Critical Stuff: IRAs are a great deal, with lots of catches.
In This Chapter: Taxes eat savings. High fees and mediocre management.
It would be easy to write a book about IRAs alone, though it would be stunningly boring and best used as a sleep aid for those nights when you simply couldn’t resist that dish of coffee ice cream. I’m going to do a pretty lightweight job of covering this, mostly for the sake of completeness because there’s so much good information online. I particularly recommend the www.Bogleheads.org site or the Bogleheads Guide to Retirement Planning which was the primary source of this information.
The universal advantage of all IRA flavors is that your funds grow tax-free, which leaves more money in the account to compound over the years. The big advantage of managing your IRA is that you can direct it to low fee funds and eliminate management fees. The biggest problem with IRAs is simply that they limit contributions to such a small amount of money. If that were not so I suspect taxable accounts would quickly disappear. But anyone planning for retirement needs to take IRAs into account. In taxable accounts you pay taxes on the money you earned to make the investment, then you pay taxes on dividends or interest as well as realized capital gains from mutual funds as a result of the fund manager churning the stocks held by the fund and/or distributing gains. Then you pay tax on the capital gain of the investment when you sell it. In a tax-deferred account, you pay no taxes on the money you invested, no taxes on churn or reinvested dividends. All you pay is the taxes on the money you take from the fund once you retire, unless you try to take it out prematurely, in which case you also pay penalties.
That’s the reason taxes are so important for retirement accounts, and the reason why IRAs are so valuable. All flavors provide shelter from at least several of those taxes. You must be careful to follow the rules when you move money in or out of an IRA or the taxes and penalties will chew up large portions of your savings. There are plenty of online resources (the bogleheads.org wiki does a fine job of converting IRS word hash into English) to determine if and how much you can contribute to an IRA, there’s no point in reproducing those here since they change over time. But here’s some fundamental points.
1. If your employer doesn’t offer a retirement account of some form, you can contribute to an IRA and deduct your contribution from your income regardless of your income.
2. If your employer offers a retirement account you can contribute and deduct additionally to an IRA if you make less than a specific amount of money. Electing not to participate in your employer’s plan doesn’t change that rule.
3. You can contribute to an IRA account even if you don’t meet those limits, but you can’t deduct the contribution from your income.
4. You can’t contribute to any IRA after you reach 70 1/2.
In 2015 the limit for contribution to all IRAs (Roth and otherwise) is $5500 or $6500 if you are over 50 (added catch-up) .
Do not consider your IRA to be just a neat way to save money tax-free. It’s for retirement. If you take money out of it before you are 59 1/2 you will owe taxes and a 10 percent penalty on whatever you withdraw. In some flavors of IRA there are exceptions to the withdrawal penalty such as disability, death, first time home buyer, etc., but you’ll still pay the tax. Once you reach 70 1/2 you MUST take money out of the account–about 4 percent per year, rising to about 10 percent by the time you reach 90. If you don’t take the money out as scheduled the IRS assesses a penalty of 50 percent of the amount you were supposed to withdraw. Yikes.
Contribution limits for Roth IRAs are pretty much the same as other IRAs though the income limits are higher. The money you put into a Roth IRA is after-tax funds, but that makes the contribution larger. The value to you of the $5000 contribution to a traditional IRA is substantially less since some of it is owed to the government as taxes. Additionally, there are no required distributions from a Roth IRA. The money grows tax-free as long as it is in the account, even if you pass it on through inheritance. So most financial advisors recommend that a Roth IRA be the last place you take money from. Additionally, the penalties and taxes from early distributions apply only to the earning of the Roth IRA, not the original contributions.
Self-employed people can take advantage of Solo 401Ks, Roth Solo 401k, SEP-IRAs and SIMPLE IRAs. again we won’t cover these in detail but here’s the basics:
Solo 401k is the self-employed flavor of 401k retirement plans. The big advantage is that there is no income limit and the contribution limit is higher and is defined by the profit of your company. Here’s the current link to the IRS description, but you can simply google solo 401k contribution limit. In 2015 the limit to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $52,000 for 2014 and $53,000 for 2015. Withdrawal rules are the same as traditional IRAs except that you can borrow up to 50% or 50,000 whichever is less.
Roth Solo 401K is a hybrid, that allows contribution of after-tax funds with an employer contribution that works like a solo 401k. Confusing, but useful.
SEP-IRA is kind of an outdated concept. Used to be the best way for high income, self-employed individuals to shelter retirement savings from taxes, but Solo and Solo Roth generally work better now.
SIMPLE IRA was designed as a less expensive way for businesses with fewer than 100 employees to provide retirement benefits. In some cases they still make sense for small businesses with employees, but you’d need expert advice to decide that.
If you have held a number of different jobs you might have multiple employer-based contribution plans of varied value. You probably pay little attention to them. It probably makes sense to roll them into your IRA. If you dig deep you’ll probably find the money in these accounts is not being managed particularly well and the fees can be big. Some of the employer retirement plans permit borrowing from the account, and you’ll lose that ability, but your fees will probably be lower and you can direct the money into a better strategy for you. Whoever you have chosen as custodian of your IRA can handle the transfer for you with no tax consequence.
Rollovers are also a way to move money into IRAs that you previously could not qualify for. For example, you can roll non-deductible IRAs into Roth IRAs — an approach called a Backdoor IRA. The approach for doing this for high-income individuals is cumbersome and tricky, but there is lots of information about it online.
You can also close out all or part of your traditional IRAs and roll them into Roth IRAs to bypass the requirement to take distributions at age 70 1/2. You pay taxes on the money withdrawn from the traditional IRA, but once it’s in a Roth you never pay taxes on it again, and it still grows tax-free. It’s a worthwhile strategy if you think your current marginal income tax rate is lower than it will be in the future.
I’m including this here mainly because the Bogleheads retirement book does, and I like their reasoning. HSAs are essentially IRAs with a particular purpose. If your health insurance is a high-deductible plan that meets IRS rules you can essentially self-insure for the difference. Contributions are deductible, and distributions are tax-free if you use them for healthcare. The fund can be invested in various ways, similar to traditional IRAs. In retirement, you can use the funds for health care, tax-free, and after age 65 you can use it for anything but you’ll pay tax like a traditional IRA. Some financial planners recommend paying medical expenses out of pocket rather than decreasing the fund which grows tax-free, especially since anything you spend above 7.5 percent of your adjusted gross income for health care is deductible. The maximum contribution to an HSA in 2015 is up to $3,350 for an individual and $6,650 for a family plus an extra $1000 for 55 and older – and these contributions are 100% tax deductible from gross income.
A surprising number of IRAs wind up with high fees and mediocre management. Fortunately, IRAs are easy to transfer, you just contact the firm you want to use, do a little paperwork, and hey, presto. they take care of it for you. There’s no tax consequence to liquidation over in-kind transfer as long as the transaction is done without a distribution. So if your current fund is in Zimbabwe municipal bonds they can be liquidated and moved to something rational.