The Bogleheads' Guide to Retirement Planning (12 page)

Being a stay-at-home spouse does not preclude you from having an IRA. Spousal traditional or Roth IRAs require only a marriage certificate and sufficient income to make both contributions. If you are over age 50, you get the catch-up contribution, too!

Many investors have IRAs even though they have never actually made an IRA contribution or inherited an IRA. Whenever you leave a job, you will usually want to roll over your 401(k), 403(b), 457, or other employer-based defined contribution retirement plan to an IRA. Although you lose the ability to take a loan from the savings (which a wise investor doesn’t do anyway), you’ll enjoy more freedom to choose investments and, almost always, significantly lower investing costs, while preserving the tax benefits. In fact, you should usually contribute even to a poorly designed 401(k) so that it can eventually be rolled over into your IRA. SIMPLE IRAs, SEP-IRAs, and solo 401(k)s can also be rolled over into an IRA, if you so desire. Although the benefits aren’t necessarily as large, you can often save a few fees and simplify your finances by doing so.

To initiate an IRA rollover, you just need to contact the custodian (such as Vanguard or Fidelity) where you want to hold the IRA (or where you already hold your IRA) and fill out a couple of pages of paperwork. They’ll do the rest.

If I told you there were a way to make your heir a millionaire for only $2,000 today, would you be interested? What if I told you I could also arrange for your descendants to be billionaires in just a few generations at the same time? It involves a completely legal inherited Roth IRA tax scheme called a stretch Roth IRA. Imagine an 18-year-old man who starts a Roth IRA with $2,000 today. He gets married at age 53 to someone 20 years his junior. He dies at 73 and leaves her his Roth IRA, which she lumps into her own. She dies 40 years later at age 93, and leaves the Roth IRA to her great-grandchild, who is 2 years old at the time of her death. The child begins taking the required minimum distributions, which at that age is just over 1 percent of the balance, much less than the amount the Roth IRA is likely to be growing each year, even after inflation. Assuming the child lives a long, healthy life (let’s say age 95) and never withdraws more than the RMD, this IRA will have provided tax-free growth for 188 years, and he will
still
leave tax-free money for heirs. Assuming a 9 percent return, the original $2,000 would be worth $229,000 at the time of the man’s death. When his wife dies, 40 years later, it would be worth $7.2 million. And 93 years later, this same IRA would have provided millions of dollars in distributions to the great-grandchild, who can leave further millions to his heirs. If he is able to invest the original IRA and reinvest the distributions at 8 percent, he could leave behind more than $9 billion. Now that’s an estate tax problem.

When you combine the magic of compounding with tax-free growth and a healthy disinclination to spend, truly amazing things are possible, all for a mere $2,000. Of course, this assumes our country and its current tax laws are still around in 200 years, but even if the benefits are only a fraction of what I’ve illustrated here, it is still the investing deal of the century.

A traditional IRA can also be stretched, but it is much more difficult to leave a large sum of money behind because of the relatively large RMDs in the last few years of the original owner’s lifetime. The pesky issue of your heir having to pay a large amount of taxes with each distribution also rears its ugly head. But you still get some tax-free growth for a large number of years. You should also note that you cannot convert an inherited traditional IRA to a Roth IRA, unless you inherited it from your spouse.

A health savings account (HSA) was originally designed to help people pay for medical care, but savvy investors use it as an extra IRA. You are eligible only if your health insurance is a high-deductible health plan that meets IRS rules. Contributions are deductible, just like a traditional IRA, and withdrawals are tax-free, just like a Roth IRA, if you use them for health care. Unlike a flexible spending account, the money does not have to be used up in that particular year. So if you don’t spend it, it just keeps growing for decades. In retirement, you can use this money for health care, tax-free, or, after age 65, you can use it for anything, but you’ll have to pay tax on it at your marginal tax rate, just like a traditional IRA.

Most HSA plans offer either mutual funds or a brokerage account. The 2009 contributions limits are $3,000 for an individual, $5,950 for a family, and an extra $1,000 if you are over 55. If eventually used to pay for health care, an HSA is better than a traditional or Roth IRA, because it eliminates not just three of the four taxable events discussed earlier, but all four of them! The benefit of tax-free growth is so great that you should preferentially pay for health care with current income or taxable savings to keep this money growing until retirement. Remember that if you itemize your taxes, any amount above 7.5 percent of your adjusted gross income (AGI) that you spend on health care qualifies for an additional tax deduction!

If you make too much money to deduct a traditional IRA contribution, you should contribute the money to a Roth IRA. But if you make too much to contribute to either, you can still contribute to a nondeductible IRA. This is simply a traditional IRA without the initial tax break. Your money grows tax-free, and when you eventually withdraw the money, the earnings are taxed at your marginal tax rate. Your original contribution is not taxed again.

The paperwork to keep track of the tax basis (what you originally contributed) through the years can be a pain, and if tax-efficient investments such as stock index funds are held in the account, you may be paying your marginal tax rate on income that would have been taxed at the lower capital gains rate if you had used a taxable investment account instead.

It takes many years of tax-free growth to make up for that higher tax rate at withdrawal. Use a nondeductible IRA under only two circumstances: first, if you need more tax-protected space to hold tax-inefficient investments such as REITs or TIPS (see Chapter 10 for more on this subject) and second, if you plan to convert the nondeductible IRA to a Roth IRA in the near future.

Many investors, even knowledgeable and sophisticated ones, struggle with deciding whether to use a traditional or Roth IRA (or a traditional or Roth 401(k)). Although there are times when the decision is quite obvious, there are so many factors involved that it is sometimes impossible to predict which one will lead to greater tax savings over the years. Using
either
of them is likely to be significantly better than using a taxable investing account, and this difference will increase the longer the money stays in the IRA.

Will your marginal tax bracket be higher now or at the time when you withdraw the money from the retirement account in the future? If you are just starting your career and have a relatively low salary, you should favor paying taxes now while you’re still in a low tax bracket by using a Roth IRA. On the other hand, a highly paid attorney at the peak of his career earnings curve will probably be in a lower tax bracket in retirement and should choose the traditional IRA. Although it is nearly impossible to know what Congress will do with the tax code a few decades from now, if you believe tax rates will be much higher in the future, then choose a Roth option and pay taxes now while rates are low, or vice versa if you believe tax rates will fall in the future. Also, if you are concerned that Congress will somehow change the law so Roth IRAs become taxable in the future (although I confess I feel this is unlikely), you should take your tax break now in the form of a traditional IRA.

Other considerations for making this decision include your ability to maximize contributions to the account, estate planning issues, tax diversification, and possible withdrawals. As mentioned earlier, a Roth IRA allows you to effectively shelter a larger percentage of your income from taxes because the contribution is made after tax. But if you cannot save enough to max out the account anyway, this is less of a consideration. If you are a low-income earner, eligible for a significant retirement savings credit, you will be required to save a lower percentage of your after-tax income to get the same amount of money as a tax credit if you use a traditional IRA.

You should also consider estate planning issues when choosing an IRA. It is possible to leave a lot more money to an heir via a Roth IRA than via a traditional IRA. Money that you intend to leave to heirs should be in a Roth IRA, if possible.

Tax diversification refers to a strategy that allows you to have less regret no matter what happens to your personal tax rate in the future. If taxes rise, you’ll be glad you put some in a Roth. If you end up having less income than you thought (or if tax rates go down), you’ll be glad you didn’t pay all your taxes beforehand. By having some money in both traditional IRAs and Roth IRAs, you have the option of reducing your taxes by withdrawing from the traditional IRA only up to the amount that allows you to stay in the lower tax brackets, and then withdrawing any additional needed income from the Roth account.

Having both types of accounts also allows you to do traditional IRA to Roth IRA conversions (we’ll get to these later) at a relatively low tax rate, if you stop working for a few years before you begin taking Social Security or pension payments. Last, if you need to withdraw some of your money from your IRA prior to retirement age, it is much easier to withdraw it from a Roth IRA, since the contributions can always be withdrawn without paying taxes or penalties.

Some types of IRAs have an income limit, and all IRAs have a contribution limit. These limits frequently change either on account of changes in law or because they are indexed to inflation, so check with the IRS or your tax adviser every year to stay up-to-date.
Table 4.1
explains the 2009 income and contributions limits.

The best way to minimize RMDs is to take the money out of a traditional IRA prior to age 70. Of course, when you do this, you lose the benefit of tax-free growth unless you immediately roll over the money into a Roth IRA. Many fully or partially retired investors opt to convert part of their traditional IRA to a Roth IRA in an effort to lower their future RMDs. Although you have to pay taxes at your marginal tax rate on the money withdrawn from the traditional IRA (or equivalent), you will never pay taxes on it again. This tactic can be especially useful in a year where your earnings were particularly low. If you can convert your traditional IRA to a Roth IRA at the 10 percent or 15 percent rate now, but anticipate being in the 25 percent plus bracket later, you can see the wisdom in this move. Others choose to convert some of their IRAs to a Roth IRA in an effort to tax-diversify. They may have never had an income low enough to contribute to a Roth IRA in the past but want some of its benefits in the future.

Nondeductible IRA holders are also prime candidates for Roth IRA conversions. In fact, many high-income investors have been contributing to a nondeductible IRA for the last few years to take advantage of an upcoming change in tax law that allows high-income investors to do a Roth conversion. It is, in essence, a back door into a Roth IRA. The tax paperwork for a nondeductible IRA can be substantial, but a planned Roth conversion can make it worthwhile.

Source:
U.S. Internal Revenue Service

Factors that should encourage you to do a Roth conversion include (a) not needing the money in the Roth for at least five years, (b) expecting to be in a higher bracket later, (c) meeting the MAGI limits now but not in the future, (d) having the ability to pay the additional tax out of current earnings or a taxable account, and (e) anticipating that you will never need to spend this money. Factors that should discourage you from doing a Roth conversion include (a) needing to pay the additional tax due out of the IRA, (b) the added income affects other items on your tax return because of the higher AGI (such as deduction phase-outs, exemptions, or tax credits), (c) expecting to be in a lower tax bracket later, and (d) fearing Congress will start taxing Roth IRAs despite current rules.

Some investors initially open an IRA at an institution with either high fees or poor investment choices and later realize the error of their ways. Luckily, you can easily correct this by contacting the institution (such as Vanguard) to which you plan to transfer the IRA, doing a couple of pages of paperwork, and letting them do the rest. IRA investments can be transferred in kind or liquidated (sold for cash) prior to transfer. But since there are no tax consequences to liquidating, you’ll usually end up paying only a few small commissions and an exit fee to escape from the situation.