Q: Last year, I briefly worked for a local school district that had a pension fund. Participation was mandatory. I contributed only $650 in the four months I worked there.
But when I tried to make my usual tax-deductible IRA contribution for the year, my bank said that brief participation was enough to prevent me from contributing. My income was more than $100,000 so I’m looking for ways to reduce my tax bill.
Is what the bank said true â€” am I out of luck?
A: Yes, if what you want is a tax deduction, said Nicholas Kaster, a senior analyst with tax research firm CCH Inc.
Anyone who is an “active participant” in a workplace retirement plan for any part of a tax year faces significant limits on how much of an IRA contribution, if any, may be deductible.
For single filers, the ability to deduct a contribution begins to phase out at $45,000 and disappears entirely at $55,000; for married filers, the phase-out range is $65,000 to $75,000. (These figures are for 2004 contributions, which can be made until April 15 of this year.)
That does not mean, however, that you can’t contribute to an individual retirement account â€” just that you can’t deduct your contribution. Anyone who has earned income can make a nondeductible contribution to an IRA.
If your income is below certain limits, you might consider contributing to a Roth IRA, which offers tax-free withdrawals in retirement. You can contribute as much as $3,000 for tax year 2004 if you are single and your income is less than $95,000 or if you are married and your income is less than $150,000. (Your ability to contribute to a Roth phases out as your income rises; singles with incomes of more than $110,000 and marrieds with incomes of more than $160,000 can’t contribute.)
With all IRAs, you can make an additional $500 “catch-up” contribution if you are 50 or older.
Q I am 30 years old and have saved $65,000 in my former employer’s 401(k).Â Â I recently switched jobs and am trying to decide where to put this money. I don’t want to roll it over into the new employer’s plan because the investment choices are not as good.Â Â Can I roll it over into an IRA?Â Â Why would I want to do this rather than just leave it with the former employer?
A: First, congratulations on not touching your 401(k) when you left your old employer! More than half of young workers cash out their retirement funds when they change jobs, according to Hewitt Associates research, and the damage to their future retirement security can be severe. Not only do they incur big tax and penalty bills for the early withdrawals, but they lose all the future tax-deferred returns their money could have earned.
If you want more investment choices than your former employer’s plan provides, you might consider rolling the old 401(k) into an IRA. The brokerage where you open the IRA can help handle the details. Another reason people opt for rollovers is for simplification purposes: they may have a number of 401(k) accounts with different employers, and want to consolidate their money in one place. Consolidation makes tracking your money easier and can help you reduce administrative or custodial fees, as well.
Using an IRA rather than a 401(k) has a significant drawback, however: your retirement money may not be as protected if you’re sued or you file for bankruptcy. The bankruptcy reform package just approved by Congress limits the amount in an IRA that can be protected from creditors to $1 million. If you think you’ll save more than that–and given what you’ve accomplished so far, there’s a pretty good chance you will–you might consider leaving your money in a 401(k), which is protected by federal retirement law from creditors.
Q: I recently received compensation for serving as executor for a deceased neighbor’s estate. The amount was just under $10,000. I am 72, single, with few assets. What is the best way to invest this money so I don’t wind up paying a chunk in taxes?
In the retirement community where I live, this is a common question, because many residents serve as executors for their neighbors, and all have very modest income.
A: The income you receive as an executor or personal representative is taxable as income in the year you receive it, and there’s not much you can do about that. What you’re probably asking is how to minimize future taxes on any gains this money might generate.
One of the easiest choices, if you really don’t want to pay any taxes, is to simply invest in a tax-free money market account. These accounts typically invest in insured municipal bonds with little risk of loss, and your money is accessible whenever you need it.
What you probably don’t want to do is invest in an annuity. These are often pushed on seniors who want tax deferral, but annuities usually come with relatively high expenses and surrender charges that could seriously eat into your stash if you needed to withdraw money.
Before you do anything, though, you might want to have a chat with a tax professional about the implications of your investment. You may be overestimating how much this money will cost you. If you’re in the 15% tax bracket, for example, you may be better off in a taxable money market account that earns a higher return. Currently, taxable money market accounts are averaging better than 2%, while tax-free money markets average less than 1%.
Many seniors get in trouble with inappropriate investments in trying to avoid a tax bite that’s really little more than a nibble.
Q: I am a 23-year-old who recently received a $20,000 gift from my parents for a future home down payment. I won’t be ready to buy for about five years, and in the meantime I would like to put the money in a low-risk, high-liquidity investment.
I’m learning toward investing in an index mutual fund tied to the Standard & Poor’s 500 benchmark of large-company stocks. Is this the best use of my money given my intentions?
A: It’s almost refreshing to hear someone refer to stocks as a “low-risk” investment, reminiscent as it is of the go-go market of the late 1990s. Ah, those were the days.
But reality hasn’t changed: Stocks and stock mutual funds weren’t low-risk then, and they aren’t low-risk now. They’re no place to put money you’re going to need in the next 10 years.
Put the cash in a money market or a “laddered” portfolio of certificates of deposit (where the money is divided among CDs that mature at different times).
Then sate your desire to get into the market by contributing as much as you can to your workplace 401(k) and a Roth IRA. Invest that money in mutual funds indexed to the S&P 500, with perhaps a little bond and cash exposure on the side.
You’ll have plenty of time to ride out the ups and downs of the market over the next 40 years until you retire.