Last time, I covered the differences between Traditional and Roth retirement accounts. Today, I’ll be talking about IRAs and workplace retirement accounts in general (I’ll get to the specifics of the 401k, 403b, 457b, and 401a in a future post).
Everybody is eligible to open an IRA (all other retirement accounts can only be offered through your employer). You can invest your IRA money in virtually anything, but the most commonly used investment vehicles are stocks, mutual funds, ETFs, and bonds.
For 2015, the maximum amount of money you are allowed to contribute is $5500 (or, if you are 50 or older, $6500). However there are some restrictions based on your modified AGI. For a traditional IRA, if your AGI exceeds a limit and you have a retirement plan at work, then you may not be able to deduct your contribution from your taxes (which is the entire point of using a traditional IRA). From the IRS website,
|If Your Filing Status Is…||And Your Modified AGI Is…||Then You Can Take…|
head of household
|$61,000 or less||a full deduction up to the amount of your contribution limit.|
|more than $61,000 but less than $71,000||a partial deduction.|
|$71,000 or more||no deduction.|
|married filing jointly or qualifying widow(er)||$98,000 or less||a full deduction up to the amount of your contribution limit.|
|more than $98,000 but less than $118,000||a partial deduction.|
|$118,000 or more||no deduction.|
|married filing separately||less than $10,000||a partial deduction.|
|$10,000 or more||no deduction.|
|If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status.|
Now, if you do decide to make a non deductible contribution to an IRA, then the IRA has a basis (just like how assets in a brokerage account have a basis). This basis will cause a lot of headache when it comes to filing taxes. Also, while you do get a slight advantage over a taxable brokerage account because you are not taxed on capital gains and dividends from investments inside an IRA, you will never be able to realize long term capital gains from your IRA investments – IRA withdrawals are always taxed at normal income rates, not long term capital gains rates. So there is seemingly no reason for you to make a non deductible contribution to a traditional IRA, but actually, there is one compelling reason for high earners, which I’ll get to after I introduce the Roth limits.
For a Roth IRA (taken from the IRS website),
|If your filing status is…||And your modified AGI is…||Then you can contribute…|
|married filing jointly or qualifying widow(er)||
|up to the limit|
> $183,000 but < $193,000
|a reduced amount|
|married filing separately and you lived with your spouse at any time during the year||
|a reduced amount|
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year||
|up to the limit|
> $116,000 but < $131,000
|a reduced amount|
Hence, if you make too much, you may not be able to contribute at all. At least, not directly. But there is a workaround, which people call the backdoor Roth.
Update 1/23/2015: I forgot to mention one of the most important characteristics of Roth IRAs. You can withdraw your contributions at any time, for any reason, without any penalties or tax consequences (because you already paid taxes on the contributions). And the IRS is generous and says that you are always pulling out contributions first. For example, suppose you contributed $5500 in both 2013 and 2014. With some investment gains, your balance grows to $12,000. You can withdraw up to $11,000 without any taxes or penalties. Once you withdraw anything more than that, then you will owe penalties and taxes because you are now withdrawing earnings (unless you meet one of the exceptions for penalties and or taxes on early withdrawal of earnings from Roth IRAs).
The Backdoor Roth
Remember that you can always contribute to a Traditional IRA, no matter how large your MAGI. If you cannot contribute to a Roth, then you will not be able to deduct your traditional IRA contribution. But that’s okay. After contributing to a traditional IRA, you immediately convert your traditional IRA to a Roth. Remember that your non deductible contribution to a traditional IRA establishes a basis for the traditional IRA. When you convert your traditional IRA to a Roth, you owe taxes on the difference between the conversion value and the basis. To minimize this difference and taxes owed on the conversion, you should convert your traditional IRA to a Roth as soon as possible. Assuming there was no such difference, you have effectively made a Roth contribution – you were taxed on the money you put in (because it wasn’t deductible), and now that money is in a Roth account, where it will grow tax free forever.
Now there is one complication to this backdoor. The IRS treats all of your Traditional IRAs, held at all of your brokerages, as one giant traditional IRA. So if you have made deductible contributions to a traditional IRA in the past, then you will owe taxes pro-rata on the contribution. For example, if your nondeductible traditional IRA contribution is only 10% of the money in all of your IRAs, then only 10% of the Roth conversion amount will be tax free, and you will owe tax on the other 90% of the conversion amount (it will be treated as income for that tax year). So the more deductible contributions you’ve made to your IRAs in the past, the less it make sense to pursue the backdoor Roth.
There is one possible solution to this problem. Some workplace retirement plans allow you to roll in your traditional IRA funds. If that’s the case, then you could roll in all of your traditional IRA money into your workplace retirement plan, and have no deductible contributions left in the IRA. However, you should be cautious with this approach, as many workplace retirement plans have poor fund selection.
Common Characteristics of Workplace Retirement Plans
[For this discussion, I’m going to use 401k as the placeholder for 401k, 403b, and 457b. The 401a is different from the others – I’ll discuss this tomorrow]
Generally speaking, a 401k will only offer a limited selection of funds which have a higher expense ratio than what you can find in a brokerage account or IRA. There are some 401k’s that offer a “self directed” option that give you some more freedom with the fund selection, but I’m pretty sure it’s still nowhere near as good as the free range you get outside a 401k.
So why would you want to use a 401k? The funds generally cost more than those you can find in an IRA, and the IRA offers the same tax advantages as a 401k. There are two big reasons: the employer match, and the higher contribution limit.
Many employers that offer 401k’s to their employees offer their employees a match on their contributions. It is typically something along the lines of a 50% match for the first 6% of their salary. So if you contribute 6% of your salary to a 401k, then your employer will contribute 3% of your salary as well. [Employers have some incentive to do this – the matching contribution is tax deductible for them]. This is free money [well technically, not really – the employer has probably already analyzed the rate at which employees actually utilize the 401k match, and used this expected value in figuring out the total cost of offering you a job and the associated workplace benefits. So really, it’s not free money, because they’ve lowered your salary to compensate for the expected cost of offering you a 401k match. But it’s much easier to refer to it as free money, and I will refer to it as such]. You will never find this kind of risk free guaranteed investment return anywhere else! Always maximize your match. Even if you think you can’t afford to live without it (because chances are, you probably can if you prioritize saving for financial independence/retirement over spending now). Even if you have high interest rate debt (because your 401k match has a much higher return than your debt!).
Higher Contribution Limit
For 2015, you can contribute $18,000 to a 401k. That’s over 3 times as much money you can contribute to an IRA! Generally speaking, the higher contribution limits (and associated tax savings) and the employer match make a 401k worth the typically high expense ratio funds available. There are, of course, exceptions. A general rule of thumb is if the product of multiplying the difference between the expense ratio of your fund of choice in a 401k and the expense ratio of a similar fund available in your IRA, by the number of years you anticipate working at that employer, is less than 30%, you should still use your 401k. As an example, if your employer’s 401k offers VTSAX with a 1.05% expense ratio (when you can find it outside the 401k with a 0.05% expense ratio), and you anticipate working for 20 years at your employer, you should still use your 401k because (1.05% – 1%)*20 = 20% < 30%. Once you leave your employer, you can rollover your 401k money into an IRA, and then choose low cost funds there. Your 401k may allow for such rollovers while you are still employed there. But it is not legally required for them to allow it.
Tomorrow I’ll cover the specifics of each of the workplace retirement plans.