Ask Liz Weston

Get smart with your money

Retirement

Use windfall to boost retirement savings

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Dear Liz: What would you suggest that someone do with $20,000 if the someone is closer to 40 than 30, single, with $100,000 of student loan debt and a $250,000 mortgage? My salary is around $100,000 a year. I have an emergency fund equal to six months of expenses and I make an annual IRA contribution since my employer doesn’t offer a 401(k) plan. Should I accelerate my student loan payments, since the interest isn’t tax deductible for me because my income is too high? Or should I invest instead? If I invest, should I put it all in a total market stock index fund or is that too risky?

Answer: Even if you’re making the maximum annual IRA contribution of $5,500 (people 50 and older can contribute an additional $1,000), you’re probably not saving enough for retirement. You can check the numbers using a retirement calculator (AARP offers a good one at its website, http://www.aarp.org). If indeed you’re coming up short, then consider opening a taxable brokerage account and earmarking it for retirement. You can use a chunk of your $20,000 windfall to get started, but also set up regular ongoing contributions.

The bulk of your retirement money should be invested in stocks, since that’s the only asset class that consistently outperforms inflation over time. If you try to play it too safe and avoid stocks, your purchasing power is likely to decline over the years instead of growing. A total market index fund with low expenses is a good bet for delivering diversification at low cost. But leaven your portfolio with bonds and cash as well, since these assets can cushion market downturns. All the returns that stocks give you in good markets won’t be much help if you panic and sell in a bad market. People who try to time the market that way often miss the subsequent rally, so they wind up selling low and buying high — not a winning way to invest.

If you don’t want to try to figure out an asset allocation, look for a low-cost target date fund. If you plan to retire in about 25 years, you’d want to look for a “Retirement 2040” fund.

Once you get your retirement savings on track, then you can start paying down that student loan debt. Target private loans first, if you have any, since they’re less flexible and have fewer consumer protections than federal student loan debt.

No earned income? No IRA contribution

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Dear Liz: In recent columns you’ve been discussing mandatory withdrawals from IRAs. Since these minimum required distributions are treated as income for tax purposes, can I use that money as the income necessary to make an IRA contribution this year? I am retired and lucky enough not to need the funds for current expenses.

Answer: Sorry. You need earned income, not just income, to make IRA contributions. For the purposes of an IRA, earned income includes wages, salaries, commissions, self-employment income, alimony and separate maintenance and nontaxable combat pay. It does not include earnings and profits from property or income from interest, dividends, pensions, annuities, deferred compensation plans or required minimum distributions from IRAs.

Should you roll an IRA into a 401(k)?

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Dear Liz: I have one comment in response to the reader who wondered whether she had to take minimum distributions from an IRA at age 70 1/2 even though she was still working. As you pointed out, she can defer taking minimum distributions from a 401(k), but she must take them from her IRA. I would point out that many 401(k) plans permit transfers from IRAs. Once the IRA becomes part of the employer plan, the transferred assets are no longer subject to required minimum distributions, as long as the employee continues working full time. This may be a viable option for someone who wants to delay or reduce the size of a mandatory IRA withdrawal.

Answer: Many people are familiar with the idea of rolling a 401(k) balance into an IRA when they leave a job. They may not realize they can roll money the other way as well if an employer permits it.

There are still several issues to consider before you transfer IRA money into a 401(k), said Mark Luscombe, principal analyst for CCH Tax & Accounting North America.

First, the rollover may not include any non-deductible contributions to the IRA. If the money in the IRA came entirely from tax-deductible contributions or from a 401(k) rollover, this won’t be a problem. If you made non-deductible contributions, they wouldn’t be eligible for transfer into a 401(k), Luscombe said.

“All of the sums rolled into the 401(k) plans must be funds subject to tax and not sums representing basis in the IRA,” Luscombe said. “If non-deductible contributions were made, only the taxable portion of the IRA may be rolled into the 401(k) plan.”

Another issue is that 401(k)s typically offer fewer investment choices than IRAs. Also, compare the fees with what you’re paying with your IRA. Some 401(k)s are run efficiently and give workers access to extremely inexpensive institutional funds, for example, while others lard on various account fees.

A final issue is that you’re likely to have less access to the funds in your 401(k) than you would with an IRA, Luscombe said, should you need to tap the cash. Many plans allow only hardship withdrawals from 401(k)s, although you may be able to access up to half of your funds with a retirement plan loan. Of course, if your intention is to delay required minimum distributions as long as possible and you won’t need the money, this point may not be a deal breaker.

Downsizing: Be realistic about the value of your stuff

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Dear Liz: We are in our 60s and looking to downsize. We’re living in an apartment now and don’t like it, so we want to buy a small house. Also, our finances took some serious hits in the recent economy and we’re trying to rebuild. But in trying to sell our possessions, we’re learning that people want us to discount the item beyond belief or even expect to get it for free. People talk about using Craigslist and EBay to generate cash but it looks like a waste of time. Do you know of other options?

Answer: Your two goals are somewhat in conflict with each other, so you need to clarify which is more important. Is your primary aim to shed your excess stuff so you can get on with your life? If that’s the case, then your focus should be on getting rid of what you don’t need rather than squeezing top dollar from it. If it’s more important to harvest the maximum value from these unwanted items, you’ll need to invest more time and effort in marketing your goods.

It may help your decision-making to get a reality check on the value of your stuff. If you believe that you have some quality items — antique furniture, rare collectibles or expensive artwork — you could hire an appraiser to give you an idea of their market value as well as some ideas where these items could be sold.

Consignment stores and auctions can sell your stuff, although you typically have to split the proceeds. Another possibility if you have quality items is to hire a company that specializes in estate sales to sell your things. These companies also typically take a hefty percentage of the sale proceeds — often 30% or more.

If what you own is mostly mass-produced, though, you’re unlikely to recoup much of what you spent. Many people erroneously cling to the idea that their possessions are worth what they paid for them, or at least something close to that. In fact, that purchase price is what economists call a “sunk cost,” which can’t be recouped. The best you can do is get fair market value for your items. “Fair market value” doesn’t mean the price you think is fair; it means what a willing buyer would pay a willing seller when neither is under any duress to buy or sell.

Craigslist and EBay are two marketplaces that can give you a pretty good idea of what those values might be.

IRA distribution could go into Roth

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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.

401(k) withdrawals can be postponed, but not those from IRAs

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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.