Retirement accounts like the 401(k) and IRA are the best tax shelters available to the ordinary investor. These accounts, along with your house, are likely to serve as the foundation of your retirement. Contribute to retirement accounts automatically, such as through payroll deduction.
401(k) plans often provide matching contributions by employers; get the match. An employer match, if available, gives you an immediate profit on your investment. It’s a great deal. Contribute at least enough to get the match. But beware of holding too much of your employer’s stock in a 401(k) account. No more than 10% of your account's assets should be invested in employer stock. Diversify the investments in your 401(k) account.
Have a 401(k) account even if your employer provides a pension or an employee stock option plan. The value of pensions and incentive compensation plans like ESOPs depend greatly on the success of your employer. If it does well, it can fund your pension and the stock in the ESOP grows in value. If it does poorly, you may find yourself way up the creek in search of a paddle. However, the assets in your 401(k) account are largely insulated from poor business performance by your employer (with the exception being employer stock in your account). The assets in your 401(k) account belong to you, and if you invest them in a well-diversified way, they'll still be there if your employer does an Enron-style belly flop.
Mind the details of your 401(k) account--fees and other charges can significantly reduce your returns. Reading through the information about a 401(k) account might put you at risk of brain death. But if you don't understand the details, you could end up being nickeled and dimed with fees and charges that make the money managers wealthy, but not you.
Your employer may offer financial planning services as part of its 401(k) plan. You could find this convenient and useful. But don't treat it any differently from other financial planning service. Ask about fees and expenses, and ask whether the planner would be compensated for selling you investments or has other conflicts of interest. Also, understand that this planner may be reluctant to advise you to sell your employer's stock, since your employer gave it the contract to administer the 401(k) plan. You should keep your holdings of employer stock down to no more than 10% of the account's assets.
Don’t borrow from your 401(k) account. This is likely to reduce the growth of your retirement portfolio. Let your retirement assets grow undisturbed.
When you leave a company, do not cash out your 401(k) account. Keep it in your old employer’s plan, transfer it to your new employer’s plan, or put it in an IRA. If you cash out your 401(k) plan, you’ll have to pay federal and state income taxes, and a 10% penalty on the assets withdrawn. That can be a significant setback to your retirement plan. Your old employer may automatically cash out your account if it contains less than $5,000. Even if you’re being cashed out, put the money in an IRA (or your new employer’s 401(k)).
The self-employed can use SEP-IRAs, SIMPLE IRAs, and other retirement plans, as well as ordinary IRAs. If you’re self-employed, you’re used to helping yourself. Set up your own retirement plan.
IRAs are available to anyone, but use other plans first. Because of limitations on deductibility and contributions, the IRA does not serve well as a primary retirement savings account. Use it if you have nothing else available, but first try a 401(k), SEP-IRA, SIMPLE IRA or other retirement plan. The IRA, however, is an important vehicle for accepting rollovers of 401(k) accounts when you leave an employer or retire.
Roth IRA and Roth 401(k) accounts are funded with aftertax dollars, but their earnings are tax free if you hold them for at least five years and make withdrawals after you reach 59 1/2. Roth accounts tend to be advantageous for people in their 20s and 30s. Also, Roth IRAs can make it easier to pass along wealth to your heirs and beneficiaries.
Don't invest retirement account assets in tax shelters. Avoid investing IRA or 401(k) assets in tax sheltered investments like deferred annuity contracts and municipal bonds. Retirement accounts are already tax sheltered and using them to buy another tax shelter is likely to impose costs on you, such as fees, expenses and lower returns, while giving you little or no additional benefit.
The best legal tax shelters for most Americans are retirement accounts. The traditional versions of these accounts let you defer taxes on the money you save. In other words, if you normally pay 30% of each pre-tax dollar of earned income in federal and state income taxes, you can delay paying those taxes, perhaps for decades, by saving that dollar in a retirement account. These accounts come in a variety of colors and models, but the most important ones are the 401(k) account and its public sector and nonprofit equivalents, the federal and military Thrift Savings Plan, the 403(b) and the 457. The IRA is available to anyone but its usefulness is limited. The self-employed have other choices, such as the SEP-IRA and the SIMPLE IRA. The wealthy love tax shelters and so should you.
In addition to tax advantages, retirement accounts have bankruptcy protection. In general, retirement accounts like 401(k) accounts and IRA accounts are protected from seizure by your creditors in bankruptcy court. It may still be possible in some states for creditors to use state court proceedings like garnishment and receivership to try to seize IRAs, while 401(k) accounts are protected from state court seizures. But people in really serious financial trouble often end up in bankruptcy court, so they can protect their IRAs in that circumstance. While most people never have to file bankruptcy, life is unpredictable and the ability to legally stash dinero where you can stop your creditors from getting at it is another advantage of these accounts.
The 401(k) account and its clones, the Thrift Savings Plan for federal civilian and military personnel, and the 403(b) and 457 accounts for nonprofit and state employees, offer two advantages. First, the salary you contribute and the investment earnings you receive are not taxed until you withdraw them. The account can accumulate assets and produce compounded profits and earnings for decades, potentially, before you need to withdraw money and pay taxes. This tax deferral supercharges the compounding effect of your investments. You can contribute up to $15,500 per year in 2007 and in 2008. Max out if you can. Persons 50 or more years old can contribute an additional $5,000, and should do so if possible.
Second, many employers “match” at least some of your contributions. For example, an employee may receive a match from an employer for the first 3% of his or her salary contributed to the 401(k) account. This would be equivalent to an immediate 100% return on the initial 3% you contribute.
To continue the example, the employee might then be allowed to contribute as much as another 7% of his or her salary. In this way, the employee will have accumulated an amount equal to 13% of his or her salary, without paying any income taxes, simply by saving 10%. Many 401(k) plans require that you stay with the company a minimum period of time, such as 3 years, before the matching funds “vest” or belong to you. Not all plans have vesting requirements. But even if you have a vesting period, an employer match, if offered, is one of the best deals in town. Don’t pass it up.
Retirement account assets (except employer stock) are insulated from risks posed by your employer. People who have pensions (lucky you) or accounts in Employee Stock Ownership Plans (ESOPs) may wonder whether it’s worthwhile to have a 401(k). The answer is absolutely yes. The value of a pension or an ESOP is highly dependent on the success of your employer. If your employer does well and operates profitably, it will be able to fund its pension plan adequately. Also, its stock price will probably do well, making your ESOP account valuable. But if your employer doesn’t do so well or goes into bankruptcy, your pension may be underfunded and your ESOP account could lose a lot of value. Employees of bankrupt airlines and former Enron employees can attest to these problems. However, your employer's poor performance won't affect the assets in your 401(k), except for company stock held in the account. Your contributions to a 401(k) account are your assets, regardless of what happens to your employer. If your employer’s 401(k) plan has a vesting period for matching funds, the matching funds are yours after you have worked that minimum period of time. Once yours, those assets remain even if your employer does poorly or goes into bankruptcy. The one employer-related risk that remains is that if the 401(k) is invested in your employer’s stock, you could lose money if that stock declines in price. We discuss this problem below; the answer is to sell most or all of your employer’s stock and invest in a diversified pool of assets. Even if you have a pension and/or an ESOP account, a 401(k) account is a darn good idea because it may turn out to be your lifeline.
Some employers may offer Roth 401(k) accounts. If you have a Roth 401(k) account, you would contribute after-tax income into it. You get no deduction for your contributions. But the earnings in these accounts are not taxed immediately, so the account grows on a tax free basis. You can eventually withdraw the earnings in the account tax free, if you hold the account at least five years and are 59 ½ or older. (The original contributions to the account are not taxed again when you take them out, since they were already taxed before you contributed them.) The tax-free earnings, which can compound for decades, are the big payoff. If your employer makes a matching contribution, the portion that matches your Roth 401(k) contributions would be kept in a separate pretax account. All withdrawals from that account would be subject to taxation as ordinary income.
Not many employers offer Roth 401(k) accounts yet. If you have the option to open a Roth 401(k), should you? Here are a couple of thoughts. First, the conventional wisdom is that if you expect to be in a higher income tax bracket in retirement than you are while working, a Roth 401(k) may be sensible. But if you expect to be in a lower income tax bracket after retiring, a conventional 401(k) is said to be better. Whether these guidelines are correct may depend on the assumptions you make about tax brackets, and how close you are to retirement age. The closer you are to retirement, the more likely a conventional 401(k) will make sense because people in their 50’s and 60’s are likely to be in the higher tax brackets and may well fall into lower brackets after retiring. Someone who is 30 years away from retiring may be better off with a Roth because he or she is likely to be in the earlier stages of his or her career, with a lower salary, and therefore be in a lower tax bracket. Unlike the Roth IRA, the Roth 401(k) is available to anyone, regardless of his or her income level. So higher income persons can have Roth 401(k) accounts, if they wish, although they should carefully evaluate its benefits to them in light of their tax situation.
While no one can predict where tax brackets are headed, the very large deficits the federal government is running, and the enormous projected funding shortfalls in Social Security, Medicare and Medicaid could portend tax increases. Reform of certain tax problems, such fixing the alternative minimum tax, could also increase the pressure to raise the regular tax brackets in order to make up for revenues lost from tax reform. All of this suggests that younger people would probably be wise to choose a Roth 401(k) account if they can.
One possibility would be to open a Roth account when you are starting out, and take advantage of your lower tax bracket. As you progress through your career, your income may rise and take you into higher tax brackets. If and when that happens, you could open a traditional account and defer taxes at the higher brackets. That would make sense if you think you'll end up in lower brackets in retirement.
Another reason to open a Roth 401(k) account is that the contribution limits for both the Roth and traditional 401(k) accounts are the same dollar amount. Thus, if you contribute the same number of dollars to a Roth 401(k) as you contributed to your traditional 401(k) account, you will effectively increase the amount you’re saving. For example, assume you pay 30% of your income in federal and state income taxes and you save $6,000 a year in a traditional 401(k). The $6,000 you contribute is equivalent to $4,200 after taxes (because that's what would be left in your hands if you did not contribute to the traditional 401(k)). In addition, the earnings in the traditional IRA will be taxable when you withdraw them. If you open a Roth, and contribute at the same level as before, your contribution will be $4,200 a year (which is the same as $6,000 after taxes). This contribution level will not generate as much compounded growth as an annual contribution of $6,000. The Roth account's earnings would not be taxed if you hold the account at least 5 years and make withdrawals only after you reach age 59 1/2. But whether or not you are better off than with the traditional account involves some guesswork about tax brackets and other issues.
If, however, you are willing to cut back your current lifestyle a bit and contribute $6,000 after taxes to the Roth (which would be about $8,571 before taxes), the Roth will generate more investment gains than a $4,200 contribution level would provide because the amount contributed is larger. It would give you the same return as the traditional 401(k)—assuming they are both invested in the same way—but you will get the Roth profits tax free if you hold the account for five years or more and are at least 59 1/2. Of course, you would have to pay more taxes now, since the $6,000 going into the Roth is not deductible. But if you can swing the additional tax payments by cutting back on current lifestyle, contributing the same number of dollars to a Roth 401(k) as you contributed to a traditional account is likely to build more wealth in the long run.
This analysis doesn't work so well if you pay taxes on the Roth contributions with money that you'd otherwise save in taxable accounts; it works best if you cut back current lifestyle and increase the total amount of saving you're doing. If you shortchange current savings in taxable accounts to fully fund the Roth, you'd have to do a comparison of the projected returns, costs and expenses of the Roth account versus the taxable account in order to figure out if you end up ahead. Because many 401(k) accounts have high fees and expenses, shortchanging saving in a low-cost, tax efficient taxable account to fully fund a Roth 401(k) account may not necessarily be a great idea.
If you’re still not sure what to do, have both types of accounts and split your contributions 50/50. That way you hedge your bets. Bear in mind that the 401(k) contribution limits apply to the total of your traditional and Roth 401(k) contributions. So contributions made to one type of 401(k) account reduce the amount of contributions you can make to the other type of 401(k) account.
Look carefully at the fees associated with the 401(k) plan. Get as much information as you can about the fees charged for or to the 401(k) account, and about other compensation received by the plan administrator. The 401(k) plan will typically be administered by a financial services firm. That firm will charge fees for managing the plan. Sometimes, these fees can seem excessive. Even though these firms collect a management fee, some of them also collect separately assessed fees for things like record keeping, a custodial fee (for keeping custody of the plan's assets), an audit fee (for hiring accountants to audit the plan), fees for legal advice given to the employer concerning the plan, fees for communications with employees (such as mailings, telephone service numbers and meetings with employees participating in the plan), and fees for seminars or workshops to educate employees about the plan. One might think these expenses would be general overhead that the plan administrator should absorb itself. But that's not necessarily the case.
The firm managing the 401(k) plan may also receive payments from mutual fund companies to include their funds in the 401(k) plan’s investment options. These payments could be seen as a conflict of interest, being made to induce the plan administrator to promote these particular funds instead of other investments that would be objectively superior. Alternatively, the plan administrator may be affiliated with a mutual fund company and want to sell "inhouse" products rather than those of competing mutual fund companies. Such an affiliation would raise similar conflict of interest questions. If you discover these third party payments, or an affiliation between the plan administrator and investment options for the plan, stay away from the mutual funds that appear to be implicated in the conflict of interest. Also, ask your employer to demand that the conflict of interest be eliminated.
There may also be fees that are charged directly to your account, rather than being paid by the plan. These fees add to your costs, even though they may not be disclosed as part of the plan’s documentation (because they are charged to you instead of to the plan). You should ask about them.
When you are evaluating the investment options offered by the plan, look into the fees charged by or for the various investment options. An example would be the management fees and expenses charged by mutual funds that are offered by the plan as investment options. These mutual fund fees and expenses would be charged in addition to the fees and charges imposed by your plan or on your account. (Yes, there can be quite a few fees and expenses attached to a 401(k) account one way or another.) Not all investment options have the same costs. Look for inexpensive choices like index funds and exchange traded funds (ETFs). Also, some lifecycle funds are inexpensive and provide a very convenient way to diversify your assets. (Index funds, exchange traded funds and lifecycle funds are discussed in our section on managing investment risks.)
If you are told that the administrative costs and charges for the 401(k) plan are very low or zero, be suspicious. There still ain’t no such thing as a free lunch. The fees could be taken directly from your account and the plan administrator may be receiving payments from third parties. Whatever the case, all of these fees and charges, one way or another, lower the investment profits you get from your 401(k) account. Obtaining information about fees and expenses isn’t always easy, because the law is in flux in this area. But do your best, and ask for information even if the plan isn’t legally required to provide it. Try to get your employer involved in asking about the fees, because it may have more leverage than you. Sometimes, you might learn some very interesting things.
If the 401(k) plan has high annual costs (i.e., 1% of the value of your account or more, including fees and expenses of the investment options, fees charged directly to your account, and fees and expenses charged to the plan), lobby to have them lowered, or ask your employer to switch the providers of some or all services for the plan. Also lobby for lower cost investment options. Over the long run, most mutual funds and money managers won’t give you returns above market averages. High or excessive fees and expenses can eat away a lot of your investment gains. Low cost investments like index funds, exchange traded funds, and inexpensive lifecycle funds are likely to leave you better off than many other investment alternatives.
If you are retiring, don’t keep your assets in the 401(k) account if its costs are high. Transfer them to an inexpensive IRA and look for low cost investments for your retirement years. If you’ve already spent your working years paying high 401(k) fees, don’t continue in retirement.
Be careful with employer stock. Many people hold their employer’s stock in their 401(k) accounts. Often, the employer stock is the matching contribution made by the employer. Sometimes, employees choose to purchase their employer’s stock. Either way, holding large amounts of your employer’s stock isn’t a good idea. It undermines the concept of diversification. You would be betting your retirement on how well your employer is doing 20, 30, 40 or more years in the future. That’s a dangerous bet, even if you think your employer is a great company. If you’re feeling sentimental about the company, talk to the Enron employees and the employees of bankrupt airlines who lost large parts of their retirement assets because of losses in their employer’s stock. Seriously consider selling all or most of your employer’s stock as soon as you can. You may have to hold it for up to three years if it comes from an employer match made before 2007; but matches made in 2007 or later should be free of such restrictions. Then, diversify your portfolio (our suggested model financial plans give you ideas for how to diversify).
There is a potential tax advantage to employer stock. When you retire, you can transfer the employer stock into a regular stock brokerage account, and pay income taxes at ordinary tax rates on the original cost of the employer stock. When you sell the stock, you would pay capital gains taxes on the amount by which the stock increased in value from its original price. (The tax rate would be likely be long term capital gains for the appreciation that occurred while the stock was in the 401(k) plan, and either short or long term capital gains on appreciation after you retired, depending on how long you hold the stock after transferring it out of the 401(k).) The other assets in your 401(k) account should be transferred to an IRA to preserve their tax sheltered status. The value of this strategy depends on your tax bracket in retirement. If you’re in a higher bracket, it may save you a meaningful amount of money, since long term capital gains are taxed at a much lower rate than the higher-level ordinary income tax brackets. But if you’re in a low ordinary income tax bracket, this strategy may save you only a little or perhaps nothing at all after the commissions and expenses of selling the stock (plus the cost of hiring tax accountants to prepare your income tax returns if you aren’t familiar with the rules of capital gains taxation). The availability of this tax advantage should not lead you to concentrate the investments in your 401(k) in your employer’s stock. If your employer’s stock does not increase in value as much as the stock market as a whole, the lower investment returns you receive could more than eliminate any tax advantage.
If you absolutely have to have some employer stock in your 401(k) account, keep the amount below 10%. If it goes above 10%, sell enough to get the percentage back down. Why 10%? Because your retirement lifestyle will probably be largely the same whether you have or lose 10% of your net worth. But lose 20% or 30%, and you’d have to start cutting back significantly. If you need another reason, federal law limits defined benefit pension plans—the good kind of pension most people can’t get any more—to having not more than 10% of their assets in the company’s stock. If 10% is good enough for the Cadillac of pension plans, it’s good enough for a 401(k) account.
We aren’t talking about Employee Stock Ownership Plans (“ESOPs”). An ESOP is a different animal, where the idea is to give employees ownership of some company stock as an incentive to perform well in their jobs. An ESOP will be concentrated in the employer’s stock because that’s its purpose. ESOPs will allow you to gradually diversify your account as you get older. You should do so when the opportunity comes. And even if you have an ESOP, you should open a 401(k) account if your employer gives you that opportunity. If your employer does badly, your ESOP account may end up worth little or nothing. But your 401(k) account, if it is properly diversified away from your employer's stock, will remain.
Employer sponsored financial planning is sometimes offered to employees as part of a 401(k) plan. This is probably worth checking out, but you still have to be careful. Sometimes, you’ll get computerized planning services. Or else, you may get consultations with live human beings (although their advice is likely to be based on a computer model). Many employers pay for the consultations, although other employers require employees to foot the bill. Some employers go one step farther and offer managed accounts, where a financial professional decides how and where to invest your money instead of just giving advice. As always, think about the amount of the fees and other expenses charged for financial planning services offered by your employer. There’s no guarantee that these services will be cost effective or the best deal around. For example, if you or your spouse have significant assets outside your 401(k) account which you don't want to reveal, the financial planning advice you get could be off the mark. In such a situation, you may be better off with an independent financial planner with whom you are willing to share all your financial information.
Professional management of your 401(k) account might improve your returns (or it might not), but the fees and expenses could get pretty high, and any additional gains could be consumed by costs. If you're considering using a professional manager offered by your employer's 401(k) plan, look at the combined annual costs, fees and expenses. If they exceed 1% of your assets, look for an alternative. Ideally, total annual fees and expenses should be pretty low, since the professional managers working for 401(k) plans will generally be using computerized software to make the investment choices. (In other words, you probably won’t get a truly personalized plan, so you shouldn’t pay high fees.) A lifecycle fund with low management fees and expenses will probably beat a managed account with high fees over time. Since most money managers don’t beat the market in the long run, management fees and expenses —whether high or low—have a lot to do with how well you do.
As with any financial planner or money manager, beware of conflicts of interest. The firm managing the 401(k) plan may try to steer you to invest in mutual funds and other products that its afiiliates offer, or to products that it is paid by third parties to promote. Or the person giving you advice, or managing your account, may receive commissions or other compensation for selling you certain products but not others. Ask about these issues.
Another potential problem is that the firm managing the 401(k) plan may be reluctant to recommend that you sell your employer’s stock, since your employer gave it the contract of managing the 401(k) plan. Many employees are too heavily invested in their employer’s stock and should diversify away from it. Your fortunes are already heavily tied to your employer. Avoid putting all your eggs in one basket; don’t tie your retirement to your employer even if the firm managing the 401(k) plan does not recommend selling the employer’s stock.
Be careful about borrowing from your 401(k) account. Many 401(k) plans allow participants to borrow up to half the value of the account, with an upper limit of $50,000. At first glance, this may seem like a nice feature. The interest you pay is credited to your account, so you are paying yourself instead of a bank. But there are problems. There may be fees charged for the loan, which could exceed fees for ordinary bank loans. If you use the money from the 401(k) account to buy a home, you cannot deduct the interest you pay on the 401(k) loan. The principal withdrawn from the account for the loan does not generate investment gains until it is replaced back into the account (which, in some 401(k) plans, might be when you complete repaying the loan years later). Even though this loss is partially offset by the interest payments you make, the investment gains missed could exceed the value of the interest. If you leave the company before repaying the loan, you have to complete repayment at the time you leave. In general, it’s better not to treat your 401(k) account as a source of credit.
When you leave a job, avoid cashing out your 401(k) account(s). Keep the funds tax-sheltered, so that they can continue to compound without ongoing tax liabilities. Leave them in your old employer's 401(k) plan, transfer them to your new employer’s 401(k) plan, or transfer them to an IRA. If you don’t keep your retirement assets in your old employer's 401(k) plan, or transfer them into another retirement account, you will owe federal and state income taxes, plus a 10% penalty if you are less than 59 ½. Then you will lose the tax free compounding of the remaining assets. The way to avoid the taxes and penalty is to keep the money in your old employer’s plan, or, within 60 days, put it in another retirement account like an IRA or a new employer’s 401(k) plan. Don’t spend the money or hold it in taxable accounts. If your account is less than $5,000, your old employer may automatically cash you out. But you can, and should, protect the tax sheltered status of those funds by transferring them into an IRA or your new employer's 401(k) plan. Compare the investment options available in your new employer’s 401(k) plan against those for an IRA, as well as their fees and expenses, and pick the better option.
The self-employed can save for retirement in a SIMPLE IRA, SEP IRA, or other plans. Self-employed individuals can save earned income in tax-advantaged plans such as the SIMPLE IRA and SEP IRA. These plans can be somewhat more complex than a 401(k) account. But they provide the opportunity to invest money on a tax-deferred basis. The contribution limits on the SIMPLE IRA are $10,500 in 2007 and 2008, with another $2,500 each year if you are 50 or older. The contribution limits for SEP-IRAs are higher, but are too complex for simple summation here. When all is said and done, you can contribute about 18% of your net income from self-employment into a SEP-IRA, but not more than $45,000 in 2007 or $46,000 in 2008.
The self-employed person who makes a pretty steady six-figure annual income may have other opportunities for tax-deferred retirement plans (including possibly a defined benefit plan). But these puppies are complex, fairly expensive to create and operate, and require professional assistance. Consult your accountant or tax attorney.
The IRA, or individual retirement account, can also be used to save money on a pretax basis. However, it is subject to a variety of income-related and other restrictions on the amounts of contributions, and the amounts of contributions that can be deducted. Basically, you can contribute up to $4,000 in 2007, $5,000 in 2008, and another $1,000 each year if you are 50 or older. The deductibility of these contributions is subject to a variety of restrictions, depending on things like your income and whether or not you or your spouse participates in an employer sponsored retirement plan. (Read the IRS’s Publication 590 at www.irs.gov/publications/p590/index.html to get a headache about these issues.) If you have no alternatives other than an IRA, open one and fund it as much as you can. People at middle income levels may be able to use IRAs fruitfully. Persons at higher income levels will find the IRA to have few advantages, except as a place in which to roll over 401(k) accounts.
The Roth IRA is a retirement account which you fund with after-tax dollars. In other words, you don’t get a deduction for the contributions you make to a Roth IRA. However, the assets grow tax free. If you hold the Roth IRA for at least five years, you will be able to withdraw the earnings in the account tax free after you turn 59 ½ (the contributions can be withdrawn tax free, anyway, because they’ve already been taxed). You can contribute up to $4,000 to a Roth IRA in 2007 (or $5,000 if you are 50 or older), and $5,000 in 2008 (or $6,000 if you are 50 or older). However, eligibility to open Roth IRAs is limited to persons whose incomes don’t exceed certain levels (in 2007, $160,000 for married couples filing jointly and $110,000 for singles; and in 2008, $169,000 for married couples and $116,000 for singles). To make things worse, the amount you can contribute begins to shrink at lower income levels (, in 2007, starting at $150,000 for married couples filing jointly and $95,000 for singles; in 2008, starting at $159,000 for married couples and $101,000 for singles). To get a stomach ache learning more about Roth IRA contribution limits, go to www.irs.gov/publications/p590/ch02.html#d0e8975.
For serial savers: while only those persons making $100,000 or less are currently allowed to convert a traditional IRA to a Roth IRA, that income limitation will be lifted in 2010, allowing anyone to convert a traditional IRA to a Roth. If you’re at too high an income level to have a Roth IRA today, you could consider making contributions to a traditional IRA, even if you can’t deduct them, and then convert it in 2010 to a Roth IRA. You would have to pay income taxes on the earnings when you convert. Nevertheless, you’d have a head start on funding the Roth IRA. But if you have one or more other traditional IRAs funded with deductible contributions, and you try to convert your nondeductible IRA to a Roth IRA in 2010, the tax rules will deem some of the conversion to come from the other IRAs and you could be taxed as if your Roth IRA was funded proportionately from all of the traditional IRAs combined. (If this doesn’t make sense, take a look at Worksheet 1-5 in IRS Publication 590 at http://www.irs.gov/publications/p590, and your antacid budget will go through the roof.) The way to eliminate this potential complexity would be to convert all of your traditional IRAs in 2010 to Roths; but you’d have to have the cash to pay the income taxes on all of them that year. One other warning: Congress could take away the ability to convert traditional IRAs to Roths even before 2010, in order to combat the federal government’s enormous budget deficits. It’s pretty easy to take away a tax benefit that people haven’t yet received. If that happens and you’ve been funding a nondeductible traditional IRA in anticipation of converting in 2010, you will have created a nice nondeductible traditional IRA for your retirement. Alternatively, Congress could raise tax rates, and the amount of taxes you'd pay upon conversion could be greater than current tax rates would indicate. Don't ignore these risks, since higher taxes by 2010 are a serious possibility.
Contributions to a Roth IRA reduce the amount of contributions you can make to a traditional IRA—in other words, the combined cap on all IRA contributions is the $4,000/$5,000 2007 limit and the $5,000/$6,000 2008 limit.
A Roth IRA may be a good idea if you think that your tax bracket in retirement will be the same as or higher than your current tax bracket. That’s not likely to be true for many persons in their 50’s or 60’s, so the case for their having a Roth IRA may not be strong. However, a younger person in a lower tax bracket may be better off with a Roth IRA because his or her retirement income may be in roughly the same bracket as his or her current income, and the contributions will have a long time to compound tax free.
Roth IRAs have estate planning advantages, such as not being subject to required minimum distributions beginning at age 70½. That makes it easier to pass the Roth IRA account to your heirs. If you don’t need certain assets for your retirement, consider opening a Roth IRA for estate planning purposes whatever your age, if your income level makes you eligible. The account will be considered part of your estate for federal estate tax purposes (you need a net worth of at least $1 million to worry about that). But you can shelter the account's earnings from taxation during your lifetime for the benefit of your designated beneficiaries.
If you can’t tell whether a traditional IRA or a Roth IRA is better for you, flip a coin and start saving. Or open both and fund them 50/50. Either a Roth IRA or a traditional IRA is a lot better than no IRA.
Avoid Investing Retirement Account Funds in a Tax Shelter.
Retirement accounts are tax shelters. You should not invest their funds in other tax shelters because you’ll get a second shelter you don’t need. For example, deferred annuity contracts are tax shelters, but tend to have high commissions and fees. So if you invest retirement account funds (which are sheltered already) in an annuity, you’ll pay commissions and fees for an extra tax shelter that you don't need. Another example is that you should not invest retirement account assets in municipal bonds. The interest on muni bonds is generally exempt from federal income taxes (and sometimes state taxes if the bonds were issued by a municipality within the state where you live). But interest rates on muni bonds are relatively low, which is a “price” you pay for not being taxed on them. You'll get little or no additional shelter if the muni bonds are held within a retirement account. You may have to pay state income tax on some municipal bonds, and you can be taxed at the federal and state level on capital gains you receive if you sell muni bonds that increase in value (from, for example, a decrease in market interest rates). But these are relatively minor considerations. If you’re going to invest in muni bonds, do so with after-tax dollars. Use retirement account dollars for taxable investments really that benefit from being sheltered.
Now, let’s turn to our discussion of financial planners.