What’s The Difference Between Roth IRA And Roth 401k?

April 04, 2018

We’ve recently received several calls on our Financial Helpline from people who entered their Roth 401(k) contributions as Roth IRA contributions in tax software and were told that they had over-contributed. Since Roth 401(k) plans are relatively new, it’s easy to get these mixed up but the differences are important and not just when filing your taxes.

What’s the same?

Let’s start with the similarities.

  • Both accounts allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years.

The differences

Now let’s take a look at the subtle, but important differences.

1. Can you contribute?

Roth 401k:

A Roth 401(k) has to be offered by your employer. If your employer offers one and you’re eligible to contribute to the 401k, you’re good to go.

Roth IRA:

A Roth IRA has income limits. (However, there is a way to get around them.)

2. How do you contribute?

Roth 401k:

If your employer offers you a Roth 401(k) option, the contributions are deducted from your paycheck for that tax year.

Roth IRA:

With a Roth IRA, you have to open the account and make the contributions yourself, either by writing a check or having an automatic transfer from your bank account. You also usually have until April 15th (April 17th this year) to make a contribution for the previous year. Not sure where to open a Roth IRA? Here are some low cost options.

3. How much can you contribute?

Roth 401k:

The total limit for employee traditional and Roth 401(k) contributions is $18,500 ($24,500 if you’re over age 50 this year) for 2018.

Roth IRA:

For IRAs, the total limit is a much lower $5,500 ($6,500 if you’re over age 50 this year). The Roth IRA contribution limit can also be reduced if your income is in the phase-out range.

Contributing to one doesn’t affect how much you contribute to the other so you can do both if you’re eligible, which means for 2018 you could feasibly be putting a combined $24,000 into Roth accounts ($31,000 if you’re over age 50).

4. What can you invest the accounts in?

Roth 401k:

With a Roth 401(k), you’re limited to the choices your plan offers but this can often include options not otherwise available like higher-yielding stable value funds and mutual funds with reduced fees.

Roth IRA:

With a Roth IRA, you can invest in almost anything, including stocks, bonds, mutual funds, annuities, and even gold coins, real estate, and your own business if you have a self-directed Roth IRA. The choices (and their fees) will depend on which financial institution you choose to use.

5. How can you get the money?

Roth 401k:

With a Roth 401(k), you’re generally limited to loans and/or hardship withdrawals before age 59 ½ if you’re still employed there and if the plan allows them. Many plans also allow you to take withdrawals at age 59 ½. You can withdraw money after you leave your employer as well.

Roth IRA:

You can take money out of a Roth IRA anytime. (that doesn’t mean there won’t be penalties or tax consequences, so keep reading)

6. Are there penalties on withdrawals?

Roth 401k:

For both types of account, Roth earnings withdrawn before age 59 ½ are subject to taxes and a 10% penalty unless you meet certain exceptions. With a Roth 401(k), withdrawals are considered contributions and earnings in the same proportion as they exist in your account. This means that if you have a balance of $20,000 but $10,000 is the amount you contributed (called the “basis”) and you withdraw $10,000, the IRS will consider 50% of that withdrawal to be earnings and you’ll be taxed and/or penalized accordingly.

Roth IRA:

One of the big differences is that with a Roth IRA, your withdrawals are considered contributions first, which is important if you need access to the any of the money before age 59 1/2. That means you can withdraw the sum of your contributions at any time without tax or penalty. Unlike with a Roth 401(k), Roth IRA earnings can also be withdrawn penalty-free for education expenses and up to $10k (lifetime limit) for a home purchase if you haven’t owned a home in the last 2 years.

7. Can you roll money from one to another?

You can roll money from a Roth 401(k) to a Roth IRA but not the other way around.

What’s the bottom line?

Roth IRAs generally provide more flexibility, both in terms of how the money is invested and withdrawn. However, Roth 401(k) accounts offer greater convenience and allow you to contribute more (and may allow you to contribute at all if you make too much money). They’re both excellent ways to shield your future income from taxes so if you’re eligible, you may want to contribute to both!

 

 

What Does Self Storage Really Cost You?

May 01, 2017

My husband and nine year old son have a new favorite television show: Storage Wars. They love watching the quirky, somewhat foul-mouthed cast of characters bid at auction for the contents of abandoned storage lockers. My guys focus on the contents of the lockers and discuss whether or not they are worth purchasing but not me. When I watch with them, I can’t help but think of the original owners of all those unused possessions and what prompted them to keep so many belongings in storage.

Most of the lockers featured on the show are full of everyday household items and furniture. The storage facility has taken possession of the unit when the original owner did not pay their monthly bill. Why did the owner rent the storage unit in the first place?

Common reasons for renting a storage unit include relocation, divorce, dislocation, military deployment and death – and increasingly, just having too much stuff. According to a Self Storage Association fact sheet, nearly one in ten (9.5%) American households rent a storage space, with about 1 in 3 renters saying they will rent for two years or longer. Even more surprising, 65% of renters have a garage, 47% have an attic and 33% have a basement at home. What is the true cost of renting that space to store all that extra stuff?

Let’s take a simple example: Taylor, age 35, recently redecorated her home, but isn’t sure she wants to get rid of her old furnishings. Her belongings have sentimental value, but they aren’t worth that much – about $2,000 – and aren’t expected to increase in value. She rents a 5’ x 10” unit for $85 per month and moves her furniture and some old toys and books, artwork and party ware into it. Assuming the rental cost of the unit goes up with inflation (estimated at 3% annually) and Taylor keeps the storage unit for 10 years, she’ll pay over $11,000 over the total period to hold on to her $2,000 worth of stuff for ten years.

What if Taylor had sold her old furniture online or at a garage sale but she only netted $1,000? Instead of paying storage costs, she used the proceeds to set up a Roth IRA and invested in a diversified, low fee mutual fund. Every month, Taylor had $85 transferred from her checking account into the Roth IRA and bought more shares of the mutual fund. Over a ten year period, the mutual fund’s average annual return was 6%. Her Roth IRA would be worth $15,235. If she kept doing what she was doing, by the time Taylor was 65 it the Roth would be worth $86,383.

Think about it. Which sounds better to you – paying over $1,000 a year to store your excess stuff or having an extra $86,000 in tax free money in retirement? Now that’s a storage war.

 

Do you have a question you’d like answered on the blog? Please email me at [email protected]. You can also follow me on the blog by signing up here and on Twitter @cynthiameyer_FF.

 

How Should You Invest In Your Roth IRA?

April 20, 2017

If you’re like many people I’ve talked to recently, you may have decided to contribute to a Roth IRA before the deadline on Tue. However, it’s not enough to open an account and fund it. After all, a Roth IRA is simply a tax-sheltered account, not an investment. You still have to decide how to invest the money. Here are some options to consider:

Use it as an emergency fund. If you don’t have enough emergency savings somewhere else, you can use a Roth IRA as part or all of your emergency fund since you can withdraw your contributions tax and penalty-free at any time and for any purpose. (Earnings are subject to taxes and a 10% early withdrawal penalty before 5 years and age 59 ½ but the contributions all come out first.) In this case, you’ll want to keep it someplace safe and accessible like a savings account or money market fund. Once you accumulate enough emergency savings elsewhere, you can invest it more aggressively for retirement.

Save for a short term goal. A Roth IRA can also be used penalty-free for a first-time home purchase (up to $10k) or education expenses. If you intend to use your Roth IRA for either goal in the next few years, you’ll probably want to keep it in savings.

Choose investments that complement your other retirement accounts. For example, you may want to use your Roth IRA for investments that may not be available in your employer’s plan like real estate, gold, commodities, emerging markets, international bonds, and microcap stocks. They can help diversify a more traditional mix of bonds and large and small cap US and international stocks.

Choose a more conservative mix for early retirement. If you’re planning to retire before becoming eligible for Medicare at age 65 and are planning to purchase health insurance through the Affordable Care Act (assuming it hasn’t been repealed and replaced), a tax-free Roth IRA can help reduce your insurance costs because the insurance subsidies are based on your taxable income. Since a large percentage of the account may be coming out over a relatively short period of time, you may want to invest it more conservatively than your other retirement investments.

Choose more aggressive investments for long term tax-free growth. If you’re not planning to withdraw your Roth IRA early, you may want to take the opposite approach and use it for the most aggressive parts of your portfolio. That’s because the account is growing tax-free and may be the last to be touched. (It helps that Roth IRAs aren’t subject to required minimum distributions.) Some examples of more aggressive investments would be emerging market and small and micro cap stocks.

Keep it simple. If this all sounds confusing and you want to just keep your investing as simple as possible, you can look at each account separately. For example, you might choose a target date retirement fund for your Roth IRA since it’s a fully diversified one stop shop that automatically becomes more conservative as you get closer to the retirement date. All you need to do is pick the one with the date closest to when you think you’ll retire and set it and forget it. If you want something more customized, you can also use a robo-advisor or design your own portfolio based on your particular risk tolerance.

Like all financial decisions, your choice begins with your goal. Are you trying to save for emergencies? Do you plan to use the account early or late in your retirement? Or do you just want to keep things as simple as possible?

 

 

 

Why a Roth IRA is a Great Graduation Gift

March 20, 2017

Are you bored with giving your teenage child gift cards and electronics for presents? Do you have a graduation gift to offer but don’t just want to give cash? This year, instead of something they’ll spend right away, consider giving the teenager in your life a contribution to a Roth IRA.

A Roth IRA is an after-tax retirement account which can be used for much more than retirement. As long as the account has been open for at least 5 years, earnings and withdrawals are tax-free after age 59 ½.  Anyone who has earned income below certain limits ($118,000 for a single filer) can contribute the lesser of their total income or $5,500 in 2017.

Does your teenager work?

The key is that your teenager has to have earned income. A teenager with a part-time job could contribute their total earnings to a Roth. Gifts don’t count, but you and other friends and family can make gifts to your teenager to cover the allowable Roth contribution.

For example, if your teenager earned $1,500 working at a restaurant, she is eligible to contribute up to $1,500 to her Roth for that year. Remember — you can gift your teenager the money for the contribution, though. In fact, you could even write a check directly to their Roth account.

A W-2 from an employer is proof of income. However, if your teenager’s income comes from sources like babysitting or moving lawns, keep careful records of how much they’ve made. FYI, your teenager does not have to file a tax return in order to make a Roth IRA contribution but does need to keep a record of that contribution. If they have paid income taxes through payroll deduction, they may want to file, though.

Why give a teenager a retirement account?

1. Tax-free growth can help make them rich.

Let’s say you gift your teenager $500 for their Roth IRA as a high school graduation present. Those funds are invested in a diversified, low fee index fund which earns 8% per year. In fifty years, thanks to the value of compounding, that investment would be worth $23,451. (See calculation.)

Do that every year instead of giving a wrapped gift (or until they can take over contributing on their own). After 50 years, your $25,000 worth of gifts would be worth $310,336. (See calculation.) That’s much better than a new telephone, isn’t it?

2. They can withdraw contributions at any time without taxes or penalty.

A Roth IRA account holder can withdraw their original contributions – but not the growth – in their account at any time without taxes or penalty. If needed, they can withdraw those contributions later on to pay for graduate school, fund the down payment on a home, cover expenses while on maternity leave or even handle an emergency. The growth on the investments could stay in the account, continuing to grow tax-free for retirement. For more explanation of the withdrawal benefits, see this post.

3. It’s not counted on the FAFSA.

The Free Financial Application for Student Aid (FAFSA) does not consider a Roth IRA account as an asset the student (or a parent) is expected to spend. However, if your student takes a withdrawal of earnings from their Roth, those earnings are counted as income for the next year’s FAFSA. If you need to access earnings to pay college expenses, the key is to wait until the student’s final year to take the withdrawal. For more tips on how assets and income affect financial aid, see this blog post.

Are you convinced? The next step is to open a Roth IRA at a reputable, low fee financial services firm. (See suggestions here on how to choose one). If your teenager isn’t 18 yet, you’ll need to open the account for them. When your teenager is about to turn 18, make sure to share this guidance with them – and keep helping them contribute to their Roth IRA if you can!

 

Do you have a question you’d like answered on the blog? Please email me at [email protected]. You can follow me on the blog by signing up here, and on Twitter @cynthiameyer_FF.

 

 

4 Financial Moves I Wish I’d Made in My 20’s

August 24, 2016

Whenever I have the opportunity to work with an employee who is just starting their career by calling the Financial Helpline to make sure they’re making all the right financial moves, I can’t help but gush a little bit. This simple phone call often sets into motion actions and habits that will legitimately change the course of this person’s life. I often wonder how my life would have been different if I’d had the Financial Helpline to call for unbiased financial guidance from someone who would have given me a straight answer, no strings attached. If I could turn back time, here’s what I’d have done differently:

Joined an HSA plan as soon as it was offered. I still remember the hoopla in the financial services community when health savings accounts were first rolled out, but I didn’t get it. I wasn’t yet a financial planner, so I didn’t fully understand why anyone would sign up for a health insurance plan that could cause them to pay full price for the first couple thousand dollars in healthcare expenses each year, and didn’t even consider signing up. Similar to many people’s logic, I avoided the HSA due to the high-deductible without taking into consideration the fact that my employer was willing to fund some (or all) of that deductible and based on my lack of health issues, I was unlikely to spend even that. By the time I realized the beauty of the HSA, I only had a couple years before it was time to switch to more comprehensive coverage since I knew my costs were going to increase.

Opened and funded a Roth IRA. I’ll never forget the day I stepped into my co-worker Tom’s office and asked him to open a brokerage account for me to begin investing in an index fund with the extra money I had been paying toward my low-interest student loan. Tom looked at me and said, “Are you sure you don’t want to use that money to fund a Roth IRA instead of a taxable account?” I nodded, thinking that I didn’t want to kiss that money goodbye for the next 35 years, so I opted for a regular brokerage account.

I was wrong. Had I instead used that money to fund a Roth IRA, I still would have had access to my deposits without tax or penalty, and I would never have to pay taxes on the growth of my investments after age 59 1/2. When asked by young people about priorities in savings, I never waiver in my answer:

  1. First get the match in your 401k. It’s free money, enough said.
  2. Then max out your HSA. If you don’t need the money tax-free for healthcare expenses, you can access it like a normal retirement account after age 65. It’s also often free money.
  3. Then fund a Roth IRA. While you are still under the income limits and the money has years to grow, take advantage of it.

Created a pet care fund. I adopted my first cat, Hattie May, my senior year of college and over the course of her short 13 year life, I estimate that I spent at least $5,000 on her care. The worst part about this is that I should’ve spent more to take care of her issues, but because I didn’t have money set aside, I skimped. This is something I’ll forever regret and I often wonder if she’d still be alive today if I’d prioritized saving for her costs. Here’s what I should’ve done: find out the cost of pet insurance for annual visits plus emergency care and then instead of buying the insurance, set that amount aside each month into a separate savings account. That way when things did come up, I would’ve had money available and if nothing came up, I wouldn’t be out the money.

Spent less money on cheap clothes. Confession: I engage in retail therapy with the best of them. I just wish I could go back to those early years and made a few less trips to stores like Old Navy and Target, where I succumbed to merchandising brilliance and bought clothes I maybe wore twice. I could’ve re-routed that money toward Hattie’s fund or a Roth IRA. The worst part is that when I went through periods of closet-cleaning during those years, I didn’t receive any tax benefit from donating those clothes as my itemized deductions weren’t high enough to qualify.

What I wish I’d done is put a limit on myself for impulse shopping. I don’t believe in going cold turkey. I do think we can all handle moderation though.

I can’t turn back time, but I can share the wisdom of my mistakes so here’s hoping you can learn from mine. What financial moves do you wish you could do over? Let me know on Facebook or send me a tweet.

Did you know you can sign up to receive my blog posts every week, delivered straight to your inbox? Just head over to our blog main page, enter your email address and select which topics or bloggers’ posts you’d like to receive. Obviously, I suggest at least “Posts from Kelley.” Thanks for reading!

 

Don’t Believe Everything You Hear

July 01, 2016

I’m the kind of person who will always try to listen with an open mind to different points of view and find something to learn from the speaker. I hear a lot of theories that way, some which appear to be myths, superstitions or misinterpretations, and some of which offer a refreshing change in perspective. In many cases, what’s true for most people might not be true for everyone. When sifting through financial advice, make sure to ask yourself if that guidance makes sense for your situation. Here are three common examples of financial guidance where you might want to think about things differently:

Question: I’ve been told that I should always have a mortgage so that I can get the mortgage interest deduction. Is that always true?

My view on it: MYTH

For each $1 in interest they pay the mortgage company, the typical family gets ~$.20 in tax relief (using the tax rate as the real payback number). To me, you lose $.80 on the dollar by paying interest. Plus if you have no mortgage, your embedded cost of living is permanently lower, so your accumulated savings and investment dollars can last a whole lot longer. Financial advisors typically say disciplined, long term investors could do better in the stock market rather than using savings to pay off a mortgage, but I’ve observed that most people prefer to have the peace of mind that comes with low or no debt so I’m not a huge fan of carrying a mortgage just to get a tax deduction.

Question: I should never contribute more to my 401(k) than my company’s matching contribution. Once I reach that, I’m told I should open a Roth IRA. Is that the right choice?

My view on it:  MYTH

Most people I see who try to implement this, forget one critical part – funding the Roth IRA. The problem with this guidance is that many people never get around to funding the Roth IRA every time they get paid. Once their paycheck hits their checking account, it gets accounted for in so many other ways.  I’d prefer to see people shoot for the maximum 401(k) contribution ($18,000 this year, plus $6,000 in catch-up contributions for those over 50) and once they max out the 401(k), THEN contribute to an IRA.

Also, maxing out the 401(k) doesn’t have to be an instant thing. You can increase your contribution level by 1-2%/year until you get there. If you have a rate escalator in your plan, sign up for it today!

Question: If I close out some of my credit cards, that should improve my credit score, right?

My view on it:  MYTH

Well, it’s not that simple! There are a lot of factors that go into your credit score. A few great places to see the multiple factors are CreditSesame.com and CreditKarma.com.

If the credit cards you want to close are relatively new, closing them may help you because it could increase your average “age of credit” (how long your open accounts have been open). But it may decrease your score because it reduces your overall credit limits and if you carry balances, it makes your “utilization ratio” higher. That’s the amount of overall credit balances divided by overall credit limit. Keeping that ratio below 25%, ideally at 0%, will be additive for your credit score. If closing accounts increases your utilization percentage, then closing the accounts can harm your score.

The thing to take away from this is that credit scores are fluid things. They change constantly. But if you take the time to review your scores and factors on the sites above, you will be able to make well informed decisions that impact your credit score.

As you go about living your life, learn how to discern the differences between good, solid personal financial management and misapplied financial principles. How? Ask a financial planning professional, pose a question on our Facebook page or ask me a question in the comments section below. Having the facts on your side can help save you from the many conflicting theories of managing your personal financial life.

 

The 3 Most Important Things Resident Physicians Can Do With Their Money

May 25, 2016

Updated for 2019 numbers

You’ve made it through eight grueling years of schooling, been accepted into a residency program, and you finally have a salary. Even though the average salary for a first year resident is a little over $50,000, it can still feel like hitting the lottery. It’s easy to start thinking about how you’ll spend that money on luxuries you’ve postponed like a nice car or an apartment in an upscale neighborhood while deferring your student loans until you’re making real money in your chosen field. After all, your friends who chose business or law have been living it up through their 20’s and you’re ready to join them.

Not so fast

Before you find room in your budget for things you may not be able to enjoy to the max while working 80+ hours per week, first make sure you’re setting yourself up for optimal financial success. I’m not saying you shouldn’t treat yourself to that luxury car you’ve been dreaming of ever since that first day of class, but first make sure you’re making the most of the savings opportunities you may not have available after residency.

I ran these past my physician husband just to make sure I wasn’t being unrealistic and he agrees. Here are three really important things you should set up before you make your residency budget.

1. Max out your Roth IRA. Take advantage of your lower salary by contributing the full $6,000 allowed into a Roth IRA. There are income limits that could eventually prohibit you from depositing to this account (they start at $122,000 for single people in 2019), so use it before you lose it. A Roth gets money into savings after tax, then allows the money to grow tax-free for life. For eventual high income earners, it’s especially critical to contribute while you can and you’re young, when the money has lots of time to grow.

2. Start paying your student loans. It can be tempting to postpone those payments as long as you can, but I caution against waiting until you feel like you can better afford it. First of all, you’re probably going to be working so much over the next three to four years that you won’t really miss the money, but second of all and more importantly, you’ll avoid throwing money away on interest. It’s all about making your money work harder for you, and using it to pay down loans with an interest rate of 6% or more in some cases can even exceed what you might earn investing the money.

3. Contribute at least to the match in your hospital’s 401(k) or 403(b) plan. Just because you don’t plan to stay at your residency hospital for the rest of your career doesn’t mean you can’t or shouldn’t participate in their retirement savings plan while you’re there. You get to take that money with you when you leave.

Most hospitals offer some type of match for employees who contribute and unless they have a longer than average vesting schedule, that match will be yours when you’re done as well. That’s free money, so don’t pass it up. If you can afford to save more than the match, consider doing so. Time is on your side right now and the more you can save while you’re young, the more the effect of compound interest will have on your future savings.

Becoming a physician in the first place is a great way to ensure a prosperous future for yourself and your family. But even doctors are prone to over-spending and under-saving, especially as the competing costs of real life (buying a house, kids, college, travel, etc.) set in after residency. By buckling down for these last few years, you can doubly ensure your long-term financial security. After all, I’ve never had anyone tell me they regretted saving more money.

 

 

3 Reasons To Make After-Tax Contributions To Your Retirement Plan

April 25, 2016

Updated for current tax figures

Are you lucky enough to have the option to save after-tax money in your employer’s retirement plan? Most employees probably haven’t given it a thought, and not many utilize the option to save more than the current $18,500 pre-tax annual employee contribution limit (plus another $6,000 if you are 50 and older).

In fact, many people are not even aware that they may be able to save additional money in their employer-sponsored retirement plan, in some cases up to the annual total defined contribution limit (from both employee and employer) of $55,000 (plus $6,000 catch up if 50 and older) or 100% of your compensation, whichever is less. Sure, the likelihood of saving that much for many people might be small.

However, if you are already contributing the maximum in pre-tax and Roth contributions, here are some reasons to save more after-tax:

Automatic savings

Saving for an early retirement or financial independence? Let’s face it. It’s unlikely you’d save that much or invest on such a consistent schedule if you had to write a check every two weeks to a mutual fund company.

That’s one reason your employer can be your best financial services provider. Saving after-tax money in your retirement plan can be as easy as clicking a button or signing a form to choose what percentage of your salary you want to save. Every paycheck, you’ll defer money into after-tax savings and invest them in plan funds, just like your regular contributions. Little by little, you’ll save and grow that extra money without having to think about it.

Ability to withdraw contributions

You should generally be able to withdraw after-tax voluntary contributions, subject to the plan guidelines on withdrawals, even before you’re 59 1/2 and without meeting a specific need like you often do for a hardship withdrawal. That means if you have an emergency, you will be able to access those funds.

However, you may not be able to withdraw associated earnings growth, and if you are, those earnings – but not your original contributions – would be subject to taxes and a 10% penalty if withdrawn prior to age 59 1/2.

Tax-free rollover to a Roth IRA

You’ll reap the biggest rewards from your after-tax contributions when you leave your company or retire. Assuming you’ve been saving for a while, your after-tax balance will contain two components: your original after tax contributions and the tax-deferred earnings growth on those contributions. The IRS allows you to separate those two components out during the rollover process, so you can do a direct rollover into multiple destinations: rolling the tax-deferred earnings growth into a traditional IRA and rolling your after-tax contributions into a Roth IRA.

That’s right. You read that correctly. Your after-tax voluntary contributions can be rolled into a Roth IRA, where any future earnings growth will then be tax-free (assuming you leave the money in the Roth for at least five years and until after age 59 ½ ). You may even be able to convert your after-tax contributions immediately to Roth and have all future growth tax-free (but then you give up the ability to withdraw it early).

Here’s an example: Jane is already contributing the maximum $18,500/year to her pre-tax 401(k) plan at XYZ Company. She wants to save extra for retirement, so she saves an additional $10,000 annually in after-tax voluntary contributions in the plan.

After 10 years, Jane has about $144,000 from her after-tax contributions ($100,000 in contributions and $44,000 in growth). She also has about $260,000 in pre-tax savings and growth from contributing the maximum. When she leaves XYZ to take a new job, she can roll her plan balances into multiple destinations: $100,000 into a Roth IRA and $304,000 into a traditional IRA or her new employer’s 401(k) plan.

Fast forward another 15 years to when Jane retires. Without adding any more money to her Roth IRA and receiving a 7% return, her account is now worth about $285,000. That’s an additional $185,000 of tax-free growth, all because she originally saved after-tax money in her 401(k) plan.

 

 

Did You Contribute Too Much to a Roth IRA?

March 09, 2016
Updated June 14, 2017

One of the downsides of the Roth IRA is that there are income limits that preclude high income earners from contributing to these accounts. But for people on the cusp or for those who unexpectedly end up earning more than they planned (or who get married during the year and only discover after the fact that they now exceed the limits), it’s actually quite common to find out after they file their income taxes that they were actually ineligible to contribute the year before.

Luckily, the IRS understands that this can happen so there are ways to fix it, but you have to take certain steps to minimize the tax consequences and avoid penalties. Here are your choices if you contributed to a Roth IRA and then found out later that you were ineligible for the contributions because you made too much money in the year of contribution: Continue reading “Did You Contribute Too Much to a Roth IRA?”

Roth IRA or Roth 401(k)?

February 18, 2016

We’ve recently received several calls on our Financial Helpline from people who entered their Roth 401(k) contributions as Roth IRA contributions in tax software and were told that they had over-contributed. Since Roth 401(k) plans are relatively new, it’s easy to get these mixed up but the differences are important and not just when filing your taxes. Let’s start with the similarities. Both accounts allow you to contribute after-tax dollars that can grow to be tax-free after age 59 ½ as long as you’ve had the account for at least 5 years. Now let’s look at the differences: Continue reading “Roth IRA or Roth 401(k)?”

Don’t Let a Backdoor Roth IRA Become a Trapdoor IRA

February 03, 2016

Updated February, 2018

I was talking with a married couple the other day who were happy that they both made high incomes but unhappy that they could not contribute to Roth IRAs and enjoy some tax-free income later in retirement. According to IRS rules, married couples who file their taxes jointly cannot contribute to a Roth IRA when their combined incomes exceed certain amounts.

However, they perked up a bit when I mentioned the possibility of still contributing to a Roth IRA – even with their high incomes – using an idea called a “backdoor” Roth IRA. It works like this: even though the IRS has an income limit on Roth IRA contributions, there is no income limit on Roth IRA conversions from a traditional IRA. So step one would be to open traditional IRAs (one for each of them) and contribute up to the annual maximum amount to each traditional IRA.

Step two would then be to convert their freshly funded traditional IRAs into Roth IRAs and pay tax on any growth that took place inside the traditional IRAs between the time they deposited money into them and the time they converted them to Roth IRAs (which should be close to nothing, assuming the steps are done within a week of each other). That’s how the “backdoor Roth IRA” works in its simplest form. But there may be a catch…

Pre-existing traditional IRA balances complicate matters

As with any financial strategy that may sound a little too good to be true, the backdoor Roth IRA strategy comes with an expensive gotcha if not done properly. Thanks to the IRS pro-rata rule, taxes on a converted traditional IRA are due not just on the funds being converted, but may also be due on any other non-Roth, never-taxed IRA monies, too.

As with any financial strategy that may sound a little too good to be true, the backdoor Roth strategy comes with an expensive gotcha if not done properly

For instance, suppose you also had a 401(k) from a previous job worth $45,000 that you rolled into a traditional IRA after leaving that job. Using the backdoor Roth IRA strategy, you deposit $5,500 of after-tax money into a separate traditional IRA and then quickly convert that $5,500 to a Roth IRA.

At first, it seems this conversion is tax free since the $5,500 traditional IRA didn’t grow to more than the original $5,500 before you converted it to a Roth IRA. The catch is that the pro-rata rule requires you to consider all untaxed traditional IRA money that you have, not just the money that you are converting when calculating any tax you may owe on the conversion.

Running the numbers

In this case, the after-tax $5,500 IRA contribution would be approximately 11% of your total traditional IRA funds ($5,500/[$45,000 + $5,500]), which means the IRS will assess taxes due against 89% of the $5,500 conversion. Instead of a $5,500 Roth IRA conversion that was more-or-less tax-free (no growth in the account yet), you will instead owe taxes on just over 89% of the $5,500 or $4,895, which would be taxed as ordinary income.

Avoiding the trapdoor

So how does one avoid this backdoor trapdoor? Ideally, anyone considering a backdoor Roth IRA should avoid rolling over any old 401(k) dollars into a traditional IRA until the calendar year after the conversion. If you’re going to use this as an ongoing strategy, you could either leave old 401(k)s in their old plans or roll them into your existing 401(k). If you’ve already rolled an old 401(k) into an IRA, you may be able to roll these funds into your current 401(k), assuming the plan allows for these incoming rollovers.

What if you have a traditional IRA that you’ve made past contributions into from years past? Well, you’re out of luck. You can still do the backdoor Roth IRA, but it won’t be tax-free.

Even though your income exceeds the limits, you can still contribute to a Roth IRA. You just have to use the backdoor. However, the key to a tax-free backdoor Roth IRA contribution is making sure there are no other untaxed traditional IRA dollars lurking in the background, ready to turn your backdoor Roth IRA into a taxable trapdoor IRA.

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