The 9 Steps to Financial Freedom (24 page)

Substantially Equal Periodic Payments to Avoid the 10 Percent Withdrawal Penalty

There is one other way to get money out of your retirement accounts and avoid that 10 percent penalty if you are not the permissible age or if your money is in an IRA or IRA rollover. You can do this by using a technique called
substantially equal periodic payments (SEPP)
. Simply put, you have to take out a specific amount of money every single year until you are 59½ or for five years, whichever period is longer.

So if you are fifty-seven and you start to take money out of your IRA account under SEPP, you will have to do so until you
are sixty-two. If you’re fifty-two when you start, you’ll have to continue withdrawing the money until you’re fifty-nine and a half—again the rule is whichever time period is longer.

The amount you can withdraw is calculated by one of three methods; the method you choose will determine the actual dollar amount you must take out yearly. This exact predetermined amount must be withdrawn every year for five years or when you reach fifty-nine and a half, whichever is longer. Very few people know about this loophole, IRS code 72(t)(2)(A)(IV), but it’s there if you need it. Make sure you consult with a financial adviser, accountant, or brokerage house who is familiar with this law.

When Do I Have to Start Making Withdrawals from My Retirement Plan?

The longer you can let it sit there, in most cases the better off you’ll be. But the government won’t let it sit there (tax-free!) forever. They want their taxes on your retirement money. According to a formula specified by the IRS, you have got to start taking money out of traditional retirement plans [except for Roth IRAs and Roth 401(k)s] by April 1 in the year after you turn seventy and a half. There is one big exception: If you are still working, your retirement money is in an employer-sponsored plan such as a 401(k), and you are seventy and a half or older, and you do not own more than 5 percent of the business, you do
not
have to make withdrawals until April 1 following the calendar year in which you do retire.

What If I Don’t Have a Retirement Plan at Work?

Ask your boss to get you one. Take a poll and you will see that almost everyone you work with probably wants one, too. Choose the best person to approach your boss to ask about establishing a 401(k) company plan or a SIMPLE for all of you.
Offer to do the research yourself or with a colleague. Many excellent plans are offered by different mutual funds companies, all of whom will set up a plan for your company’s needs; Fidelity Investments (800-343-3548 or visit
www.fidelity.com
) and Vanguard Group (800-662-7447 or visit
www.vanguard.com
), for example, are two of the largest 401(k) money managers and wonderful places to start looking.

If you are working for a company that still won’t offer you a retirement plan, your only other option is an
IRA
, or
individual retirement account
. You can make an IRA contribution of up to $5,000 for yourself, and if you’re married, you can also contribute $5,000 for your nonworking spouse. Individuals who are fifty or older as of the end of the year could contribute an additional $1,000 in 2012, for a maximum contribution of $6,000. All IRA contribution limits are adjusted annually in line with inflation. In order to make a contribution, the combined income of both spouses has to be at least equal to the amount contributed to the IRA. You can also have a traditional IRA in addition to an employer’s retirement plan, but your contributions may not be tax-deductible.

There are three different kinds of IRAs that you can choose from: a traditional IRA, the spousal IRA, and the Roth IRA. Here are the new specifics.

The Traditional IRA

If your earning allows it, the traditional IRA gives you a current-year tax deduction. If you are eligible, you can contribute $5,000 to your IRA, and if you are in the 25 percent tax bracket, you will save $1,250 that year in income taxes ($5,000 × 25%). What is more, while the money is in the IRA, both your
contributions and the IRA’s earnings grow tax-deferred, which means that the income taxes on any growth of the funds are deferred until you actually withdraw any of the money, at which time you will pay ordinary income tax on the amount withdrawn each year. With a traditional IRA, in most cases you cannot withdraw the money prior to age fifty-nine and a half without paying a 10 percent penalty on the amount withdrawn. (Exceptions to this are if you use SEPP,
this page
, or for the reasons listed below.) On the other end, if you do not need the money, it can sit there until you have to start making withdrawals by April 1 of the year after you turn seventy and a half. But remember, if after that date you have not taken out the required amount there is a 50 percent penalty on the amount that should have been withdrawn. The spousal IRA follows the same guidelines.

Who Can Withdraw Money Penalty-Free from a Traditional IRA?

There are two other circumstances in which you are permitted to make an early withdrawal without paying the penalty.

1. If the money is used by a “first-time home buyer” to purchase a principal residence. The distribution may come from the buyer’s IRA or from an account belonging to the buyer’s spouse, or the child, grandchild, or ancestor of either the taxpayer or the taxpayer’s spouse. There is a lifetime limitation of $10,000 that can be treated as penalty-free “first-time home-buyer” distributions.

2. Distributions for higher education expenses at an eligible education institution to the extent that such distributions do not exceed the qualified higher education expenses of the taxpayer, taxpayer’s spouse, or any child or grandchild of either the taxpayer or the taxpayer’s spouse for the taxable year.

Who Can Take Advantage of the Traditional IRA Deduction?

The traditional IRAs, including spousal IRAs, have rules regarding deductibility that are determined by whether the taxpayer is covered by a qualifying retirement plan at work and, if so, by what the taxpayer’s filing status and income are for the year. In 2012, the range was $58,000-$68,000 for single taxpayers and $92,000-$112,000 for married filing jointly (MFJ). However, a spouse will not be considered covered by a retirement plan simply by virtue of the other spouse’s being covered. The spouse without a qualifying retirement plan will be able to make a fully deductible contribution to an IRA if the modified joint AGI does not exceed $173,000. Between $173,000 and $183,000, deductibility is phased out.

The Roth IRA

The Roth IRA differs, in that you do not get to take a current-year tax deduction in the year that you put the money in, or, for that matter, ever, but—here’s the lure—from the moment of deposit, no matter where you deposit it or what your return, your contribution grows tax-free. When you take your original contributions out, you will not pay any taxes or penalties whatsoever. That’s right, you can take your initial contributions out anytime, regardless of your age, without taxes or penalties (subject to a special rule on withdrawals of converted IRAs within five years of the conversion). And to get your hands on the earnings tax-free, the only rules are these: The money your contributions earn has to stay in the account for at least five years before you can withdraw it without taxes or penalties, and you have to be at least fifty-nine and a half years of age. The other ways to get your hands on the earnings penalty-free are if the owner has died or is disabled, or if the distribution is made for a qualified “first-home” purchase ($10,000 lifetime limitation is applicable) as long as the five year rule is met.

Who Can Take Advantage of the Roth IRA?

In 2012, up to $5,000 (or $6,000 if you are at least 50 years old) can be contributed by single taxpayers having less than $110,000 in modified adjusted gross income (MAGI). Married taxpayers filing jointly have full eligibility if they have a MAGI of $173,000 or less. Eligibility is lost at $125,000 MAGI for single taxpayers and $183,000 MAGI for MFJ. Taxpayers can have a combination of Roth IRA and traditional IRA accounts as long as the combined contributions don’t exceed the yearly maximum allowable for either type (which can be as much as $5,000 [or $6,000 for those at least fifty], as of 2012).

A law that went into effect in 2010 now makes it possible for anyone—regardless of how high their MAGI is—to invest in a Roth IRA. If your MAGI is greater than the limits above you first must make your contribution to a traditional IRA. Once you have done that you can then convert that traditional IRA to a Roth IRA. I recommend consulting with a tax adviser before you proceed with this strategy. It can indeed be a very smart move for you, but there are some rather confusing tax rules that come into play. That’s where a tax pro with experience in Roth conversions will be indispensable.

IRA Conversions and Qualifications

As of 2010, anyone—regardless of income—can convert to a Roth IRA. If you do this, what you need to know is that even though you may be under the age of fifty-nine and a half when you take the money out of your traditional IRA to convert to a Roth, the 10 percent penalty tax will not apply—but you
will
owe ordinary income tax on any money that you converted.

To Convert or Not to Convert, That Is the Question

Because the Roth IRA and the conversion feature continue to cause tremendous confusion, many websites and help departments
at brokerage firms have been set up just to answer this question for you, given your particular circumstances—most of them in the hope that they will end up with your IRA money one way or the other. Try them out and do the calculations for yourself, using the sources available to you, and see if it makes sense for you in your particular situation to convert or not and then check your answers with a professional.

If you do decide to do a conversion, make sure that you can pay for the taxes out of your savings or your income, but not from the money in the IRA. Also, remember that no one ever said you have to convert all the money that is in your traditional IRA into a Roth; you may just want to convert a small amount so the tax bite is not so bad. Before you do anything, however, I would suggest getting a professional opinion—from someone who does not want to get your IRA money to invest, such as a CPA or an enrolled agent who does not take money under management.

Roth IRA and Roth Conversions

Q. If I open up a new Roth IRA and contribute $5,000 a year or convert my traditional IRA to a Roth IRA do I still have to wait till I am fifty-nine and a half to take the money out without penalty?

A. No. The rules that govern Roth IRAs and converted Roths are different than the rules that govern traditional IRAs.

In a contributory Roth IRA you can at any time you want, regardless of your age or time the money has been in the account, withdraw your original contributions without any taxes or penalties. So let’s say you are now thirty-nine years old and for the past three years you have put $5,000 a year into your Roth IRA. You have put in a total $15,000 of original contributions. At any time you want, you can withdraw up to $15,000 without penalties or taxes. Remember, you are only thirty-nine, not fifty-nine and a half, but that does not matter. The money has only
been in there three years, but that, too, does not matter. Your yearly contributions can be withdrawn at any time, with no restrictions whatsoever and without taxes or penalties.

However, the
earnings
on your contributions have to stay in the account until you are at least fifty-nine and a half years old and the account is more than five years old. So let’s say that the $15,000 over those three years grew to $17,000. Yes, you could withdraw the $15,000 at any time, but the growth on that money or the $2,000 has got to stay in the Roth IRA till you are fifty-nine and a half and for at least five years before you can withdraw it without taxes or penalties.

Roth Conversions

When you convert money from a traditional IRA to a Roth IRA, the withdrawal privileges work like this. The money that you originally converted has got to stay in the Roth account for more than five tax years or until you are fifty-nine and a half, whichever comes first, before you can withdraw it without taxes or penalties. You do not, however, have to be fifty-nine and a half to withdraw the converted amount to avoid the 10 percent penalty, you just have to have met the five-year holding requirement. So let’s say that you are thirty-nine and you convert $50,000 from a traditional IRA to a Roth. That $50,000 has got to stay in the Roth IRA for at least five years. After that time, even though you are just forty-four, you can withdraw all $50,000 without any taxes or penalties. The earnings on that $50,000, however, cannot be withdrawn without penalties or taxes until you have attained the age of fifty-nine and a half.

Q. When does the five-year period begin for contributory Roth IRAs? This confuses me, since I am putting money in every year.

A. The time clock starts for all your contributions from the
year of your first contribution. So let’s say in the year 2011, you deposit $5,000 into a Roth. The five-year time clock began—on January 1, 2011. Every contribution made from this point on will be backtimed to the year 2011.

Q. When I die, will my beneficiaries have to pay income taxes on the money that I leave them in a Roth IRA?

A. No. That is one of the beauties of this account. The money that you leave your beneficiaries via a Roth will be income tax-free when they take it out.

Q. Do I have to start taking money out of a Roth IRA when I turn seventy and a half, like I do with my traditional IRA?

A. No. You can leave the money in there for as long as you want.

Q. Can I convert my 401(k) to a Roth IRA?

A. Yes.

Q. Can I have a 401(k) and a Roth IRA?

A. Yes. In fact, you can have almost any retirement plan and also have a Roth IRA if you meet the AGI income levels listed below.