Ask Liz Weston

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IRA

Q&A: Here’s a big tax mistake you can easily avoid

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Dear Liz: I’m self-employed and my wife wasn’t working last year. In December, we returned to California and found a small home to purchase using $107,000 I took out of my IRA. Since we weren’t quite certain of what our income would be, we received our health insurance in Oregon through an Affordable Care Act exchange.

When we filed our taxes we got hit with a $20,000 bill for the insurance, because we earned too much to qualify for subsidies, and a $10,000 bill for the IRA withdrawal. Our goal was to own our home outright, which we do, but now we have a $30,000 tax bill hanging over us.

Can we work with the IRS somehow on this? We didn’t “earn” the $107,000; we invested it in a home. It wasn’t income, so why should we be punished for using our savings to purchase a home?

Answer: If you mean, “Can I talk the IRS out of following the law?” then the answer is pretty clearly no. The IRA withdrawal was income. It doesn’t matter what you did with it.

Consider that you probably got a tax deduction when you contributed to the IRA, which means you didn’t pay income taxes on that money. The gains have been growing tax deferred, which means you didn’t pay tax on those, either.

Uncle Sam gave you those breaks to encourage you to save for retirement, but he wants to get paid eventually. That’s why IRAs and most other retirement accounts are subject to required minimum distributions and don’t get the step-up in tax basis that other investments typically get when the account owner dies.

(If you did not get a tax deduction on your contributions, by the way, then part of your withdrawal should have been tax-free. If you’d contributed to a Roth IRA, your contributions would not have been deductible but withdrawals in retirement would be tax-free.)

The IRS does offer long-term payment plans that may help. People who owe less than $50,000 can get up to six years to pay their balances off. You would file Form 9465 to request a payment plan. The IRS’ site has details.

Here’s a good rule to follow in the future: If you’re considering taking any money from a retirement account, talk to a tax professional first. People often dramatically underestimate the cost of tapping their 401(k)s and IRAs; a tax pro can set you straight.

Q&A: Is it smarter to save for retirement or pay off debt first?

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Dear Liz: I graduated from college in May and began a full-time job in October making $36,000. I also do freelance work and receive anywhere from $500 to $1,000 a month from that. I live at home, so I don’t have to pay for rent or groceries, which really helps. Currently, I have just over $18,800 in student loans at an average interest rate of 4.45%. I have also opened a Roth IRA.

My plan currently is to contribute $500 a month to my IRA in order to max it out, and pay $700 a month to my student loans in order to get them out of the way quickly. Or is it better to skip the Roth and put that extra $500 toward my student loans? That way, I would be debt free when I move out of my parents’ house next year. The stock market has done nothing but fall since I opened my account, and I am reading that it could do the same this year as well. But I have also read that it’s good to just keep consistently contributing to an IRA when your debt isn’t high-interest to reap the rewards of compounded returns.

Answer: It’s generally a good idea to start the habit of saving for retirement early and not stop. What the market is doing now doesn’t really matter. It’s what the market does over the next four or five decades that you should care about, and history shows that stocks outperform every other investment class over time.

The $6,000 you contribute this year could grow to about $100,000 by the time you’re in your 60s, if you manage an average annual return of around 7%. (The stock market’s long-term average is closer to 8%.) And Roth IRAs are a pretty great way to invest, because withdrawals are tax-free in retirement.

That said, your other option isn’t a bad idea either. You are not proposing to put off retirement savings for years while you pay off relatively low-rate debt, which clearly would be a bad idea. Instead, what you’re losing is the opportunity to fund a Roth for one year. That’s an opportunity you can’t get back — but you could fully fund the Roth next year, and perhaps use some of your freelance money to fund a SEP IRA or solo 401(k) as well.

Either way, you should be fine.

Q&A: Why do 401(k) and IRA contributions have such different rules?

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Dear Liz: Can you please explain to me why the IRS allows an employee in a workplace 401(k) to contribute $19,000 but a wage earner without a 401(k) can contribute only $6,000 to an IRA? This seems grossly unfair. Why does one group get to save three times as much for retirement?

Answer: Congress works in mysterious ways, and this is far from the only weird byproduct of tax law.

The 401(k) and the IRA were created through different mechanisms.

The 401(k)’s birth was almost accidental. Benefits consultant Ted Benna created the first 401(k) savings plan in 1981, using a creative interpretation of a section of IRS code. Benna crafted the plan to provide an alternative to cash bonuses, not to replace traditional pensions — although that’s what it ended up doing.

IRAs, by contrast, were created deliberately by Congress in 1974 to provide a way for people to save independent of their employers.

Raising the IRA limit would be costly to the budget, while decreasing 401(k) limits would be unpopular, since so many people rely on them for the bulk of their retirement savings.

You aren’t, however, limited to saving only $6,000 annually for retirement. You can always save more in a taxable account. You wouldn’t get the tax deduction for contributions, but your investments can qualify for favorable long-term capital gains treatment if you hold them for at least one year.

Monday’s need-to-know money news

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Today’s top story: Free investments can come at a cost. Also in the news: How to not be your own worst enemy when investing, 5 things to cut your tax bill by December 31st, and how to increase your 401(k) or IRA contributions for 2019.

Free Investments Can Come at a Cost
Free doesn’t always mean without cost.

Don’t Be Your Own Worst Enemy When Investing
Look for help.

Do These 5 Things by Dec. 31 to Cut Your Tax Bill
You’ve still got time.

Increase Your 401(k) or IRA Contributions for 2019
Boost your retirement savings.

Tuesday’s need-to-know money news

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Today’s top story: How much you should contribute to an IRA and how often. Also in the news: Creating a meaningful financial plan, what you should tell your financial advisor, and how to avoid drunk shopping binges.

How Much Should I Contribute to an IRA — and How Often?
Establishing a schedule.

Ask Why, Not What for a Meaningful Financial Plan
Setting the tone.

What You Should Tell Your Financial Advisor
Important information to share.

How to Avoid Drunk Shopping Binges
Valuable advice.

Q&A: If you’re putting money in a 401(k) and an IRA at the same time, be ready for the taxes

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Dear Liz: I recently returned to a regular 9-to-5 job after freelancing for several years. I contributed the maximum amount to an IRA while self-employed and continued to do so after starting my new job. I was surprised to learn when doing my taxes this year that I could not deduct my IRA contributions because I was also contributing to my company’s 401(k) plan.

Other than increase my 401(k) contributions at the expense of future IRA funding, are there any actions I can take?

Answer: The ability to deduct IRA contributions when contributing to a workplace retirement plan phases out once your modified adjusted gross income reaches certain limits. For single filers, the deduction starts to phase out at $63,000 and disappears at $73,000. For married couples filing jointly, the phase-out is from $101,000 to $121,000.

Your next move depends on your goals and situation. If you’re primarily concerned with reducing your current tax bill and you’re likely to be in a lower tax bracket in retirement, as most people will, then you should funnel more money into your 401(k) rather than funding your IRA.

If, however, you expect to be in the same or higher bracket in retirement, or if you want more flexibility to control your tax bill in your later years, consider contributing to a Roth IRA in addition to your 401(k). Roths don’t offer an up-front deduction, but withdrawals in retirement are tax free. Also, unlike 401(k)s and traditional IRAs, there are no minimum required withdrawals in retirement.

There are income limits on the ability to contribute to a Roth IRA. For single people, the ability to contribute phases out between modified adjusted gross incomes of $120,000 to $135,000 in 2018. For married couples filing jointly, the phase-out is between $189,000 and $199,000.