12% of the value of the loan.

Also, the amount you’ll receive will be much less than the total equity you’ve built up.  This amount is usually a little more than half of your home equity.  (The limit for FHA reverse mortgage loans is $625,000, even if your home is appraised much higher.)  Using this calculator, a 75-year-old Seattle couple who owns their $400,000 house free and clear (no mortgage debt), could take out a lump sum of $202,424, or receive a fixed payment of $1,467 per month.  They would also pay over $16,000 in fees (not to mention the interest that’s factored into the loan amount.)  Remember: a reverse mortgage should only be used after other retirement options fail.

Note that the above numbers are based on current interest rates, and will vary over time.  But, when a person actually initiates the fixed payment option in a reverse mortgage, that monthly dollar amount IS fixed over time, just like the payments you make on a regular fixed mortgage.  Keep in mind, though, that the payments are NOT adjusted for inflation, hence the real value of your received payments will likely decline by about 3% per year on average due to rising costs of living.

The FHA HECM site on fees:

Two mortgage insurance premiums are collected to pay for HECM: an upfront premium (2 percent of the home’s value), and a monthly premium (which equals 0.5 percent per year of the mortgage balance).

A lender can charge an origination fee up to $2,500 if the home’s appraised value is less than $125,000. If the home is valued at more than $125,000, lenders can charge 2% of the first $200,000 of the home’s value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000.”

Another negative is that your heirs will receive less due to the decrease in your home equity.  If your kids are already set up independently by the time of your death, this may not be a big concern.

A reverse mortgage can keep your retirement moving forwards

The bottom line is that if you end up struggling in retirement, a reverse mortgage might be the best unconventional alternative to meeting your income needs.  Fixed ‘tenure’ payments (or any combination of the other payment options) can be made to you for life without risking foreclosure on your home.  Wait until you really need the costly loan before taking it.  That allows you to build up equity (pay off your mortgage before reversing it for best results) and get older, both of which increase your monthly payments.

Of course, the best retirement solution is to avoid taking out expensive loans for your retirement.  Instead, invest as much as you can for retirement before you get to it, defer retirement a few years if needed, find other (or increase) income sources, and live beneath your means.


In addition to the FHA site linked above, here’s another handy reverse mortgage FAQ if you want to learn more.

Do you know how much you need to save for retirement, college, or a home?

This handy savings calculator from Lifetuner.org helps you answer that question.  Just plug in a yearly savings amount (like $200/month = $2400/year), the ages you start and stop investing, your desired retirement age, and an interest rate.  For this last assumption, I would use 6.8% (or 7% if decimals are too much to handle) to match the historical, real (inflation-adjusted) stock market return.  That way you won’t fool yourself into thinking you’ll have more purchasing power (which is what matters) than you really will have.

You can run up to three side-by-side simulations.  Compare starting ages, amounts you save, or the difference due to small interest rate changes.  This is a great calculator for estimating the return from regular investing, or the difference in gain from, say, a 0.5-1% increase in return due to switching to low-fee index funds, which beat the returns from (higher-fee) actively-managed mutual funds 70 – 80% of the time.

You can use this to calculate ANY regular investment, not just one for retirement.  For example, if you want to have a house downpayment in 3 years, assume a bond fund return of 3-5% (rates are low today) and then see how much you’d need to invest yearly to achieve your goal.  The longer you can wait, the more you’ll have.

Or, to calculate savings for your kid’s college (new parents, pay attention!), enter your kid’s current age as the ‘start saving’ age and 18 as the ‘stop saving’ & “retirement” ages.  (“Retirement” in this calculator just means the date when you want to know how much you’re investment will be worth.)  Use the historical, real, stock market return of 6.8% if you have a long time (>5 years) to invest, since that’s where your college savings should be.

Hack your Roth for tax-free short-term savings (Re-thinking the Roth IRA – Part 2)

You may remember my admonitions that ‘retirement savings are for retirement!’, but today I’m going to show you how to use your Roth as a sort of savings ‘hybrid’: you can use the Roth as short-term savings vehicle AND get the benefits of tax-free interest for retirement.  Before we get any further into this, make sure you understand how the Roth IRA works.

You may have decided that investing in a Roth IRA isn’t the best move for your retirement (opting instead for a 401k perhaps.)  Contributing to a Roth may still be a smart move, even if you want to use the money sooner rather than at retirement.  (Anyone with earned income whose modified adjusted gross income is less than $105,000 can contribute to a Roth IRA, regardless of age or participation in other retirement plans, like a 401k.)  Before we delve into the details, I want to let you know that this is an ADVANCED (though not hard) technique.   Make sure you understand all the details before deciding to use it.  (Post a comment with any questions you have.)

Recall that a Roth IRA lets you contribute after-tax dollars to a variety of investments including index funds, individual stocks and bonds.  The benefit over a ‘normal’ taxable account is that the money then grows tax-deferred, meaning you don’t pay interest on reinvested dividends or interest.  Plus, if you take out the gains AFTER age 59 1/2, you don’t pay any taxes on those either!  The catch is that if you DO take out any gains before turning 59 1/2, you generally must pay a 10% penalty on top of regular income taxes.  BUT, because you’re contributing after-tax money already, you can pull out amounts up to the value of your contributions with NO penalties/taxes at any time you want!

For example, say you contributed $2,000 to a Roth IRA in 2007, then another $4,000 in 2008.  You can take out up to $6,000 with no penalties/taxes.  IF however, your account increased to $7000 in value due to appreciation, you can still only take out up to the $6,000.  The extra $1000 gain must remain in the account until you’re 59 1/2 to avoid penalties (with a few exceptions detailed here.)

Since your money accumulates tax-free, you earn a higher after-tax rate of return in a Roth than in a taxable account.  If you’re earning say, 6% interest on $5000 and you’re in the 25% tax bracket, your after-tax return is only 4.5%  ($225 per year) in a taxable account.  If you had that money in a Roth IRA instead, you’d earn the full 6% ($300), which equals 33% more money per year.  Over time, small differences in interest rates make a huge impact on your wealth due compounding interest as shown by the below graph.*

Roth IRA vs taxable account - real growth difference

After 5 years, your Roth IRA will have $400 (7.5%) more in it, in 10 years, about $900 (15%) more.  When we combine the two facts above, being able to take out contributions at any time plus tax-free growth, we get a great way to use the Roth IRA as BOTH a short-term savings vehicle AND a way to earn higher returns on that money.

First, open a Roth IRA account that is completely SEPARATE from any Roth IRA account you might have designated for retirement.  This is because you do NOT want you to think of any Roth money you set aside for short-term savings as retirement money.  This makes it easier to keep track of your contributions that you plan to take out.  I have two Roth IRA accounts at Vanguard, one for retirement (invested 100% in stock index funds) and one for short-term savings, like emergencies, invested 100% in a diversified bond index fund.  Here’s how it looks:

Roth IRA - 1 is for retirement (hands off!) and Roth IRA - 2 is for short-term savings

Next, use an Excel spreadsheet, like the one I developed here, to track your Roth IRA contributions.  Your spreadsheet should have at least two columns: one that shows the amount of money you either contributed or took out of ANY of your Roth IRA accounts and one that shows the date of the transaction.  To find past contributions, the financial institution where you have your Roth IRA should keep records of these transactions for a few years (or check all Form 5498’s that you might have received from your financial institution(s) over the years.)  Make sure you never take out more than you’ve contributed, or you’ll likely face taxes or penalties.

Next, fund your separate, non-retirement Roth IRA with money that you need in the short (or long) term.  If you’re saving for the short-term, like an emergency fund, choose a relatively safe investment like a bond or money market fund.  The beauty of using a Roth for an emergency fund is that you get the benefits of easily-accessible principle (your contributions) with the added bonus of tax-free growth that can be used for retirement.**

This is great because your emergency funds might be invested for a really long time, if you’re lucky enough to avoid costly emergencies.  In light of this, you’d like to maximize your gains by avoiding taxes while the money sits there.  You can use a similar strategy when saving for a down payment on your first home.  If (and ONLY if) you’ve had a Roth account open for at least 5 years, you can use up to $10,000 of Roth IRA gains towards a first-time home purchase tax- and penalty-free.  So in this special case, you can even use the earnings (plus all the contributions) from your Roth IRA.

(Remember, you must have opened a Roth IRA account and deposited money into it at least 5 years ago to use this exception.  There is a similar exception for qualified education expenses, except the earnings withdrawals are NOT tax-free, only 10% penalty-free.  However, there are better ways to save for education.)

As a final note, remember that the IRS doesn’t care which IRA accounts you deposit to or take money out of, all that matters is your total contributions & distributions from all your Roth IRA accounts combined.  (Even so, I strongly recommend keeping Roth accounts you intend to use for short-term events separate from retirement-designated Roths.)

Start using this strategy today by opening a Roth IRA online at a reputable mutual fund house like Vanguard, Fidelity or T. Rowe Price.  With minimum initial deposits as low as $50 for T. Rowe Price, there’s no excuse for not starting a Roth.

* The graph is inflation-adjusted because we always want to talk about ‘real dollars’, aka purchasing power.  Another way of saying this is that we don’t really care about how many dollars we have, but how much stuff we can buy with them.  If we didn’t factor in inflation, we would actually understate how valuable the tax-savings from a Roth are.

** If you really want to optimize your investment performance, you could periodically (perhaps annually) move the gains on your non-retirement Roth into a Roth you’ve designated for retirement.  You would do this in order to move these gains (which shouldn’t be taken out until retirement) into a more volatile long-term investment, like a stock index fund, rather than having them sit in a stable, but lower expected return, short-term investment.

Start a retirement fund with fifty bucks (it’s that easy…)

… thanks to T. Rowe Price’s Total Equity Market Index fund (ticker: POMIX.)  Most funds require a few thousand dollars to open an account.  T. Rowe Price lets you open, say, a Roth IRA, with as little as $50 as long as you sign up for minimum automatic monthly contributions of $50 as well (taken right out of your checking account.)  With this particular fund, you get a low-fee, broadly diversified, US stock market index fund.  It’s the kind of thing you can invest in regularly and forget about until you’re within 10 years of retirement.


(If you invested the bare minimum of $50 per month for 30 years at 7% interest, you’d have over $58,000.   Plus, you would only have invested $18,000 of your own money [= $50 * 12 * 30]. That’s an extra 40 grand in your pocket just for 50 bucks a month!)

POMIX’s expense ratio is a low 0.40% (not quite as low as Vanguard’s 0.18%, or Fidelity’s approaching-absolute-zero Spartan fund ratio of 0.10%.  Unfortunately, they generally require $3,000 and $10,000 to open an account, respectively.  If you have at least $3000, or can save it up, I recommend opening a Vanguard account instead, and investing in their total stock market index (ticker: VTSMX.)

UPDATE 11-16-2010: Vanguard now offers a $1,000 initial minimum ‘STAR’ fund that is a balance of 60% stock and 40% bonds.  This is an excellent way to get a ‘foot in the door’ and start building an investment account with Vanguard, my favorite choice for individual investors.  If you’re under 50 and investing for a retirement that’s still 10 – 15+ years away, switch your investment to the VTSMX fund mentioned above when you accumulate over $3,000.

Bottom Line

If you’re not saving for your retirement (or for whatever long-term goal you have), and you don’t have a few thousand laying around to open an account, you can still start with $50 today!

Re-thinking the Roth IRA – Why the Roth IRA may NOT be the best retirement vehicle for you

In this article we’re going to discuss why the Roth IRA may NOT be your best retirement vehicle (and why it certainly shouldn’t be your only one.)  If you’re not already familiar with a Roth IRA and how it compares to a Traditional IRA, please read this.

(Quick refresher: Traditional IRAs and 401ks allow you to avoid paying taxes on contributed income in the current year, but when you take the money out in retirement, you must pay taxes on it at your regular income rate.)

So, which one is better for you?  If you expect your marginal tax rate to be higher in retirement than currently, it may make sense to put some of your money into a Roth IRA (Only after you max out your employers matching contribution on your 401k; never refuse free money!)  Say you’re a student with a part-time job, and your marginal tax rate is 10%.  Assuming you’re significantly wealthier when you retire, you might be in the 25% tax bracket at age 60 and beyond.  Thus, it doesn’t make sense to save 10% on  taxes today, when you may pay 25% on your marginal income at retirement.

On the other hand, if you believe your retirement tax rate will be lower than your current tax rate, then a 401k or Traditional IRA may make the most sense hands-down.  (Imagine that you and your wife are fully employed and are supporting kids or a mortgage.  In retirement, you may not have those expenses, and thus can live on less income, which might reduce your tax bracket.)

Either way, the best retirement plan for you is likely to have some money in both types of accounts (if not all of it in a 401k.)  Let me explain why:

Fill up those low brackets!

1) The first reason (other than employer-matching) to funnel money into a 401k is to ‘fill up’ your lower tax brackets.  This concept (and many others  in this article) is excellently described here at ‘The Finance Buff’s’ site.  I highly recommend your read his article as well, especially if you have any questions about the below.  His graph (see below) illustrates what I mean:


Because the United States tax system is progressive, the first dollars of income you have are taxed at a lower rate than the last (or marginal) dollars.  In 2008, a married couple filing jointly could take 2 exemptions and the standard deduction and not pay ANY taxes on their first $17,900 of income.  Then, they’d pay 10% on their next $16,050 (“taxable income.”)  After that, they move into the 15% tax bracket and pay that rate on their next $49,050.

For simplicity, let’s assume that a 401k is your only source of income and that when you retire, the tax brackets will remain the same as they are in 2008*.  If you withdraw less than $83,000 (adding up all the amounts in the 10%, 15% and “0%” brackets above), you’ll pay only 15% at the marginal dollar of income.  If you and your spouse make, say, $100,000 combined today, you’re in the 25% bracket.  Thus, it would make sense for you to contribute to a 401k and save the 25% now, paying the 15% later (rather than a Roth which would save you the 15% later, but cost you 25% today.)

In addition to filling up your retirement low tax brackets with 401k income, there’s another reason why a 401k might be a better choice than a Roth IRA.

Like a Ford Explorer, it’s easy to rollover a 401k

2) You can rollover a 401k into a Roth IRA (after leaving your employer), paying the taxes in the year you convert the Roth.  What this means is that you effectively (but not really) cash out your 401k into a Traditional IRA, then, you convert the Traditional IRA into a Roth IRA.  You have to pay regular income taxes on the value of the conversion (because you were never taxed on the 401k contributions.)  Why might you want to do this?  Let’s look at an example:

Say you’re currently in the 25% tax bracket and expect to remain in that bracket in retirement.  Because you’ve read this article, you contribute to your 401k to fill up your lower brackets for retirement.  This year however, you’re fed up with the rat race.  Maybe you quit your old job to take a sabbatical, go back to school, or start your own business.  If your new marginal bracket is low (say 15%), you could rollover some money from your 401k/Traditional IRA to a Roth IRA, only paying 15% tax to do so.  If this chunk of your 401k represented money you would’ve paid 25% on in retirement, you’ve just saved yourself 10% (=25% – 15%)!

In closing…

There are other reasons that I’ll let you read about in the above-mentioned article by The Finance Buff (including avoiding phase-outs and the dreaded Alternative Minimum Tax.)  For most people though, I believe the above two reasons, especially the ‘filling lower brackets’ strategy, are the most important.

Don’t get me wrong, there are still some great reasons for using a Roth IRA for retirement.  Like ‘hedging’ against higher future taxes and not being forced to take the minimum distributions at age 70.5 that you have to with a Traditional IRA/401k.  There are also some non-retirement Roth IRA usages that I’ll discuss in the next column.

Bottom-line: For most people, the 401k/Traditional IRA should make up the bulk of their retirement contributions.  I see entirely too many personal finance sites that recommend putting your money into a Roth IRA as soon as you max out your employer matching.  This is dangerous, blanket advice, which I think is dead WRONG for many people.

Even if you determine the Roth isn’t the best thing for your retirement money, check out how to ‘hack your Roth’ for use as a tax-free, short-term investment vehicle.

Note: I’m not an accountant, so please review your personal tax situation with one, or make sure you understand it when planning for your own retirement.  As always, if you have specific questions about the above, please comment on this article or email me.

* This would be a good approximation if real dollar (inflation-adjusted) tax brackets stay the same.  However, it may be that tax rates increase in real dollars.  This could be due to, oh, I don’t know, our MASSIVE and increasing federal debt in the US.

All about the Roth IRA – your key to tax-free retirement!

If you’ve read my primer on retirement, you should have a good idea of the benefits of investing in a Roth IRA. If you haven’t read it, let me give you a quick rundown before we get into the gritty details:

Meet the Roth IRA

Unlike a Traditional IRA (“Individual Retirement Account”), with a Roth IRA you have to pay taxes on the income that you invest. (The money you put into a Roth IRA is called a “contribution.”) However, instead of that money (plus all the growth) being taxed when you take it out at retirement (after age 59 1/2), with a Roth IRA you get to make the withdrawal tax-free (The money that you take out of a Roth is called a “distribution.”)

Also, like a Traditional IRA or 401k, all the growth and reinvested dividends in a Roth IRA grow tax-free while they remain in the Roth account.

That’s the Roth IRA in a nutshell. Now let’s look at some of the details below that might also sway your decision on where to put your retirement money. (And for a complete look at those details, you can check out IRS publication 590. I’ll warn you though, it’s as dry as the name suggests.)

The Roth IRA has “rules and $#%&” too…


In order to contribute money to a Roth IRA, you must have “earned income” that amounts to at least as much you’re going to invest. Thus, if you want to put in $2500 into your Roth IRA in 2010, you must’ve received at least that amount of earned income in the same year. This then begs the question, “what the heck counts as earned income?”

Earned income (or “compensation”) is defined as wages, salaries, tips or professional fees. Essentially, it’s what shows up on your W-2 as “wages, salary, tips” etc. This does NOT include money from investments like interest, dividends, or capital gains. Also NOT included as compensation are payments from social security, disability, pensions, annuities or income from property.

The most you can contribute in one year to a Roth IRA is $5,000 for 2010 (that is, if you ONLY contribute to a Roth IRA for retirement.) This amount will be adjusted in $500 increments, when required, to keep pace with inflation. There is one exception to this maximum IRS limit: if you’re 50 years old or older prior to 2011, you can contribute an additional “catch up” amount of $1,000 to your Roth IRA, for a grand total of $6,000 in 2010.

In 2010, in order to contribute to a Roth IRA, you also must have an Adjusted Gross Income (AGI) of less than $121,000 if you’re filing single ($177,000 for those married filing jointly.)  Also, the amount you can contribute to a Roth IRA is “phased out” for those filing single whose AGI is between $106,000 ($167,000 if filing jointly) and $121,000 ($177,000 filing jointly.)

One nice thing about the contributions to a Roth IRA is that for a given year (say, 2010), you have until the tax deadline in the following year to make contributions. Therefore, for most people, April 15th 2011 would be the last day you could make Roth IRA contributions for 2010.

(Special note on employer-matching contributions for Roth 401ks: Employer-sponsored Roth 401ks are similar in their tax treatment to Roth IRAs (and similar in their contribution limits to ‘regular’ 401ks, which are pre-tax.  One important difference is that employer matching contributions are ALWAYS pre-tax, and will go into regular 401k accounts, even if your own contributions are sent to a Roth 401k.)


If the idea of receiving tax-free income in your golden years isn’t enough, the Roth IRA also has some other benefits when it comes to receiving distributions.  These benefits give you some flexibility and liquidity that is usually reserved for taxable accounts.

Distribution of your regular contributions – You can take out the amount you’ve contributed to a Roth IRA tax- & penalty-free at anytime (I recommend only doing this if you really have to; chant the mantra: “Retirement savings are for retirement!”) For example, let’s say you’ve contributed $5000 per year for 4 years to your Roth IRA. Then, at age 42, you lose your job and need to tap your IRA in this emergency situation. You could take up to $20,000 worth of distributions from your Roth IRA without penalty tax-free, since you made an equal amount of contributions over the years.

Qualified Distributions – With a Traditional IRA, you can generally only take the money out without penalty if you’re over 59 1/2, and then you still have to pay normal income tax on that money. With a Roth IRA, some of the ways in which you can take out money tax and penalty-free are known as “qualified distributions.”

“A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

  1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
  2. The payment or distribution is:
    1. Made on or after the date you reach age 59½,
    2. Made because you are disabled,
    3. Made to a beneficiary or to your estate after your death, or
    4. One that meets the requirements listed under First home under Exceptions in chapter 1 [of IRS publication 590] (up to a $10,000 lifetime limit).”

If you receive a distribution that is not a qualified distribution, you may have to pay the 10% additional tax on early distributions.

Item D means that if you’re a first-time home-buyer, you can take a distribution of up to $10,000 in earnings (after using all the contributions) for the purchase of this home (as part of a down-payment, for example.) If your spouse has a Roth IRA and is also a first-time home-buyer, she could use $10,000 of her Roth IRA in the home purchase as well (for a total of $20,000 between the two of you.) Note that you can also use your Roth IRA distributions in the same way for a child, grandchild, parent or other ancestor that is a first-time home-buyer.

Additionally, should you kick the bucket early, your beneficiaries can use your Roth IRA distributions tax-free. This makes a nice life insurance bonus out of the Roth IRA (for your sake, a benefit that hopefully won’t be used!)

You can also use Roth IRA distributions penalty-free (but not tax-free) for up to the amount required to pay for your qualified higher-education expenses (as long as you paid for those expenses with savings, loans, wages, a gift or an inheritance, and NOT through a tax-free scholarship or grant.)  Even though your Roth earnings withdrawals are not tax-free for qualified higher education expenses, you may be able to used tuition deductions or education credits to offset the taxes from that income.  (However, there are much better ways to save for eduction.)

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

This means that if you want to start a retirement fund but think that in several years you might decide to buy a house (for the first time) or go back to school, a Roth IRA may be a good place for your money in any event.  However, I would caution that if your plan is to use a Roth IRA to fund something other than your retirement, you can’t really count that Roth IRA money as part of your future retirement.

As stated in my article on retirement, I believe that funds set aside for retirement should ONLY be used for that purpose. So, make sure you keep your “true” retirement money separated (at least in your mind) from your “maybe-for-school-or-a-house, maybe-for-retirement” money.

Conversion – You can also convert a Traditional IRA or 401k/403b into a Roth IRA. Keep in mind that you’ll have to pay the taxes in the current year at ordinary income rates on the basis amount of Traditional IRA that you’re converting.  So, if you’re in the 25% tax bracket and convert a $100K Traditional IRA to a Roth, you’ll pay $25K in taxes that year.  (For 2010 conversions ONLY, you have the option of spreading the $100K of income equally over 2011 and 2012.)

Avoid the 10% penalty on withdrawals of Roth funds from converted IRAs

One important exception to the general rule of being allowed to take contributions out of Roth IRAs at any time tax & penalty-free is converted IRAs.  If you convert a Traditional IRA/401k to a Roth IRA, you cannot take out any money within the 5 tax-year period starting with the year that the conversion was made unless you want to pay the 10% penalty (bad idea.)  So, if you convert in tax year 2010, you can’t withdraw those rollover contributions until January 1st, 2015.

Ready, set, Roth!

Now you should have a deeper understanding of the Roth IRA, a powerful retirement vehicle that could save you a bundle in taxes after you retire. If you combine the over-59 1/2 tax-free distributions with the additional distribution flexibility of funding your first home purchase or higher-education costs with your Roth, this IRA might be the right investment vehicle for you.

(To find out why the Roth IRA may NOT be the best retirement vehicle for you, read this.)