Dear Liz: You recently answered a reader who wondered whether he could delay mandatory distributions from his traditional IRA because he was still working. You said correctly that he could delay taking required minimum distributions from a 401(k) but not an IRA. But as long as the questioner is working full time and meets the other tests, he could contribute to a Roth IRA. That would allow him to re-invest part or all of the required distribution. Tax would have to be paid on the distribution, but the money could continue to be invested in an account that isn’t taxed on the earnings annually.
Answer: That’s an excellent point. Withdrawals from IRAs, SEPs, SIMPLE IRAs and SARSEPS typically must begin after age 701/2. The required minimum distribution each year is calculated by dividing the IRA account balance as of Dec. 31 of the prior year by the applicable distribution period or life expectancy. (Tables for calculating these figures can be found in Appendix C of IRS Publication 590, Individual Retirement Arrangements.)
Anyone who has earned income, however, may still contribute to a Roth IRA even after mandatory withdrawals have begun, as long as he or she doesn’t earn too much. (The ability to contribute to a Roth begins to phase out once modified adjusted gross income exceeds $112,000 for singles and $178,000 for married couples.) There are no required minimum distribution rules for Roth IRAs during the owner’s lifetime. As you noted, the contributor still has to pay tax on the withdrawal, but in a Roth IRA it could continue to grow tax free.
Dear Liz: I just turned 70. Must I draw now from my IRA? I still work full time. I heard from one investment company representative that since I work, there is an exemption that I may not have to start withdrawals. Is this true?
Answer: Withdrawals from retirement plans typically must begin after age 70-1/2. You can postpone withdrawals from your company’s 401(k) plan past the typical required minimum distribution age if you’re still working, but not from traditional IRAs.
“An IRA owner must commence distributions from an IRA by April 1 of the calendar year following the year in which the IRA owner turns 70-1/2,” said Mark Luscombe, principal analyst for tax research firm CCH Tax & Accounting North America, “regardless of whether they are still working or not.”
With 401(k) plans, required withdrawals can be delayed to April 1 of the year following the year you retire, unless you’re a 5% or more owner of the business, Luscombe said.
It’s important to get this right, since failing to make required minimum distributions triggers a tax penalty of 50% on the amount not withdrawn that should have been. The required minimum distribution rules apply to all employer-sponsored retirement plans, including profit-sharing plans, 401(k) plans, 403(b) plans and 457(b) plans, the IRS says, as well as to traditional IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs. Required minimum distribution rules also apply to Roth 401(k) accounts, but not to Roth IRAs while the owner is alive.
Dear Liz: I’m working as a contractor in Afghanistan. Since we are overseas in a combat zone, our pay is nontaxable. Can I contribute some of this untaxed money to a Roth IRA and still be able to withdraw it tax free in retirement? I’ve heard that’s true, but the way I read the law it seems that the money has to come from “taxable” wages or something along those lines. I need clarification.
Answer: If you were serving in the military, rather than as a contractor, you would be able to contribute some of your untaxed combat-zone pay to a Roth IRA and have tax-free withdrawals in retirement. That’s a unique perk of the military, however.
Service members’ tax-free combat zone pay qualifies as income for purposes of making an IRA or Roth IRA contribution because of the 2006 Heroes Earned Retirement Opportunities Act, said Joseph Montanaro, a certified financial planner with USAA.
If your pay is tax free as a contractor, it’s probably because you qualify for the foreign earned income exclusion, which protects some or all of your pay from U.S. taxes (up to $95,100 for 2012), Montanaro said. Your eligibility for this exclusion has nothing to do with working in a combat zone. It has to do with your residence or physical presence abroad.
Income that is excluded this way cannot be used as compensation for the purpose of making an IRA contribution, Montanaro said. It would, however, have to be included when determining your eligibility to make a Roth contribution.
Dear Liz: I’ll be done paying off my car in a couple of months. What’s a good strategy for redirecting that money once it’s paid off? Should I use the whole amount each month to start saving for my next car, or would I be better off splitting it up and putting it into several savings “buckets” such as retirement, emergency and my next car? I’m 35, have an emergency fund equal to four months’ living expenses and only one other debt, a very low-interest student loan.
Answer: If you aren’t already contributing to a retirement plan, you should be. If you aren’t contributing enough, that should be your priority even before you pay off your debt.
Market researcher and Yale University professor Roger Ibbotson has found that people who start saving for retirement after age 35 have an extremely difficult time “catching up.” They’ve lost a crucial decade or more, and often can’t set aside enough to offset their late start.
If you are on track for retirement and are comfortable with your emergency fund, saving to pay cash for your next car is a reasonable course.
Dear Liz: My life insurance policy of $500,000 will end in four years, when I’m 63. My wife’s policy ends at age 62. Our kids are 28 and 25 and successfully launched with careers. I also have a $180,000 life insurance policy through my job that expires when I plan to retire, also at age 63. My wife and I have long-term-care insurance policies. We have $170,000 in an active investment account plus $1.4 million in our 401(k)s. Our kids also have trust funds that they will get when they turn 30 of about $80,000 each. Should I buy more life insurance for 10 to 15 years? Our estate, which is in a living trust, will pass to the kids. Our house is worth about $1 million.
Answer: The first question you must ask when it comes to life insurance is whether you need it. If you have people who are financially dependent on you, you typically do. If your wife has sufficient retirement income should you die, and vice versa, then you probably don’t.
So-called permanent or cash-value life insurance is often sold as a way to pay estate taxes, but again, it doesn’t look as if you’ll need that coverage. Congress increased the estate tax exemption limit for 2012 to $5.12 million, and that amount is tied to inflation going forward.
Still, this is a good question to pose to a fee-only financial planner, and you should be seeing one for a consultation before you retire in any case. Retirement involves too many complicated, irreversible decisions to proceed without help.
Dear Liz: I am approaching being able to retire in three years at 56, but I’m really concerned with the current market conditions. I have around $320,000 in 401(k) and 457 accounts now, all of it invested in stocks. Should I scale this back to more moderate allocations? My pension will pay me around $5,200 a month, so I do not anticipate needing to withdraw from my investments before age 59.
Answer: Even if you’ve been a die-hard do-it-yourself investor until now, it’s time to get help. Retirement decisions can be incredibly complicated, and you may not have time to recover from mistakes.
A fee-only financial planner would ask, among other things, what your current living costs are and what additional expenses you expect, such as buying another car, taking trips and so on. Those details can help determine whether your savings are adequate. The planner also would ask you how you plan to pay for healthcare in retirement, since Medicare doesn’t kick in until age 65, and an individual policy at your age could eat into that pension check. Even with Medicare, Fidelity Investments estimates, a 65-year-old couple retiring this year would need $240,000 to cover medical expenses throughout retirement — not counting any money they might need to pay for nursing home or other custodial care.
What a planner probably wouldn’t do is approve having 100% of your investments in stock at any age, even with a nice pension. You may have time to ride out another market downturn, but watching half of your life savings disappear might increase the chances you’d sell out in a panic. Having a more moderate allocation that includes bonds and cash could help cushion those market swings and keep you invested.
You can get referrals to fee-only planners who charge by the hour at the Garrett Planning Network, http://www.garrettplanningnetwork.com. If you’re looking for fee-only planners who charge a retainer or a percentage of assets, you’ll find those at the National Assn. of Personal Financial Advisors, http://www.napfa.org. NAPFA has tools for consumers at http://www.napfa.org/consumer/Resources.asp and the Financial Planning Assn. has tips on choosing a financial planner at http://www.fpanet.org/FindaPlanner/ChoosingaPlanner/.
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Dear Liz: You recently suggested an insurance salesman be reported to state regulators because he suggested a reader stop funding a 401(k) and instead fund an insurance contract with after-tax dollars. You were way out of line. It’s very likely tax rates will be going up, so it may make sense to trade a tax benefit now for a better one in the future.
Answer: You might have a valid point if the reader were wealthy enough to be funding a life insurance policy or annuity in addition to his 401(k) contributions. Wealthier people are already facing higher tax rates, and they are more likely to be in the same bracket, or perhaps even a higher one, when they retire.
The fact that the insurance salesman suggested the reader redirect his retirement contributions to the insurance contract indicates the reader didn’t have the cash flow to do both. So it’s still quite likely that the reader will drop into a lower tax bracket in retirement, in which case he’s given up a valuable tax break now for a less valuable one in the future.
A red flag should go up anytime an insurance salesperson recommends you stop funding a tax-deductible retirement plan or that you tap home equity to buy whatever he or she is selling. That indicates the product was designed for someone wealthier than you. At the very least, you should run the purchase past a fee-only financial planner — someone who doesn’t earn commissions on product sales — to make sure you’re getting the whole story.
Dear Liz: I started a new job, but unfortunately it does not offer a 401(k). I have an IRA but don’t contribute to it. What is the best way to contribute so I can discipline myself in saving for retirement? I am 47.
Answer: The best way to save for retirement is to leave the issue of discipline out of it. If you have to discipline yourself to make the right choice every paycheck, you’ll wind up spending the money rather than saving it.
Instead, put your savings on automatic. You can contribute $5,500 year to your IRA. Divide $5,500 by the number of paychecks you get in a year and set up an automatic transfer of that amount. If you’re paid every other week, for example, you would divide $5,500 by 26 paychecks to get $211.54, which is the amount you should have transferred into your IRA every two weeks.
If you can save more, then open a regular brokerage account and set up automatic transfers into that. You won’t get a tax break for your contributions, but if you hold your investments for at least one year you’ll qualify for long-term capital gains rates that are lower than regular income tax rates.
Once you’ve set up these transfers you need to keep your hands off the money. Don’t treat your retirement funds as emergency cash or tap into them for any other reason. You’re getting a late start and you’ll need every dollar you can save if you want a comfortable retirement.
Dear Liz: Recently, someone from an insurance company proposed that I stop investing through my 401(k) at work and instead invest in his insurance company contract with after-tax dollars. He claims the funds would be guaranteed so that I would never lose principal, although there would be a cap on how much I could make in any given year. His claim is that it is better to forgo the tax deduction I would get from my 401(k) contributions so that I can take the money out of this contract tax-free in 20 or 30 years. I think I am too old for this program (I am 61 now) but I thought it might be appropriate for my daughter when she enters the workforce in a few years.
Answer: You may have been pitched an equity-indexed annuity. These are extremely complex investments that should not be purchased from someone who misrepresents how they work and who encourages you to forgo better methods of saving for retirement.
Withdrawals from annuities are not tax-free. You would not have to pay income tax on the portion of the withdrawal that represents your initial contributions, but any gain would be taxable at regular income tax rates.
Furthermore, most people fall into a lower tax bracket in retirement. That makes the tax break offered by 401(k) contributions especially valuable, because you’re getting the deduction when your tax rate is higher and paying the tax when your rate is lower.
The Financial Industry Regulatory Authority, which regulates securities firms, has warned that most investors consider equity-indexed annuities and other annuity products “only after they make the maximum contribution to their 401(k) and other before-tax retirement plans.”
Even then, you probably have better ways to save. Contributions to a Roth IRA would not be tax-deductible, but withdrawals in retirement would be tax-free. If you’re able to save still more, you could contribute to a regular, taxable brokerage account and hold your investments at least one year to qualify for long-term capital gains rates, which are lower than regular income tax rates.
The other possibility is that the insurance salesman was pitching a life insurance policy that would allow you to take out a tax-free loan. Although life insurance is sometimes pitched as a retirement savings vehicle, it’s an expensive way to go. In general, you should buy life insurance only if you need life insurance. To help ensure a policy is suitable for your situation, you should take it to a fee-only financial planner—one who does not make commissions from selling investments–for review.
In any case, you don’t want to do business with someone suggests you stop funding your workplace retirement plan, and you certainly don’t want to refer him to family members. What you should do instead is pick up the phone and report him to your state insurance department.