By Peter Anderson10 Comments – The content of this website often contains affiliate links and I may be compensated if you buy through those links (at no cost to you!). Learn more about how we make money. Last edited November 5, 2018.
When starting to invest one of the first things that you’ll have to decide is how you want to invest.
Will you choose a tax advantaged retirement vehicle like the 401k or Traditional IRA?
Will you use a Roth IRA that is funded with post-tax dollars?
Will you go down the road of taxable investing through a brokerage account?
Will you use something new like peer-to-peer lending?
All of these are things you are important to consider when setting up your retirement accounts, as it can affect many different aspects of your financial picture.
For me I don’t consider myself a super-savvy investor, but I do feel like I’ve got a pretty good hold on what I want to do for our savings and retirement accounts. I want to invest in mostly passive index funds, and invest in the following account types – in this order:
Invest in Roth IRA to max: First, I want to invest in our Roth IRA to the max of $6000 per investor – $6000 each for my wife and I.
Invest in company 401k to max: Next we’ll be investing in my company 401k up until the max. I’m not sure we’ll be meeting that maximum this year because of other expenses that have come up.
Investing in taxable accounts: Next we would be investing in taxable investments, most likely through an account with Betterment, Wealthfront or one of the discount online brokerages.
So why am I starting our investing via a Roth IRA?
Why We’re Investing With A Roth IRA First
There are a few reasons why we’re investing with a Roth IRA first.
Tax advantages: We really like the idea of investing our money in a Roth IRA, letting it sit there, and never having to pay a dime more in taxes on the contributions or earnings as long as we wait until retirement to withdraw it.
Tax diversification: The Roth IRA is a part of our tax diversification plan, where we invest in both pre-tax and post tax investments so as to hedge our bets when it comes to current and future tax rates and which will be higher or more to our advantage. We’re investing a portion in Roth, and a portion in our 401k which will be taxable at withdrawal.
The Roth allows for flexibility: One thing we like about the Roth IRA is the fact that you can take out your contributions at any time without having to pay it back like the 401k. While it isn’t a good idea to be withdrawing your retirement funds, it can be good to know that in a pinch you can withdraw those contributions. (Note: You can’t withdraw earnings without penalty, only contributions).
College savings and home purchase withdrawals: The Roth IRA also allows account holders to withdraw from contributions and earnings to use the funds to pay for their first home, or for college bills. Normal early withdrawal penalties are waived in these cases.
Easy to start, and tons of options: Opening a Roth IRA is super easy and can be done within a half hour to an hour if you want. Plus companies like Vanguard are making it easier to start, reducing their minimum investments in a wide range of funds to only $1000 to start. Most people should be able to scrape together $1000 to start their Roth IRA! In addition, the companies are making a wide range of investments available to account holders, with many more choices than a traditional 401k.
Roth can be passed down to heirs tax free: While it wasn’t one of our main reasons for choosing the account, the fact that your heirs can withdraw the money tax free from the account upon your death is a plus. The withdrawals are tax free, just like for you.
So those are some of the pluses of the Roth IRA, and why we’re choosing to invest in those accounts first. Of course, we’re hoping to also invest in our company 401k after our max Roth contribution has been reached, as well as possibly some other taxable investments later on if we have a good year and can max out both the Roth and 401k (unlikely).
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Roth IRA Rules
If you’re looking to invest in a Roth IRA as well, here are some posts you might find helpful.
So are you investing in a Roth IRA? If so why? If not, why not? Tell us your thoughts on whether the Roth is the best place to start investing in the comments.
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Do you earn too much to make a Roth IRA contribution?
Under IRS rules, you’re prohibited from making a Roth IRA contribution if your modified adjustable gross income is more than:
$183,000 if you’re married filing jointly, or
$125,000 if you’re filing as a single person or head of household
If you fall into this category, you can’t make a Roth IRA contribution, right? Wrong.
While you can’t make a direct contribution to your Roth IRA, that doesn’t mean you should write off the idea of funding your Roth IRA this year.
You can still make an indirect contribution to your Roth IRA regardless of how much money you earn, and whether it’s a direct or indirect contribution, what’s most important is getting that money into your Roth IRA where it can grow tax-free and where you can withdraw it tax-free in your retirement years.
So how do you make an indirect Roth IRA contribution? It all starts with a 2010 congressional rule change.
Note: Check here for the latest Roth IRA Rules and Contribution Limits for 2012.
Roth IRA Conversion Limit Rule Change
The key to making an indirect Roth IRA contribution is a 2010 rule change in which Congress eliminated the income limit for performing a Roth IRA conversion.
Prior to 2010, if you had adjustable gross income in excess of $100,000, the IRS prohibited you from converting a Traditional IRA or an old 401k to a Roth IRA.
But now that the income limit has been lifted, anyone (regardless of income) can perform a Roth IRA conversion.
At this point, you’re probably asking yourself, “So what? The income limits on contributions are still in effect, and I earn too much!”
That’s a good question, and the answer is that the elimination of the income limit on Roth IRA conversions paves the way for you to make a Roth IRA contribution – regardless of income.
Fund Your Roth IRA Regardless of Income
How? Because anyone (regardless of income) can make non-deductible contributions to a Traditional IRA. For most people, the advantage in making a Traditional IRA contribution is that it’s tax deductible, but odds are that you can only make non-deductible contributions due to your high income. And that’s good, because those are exactly the type of contributions you want to make.
Once you fund your Traditional IRA with non-deductible contributions, you can then convert your Traditional IRA to a Roth IRA and… Presto! You just funded your Roth IRA.
Done right, you should avoid income taxes on the conversion since you haven’t had time to generate any investment earnings, and you don’t owe conversion taxes on contributions which were originally non-deductible.
For example, let’s say you’re married, 40 years-old, and earn $300,000 per year. Under IRS rules, you’re prohibited from making a direct contribution to your Roth IRA since your $300,000 income exceeds the $183,000 income limit for married couples.
However, you can still contibute $5,000 in after-tax non-deductible contributions to a Traditional IRA, and then convert that Traditional IRA into a Roth IRA tax-free.
Is it really that simple? Yes, and… no.
Potential Pitfalls
Such a conversion isn’t always a tax-free event. It is if you don’t already have a Traditional IRA. But if you already have one, it can get complicated.
Why? As previously stated, most people make Traditional IRA contributions in order to take advantage of the tax break. So if you already have a Traditional IRA, in all likelihood, it’s funded with tax deductible contributions.
You can still make your non-deductible Traditional IRA contribution, but the IRS won’t let you convert only your non-deductible contributions. Any Roth IRA conversion you perform will trigger income taxes on those portions of the conversion amount which represent original tax deductible contributions and earnings, and the IRS requires you to treat your cost basis as a percentage of tax deductible and non-tax deductible contributions.
For example (and this is a simplistic example), let’s say you’re married, 40 years old, and earn $300,000 per year. You decide to make an indirect Roth IRA contribution by following the steps outlined above, but you also already have a Traditional IRA worth $30,000 – of which $10,000 represents earnings, while the remaining $20,000 represents your original tax deductible contributions.
If you make a $5,000 non-deductible contribution to your Traditional IRA, then attempt to convert $5,000 of your Traditional IRA to a Roth IRA, you will owe the IRS income taxes.
Why? Because the IRS determines the cost basis of your conversion by looking at your total contributions – in this case, $20,000 in deductible contributions and $5,000 in non-deductible contributions.
In percentage terms, this means that 80% of your contributions are tax deductible, while the remaining 20% are not. As such, if you attempt to convert a portion of your Traditional IRA, 80% of your conversion is taxable, while the other 20% is not. In addition, if you convert any of existing funds which are the result of past investment earnings, those are subject to income taxes as well.
In the above example, we now have $45,000 in your Roth IRA – $20,000 in deductible contributions, $5,000 in non-deductible contributions, and $10,000 in earnings.
Assuming an effective tax rate of 35%, converting your entire Traditional IRA to a Roth IRA will trigger a $10,500 income tax bill. Why? Because your deductible contributions are taxable ($20,000 x 35% = $7,000) and your earnings are taxable ($10,000 x 35% = $3,500).
So if you decide to go this route, make sure you seek the advice and guidance of a certified financial professional. Also, make sure you have plenty of cash on hand to pay your conversion taxes if you still wish to move forward with a conversion.
Act Before the Conversion Limit Comes Back!
A Roth IRA can be a great place to grow your retirement savings, so don’t give up if you earn too much to make a direct Roth IRA contribution.
You can always make non-deductible Traditional IRA contributions and then convert to a Roth IRA. However, take advantage of this “backdoor” contribution method while you can. Don’t simply assume that it will always be available. Congress can always legislate a new income limit for Roth IRA conversions, and then you’ll be shut out again.
So don’t take your current opportunity for granted.
This is a guest post by Britt who writes for Your-Roth-IRA.com, a website which looks to educate people concerning Roth IRA regulations.
It’s important to know, because an inherited Roth IRA can trigger:
– Estate Taxes, and/or – Income Taxes
Estate Taxes
Contrary to conventional wisdom, an inherited Roth IRA does not pass on to its heirs tax free, unless the sole heir is also the deceased owner’s spouse.
Just like any other asset, a Roth IRA is subject to estate taxes.
So if you inherit a Roth IRA as part of an estate large enough to be subject to inheritance taxes, you will likely owe inheritance taxes on the Roth IRA as well.
However, keep in mind that the deceased owner’s original after-tax Roth IRA contributions are NOT subject to estate taxes – only the tax-free earnings generated on those principal contributions.
The 10% Early Withdrawal Penalty
What happens if you inherit a Roth IRA and immediately withdraw some or all of the funds? Is your withdrawal subject to the early withdrawal penalty if you’re under age 59 ½?
According to the Roth IRA withdrawal rules outlined in IRS Publication 590, the 10% early withdrawal penalty is waived if “you are the beneficiary of a deceased IRA owner.”
So if you recently inherited a Roth IRA, you don’t have to worry about triggering a 10% early withdrawal penalty.
Income Taxes
Nevertheless, you do need to worry about income taxes.
Generally speaking, the original tax-free contributions of the deceased Roth IRA owner are not subject to income taxes. But the earnings on those contributions are subject to income taxes if the account fails to meet the requirements of the Roth IRA 5 year rule.
So what are the requirements of the 5 year rule?
A Roth IRA meets the 5 year rule requirement on the first day of the fifth tax year after the Roth IRA was opened and funded.
For example, let’s say you opened and funded a Roth IRA on May 5, 2010. Under this scenario, when will your Roth IRA meet the requirements of the 5 year rule?
On January 2, 2015.
Why?
Because 5 tax years will have passed since the time the account was opened and funded – 2011, 2012, 2013, 2014, and 2015.
Remember this rule, because it’s an important one to remember if you wish to minimize the tax liability of an inherited Roth IRA.
Also keep in mind that different rules apply to spousal and non-spousal beneficiaries.
Spousal Beneficiaries
If you inherit a Roth IRA from your spouse, you have two options:
Elect to treat the Roth IRA as your own, or
Delay your withdrawals until the time when your deceased spouse would have reached age 70 ½
If you elect to treat the Roth IRA as your own, it takes on all the characteristics of your own Roth IRA – the same as if you had opened and funded it yourself.
At this point, simply follow the normal Roth IRA rules, and you can avoid taxes altogether.
Non-principal withdrawals before age 59 ½, or before the requirements of the 5 year rule are met, will trigger an early withdrawal penalty and income taxes, but the original principal contributions can be withdrawn tax-free and penalty-free at any time.
In addition, you can make addition contributions to the inherited Roth IRA (assuming you qualify to make Roth IRA contributions), and you can allow funds to grow tax-free in the Roth IRA for as long as you wish (there’s no minimum distribution age).
Alternatively, you can elect to delay your withdrawals until the time when your spouse would have reached age 70 ½.
Under this scenario, you must begin making annual minimum withdrawals from the inherited Roth IRA starting in the year in which your spouse would have turned age 70 ½.
Essentially, the inherited Roth IRA will take on the same rules governing a Traditional IRA (except you won’t owe income taxes on qualified withdrawals).
Non-Spousal Beneficiaries
If you inherit a Roth IRA from someone other than your spouse, you:
Can’t treat the Roth IRA as your own
Can’t make new contributions to the Roth IRA
Must follow the minimum distribution rules
The first two points are self-explanatory, but what are the minimum distribution rules?
Under the minimum distribution rules, you have two options as a non-spouse beneficiary:
Take the entire distribution by December 31st of the fifth calendar year following the year of the Roth IRA owner’s death, or
Receive the entire distribution over a lifetime
Under the first option, you can withdrawal all the funds in the Roth IRA tax-free if you play your cards right.
For instance, assume you inherit a Roth IRA from your dad in 2012. He originally opened the account in 2010, and it’s composed of $10,000 in after-tax contributions and $2,000 in earnings.
You can immediately withdraw the $10,000 principal tax-free and penalty-free. But withdrawal of the $2,000 in earnings will trigger income taxes until the account meets the requirements of the 5 year rule.
On January 2, 2015, you’re free to withdraw the remaining $2,000 without taxes or penalties, because the account will meet the 5 year rule requirements, and you will have successfully withdrawn all of the funds in the account before December 31, 2017 (the fifth calendar year following your father’s death).
Under the second option, you can elect to receive an annuity which pays out over the course of your expected lifetime.
If you choose this option, the length of your expected lifetime is predetermined by IRS tables based on your current age and the current value of the account.
Conclusion
Unless you’re the spouse of a deceased Roth IRA owner who elects to treat the inherited Roth IRA as your own, the tax and legal implications of inheriting a Roth IRA can get extremely complicated.
Even if you manage to avoid inheritance taxes, certain types of withdrawals will be subject to income taxes. And certain actions on your part, such as making a contribution to an inherited Roth IRA as a non-spousal beneficiary, are strictly prohibited.
It is well worth your time and money to seek the guidance of a competent estate attorney, accountant, and/or financial advisor.
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It’s important to pay attention to any upcoming changes in the rules, because modifications in the maximum contribution limits, annual income limits, or other factors can throw a wrench right in the middle of your retirement plans. So let’s take a look at the latest information from the IRS.
2012 Maximum Roth IRA Contribution
Between 2011 and 2012, the IRS made no changes to the maximum Roth IRA contribution.
Just as in 2011, the maximum amount you can contribute to your Roth IRA in 2012 is:
$5,000 if you’re under age 50
$6,000 if you’re age 50 or older
Keep in mind that you qualify for the $6,000 maximum contribution as long as you turn 50 years old on any calendar day in the calendar year. So, for instance, let’s say you turn 50 years old on December 31, 2012. You can contribute $6,000 to your Roth IRA for the 2012 tax year on May 1st, even though you’ll technically only be 49 years old when you make the actual contribution.
However, even though the maximum contribution limit didn’t change between 2011 and 2012, not everyone is eligible to make the maximum contribution. Due to their income, some people have smaller contribution limits or earn too much to make any contribution at all. That’s because the IRS sets income limits that determine who is and isn’t eligible to make a Roth IRA contribution.
2012 Roth IRA Income Limits
While the maximum contribution limits did not change this year, the 2012 Roth IRA contribution limits did change.
Below are the new limits determined by your tax filing status:
Married Filing Jointly
If you plan to file your taxes as “married filing jointly,” then you can contribute a maximum of:
$5,000 if your income is $173,000 or less and you’re younger than age 50
$6,000 if your income is $173,000 or less and you’re age 50 or older
$0 if your income is $183,000 or more, regardless of your age
If you earn somewhere between $173,001 and $183,000, then your maximum contribution limit phases out to zero based on the IRS phase out rules.
Single, Head of Household, or Married Filing Separately
If you plan to file your taxes as “single, head of household, or married filing separately (assuming you didn’t live with your spouse at any time during the year),” then you can contribute a maximum of:
$5,000 if your income is $110,000 or less and you’re younger than age 50
$6,000 if your income is $110,000 or less and you’re age 50 or older
$0 if your income is $125,000 or more, regardless of your age
If you earn somewhere between $110,001 and $125,000, then your maximum contribution limit phases out to zero based on the IRS phase out rules.
Married Filing Separately
If you plan to file your taxes as “married filing separately,” but you did live with your spouse at some point during the year, then you can contribute a maximum of:
$5,000 if your income is $0 and you’re younger than age 50
$6,000 if your income is $0 and you’re age 50 or older
$0 if your income is $10,000 or more, regardless of your age
If you earn somewhere between $1 and $10,000, then your maximum contribution limit phases out to zero based on the IRS phase out rules.
Roth IRA Conversions
What about Roth IRA conversions?
The 2012 Roth IRA conversion rules are identical to the 2011 rules, meaning anyone can convert a 401k or a Traditional IRA to a Roth IRA regardless of income.
In years past, the IRS barred high income earners from making Roth IRA conversions. But in 2010, Congress allowed the $100,000 income limit on Roth IRA conversions to disappear. It may reappear sometime in the future, but as of now, it looks like 2012 will be another year without the conversion income limit. So if you’re a high income earner who’s never had the opportunity to make a Roth IRA contribution, take advantage!
Anyone, regardless of income, can make non-deductible Traditional IRA contributions, then convert those non-deductible Traditional IRA contributions to a Roth IRA tax free (since your original contributions have already been taxed). Effectively, it’s a back door method for high income earners to make Roth IRA contributions.
However, if you choose to go this route, beware of the pitfalls. Seek the advice of a financial professional who can guide you through the process – especially if you’ve made Traditional IRA contributions in the past. The IRS doesn’t allow you to segregate your non-deductible and deductible Traditional IRA contributions when making a conversion, so if you currently have a Traditional IRA, odds are that you’ll owe taxes on a conversion.
Summary
The 2012 Roth IRA rule changes from 2011 Roth IRA rules were relatively minor.
The maximum annual contribution limits remained unchanged at $5,000 and $6,000 respectively.
However, the annual income limits did change with the range for married couples moving from $169,000-$179,000 to $173,000-$183,000 while the range for singles changed from $107,000-$122,000 to $110,000-$125,000.
As of this writing, all other parameters remain the same year over year.
Can you make contributions for your child or a non-working spouse? What if you’re retired?
These are great questions, and the answer essentially hinges on two things – your type of income and the amount of your income.
As long as you meet the IRS requirements regarding your income, you can make a Roth IRA contribution. Nothing else really matters.
Your age doesn’t matter, and in a sense, the amount of income you earn doesn’t matter either. But we’ll address that later in this article. First, let’s take a look at the essential criteria for determining your ability to contribute to a Roth IRA.
Earned Income
In the eyes of the U.S. government, not all income is created equal, and you need a certain type of income in order to make a Roth IRA contribution.
A good rule of thumb for determining Roth IRA eligibility is whether or not you traded your time for an incremental amount of money. Eligible income is earned through active income generating activities and not passive ones. For example, if you work a 9 to 5 job, then the wages you earn from that job qualify. But if you derive all of your income from investing in real estate, then you probably don’t qualify for a Roth IRA contribution.
According to the IRS, types of eligible income include wages/salaries, sales commissions, tips, job-related profit sharing, and bonuses.
Passive forms of income are NOT eligible for Roth IRA contributions. How do you know if your income is passive? Remember, a good rule of thumb is whether or not you traded your time to earn the money. For instance, let’s say you spend the year vacationing abroad and you don’t work at all. By definition, any income you earn during the course of the year is passive income.
According to the IRS, types of non-eligible passive income include capital gains, dividends, interest, rental income, mineral extraction royalties, disability payments, welfare payments, social security payments, annuity income, and pension income.
If you have active income, you’re eligible to make a Roth IRA contribution – as long as your income falls within the pre-established IRS income limits.
Roth IRA Income Limits
Assuming you have the right type of income to make a Roth IRA contribution, you’re still subject to IRS income limits which cap your eligibility.
These income limits change from year to year, but for the current year, you’re prohibited from making a Roth IRA contribution if you earn more than:
$183,000 if you’re married filing jointly
$125,000 if you’re single, head of household, or married filing separately and did not live with your spouse for any part of the year
$10,000 if you’re married filing separately and you did live with your spouse for any part of the year
Keep in mind that these are just the upper limits. As you approach these limits, your maximum contribution limit phases out.
But assuming you have the right type of income and your annual income falls below the IRS income limits, you’re eligible to make a Roth IRA contribution regardless of other factors.
Is There a Roth IRA Age Limit?
Currently, the IRS does not restrict Roth IRA eligibility based on age.
Nevertheless, because of the need to have earned income, some age groups are less likely to be eligible.
For instance, most 5 year-olds are not eligible to make a Roth IRA contribution. They can’t claim their allowance or cash gifts from grandma as income.
However, some 5 year-olds are eligible. For instance, professional child actors generate earned income which can be contributed to a Roth IRA.
Likewise, no upper age limit exists either. While most 90 year olds are not eligible because they’re usually living off of social security benefits and investment income, some 90 year olds are eligible. For instance, a 90 year-old working part-time at McDonald’s is eligible to make a Roth IRA contribution.
In short, there is no Roth IRA age limit. Eligibility is determined solely on the basis of the amount and type of annual income you generate.
And even the amount you earn is not completely restrictive.
The 2010 Roth IRA Conversion Rule Change
Prior to 2010, if you wanted to convert an old 401k or Traditional IRA to a Roth IRA, your ability to do so was subject to a $100,000 annual income limit.
But in 2010, Congress did away with the income limit entirely.
As a result, anyone (regardless of their level of income) can perform a Roth IRA conversion.
This is a significant change, because it essentially eliminates the income limits on making a Roth IRA conversion.
Why? Because no income limits exist in regard to making non-deductible contributions to a Traditional IRA.
For example, let’s say you earn $300,000 per year. Under the IRS income limits, you’re prohibited from making a direct contribution to your Roth IRA.
However, you’re NOT prohibited from making non-deductible contributions to a Traditional IRA. So you contribute $5,000 in after-tax dollars to a Traditional IRA.
Since the income limit on Roth IRA conversions no longer exists, you can then turn around and convert your Traditional IRA to a Roth IRA. The conversion will be tax-free since the money you’re converting is composed of non-deductible contributions.
In the end, the result is the same as if you had made a direct contribution to your Roth IRA!
However, Keep In Mind…
It’s always a good idea to consult with a professional financial advisor. Keep in mind that if you’re planning to perform a Roth IRA conversion and you’ve previously made both deductible and non-deductible contributions, the IRS won’t let you segregate the two and only convert the non-deductible contributions to your Roth IRA. So make sure you know what you’re doing.
Also keep in mind that your ability to make a Roth IRA contribution is also limited by any amounts you contribute to a Traditional IRA in the same year.
For instance, if you’re eligible to make a maximum annual contribution of $5,000 to your Roth IRA, this is the amount you can contribute in total to both your Roth IRA and your Traditional IRA. So if you decide to contribute $2,000 to your Traditional IRA, you’ll only be able to contribute $3,000 to your Roth IRA. And if you decide to contribute $5,000 to your Traditional IRA, then you can’t contribute anything to your Roth IRA.
This is an article from Britt at http://www.your-roth-ira.com, the Web’s #1 resource for Roth IRA information.
Me: “Who helped you select the funds in your 401(k)?”
Client: “Ummm…..I just picked a few options really quick.”
Me: “How much time did you spend researching what you picked?”
Client: “I didn’t.”
Me: <sigh>
This sort of exchange happens more often than it should. What most investors don’t realize is that at some point, your 401(k) will most likely be the largest income-producing asset you own.
Sure your home could be worth more, but; the last time I checked your home doesn’t send you a monthly check when you retire.
There are several reasons why 401(k)s make sense for so many people. But the primary reason you should take advantage of your 401(k) is that once it’s set up there’s nothing much left to do (except the occasional review as I’ll discuss).
Your 401(k) can be automatically funded using your earnings at your job – you won’t have to remember to make contributions.
However, there are some 401(k) no-no’s I think you should avoid. And the sad part is that many people make these mistakes…don’t become one of them.
1. Not Saving at All in a 401(k)
If you have a 401(k) available to you and you haven’t taken advantage of it . . . why not? Again, once you have it set up, there’s not much left to do.
Investing within a 401(k) will help you automatically save for retirement without hardly thinking about it. Before you even have access to your spending money from your paycheck, your 401(k) contribution will be made. Easy peasy.
You need to start investing for retirement. Unless, of course, you like the idea of living on Social Security payments alone (that’s a scary prospect). Even if you’re wealthy, why not save even more for the future?
2. Just Saving Enough to Get the Match
Some employers offer a match up to a certain percentage of your contributions into a 401(k). This is a fantastic benefit you should certainly use – but you shouldn’t stop there.
Chances are you should invest more money into your retirement than what your employer will match in your 401(k). It would be a good idea to research how much money you need to retire and consistently contribute to that amount.
3. No Match, No Savings
Employers are not required to match your 401(k) contributions. If your employer isn’t matching your contributions, should you just skip investing into your 401(k)?
No. Of course not!
Remember, the 401(k) is a great way to automatically make contributions toward retirement. Take advantage of this super easy way to invest your money. It’s still worth it.
4. Investing Purely Into Target Date Funds
To put it lightly, I rather dislike target date funds. Many times, you’ll find target date funds as options within your 401(k).
Target date funds are funds that usually have a year at the end of the name – the year you might like to retire. The idea is that you choose a target date fund that targets the year you’d like to retire, invest in that fund, and watch that portfolio shift from an aggressive strategy to a conservative strategy.
This sounds dandy, but the problem is that the mutual funds within these target-date funds are usually pretty cruddy. How so? Here are two downsides you’ll often see:
High fees – The mutual funds just have outrageously high fees that are going to take money from you that you could have used to invest.
Weak performance – The mutual funds do pretty poorly when compared to other mutual funds or market benchmarks.
William Baldwin, a contributor for Forbes.com, writes:
Whoever is buying the [target retirement] funds would not be at the genius level. They have not figured out that they are getting ripped off.
When you invest in your 401(k), do your homework and find out about your investment options – don’t let your employer’s default choice be your choice unless it’s a good one (it probably isn’t).
5. Not Getting Professional Help Choosing Your 401(k) Investments
Okay, so if you’re supposed to pick the investments in your 401(k), how do you know which ones to choose? It’s best to hire a professional.
A good financial adviser can drill down into the specifics of the investments within your 401(k) and point out ways to improve your portfolio – and show you which funds you should avoid like the plague.
Don’t go it alone. Get good help and you’ll save more and earn more.
6. Asking Your Coworkers for Help Choosing Your 401(k) Investment Options
I can assure you that most of your coworkers haven’t given much thought into the funds within their 401(k). Get professional help, not the off-the-cuff recommendations of those who don’t live and breathe investments on a day-to-day basis.
Unfortunately, you might find yourself pressured to choose investments within your 401(k) during work when you need to be working, not making decisions about your long-term future.
Instead, spend some free time after work to sit down with a financial adviser who knows their stuff.
7. Not Reviewing Your 401(k) Plan Consistently
While the 401(k) plan is a great way to ensure contributions are made by having them come directly out of your paycheck, that doesn’t mean you can sit back, relax, and forget about your 401(k) altogether.
Instead, you need to review your 401(k) plan on a regular basis.
Should new funds become available within your 401(k), you’ll want to know about them and consider them as potentially better options for your investments. You’ll also want to consider the volatility of your investment mix as you get closer to retirement.
8. Borrowing from Your 401(k)
Borrowing from your 401(k) is definitely a no-no. I say this for two reasons:
You’ll make less money – Money not invested is money that’s not earning money. Taking money out of your 401(k) defeats the whole reason you put it in there in the first place!
You might find yourself paying extra penalties and taxes – If you don’t have enough money to pay back your 401(k) loan in time, your unpaid balance will be considered a distribution. That means you’ll be looking at a 10% penalty in addition to higher income taxes.
John Wasik, a contributor for Forbes.com, writes:
Repeat after me: My 401(k) is not a piggy bank, nor is it a good source of cash.
Don’t borrow from your 401(k). You should have an emergency fund in place for emergencies.
9. Market Timing With Your 401(k) Investments
Your 401(k) is a great long-term investment vehicle – but not something you should play around with as the market fluctuates.
Find the right funds with the help of a professional, reevaluate your funds from time to time, but whatever you do don’t let your emotions dictate your investment decisions.
10. Making Terrible 401(k) Decisions When You Leave Your Job
When you leave your job, whatever you do, don’t cash out your 401(k). Remember those penalties and tax implications if you take a 401(k) loan and don’t pay it back? Well, the same applies here.
However, I would encourage you to consider a Roth IRA conversion with your 401(k) after you leave your job.
Not only will that open up many more investment options than your old employer gave you, but throughout the process, you’ll learn a great deal about how investments work. Note, however, that while it’s worth considering, it’s not always the right thing to do.
Talk with a financial adviser to determine if a Roth IRA conversion is right for you.
401(k)s are a wonderful investment choice as long as you avoid all these no-nos. Do your research, invest with intentionality, and you’ll be just fine.
Typically, most people automatically assume they should roll over their old 401(k) into a traditional IRA. However, a lot of people have been asking about another option lately – and that’s whether you can roll your 401(k) over into a Roth IRA instead.
Fortunately, the definitive answer is “yes.” You can roll your existing 401(k) into a Roth IRA instead of a traditional IRA. Choosing to do so just adds a few additional steps to the process.
Whenever you leave your job, you have a decision to make with your 401k plan. Most people don’t want to let an old 401(k) sit idle with an old employer, and could benefit immensely by moving those funds somewhere that could benefit them more in the long run. Let’s see if I can help you make “cents” of the situation.
But first, let’s look at the rules behind the strategy of rolling over your 401k into a Roth IRA.
Table of Contents
Need to open a Roth IRA?
My favorite online broker is Ally Invest but you can check out our recap on the best places to open a Roth IRA and the best online stock broker sign-up bonuses. There are many good options out there, but I have had the best overall experience with Ally Invest. No matter which option you choose the most important thing with any investment is to get started.
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Roth IRA Rollover Rules From 401k
As a reminder, you must generally be separated from your employer to roll your 401k into a Roth IRA. However, some employers do permit an in-service rollover, where you can do the rollover while still employed. It’s permitted by the IRS, but not all employers participate.
Before January 1, 2008, you weren’t able to roll your 401(k) into a Roth IRA directly at all. If you wanted to do so you had to complete a two-step process. (Keep in mind that this would also apply to old Simple IRA’s, SEP IRA’s and 403b’s, 457, and qualified pensions, too)
Open a Traditional IRA.
Convert the Traditional IRA to a Roth IRA.
However, the law changed shortly after and this option became available. Still, just because the law has made this option available doesn’t mean you can definitely roll your old 401(k) into a Roth IRA no matter what. Unfortunately, it all depends on your plan administrator.
For example, recently I had two clients who intended to roll their old retirement plans into a Roth IRA.
One client had an old military retirement plan- Thrift Savings Plan (TSP) – and the other had an old state retirement plan. After helping each of them complete the required paperwork, I came across an interesting discovery.
The TSP rollover paperwork had a box you could mark if you wanted to roll over the plan into a Roth IRA (the instructions had been added to make sure you had a Roth IRA already established). However, the state retirement plan did not give that option.
The only option was to open a traditional IRA to accept the rollover and then immediately convert it to a Roth IRA. That certainly seemed like a hassle at the time, and it definitely was.
However, this man’s state retirement plan is not the only one I’ve encountered with these extra “rules.” Many 401(k)’s and 403(b)’s come with the same “No-Roth IRA Rollover” option. This option was supposed to be mandatory in 2010, but some still do it on a voluntary basis.
At the end of the day, this means you should explore this option thoroughly before automatically assuming it would work in your case. Ask questions, consult your financial advisor, and read through all of your rollover paperwork carefully before you begin moving in this direction.
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Recap on Roth IRA Conversion Rule
These days, nearly anyone can take all of their traditional IRAs and old retirement plans and convert them to a Roth IRA. The amount you convert will be taxed, but it still can be an attractive move for those that feel that taxes are going nowhere but up.
How Do I Rollover if I Receive the Check?
If you receive a distribution check from your 401(k) rollover to a Roth IRA, then chances are good they will hold around 20% for taxes. If you want a direct 401(k) rollover to a Roth IRA, you may want to send that check back to your employer 401(k) provider and ask to be sent all of your eligible retirement distribution directly to your new Rollover IRA account (not as a check, or they will just give you 80% again).
You have 60 days upon receiving the check to get the money into the Roth IRA- no exceptions! So don’t procrastinate on this one.
What About the Roth 401k?
If your employer offers a Roth 401k and you were savvy enough to take part, the path to a rollover will be much easier. When you’re converting one Roth product to another, there is simply no need for conversion. You would simply roll the Roth 401(k) directly into the Roth IRA with the help of your plan provider.
Roll Your 401(k) by Following These Steps
You have to have a Roth IRA open/established before you can do any of this.
Ask your plan provider about the paperwork required to roll your plan over, then complete the paperwork in a timely manner.
Enjoy the tax-free growth of your Roth IRA!
4 Signs It Makes Sense to Roll Your 401(k) into a Roth IRA
If you’re thinking of rolling your 401(k) into a Roth IRA instead of a traditional IRA, you have plenty of reasons to do so. Not only do Roth IRAs let you invest your dollars in the same investments as traditional IRAs, but they offer additional perks that can help you save money down the line. Here are four signs that a Roth IRA might actually be your best bet.
1. You expect to pay higher taxes in the future.
Since Roth IRAs use after-tax dollars, you’ll have to pay taxes upfront on any funds you roll over. However, you won’t have to pay taxes on your distributions, which could be extremely beneficial if you’re taxed at a higher rate when you reach retirement. You’ll pay taxes either way – now or later. But with a Roth IRA, you can rest assured your withdrawals will be tax-free.
2. You want to take withdrawals when you’re ready, and not a minute before.
While traditional IRAs force you to begin taking withdrawals at age 70 ½, Roth IRAs do not have this stipulation. Because of this, you can squirrel your Roth IRA funds away until you’re ready to use them.
3. You expect to earn more money in the future.
If you plan to earn lots of money in the future – or earn a high income now – you should consider rolling your funds into a Roth IRA instead of a traditional IRA. For single filers in 2023, the maximum income allowable for contributions to a Roth IRA starts at $138,000 and ends at $153,000. Learn more about Roth IRA rules and contribution limits here.
For married filers, on the other hand, the ability to contribute to a Roth IRA begins phasing out at $218,000 and halts completely at $228,000 for 2023. The more you earn in the future, the harder it will become to contribute to a Roth IRA and secure the benefits that come with it.
4. You want to increase your tax diversification.
Contributions to traditional IRAs are tax-advantaged, meaning you won’t pay taxes on your invested funds until you begin taking withdrawals at retirement. Roth IRAs, on the other hand, are taxed up front but offer tax-free withdrawals after age 59 ½.
If you’re unsure how your tax and income situation might pan out in the future, having both types of accounts – a traditional IRA and a Roth IRA – is a smart move in terms of diversifying your future tax exposure.
401k to Roth IRA Rollover Rules
Details
Eligibility
You can roll over a 401k to a Roth IRA if you have left the employer sponsoring the 401k and are no longer contributing to the plan. Some plans also allow in-service rollovers, but it’s best to check with your plan administrator for details.
Taxes
When you roll over a 401k to a Roth IRA, you will owe income taxes on the amount you convert. This is because contributions to a 401k are made with pre-tax dollars, while contributions to a Roth IRA are made with after-tax dollars.
Conversion Limitations
There is no limit on the amount you can convert from a 401k to a Roth IRA. However, the amount you convert will be added to your taxable income for the year in which you make the conversion, which could have tax implications.
Timing
You can convert a 401k to a Roth IRA at any time, but it’s important to consider the timing of the conversion carefully. If you convert when your income is higher, you will owe more in taxes.
Penalty-Free
If you are 59 ½ or older, you can convert a 401k to a Roth IRA penalty-free. If you are younger than 59 ½, you may be subject to a 10% early withdrawal penalty on the amount you convert.
The Bottom Line – Rolling Over 401k into a Roth IRA
Rolling your 401(k) into a Roth IRA is a smart decision for many investors, but it may not be right for everyone.
Some financial advisors may suggest rolling over your 401k into a Roth IRA to take advantage of the tax-free growth the account offers. While this can be a great option for some, it’s important to consider if you’ll be able to afford to pay the taxes on your contributions and earnings when you eventually withdraw them.
Before you pull the trigger, make sure to investigate all of your options and consider speaking with a tax professional. When it comes to complex investment vehicles and taxes, what you don’t know can hurt you
FAQs on Rollover 401k to Roth IRA
Can you roll over 401k to Roth IRA without penalty?
Yes, you can roll over funds from a 401(k) to a Roth IRA without incurring any penalties, but there are some important rules and restrictions to be aware of.
First, you’ll need to meet the eligibility requirements for a Roth IRA, which include having earned income and not exceeding certain income limits. If you’re eligible, you can roll over funds from your 401(k) to a Roth IRA by asking your 401(k) plan administrator to transfer the funds directly to your Roth IRA account. This is known as a “direct rollover” and it allows you to avoid paying any taxes or penalties on the funds.
However, there are limits on how much you can contribute to a Roth IRA each year, and there may be tax consequences if you exceed those limits. It’s important to consult with a financial advisor or tax professional before making any decisions about rolling over funds from a 401(k) to a Roth IRA. They can help you understand the rules and restrictions and determine if a rollover is the right move for your financial situation.
What are the disadvantages of rolling over a 401k to a Roth IRA?
There are a few potential disadvantages to rolling over funds from a 401(k) to a Roth IRA. These include:
1. Tax implications: When you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This can be a disadvantage if you’re in a high tax bracket and don’t have other funds available to pay the taxes.
2. Loss of employer matching: If your employer offers matching contributions to your 401(k), you’ll lose out on those contributions if you roll over your funds to a Roth IRA.
3. Loss of certain benefits: 401(k) plans may offer certain benefits, such as loan provisions and hardship withdrawals, that are not available with a Roth IRA. If you roll over your funds to a Roth IRA, you’ll lose access to these benefits.
Overall, rolling over funds from a 401(k) to a Roth IRA can be a good move for some people, but it’s important to carefully consider the potential disadvantages and consult with a financial advisor before making any decisions.
What is the tax penalty for rolling 401k to Roth IRA?
If you roll over funds from a 401(k) to a Roth IRA, you’ll have to pay taxes on the amount you roll over. This is because funds in a 401(k) are pre-tax, meaning you don’t have to pay taxes on them until you withdraw the funds. When you roll over the funds to a Roth IRA, you’re essentially withdrawing the funds and then depositing them into the Roth IRA, so you’ll have to claim that amount of reportable income.
Since you’re “rolling over” and not taking a distribution you won’t have to pay the 10% early withdrawal penalty if you’re under the age 59 1/2. If you do choose to this be prepared to pay the taxes on the rollover out of pocket. Otherwise if you use your 401k money to pay the taxes you will be penalized on that amount.
What is the Roth five year rule?
The Roth 5 year rule is a requirement for certain tax-free withdrawals from a Roth IRA. In order for a withdrawal from a Roth IRA to be tax-free, the account must have been open for at least 5 years and the withdrawal must be made after the age of 59 1/2. If these conditions are not met, the withdrawal may be subject to taxes and penalties.
The Roth 5 year rule applies to both contributions and earnings in a Roth IRA. For example, if you make a contribution to a Roth IRA and then withdraw it within 5 years, the withdrawal will be subject to taxes and penalties unless it meets one of the exceptions to the rule. The same is true for earnings on your contributions – if you withdraw earnings from a Roth IRA within 5 years, they will be subject to taxes and penalties unless an exception applies.
There are a few exceptions to the Roth 5 year rule, including:
-Withdrawals made to pay for qualified higher education expenses -Withdrawals made to pay for qualified first-time homebuyer expenses -Withdrawals made due to the account holder’s disability -Withdrawals made by a beneficiary of the account after the account holder’s death
It’s important to understand the Roth 5 year rule and the exceptions to it before making any withdrawals from a Roth IRA. If you’re not sure whether a withdrawal will be subject to taxes and penalties, it’s a good idea to consult with a tax professional.
Welcome to another Ask GFC! If you have a question that you want answered you can ask it here.If your questions get featured on GFC TV or the GFC Podcast, you are the lucky recipient of a copy of my best selling book, Soldier of Finance, and a $50 Amazon gift card.So what are you […]
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There’s a lot written all over the web and elsewhere about what to do with retirement plan rollovers, like 401(k) plans, 403(b) plans and even IRAs. But rarely discussed is what to do with a 457 rollover. As luck would have it, we received just such a question on Ask GFC: Can a distribution ($50,000) […]
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