The Bogleheads' Guide to Retirement Planning (11 page)

The laws governing the use of IRAs are enacted by Congress and revised periodically. The first IRAs were established in 1974 with a maximum annual contribution limit of $1,500 per year. Any money placed into your IRA was deducted from your taxable income, reducing your immediate tax liability. IRA withdrawals were subject to ordinary income taxes. There was also a 10 percent tax as a penalty if the funds were withdrawn before age 59½.

For the first few years, IRAs were limited to those who didn’t have a retirement plan at work. However, in 1981, Congress made them available to all Americans. At the same time, Congress raised the contribution limit to $2,000 and established a spousal IRA for nonworking spouses. The maximum annual contribution limit to a spousal IRA was $250 per year. In 1986, Congress placed an income cap on those who could contribute to the accounts so people earning over a certain amount could no longer deduct their IRA contributions from their taxes. In 1996, Congress raised the spousal IRA contribution limit from $250 to $2,000, matching the contribution limit for employees. In 1997, income thresholds were raised, allowing those with higher incomes to deduct contributions, especially if they did not have a retirement account at work. In 2002, contribution limits on traditional IRAs were increased, and catch-up contributions for people age 50 and over were allowed for the first time. Congress also instituted a retirement savings tax credit that gave low-income people cash to put money away for retirement.

Congress also established the Roth IRA in 1997. It allows for after-tax contributions and tax-free growth and withdrawals, which means that both growth and income in Roth IRAs are completely tax-free. In 2006, income limits for contributions to Roth IRAs were raised.

There is no doubt that the IRA will continue to evolve in future years, and the prudent investor will pay attention to the changes. However, it is unlikely that Congress will take away the special advantages of IRAs anytime soon.

Remember how a typical taxable investment account works to best understand the advantages of different IRA accounts. As explained in the previous chapter, there are several investment-related taxable events. We will now go through each type of IRA to explain the rules of each and the unique ways they reduce taxes. To review, income taxes are paid by individuals under four scenarios:

Traditional IRAs have many rules regulating money going in and out that must be followed carefully. You must have U.S. taxable compensation to use one of these accounts. Compensation is defined as wages, salaries, and alimony but not dividend, interest, or capital gain income. The money must be received during the same year as the contribution, although you can make the contribution as late as April 15th of the next year. This rule applies to all types of IRAs.

You can contribute to the account only if you make less than a certain amount of money. The IRS uses the modified adjusted gross income (MAGI) to determine if you make too much to use an IRA. The adjusted gross income is just the last line on page 1 of your 1040 form. To get the MAGI, you have to add back a few of the deductions you took elsewhere on your taxes. It tends to get a little complicated, but most people are either well below the limits or well above them and so don’t have to make the calculations. If you do, consult the IRS instructions or your favorite tax adviser. The limits have a phase-out range, where you can’t take the full deduction, but you can still take a partial deduction. The MAGI limits for 2009 for a traditional IRA are $53K-63K for those filing separately and $85K-$105K for joint filers (the deduction is phased out over the specified ranges). Bear in mind these limits
do not
apply if you do not have a retirement account at work. If you have a plan available at work but elect not to use it, the limits do apply. Also, keep in mind that even if you cannot deduct an IRA contribution, you can still make one. This is called a nondeductible IRA and will be discussed later.

You can contribute only a certain amount of money. You cannot contribute more than you make, but assuming you earn more than the annual limit, your maximum contribution in 2009 is $5,000, with a special $1,000 catch-up contribution for those 50 and over. You can have as many different IRA accounts as you like, but the total contribution across all accounts (traditional and Roth) for the year is still $5,000 per person.

You cannot contribute once you reach age 70½, and you must open the IRA at an institution approved by the IRS, generally a bank, credit union, brokerage, or mutual fund company. You can often do it online or by mail, but even if you open it in person, it usually involves only a couple of pages of paperwork.

Remember that this account is for retirement. Although some exceptions are made, you really shouldn’t plan on touching this money until you are at least 59½. The IRS will charge you not only the taxes that would normally be due on your withdrawal but also an additional 10 percent as a penalty to discourage the withdrawal. So think twice before taking money out early. The exceptions to avoid the additional 10 percent tax include disability, death of account holder, first-time homebuyer, health insurance premiums, health-care expenses, educational expenses, tax levies, or retired early and taking substantially equal payments (SEPP). More information about SEPP can be found in Chapter 13. To claim one of these exceptions, you must have had the IRA at least five years, or the 10 percent penalty applies.

You have to take the money out of the account. Uncle Sam isn’t too keen on you
never
paying taxes on this money, so, beginning at age 70½, you’ll have to start taking out required minimum distributions (RMD). For the first few years, the RMD is about 4 percent of the account, but by the time you are in your 90s, it is about 10 percent of the account value. Do not forget to take this out every year, or you will pay a very stiff penalty; 50 percent of what you should have taken out will go to the IRS!

Finally, you cannot borrow money from an IRA. A withdrawal is a withdrawal—you must pay any applicable penalties and you cannot pay it back later.

Roth IRAs were introduced as part of the Taxpayer Relief Act of 1997. They were originally called American Dream Savings Accounts but were later renamed after their chief advocate, Senator William Roth of Delaware. The individual investor owes Senator Roth a great deal of gratitude for his work on our behalf. The Roth IRA is perhaps the greatest gift ever given to the American investor.

The rules are slightly different from a traditional IRA, however. You still need to have U.S. taxable compensation to use the Roth account. However, the income limits (again, using MAGI) for Roth IRAs are much higher than for traditional IRAs, $101K-116K for single filers and $159K-169K for joint filers in 2009. The contribution limits are the same as for a traditional IRA, and the same catch-up contribution and spousal contribution are also allowed. An additional benefit is that more after-tax money can be sheltered in a Roth IRA than in a traditional IRA. For example, if your marginal tax bracket is 25 percent, $5,000 put in a traditional IRA is really only $3,750 after tax (the government owns the other $1,250 in the form of a tax liability at withdrawal), whereas $5,000 in a Roth IRA is $5,000 after tax for you.

The rules on withdrawals are similar to those for traditional IRAs, with some notable exceptions. You shouldn’t touch the money until age 59½ (the same exceptions apply), and you can’t borrow the money in the form of a loan. But there are
no
required minimum distributions. You never have to take the money out of your Roth IRA if you don’t want to. In fact, if you leave it in your will to a great-grandson, that money can be sheltered from taxes for a period of time upward of 150 years. This particular tax-reduction strategy is known as a stretch Roth IRA, and we’ll discuss it later. Because of these very favorable rules, a Roth IRA should be one of the first places you put money for retirement and one of the last places you withdraw it from. But even if you do decide you want to take your money out, that’s easier with a Roth, too. The 10 percent penalty and the five-year holding rule that apply to early traditional IRA withdrawals apply only to the
earnings
for a Roth IRA. The original contribution can be withdrawn tax- and penalty-free at any time, including the day after you contributed it, if you really need the money.

Although employer-based retirement accounts will be covered in another chapter, the employer-based retirement accounts for a self-employed person essentially function as big IRAs. There are four types of IRAs that a self-employed investor might consider: a solo 401(k), a Roth solo 401(k), a SEP-IRA, and a SIMPLE IRA.

The 401(k)s first came on the scene in 1978, when section 401(k) of the tax code was written. They were popular with employers because they cost less money than traditional defined contribution plans, and they were popular with employees because of the matching funds and the control offered to employees over their financial future. But they did not serve self-employed individuals very well. It wasn’t until 2001 that changes were made to benefit the self-employed, and, thus, the birth of the solo (or self-employed) 401(k).

As with a traditional IRA, you must have U.S. taxable compensation, but the advantage is that there is
no
income limit for contributions, and there is a much higher contribution limit. In fact, it is possible to shelter up to $49K in 2009, $54.5K if you are 50 years old or older. Of course, to put that much away, you must have sufficient income. To max out a solo 401(k), your pretax profit must be at least $205K in 2009. You can defer your first $16,500 into the solo 401(k) as the employee’s contribution, but additional money comes as the employer’s contribution. This amount is limited to 20 percent of your net business income (including the employer’s contribution but not the employee contribution) after subtracting half of your self-employment tax.

The withdrawal rules are exactly the same as with a traditional IRA, except you can borrow up to $50,000 (or 50 percent, whichever is less) of the amount. Borrowing from a 401(k) isn’t a good idea because the borrowed money is no longer growing, but at least the interest you pay goes to you instead of a bank. A solo 401(k) can also be rolled over into a traditional IRA, should you so desire, although there is really not a huge advantage to doing so (unless you plan a Roth IRA conversion), because solo 401(k) fees are so low, especially at companies such as Vanguard, Fidelity, and
www.401kbrokers.com
.

This option became available in 2006. Like a Roth IRA, the Roth portion of the solo Roth 401(k) is an after-tax contribution, which then grows tax-free and allows for tax-free withdrawals in retirement. The employer contribution, however, is always traditional, meaning it has an up-front tax deduction and is taxed upon withdrawal in retirement. The income limits and contributions limits are otherwise exactly the same as with a solo 401(k), although you are effectively sheltering more money by using the solo Roth 401(k) than with the traditional solo 401(k). Vanguard, the mutual fund company favored by Bogleheads for its low costs, recently added the Roth option to its solo 401(k).

Prior to the advent of the solo 401(k), this account was the best way for a self-employed high-income earner to shelter income from taxes in a traditional manner. The maximum contributions are exactly the same as with the Solo 401(k) for a high-income earner, except that they come from the employer, not the employee. The result is that you actually need a higher income to max out a SEP-IRA than a Solo 401(k). In 2009, you need an income of $255K, $50K more than with a solo 401(k). When you also consider that SEP-IRAs have no Roth option, smaller catch-up contributions, and no option to take out a loan, there really is very little reason to choose a SEP-IRA over a Solo 401(k). SEP-IRAs used to be more available and significantly cheaper than a solo 401(k) plan, but that is really no longer the case, with companies such as
www.401kbrokers.com
and Vanguard entering the fray. A SEP-IRA can always be rolled over into a solo 401(k), of course, should you change your mind or want to switch from an existing SEP-IRA.

SIMPLE stands for Savings Incentive Match Plan for Employees. It was designed as a less-expensive, less-hassle alternative to a typical 401(k) for a small business (less than 100 employees). However, a solo 401(k) is so easy to use that there is little reason to use a SIMPLE IRA if you have no employees (or just a spouse as an employee). Compared with a solo 401(k), a SIMPLE IRA has a lower contribution limit ($11,500 in 2009), a lower catch-up contribution limit ($2,500 in 2009), higher fees, more paperwork, no Roth option, no loan option, and no ability to roll over a traditional or SEP-IRA into it. Like a 401(k), a SEP-IRA, or a solo 401(k), you can eventually roll over the money into a traditional IRA. Although a case can still be made for a small business to use a SIMPLE IRA, there is no reason for a sole proprietor to do so.

There are a few additional types of IRAs that are really just variations of the types already discussed. You are likely to encounter one or more of these along the path to retirement bliss. You should also know how to change your IRA from one custodian to another and understand the contribution limits of each type of IRA.