Primer on 401(k), Roth IRA and related decisions - Edit 2
Before modification by Aeryn at 09/11/2012 10:21:43 PM
THIS DOES NOT CONSTITUTE INVESTMENT ADVICE OR TAX ADVICE No part of the below post is guaranteed to be accurate. This is not a solicitation or an offer to sell any financial product or service.
It's also not spam, although I'm realizing now it looks like one. It's a collection of information that I've found useful in my personal savings decisions. And also my opinion. As it happens, I am licensed and qualified to dispense investment advice, but not tax advice, so please consult your tax advisor.
401(k)
Does your employer have a 401(k) plan? You should contribute, and more than the default 4 or 5%. Put in as much as you can bear. It is good because - contributions are exempt from federal and state taxes (not FICA though). It moves you into a lower tax bracket, and also reduces your income when it comes to Roth IRA considerations. Any match from the employer is essentially free money (watch the vesting period, though).
The investment choices are probably very limited and not very good, but it doesn't matter. The vast bulk of it should be in equities. If you are close to retirement (less than 10 years), then maybe 40% in fixed income. Interest rates are at their historical lows, there is no way for them to go but up (looking at a 10+ year time horizon), and when interest rates go up, the value of your fixed income funds goes down.
401(k) Roth
Your 401(k) plan may have a Roth option, where you can also after-tax money. Roth IRA is a better place to put your after-tax money (more investment choices and flexibility), but it's subject to a $5,000 annual limit and income cap ($110,000 in 2012). I personally also find after-tax contributions more painful.
Roth IRA
DO THIS one. If you don't have an account yet, open one today. It's very easy, you can do it online. Go with Fidelity if you don't have a preferred provider. It is the best long-term saving vehicle.
As far how to invest it, there are two philosophies. 1) Since Roth IRA can be seen as a proxy savings account, it should be a lot more conservative. And it's a better location for fixed income than a personal brokerage account because of its tax-free feature. (In your personal account, try to own more equities, which are taxed at lower rates than income from bonds, and you can offset their gains against losses). 2) The other philosophy is to put the highest return investments in the Roth IRA. For example, suppose you want to buy a mutual fund which is going to return 20% per year for the next 20 years (ha!). Well, ok, yeah, let's suppose you are buying a Emerging Market Small Cap fund, like Driehaus or Wasatch or Matthews Asia or Fidelity EM Discovery, then Roth IRA is the best place for it in terms of tax consequences. If it's in your 401(k), you have to pay tax (ordinary income, ~30%) on that entire future super-grown value. If it's in your personal account, you have to pay long term capital gain tax (~15-20%) on the appreciation, which will be the bulk of the value. If it's in the Roth IRA, it's all yours, tax-free, forever.
IRA
If your employer doesn't have a 401(k) plan, you should open an IRA account, which you can fund with pre-tax money. The disadvantage over 401(k) is a much lower annual contribution limit ($5000 in 2012). The advantage is your choice of a custodian and more investment choices.
IRA Rollover
When you leave a job, you get a choice what to do with your old 401(k): roll it into your new 401(k) plan, or into a Rollover IRA account. (I'm not even mentioning the "cash it out" option, you should NEVER do that. Do NOT for any reason withdraw from your IRA accounts (Roth IRA excepted if you set out to use it as a savings account from the get-go) - the only exemptions to this are: 1) You have just murdered a cop and need to flee the country, and 2) You plan to die in the next 5 years.)
Rollover IRA is the better choice here - you have much more flexibility and more investment choices.
Roth IRA Conversion
And now to what prompted me to write this post. So, Roth IRA is the best, within the limitations of an income can and $5k annual contribution, right? Except there is a loophole which throws all those caveats out the window, and that is the IRA to Roth IRA conversion.
Out of all this, I drew one slam-dunk conclusion:
Final word. In your IRA and personal brokerage, you can buy individual stocks. Don't. If you take the money to Vegas, you'll enjoy the process more. Buy mutual funds.
It's also not spam, although I'm realizing now it looks like one. It's a collection of information that I've found useful in my personal savings decisions. And also my opinion. As it happens, I am licensed and qualified to dispense investment advice, but not tax advice, so please consult your tax advisor.
401(k)
Does your employer have a 401(k) plan? You should contribute, and more than the default 4 or 5%. Put in as much as you can bear. It is good because - contributions are exempt from federal and state taxes (not FICA though). It moves you into a lower tax bracket, and also reduces your income when it comes to Roth IRA considerations. Any match from the employer is essentially free money (watch the vesting period, though).
The investment choices are probably very limited and not very good, but it doesn't matter. The vast bulk of it should be in equities. If you are close to retirement (less than 10 years), then maybe 40% in fixed income. Interest rates are at their historical lows, there is no way for them to go but up (looking at a 10+ year time horizon), and when interest rates go up, the value of your fixed income funds goes down.
401(k) Roth
Your 401(k) plan may have a Roth option, where you can also after-tax money. Roth IRA is a better place to put your after-tax money (more investment choices and flexibility), but it's subject to a $5,000 annual limit and income cap ($110,000 in 2012). I personally also find after-tax contributions more painful.
Roth IRA
DO THIS one. If you don't have an account yet, open one today. It's very easy, you can do it online. Go with Fidelity if you don't have a preferred provider. It is the best long-term saving vehicle.
- You fund this account with after-tax money from your bank account.
- The earnings (income received or increase in value) are not subject to tax as long as you wait until age 59.5 to withdraw them.
- Unlike regular IRA, Roth IRA is not subject to minimum required distributions (which start at age 70 for IRAs).
- BEST of all - after you've had this account opened for 5 years (which is why you need to do it today), you can withdraw your contributions without any tax or penalty. So, if you put in $500 today, and in 5 years, it grows to $600, you can withdraw your original $500 without any repercussions or taxes, and the $100 will remain in the account.
As far how to invest it, there are two philosophies. 1) Since Roth IRA can be seen as a proxy savings account, it should be a lot more conservative. And it's a better location for fixed income than a personal brokerage account because of its tax-free feature. (In your personal account, try to own more equities, which are taxed at lower rates than income from bonds, and you can offset their gains against losses). 2) The other philosophy is to put the highest return investments in the Roth IRA. For example, suppose you want to buy a mutual fund which is going to return 20% per year for the next 20 years (ha!). Well, ok, yeah, let's suppose you are buying a Emerging Market Small Cap fund, like Driehaus or Wasatch or Matthews Asia or Fidelity EM Discovery, then Roth IRA is the best place for it in terms of tax consequences. If it's in your 401(k), you have to pay tax (ordinary income, ~30%) on that entire future super-grown value. If it's in your personal account, you have to pay long term capital gain tax (~15-20%) on the appreciation, which will be the bulk of the value. If it's in the Roth IRA, it's all yours, tax-free, forever.
IRA
If your employer doesn't have a 401(k) plan, you should open an IRA account, which you can fund with pre-tax money. The disadvantage over 401(k) is a much lower annual contribution limit ($5000 in 2012). The advantage is your choice of a custodian and more investment choices.
IRA Rollover
When you leave a job, you get a choice what to do with your old 401(k): roll it into your new 401(k) plan, or into a Rollover IRA account. (I'm not even mentioning the "cash it out" option, you should NEVER do that. Do NOT for any reason withdraw from your IRA accounts (Roth IRA excepted if you set out to use it as a savings account from the get-go) - the only exemptions to this are: 1) You have just murdered a cop and need to flee the country, and 2) You plan to die in the next 5 years.)
Rollover IRA is the better choice here - you have much more flexibility and more investment choices.
Roth IRA Conversion
And now to what prompted me to write this post. So, Roth IRA is the best, within the limitations of an income can and $5k annual contribution, right? Except there is a loophole which throws all those caveats out the window, and that is the IRA to Roth IRA conversion.
- Remember that IRA where you rolled your old 401(k) plan? You can now convert all or part of it (as little or as much as you want) to a Roth IRA account. By "convert", I mean, move the securities from the IRA to the Roth IRA account, and pay tax (federal + states) on the value of the securities on the day you move them.
- The $5,000 annual limit? Doesn't apply.
- The $110,000 income cap? (It's actually a phase-out between $110k and $125k). Starting in 2010, it doesn't apply.
It's a bit of a racket, actually. Tax-deferred and tax-exempt accounts were designed as savings vehicles for the middle class that cost the government money in lost tax revenue - that's why there are contribution limits and income caps. Yet with the 2010 change, you can be a millionaire with $500,000 in the IRA account, convert it all to Roth IRA, and enjoy tax-free investment growth. - So suppose you move $10,000 into Roth IRA today, and in the next 6 months, the market drops, and the Roth IRA is worth only $6,000. You'll still owe taxes on the full $10,000 amount. EXCEPT - you can reconvert! You say "never mind," and move the $6,000 back into the IRA, and the tax bill is canceled.
- If you convert in 2013, you have until your tax-filing deadline in 2014 to undo it, which is October 2014 at the latest (if you apply for tax filing extension). So if in Jan 2013 you are feeling optimistic about the market, you can convert and then watch your investments for the next 1 year 10 months. If they decline in value, you should reconvert, and you've risked nothing.
- After a reconversion, you need to wait until the next calendar year to convert again (that would be Jan 2015 in our example), and the merry go around starts again!
Out of all this, I drew one slam-dunk conclusion:
- If you see the market drop significantly, like 10-20%, do the Roth IRA conversion right then! However you feel about future tax rates, this is a gift. Just make sure you can pay the taxes due out of your regular money (not the Roth IRA).
Final word. In your IRA and personal brokerage, you can buy individual stocks. Don't. If you take the money to Vegas, you'll enjoy the process more. Buy mutual funds.