Retirement Guide
Seven Steps to Saner Savings
02.25.08,
12:00 AM ET
Congress just keeps creating new accounts, new rules and new traps.
Saving for retirement can be tough. We don't mean choosing between growth funds and value funds. We mean picking through the rat's nest of tax-favored savings accounts created by Congress. Each has its own limits, benefits, eligibility rules and traps.
With Apr. 15 approaching, you may want to open an Individual Retirement Account for 2007. Which type? Do you earn too much to qualify? (There is scarcely a tax benefit on the books without a complicated phaseout attached.) So you download the Internal Revenue Service's 108-page Publication 590 on IRAs. Make sure it's the latest version; since 1987 Congress has made 63 changes to the rules for IRAs and 401(k)s, according to a tally by tax publisher CCH.
"It's just a maze," laments Mark Davis, a 45-year-old materials engineer from Marshville, N.C. During 2007 he contributed the maximum $15,500 allowed to his 401(k) at ATI Allvac. Recently he opened Roth IRAs for himself and his wife, Barbara, 46, with the maximum 2008 contribution of $5,000 each. Davis is earning too much to open a deductible IRA for himself but not too much to deduct a "spousal IRA" for Barbara, a homemaker. He decided, however, that since his 401(k) is filled with pretax money--meaning they'll owe ordinary income tax on all withdrawals in retirement--they should hedge their tax bets by opening a Roth for each of them. Aftertax money goes into a Roth, and all withdrawals, after five years and age 591/2, are tax free.
Now Davis plans to read up on the new Roth option in his 401(k) plan and to consider how best to invest (in a taxable account) the cash he got last year from selling stock options. Impressive. Yet these dogged savers have simpler choices than some couples. They don't have kids, so they don't need to decide how best to save for college. And, mercifully, he doesn't have to figure out Health Savings Accounts because his employer doesn't offer him one.
No matter how complicated your situation, these seven steps, along with the table on page 42, should help you tame the savings account insanity.
1. Grab your employer's match in a 401(k). If you're offered a 401(k) at work, put at least enough of your salary in it--most commonly 6%--to qualify for the full matching contribution from your employer. If you dislike the investment choices in your 401(k), hold your nose and contribute anyway; you may be able to roll your money into an IRA that gives you more choice (see story). Decide whether to contribute even more to your 401(k) after taking the next two steps.
2. Fund a Roth IRA. A Roth provides both tax-free growth and an escape hatch if you need cash. After age 591TK2 all withdrawals are tax free, no matter what you use them for. But you can take back your original contributions at any age, without paying taxes or penalty. Another advantage: If you don't need the cash, you don't have to start draining a Roth after age 701/2, as you do other IRAs. "You control the spigot," says Clifford Caplan, a financial planner in Norwood, Mass. You can even leave the Roth to your children or grandchildren, who can string out tax-free growth and withdrawals over their own projected life spans.
True, when you open a Roth you forgo the current tax deduction you could get by opening a deductible IRA (if you're eligible) or funneling more pretax dollars into your 401(k). But listen to the Democratic presidential candidates and look at the federal deficit projections. The looming prospect of higher tax rates is a good argument for a Roth.
Think you're not eligible? Both eligibility and contribution limits are rising; for 2008 a couple can contribute $10,000 to Roth IRAs ($12,000 if they're 50 or older) with up to $159,000 in adjusted gross income. Note that AGI doesn't include salary you've put in a pretax 401(k). If you still earn too much, be sure to read step 6.
3. Build up taxable accounts. Today's erratic stock markets, economy and tax code bring home why it's smart to keep a chunk of your savings in taxable accounts. You can always get your hands on the money. The accessibility of money in tax-sheltered accounts is contingent on your complying with the social engineering schemes coming out of Congress. (In this weird world, withdrawing money from an IRA to buy a first home is virtuous, withdrawing money to expand your business is not.)
You can usually get a loan of up to $50,000 from your 401(k), but there are gotchas and pitfalls. If you lose your job and don't immediately repay a 401(k) loan, you'll owe a 10% penalty, as well as taxes, just when you're cash-shy. In fact, more than 1 million taxpayers, including some very well-educated ones, end up paying penalties each year for early withdrawals from their retirement accounts. In January the U.S. Tax Court upheld a penalty against Shawn Timothy Hynes, a University of Pennsylvania law school graduate who took $16,000 out of his 401(k) to tide him over while he studied for the bar and waited to start a job as a securities litigator at Simpson Thacher & Bartlett.
Beyond flexibility, there are--odd as it sounds--tax advantages to taxable accounts, particularly if you hold the right assets in the right accounts. Any funds you take out of a pretax 401(k) or IRA are taxed as ordinary income, at a current top rate of 35%. But long-term capital gains realized in regular accounts are taxed at a maximum 15%. Yes, Democrats might raise the capital gains rate. But it's still likely to be lower than the top ordinary income tax rate. Moreover, you can harvest capital losses from your taxable portfolio and use them to offset any gains you want to take, as well as up to $3,000 a year in ordinary income (say, from salary).
"Most investors ignore the asset-location issue. They fail to recognize the significant impact of placing the right assets in the right buckets," says John Nersesian of Nuveen Investments' Wealth Management Services. General advice: Use taxable accounts to hold individual stocks (these present better opportunities for loss harvesting) and index funds or exchange-traded index funds that don't throw off much taxable income. Put your assets with the highest growth potential in a Roth. Taxable bonds and REITs belong in a pretax 401(k) or IRA; the income they generate is taxed at ordinary rates anyway, and this way the tax is deferred. Also good for your pretax 401(k) or IRA are assets that generate short-term gains, which are taxed at ordinary income rates--stocks you trade a lot and actively managed small-company or international funds.
Having taxable accounts also allows you to better control how much taxable income you recognize each year in retirement. Finally, at your death (at least under current law), assets held in a taxable account get a step-up in basis, meaning your heirs will owe no capital gain tax on appreciation taking place in your lifetime.
4. Fatten your 401(k). The maximum annual employee contribution (both pretax and Roth) combined for 2008 is $15,500, with an extra $5,000 allowed for workers 50 and older. "It's stunning the number of high-income people who miss the catch-up provision," says Brian Jones, a financial planner in Fairfax, Va.
About 20% of 401(k) plans now offer the Roth 401(k) option, first allowed in 2006. As with a Roth IRA, aftertax money goes into the Roth K, but money withdrawn in retirement isn't taxed. A Roth K makes sense if you're young and likely to be earning more and paying tax at a higher rate in the future. Roth Ks have no income limitation.
A Roth isn't a good idea if your combined federal and state tax rate is likely to decline--say, if you're working in high-tax New York and plan to retire soon to state-income-tax-free Florida.
Also, beware of tricky tax code interactions caused by all the goodies that get taken away as your income rises. Using a pretax 401(k) might reduce your adjusted gross income enough to make you eligible for a more flexible Roth IRA; or might keep you from losing the child credit; or might allow you to deduct interest on college loans. If you make between $50,000 and $200,000, you should memorize the several hundred pages of IRS publications and instructions that relate in some way to things being phased out. Or hire an accountant.
5. Consider college costs. Difficult issue for parents: Should they max out contributions to their retirement accounts before saving expressly for college? Stashing all your savings in retirement accounts increases the chance your kids will qualify for financial aid; colleges expect parents to contribute up to 5.6% of their nonretirement assets (including, sometimes, home equity) each year but don't count parents' IRAs and 401(k)s. Even with a gross income of $200,000 you might qualify for aid, depending on how many kids you have in school, where they're going and how much in countable assets you have.
However, if you're going to need to dig into those retirement accounts for college anyway, the money is probably better saved elsewhere. The problem is not just that you might end up paying a penalty in addition to ordinary income taxes if you pay college bills from your 401(k). In the Alice-in-Ivy-Land financial-aid world, colleges count what you take from a retirement account to pay their inflated bills as current income to you--making your kid less likely to qualify for aid the next year.
A good home for savings you expect to use for college costs is a 529 state college savings account. You don't get a federal tax deduction for putting money in a 529, but you get tax-free growth--withdrawals aren't taxed if used for college. Plus, 30 states give residents a tax break for contributing to the state's own plan.
6. Play the conversion game - Open a non-deductible IRA. High-income folk who aren't eligible to open a deductible or Roth IRA are allowed to open a nondeductible IRA instead. Earnings are tax deferred, not tax free as they are in a Roth. Is it worth it? Sometimes, answers Craig Brimhall, vice president of retirement wealth strategies for Ameriprise. In fact, he's been putting the maximum in one of these IRAs for his wife, Melanie, 46, since 2006.
What entices Brimhall is that under current law, starting in 2010, anyone--no matter what their family income--can convert a pretax or aftertax IRA into a Roth. (Currently conversion isn't allowed for families with $100,000 or more in income.) In a conversion you withdraw funds from an IRA, pay any ordinary income taxes due (preferably with non-IRA funds) and put the withdrawn funds into a Roth, where all future growth is tax free. Since Melanie's IRA is funded entirely with aftertax contributions, only the earnings in her account will be taxed in the conversion.
Those doing conversions in 2010 get a special break: They can recognize the income from the IRA withdrawal in two installments, in 2011 and 2012. (This bizarre two-year delay owes its life to a congressional budget gimmick.) "I want us to have some tax-free pots of cash to draw on later in life," Brimhall says.
Brimhall didn't open a nondeductible IRA for himself because he already has a fat pretax IRA, filled with money rolled from a pretax plan at a previous job. When you convert to a Roth, you have to withdraw a proportionate share from your pretax and after-tax IRAs. So for him the withdrawals would be mostly taxable.
7. Do an HSA. To open a health savings account, you must have health insurance with a deductible of at least $2,200 for a family plan or $1,100 for individual coverage. You can then contribute a maximum of $5,800 pretax dollars for family coverage ($2,900 for individual) to the HSA. You can also put in an extra pretax $900 for each covered family member who is 55 or older. HSA withdrawals, either for health expenses or in retirement, are tax free. So you get a tax break on both ends.
An HSA works best if you pay your current health bills with other funds and let what's in the HSA grow--in other words, if you're healthy and affluent. Only 20% of employers offer HSA plans. But they're catching on among high-income, self-employed folk.
Already retired? Find out how you could raise your living standard by trading in your Social Security check for a bigger one. Visit www.forbes.com/retirement.
