When I’ve given speeches at community groups, I’m often surprised to hear, “This sounds like a lot of work.”
It’s hard to know what to say to this. Do I say:
– “But it’s worth it.”
– “Not really”
– “Maybe a little work, but it focuses your mind on saving instead of spending”
None of these approach the truth. Saving money isn’t easy or hard….it’s a complete mindset change.
Finding Opportunity Where You Don’t Expect
As I wrote in Can’t Save? Write it Out, Bitches!, often, we don’t look hard enough for opportunities. I took a quick trip to the store yesterday for bread and ketchup to work on my famous sloppy joes (well, not yet famous, but I’ve not given up). Without thinking, I jumped in the car and paid full-on retail for both of these items.
In today’s world, with my iPad sitting on the counter, it wouldn’t have been hard to find a coupon. In fact, a look this morning (that took less than three minutes) found me $.50 off the bread I purchased and $.25 off the ketchup. Lots of savings? No, but by changing my mindset and doing this all the time, I can find tons of opportunities, no matter where I am.
– Saving on insurance with comparison sites
– Saving on airfare and hotels with online discounters
– Saving on restaurants with newspaper coupons
It’s easy to find ways to save, but instead of just grabbing the keys and leaving home, you need to take a few minutes.
It isn’t frugal as much as it’s smart
I’ll be the first to tell you that I have no interest in saving $.75 on bread and ketchup. However, if it’s the same ketchup and bread, the same hotel room, the same airline, and I don’t have to take significant time to find the deal…that’s not about saving $.75. It’s about learning to treat money with respect.
So, the next time you grab the keys to head to the store, think for a moment. Could I look for deals online? Could I find aggregator sites that would help me get this done better/cheaper/quicker (or all three at the same time?). Could I be saving daily with discount codes, coupons and deals for the same stuff I was going to buy anyway? Better yet, could this be the Roth IRA contribution you weren’t able to make this year because you “didn’t have any money?”
Photo: Saad Faruque
“No one knows the day or the hour…”
Unfortunately, that phrase is so true. We here in the O.G. house, along with the whole FFA crew, join those across the world in thinking about (dare I say ‘praying for’) those impacted by the terrorism in Boston, the terrible storms in the Midwest, and the explosion in Texas. The phrase “when it rains, it pours” comes to mind.
These recent events have encouraged me–nay, they’ve compelled me, to write another bit about protection planning. There are three crucial pieces to a well-designed protection plan and collectively, they are the single most important part of your overall financial plan. I don’t care what funds you use, what your company 401(k) match is, or even how many pre-IPO shares of Google you own – without an adequate protection plan in place, you have nothing.
Are you worried about your protection strategy? Here are three steps to an iron-clad protection plan.
Step 1: Forget the 6 months notion – head right to 12 months of cash
Many financial professionals suggest three to six months worth of expenses in a cash reserve position. That’s baloney. If you were sick or injured, would you want to be counting backwards from 90 until you run out of money? I didn’t think so. Skip three months and six and head right to 12 months of lifestyle-sustaining cash reserve, especially if you work for yourself or in an unstable industry…and what industry ISN’T unstable these days? This will take some work to figure out, because it’s not just your annual salary, but rather what you need to sustain your lifestyle for the next 12 months. We’ve discussed saving in a Roth IRA as a dual-purpose account HERE if that suits you better.
Why do you need so much in cash?
First of all, what exactly is “so much” anyway? Obviously, “so much” is a relative and personal term – I have one client who “only” has $90,000 in his savings. That’s on top of the “nearly empty” checking account with $55,000 in it. Oh, and he spends $60,000 a year – 100% covered by his pension. Cash is king. It allows you to negotiate (doctors have different “cash” prices – as do other businesses) and is easily accessible. The last thing you want in an emergency is to be floating credit card balances while your insurance company decides how and when they’re going to pay. Get emergency cash now. Make a plan and do it.
Step 2: Buy disability insurance beyond what your company provides
This is an increased cost, no doubt, but who among us could live on less than 50% of your current income? I know things around here would get a little tight, for sure! Remember what I said a few minutes ago about “lifestyle-sustaining” income? If something tragic happens, should that mean that your kids can’t play soccer anymore? What about dance class? If you’re no longer able to work for the rest of your life, do you think you should continue to build up a retirement nest-egg? Disability coverage only usually pays until age 65! Then what will you do?
It’s usually best to find your own outside coverage in addition to what your employer provides. Group coverage will be 100% taxable when you receive it. Coverage paid for entirely by you is 100% tax-free.
Take this example:
Let’s say you make $80,000 a year as an electrical engineer. You have group disability of 60% that kicks in after you’ve exhausted all your vacation and sick time. Sixty-percent of $80,000 is $48,000, right? Now, let’s subtract 25% for taxes, so that leaves you with $36,000, or roughly $3,000 a month. You were making $5,000 a month after tax. Can you today cut two grand out of your household budget? No? I didn’t think so. Everyone’s cost may be different, but let’s say a disability policy that pays you $2,000/mo DI costs $150/mo. That’s $1,800 a year…is it worth it? Let’s put it another way: Your boss says, “Hey Jimmy, we’re going to cut your salary from $80,000 to $78,200 from now on, but if you even get sick or can’t work ‘cause you’re too hurt, you’ll get all your pay until you retire.” What would you think? I think you’d take that plan.
Go, right now, do not pass go, do not collect $200, go now and acquire an disability application. Fill said application out and send in the first month’s premium. Do it now.
Step 3: Buy a gazillion dollars of life insurance.
I won’t spend a ton of time on this – we’ve discussed this many times before….but whatever you think you need for life insurance, double it…then double it again. Too many people buy only a minimal amount of life insurance. If people rely on you for money now or in the near future, go online to a life insurance wholesale shop (if you can’t think of any, in the US, google “buy life insurance”…there are a lot of interesting blogs about life insurance. If you are based in UK, then I recommend reading this blog for latest news and updates related to life insurance.) and purchase a policy. Twenty or thirty years should do it and the policy had better have lots of zeros (at least 6) and a number bigger than 1 at the beginning. Does that sound like too much coverage? If you ask any financial planner who’s had a client die–who’s had the unfortunate task of delivering a life insurance check to a widow or survivor–they all know that the survivor nearly always says the same thing: “Is that it? How am I supposed to make it on that?”
If you want to get technical, read this to figure out how much you’ll need.
I hate that these evil and terribly tragic things happen. I, in no way shape or form, can justify them or even begin to make sense of them. In the days and weeks ahead, we’ll hear from the culprits and it still won’t make sense. What I do know is this: We cannot ever predict the future. We can only have a plan on the shelf to execute once tomorrow is here.
Just when you thought the show couldn’t get any better, we bring you another awesome episode!
Barbara Friedberg joins our normal roundtable of Carrie Smith and Dominique Brown for “case analysis” on a hypothetical couple with student loans, children and credit card debt.
PK from DQYDJ.NET discusses the Monty Hall problem, and how you can apply it to your life and decision making.
Finally, OG & I top off the program with a look at our Top 5 Investment Options for New Investors. I think you’ll be surprised by our discussion!
<> Open, Welcome back to OG.
<> On the Blog: Emergency Funds, do you need one?
<> PK from DQYDJ.NET: The Money Haul Problem
<> Let’s Give Something Away! Congrats to Lance at MoneyLifeAndMore.com, who won our free copy of Keith Ferrazzi’s Never Eat Alone!
<> Roundtable, Featuring Barbara Friedberg of Barbara Friedberg Personal Finance
<> Top 5 Investment Types for New Investors
(I’m on the road Monday from Michigan, so more detailed show notes will follow on Tuesday)
Divorce is ugly. Except under the most limited circumstances, no one wins in the divorce game. Then, you add the complexity of money into the equation and it gets downright hideous. In that emotional time, it’s easy to understand why so many people divide IRAs, 401(k)s, and other retirement accounts sub-optimally.
You can’t just “take the money out and give it to my spouse” That would be a big mistake. Let me count the ways:
Let’s assume you own a $250,000 401(k) balance. The judge rules that you’re required to split that 50/50 with your spouse, so you decide it would be easiest to make a phone call and take the money out. Ouch. If you do that, you’ll be hit with a 10 percent early withdrawal penalty (yes you, not your spouse, and only if you’re under 59 1/2) and then the amount you removed is added to your taxable income for the year. Now, for many reading this blog, you’ve just lost 35-45%.
So how do you give $125,000 to someone? Oh that’s easy – you gift that to them. But in your haste, you didn’t do this correctly either. To gift it, you either need to reduce your lifetime exemption by filing a form 706 with your income taxes next April, or pay a gift tax of 50%.
Long story short: “taking it out” could be a massive financial mistake.
Instead, consider asking for a QDRO, or Qualified Domestic Relations Order (pronounced quad-row). A QDRO put together by a competent attorney and signed off on by the judge makes this transfer a ton easier.
First, it directs your retirement plan company to establish another qualified plan in the name of your spouse. Then, it directs a tax-free transfer to that newly established account. No taxes, no penalties. Easy as pie.
Once you’ve begun working on that, you’ll want to make sure the QDRO says that your soon-to-be ex-spouse can’t make any loans or transfers from the account until it’s been split; or you could just pick a date to make the transfer effective on (retroactive) and put a fixed dollar amount based on that date’s plan balance. This would protect the new beneficiary from being bamboozled by his or her ex.
Finally, don’t forget about pension plans. A lot of those can be “QDROed” too. For example, let’s assume your spouse earned a pension at his job of $4,000 during the 30 years he worked. He was married to you for 20 of those 30 years – making you the owner of 2/3 of his $4,000 per month. By putting the QDRO in place before he retires, she can have her own pension plan – quite the deal!
At the end of the day, divorce planning with money is just as important as married couple planning. If you don’t do it, you’ll regret it. Take the time to review everything – hire a professional and don’t try to cut corners. The costs are too severe.
Today’s post is part of a larger effort in the personal finance community to discuss Roth IRAs. Congratulations to Jeff Rose of Good Financial Cents for organizing such an effective Roth IRA movement day.
I remember when I was maybe nine. My dad FINALLY let me order my own banana split at the local Tastee-Freeze.
I’d watched him down banana splits with pride. First he’d take care of the cherry and whipped cream. Then he’d cut into the bananas and shovel them into his mouth along with heaping helpings of three big scoops of ice cream.
At age nine I was firmly convinced that more = better in the world of ice cream.
More = better with retirement accounts also, and the Roth IRA is like the banana slices along the side of those three big piles of ice cream.
Some of you may be thinking, “why isn’t the Roth IRA those three wonderful scoops of ice cream?” ….or maybe “how come it isn’t the cherry on top of the whole thing, like the crown jewel?”
The answer is simple: there are other ways to save, and the Roth IRA goes better along with them than without. In other words, you can have a banana or you can have ice cream.
The Roth IRA allows you to eat your bananas with ice cream on the same spoon. Confused yet? So am I, so let’s move on. I’ll explain that later.
What is a Roth IRA?
A Roth IRA is a tax shelter available to US taxpayers. Unlike a Traditional IRA, which gifts the possibility of a tax break today, Roth IRA contributions don’t help your current tax situation. Instead, Roth IRA money is distributed for your later goals on a tax free basis, assuming you follow some fairly simple IRS rules.
How Much Can I Contribute?
Roth IRA contribution amounts change yearly, so it’s best to consult the IRS website for the official answer to this question. Use Google or Bing to search “Roth IRA Contribution Limits (YEAR) .gov” and you’ll find the site. Here’s the most current page at the time of writing.
Persons over age 50 are allowed to make additional contributions above those persons who are younger. These are commonly referred to as “catch up” provisions.
Are There Income Limitations?
Yes, there are. As with contributions, income limits change often, so it’s best to consult the IRS website for these details.
In general, there is a top amount of money you’re allowed to earn each year and still make full contributions. Then, there is a phase-out income zone. If your income falls in this zone above the full contribution limit, you may contribute, but not the full amount.
Finally, people earning above the phase-out zone are not allowed to contribute to a Roth IRA. However, you may use a conversion Roth IRA tactic that we describe in detail in another piece. See: Help! I Make Too Much Money to Contribute to a Roth IRA!
What Type of Investments Are Available?
You can invest in nearly any type of investment, but most people stick with the basics: stocks, bonds, mutual funds, exchange traded funds, and certificates of deposits.
While it’s possible to invest in actual real estate property or actual pieces of precious metals, there are complicated rules around these investments and you should consult with experts who are knowledgeable in these areas before trying to invest.
When Can I Withdraw Funds?
The Roth IRA has different rules for your contribution and the interest your account earns.
Your contribution may be withdrawn at any time, without penalty. We discuss this in detail in this piece. See: Emergency Fund or Roth IRA?
The interest the account earns must stay in the account until you’re age 59 1/2 or older. At that time, you may remove interest without penalty as long as the money has been in the account at least five years.
You may also remove money for other goals pre-59 1/2, such as a first time home purchase or for qualified college expenses. In these cases, funds aren’t considered tax free, but are only tax deferred. However, you do have the flexibility to save for goals other than college without worrying about dividend interest or capital gains taxes.
Can I Change Existing IRA Accounts Over to a Roth IRA?
Sure. However, these accounts have different rules. Here’s a link to the IRS website which explains Roth Conversion IRAs.
Why is a Roth IRA Like the Banana?
Remember how I mentioned that my dad would spoon some Roth IRA into his mouth along with some of the ice cream?
When I finally was allowed to order my own banana split, I learned the magic: bananas and ice cream are flippin’ awesome together.
People ask all the time which is better, a Roth IRA or a Traditional IRA or 401k plan? My answer is this: it isn’t about one or the other. Traditional IRA plans and 401k plans give you nice tax breaks today. You should utilize those. But a Roth IRA gives you healthy tax breaks and flexibility down the road.
Because we don’t know what tax brackets are going to look like in the future, a Roth IRA allows you to hedge your bet on tax brackets and instead have plenty of options later.
How Do I Maximize My Roth IRA Contributions?
Because you’re allowed to change Roth IRA contributions back out, there are strategies which can take advantage of possible market fluctuation during the year. Here’s one such strategy: Your Roth IRA Conversion: Super-Sized
(photo credit: Gabrielsaldana, Flickr)
Our normal Friday Blog Post of the Week! segment will return next week.
The Roth IRA is a Swiss Army knife for financial success.
In short: is it worth all the trouble jumping through hoops to get as much money into the Roth IRA as possible?
In a word: indubitably (I’ve wanted to use that word since I heard it in Mary Poppins. 10 points!)
While I’ll agree that if the only upside to these strategies are immediate returns on a few exotic Roth IRA gyrations, you’ll only gain a few extra dollars in your pocket for what seems like a lot of work.
…and I get exhausted switching television channels, so let’s not talk about work.
I prefer easy and exciting.
The Roth IRA has one exciting feature beyond those we’ve listed previously—flexibility later in your planning.
The problem with financial planning
When I read well-meaning blog posts about retirement or education planning (including my own), the writer always discusses assumptions.
You know what happens when you assume…but what choice do we have?
We’ll have to assume that the tax rate will go up/down/stay level.
We have to project inflation rates.
Finally, we have to decide when we’re going to die. (Well, at least you do…I’ve got my cryogenic tank next to Walt Disney ready to go. I’m gonna live forever.)
Back on point: Roth IRA plans, for those of you uncomfortable with this type of tax shelter, give you no tax break today but offers tax free income down the line. Many (yawn) dissenters say that tax treatment of a Roth IRA is irrelevant. You’ll pay the tax today or tomorrow. It’s all the same.
No it isn’t.
We’re working for maximum tax flexibility, not a few random bucks. Because I can’t predict income tax rates, capital gains rates, or estate tax rates, I’m going to create a financial future that is as flexible as possible, as soon as two current criteria are met:
– I’ve done what I can to maximize deductions today. I know what tax rates are right now, so I’ll take my tax break, thank you.
– I’m not locking up money unnecessarily for down the road when I’m experiencing short term needs for cash.
Here’s the Roth IRA Game
When you reach retirement, let’s pretend you want to live on $60,000. Tax brackets in America are tiered, meaning that you’ll pay 10 percent on the first dollars you make, until you hit the 15 percent bracket, which is what you’ll pay beginning with the first dollar in that bracket, until you reach the 25 percent bracket…..
Because we don’t know what tax brackets will be in the future, let’s pretend the 25 percent line will be at $50,000.
You Have Two Pots of Money
Most people have a pre-tax retirement plan. As I mentioned, I like my current pretax deductions, so I’ve maximum funded those. Therefore, I have monster amounts of money (otherwise known as oodles) inside of them. These dollars must come out of the plan and get taxed.
I’ll remove $50,000 per year from this plan. Some of it will be taxed at the 15 percent bracket and some at the 10 percent bracket.
Here’s Where the Roth IRA Comes In
Finally, I remove $10,000 from my Roth IRA. Now I’m living in the 25 percent tax bracket but the government is taxing us at the top of the 15 percent bracket.
Lots of Work for Big Payoffs
Now, I’ve avoided a 25 percent tax each year (or whatever my top tax rate would be….) on $10,000, or $2,500 in taxes. Of course, I paid those taxes already, but remember, if I’m worried about the HUGE AMOUNT OF WORK this takes, I’m only investing money after I’ve already secured current tax breaks.
First of all, you make how much money?
If you make so much money you can’t contribute to a Roth IRA, then a certain amount of back slapping and high-fiving are in order.
If you need a refresher on the Roth IRA limits to determine if you can contribute, we’ve got your back:
|If You Have Taxable Compensation and Your Filing Status Is…||And Your Modified AGI Is…|
|married filing jointly or qualifying widow(er)|
Less than $173,000
you can contribute up to the limit.
at least $173,000 but less than $183,000
the amount you can contribute is reduced.
$183,000 or more
you cannot contribute to a Roth IRA.
|married filing separately and you lived with your spouse at any time during the year|
you can contribute up to the limit.
more than zero (-0-) but less than $10,000
the amount you can contribute is reduced.
$10,000 or more
you cannot contribute to a Roth IRA.
|single, head of household, or married filing separately and you did not live with your spouse at any time during the year|
less than $110,000
you can contribute up to the limit.
at least $110,000 but less than $125,000
the amount you can contribute is reduced.
$125,000 or more
you cannot contribute to a Roth IRA.
Information courtesy of the IRS
A couple things to point out in our table above:
– First, don’t think just because you make a lot of money and your spouse doesn’t that you can just file “married and separate.” The IRS thought you might consider that maneuver, and now caps income at $10,000 for those who consider that loop-hole.
Also, be aware of what “Modified” AGI means. Leave it to the government to complicate an already complex issue.
Here’s how you calculate your “Modified” AGI (also courtesy of the IRS)
- Subtracting the following.
- Roth IRA conversions included on Form 1040, line 15b; Form 1040A, line 11b; or Form 1040NR, line 16b. Conversions are discussed under Can You Move Amounts Into a Roth IRA, later.
- Roth IRA rollovers from qualified retirement plans included on Form 1040, line 16b; Form 1040A, line 12b; or Form 1040NR, line 17b.
- Add the following deductions and exclusions:
- Traditional IRA deduction,
- Student loan interest deduction,
- Tuition and fees deduction,
- Domestic production activities deduction,
- Foreign earned income exclusion,
- Foreign housing exclusion or deduction,
- Exclusion of qualified bond interest shown on Form 8815, and
- Exclusion of employer-provided adoption benefits shown on Form 8839.
- First, open a non-deductible IRA at your favorite brokerage house (Fidelity, E-trade, Schwab, etc.).
- Next, fund your non-deductible IRA up to your maximum IRA contribution limit ($5,000 for those under 50; $6,000 for those turning 50 in the tax year of the contribution);
- Wait at least 30 days, or a statement cycle so you can show the money was in an IRA – *DO NOT INVEST YOUR MONEY DURING THIS 30 DAY WAITING PERIOD;
- Then, call your brokerage firm and perform a Roth IRA Conversion of your IRA money. You’ll owe tax on the gain (probably just a couple cents of interest), but other than that…pretty easy!
You’ll likely have to fill out a special tax form next year (IRS Form 8606) discussing the conversion, but there will be no tax, no penalty, and now you have a Roth IRA.
A couple of rules:
- If you have other IRA money (other than the $5,000 you just put in), you cannot just tell the IRS you want to convert the non-taxable kind. You have to convert IRAs pro-rata which mean only a percentage of your money will be tax free. If you have other IRA money (not 401(k) money, IRA money), before embarking on this strategy – discuss this with a knowledgeable tax advisor who knows what they’re taking about.
- Unlike a normal Roth IRA contribution, you do not have immediate access to these dollars. You can access them after 5 years – just like any other conversion monies.
- Don’t tempt fate and try to do this at the end of a tax year. There are too many chances for last minute screw-ups. Complete this process during the middle part of the year so you have plenty of time to fix problems before the year’s over. The IRS doesn’t like multiple 1099 forms and stuff like that…as an aside, neither does your accountant.
So there…badaboom, badabing. Now even the 1%-ers can have a Roth. Just like Congress intended.
This is part 1 of a series of posts by theOtherGuy over the next three Tuesdays on Roth IRA strategies.
Among the greatest inventions created by man are:
1) The wheel.
3) Internet blogs.
4) The Roth IRA.
If you’ve been living under a rock and have no idea why a Roth IRA made the list, let’s take a five word primer: Tax. Free. For. Ev. Er. (I know they’re not all words, but get used to it; I’m a finance guy, not some kind of English guru).
If 100 percent tax free retirement money doesn’t get you all hot-and-bothered, I’m not sure what will.
Houston, We Have Some Problems
Contributions are limited by your income. In 2012, for a single person to contribute to a Roth IRA he or she would have to have a Modified AGI of less than $110,000 to contribute the full amount. For married couples, income limits are phased in beginning at $173,000.
The amount you can contribute per year is capped. You’re allowed to contribute $5,000 per year ($6,000 if you’re over age 50). At most, married couples are limited to $10 – $12,000 per year per family. That still gives you plenty of money to save if you’re 30 years old, but if you’re more…shall we say…”middle aged” (editors note: take it easy on us older people—AvgJoe) then you may be running out of years to max fund this terribly awesome retirement savings vehicle.
So, how can you get more money in a Roth IRA if you’re only able to contribute $5,000 per year? Use a Roth IRA conversion instead.
Disclaimer: What I’m about to share with you could cause MAJOR financial harm if you don’t complete the steps perfectly. I strongly recommend you work this out with a tax and financial professional who knows your unique situation and who can help you make sure you get this right. We can’t be responsible for the zillion dollar tax bill they received because they missed a step.
Why Should I Convert?
Let’s say you’re 28 years old and have $40,000 sitting in an IRA that’s from your old 401k plan(s). You also have an existing Roth IRA–and you’re contributing–but it’s growing slowly.
If we assume your $40,000 grows at 7% per year, then that account should be worth about $685,000 by the time you’re 70 years old.
You probably don’t care, but here’s why you should: at age 70 and 1/2 (well, technically, by April 1, the year following the year in which you turn 70 1/2) you have to take money out of your IRA. It doesn’t matter if you don’t need the cash. Your friends at the IRS want their tax money. So, if you have $685,000 in an account at age 70, you’re going to need to take out approximately $25,000 that year. Then you’ll take out more each year until you die.
All of this money will be taxable. Ouch.
Let’s do a Roth IRA Conversion for 2011 this year instead.
What Would Happen To Your Old 401k Money In a Roth IRA?
You guessed it; no taxes, no minimum withdrawals. One hundred percent tax free forever. That’s why turning old 401k money into Roth IRA funds is a great idea for most people.
Here’s a Plan to Super Size Your Gains:
Each year for the next four years, take all $40,000 from your IRA and perform what’s called a Roth IRA Conversion. I’ve been throwing this phase around quite a bit, so let’s explain how it works.
With a conversion, you agree to pay taxes today on the amount you flip to a Roth IRA Conversion in 2011 in exchange for never paying taxes ever again on that money. It’s a great deal – provided you do it right.
You may think, “But it’s 2012 now!” Remember: it’s currently 2011 tax time.
Most people are familiar with the Roth Conversion concept, but let’s Super Size it.
Making Lemonade From Lemons
What happens if you convert your $40,000 on January 1 and invest it in some crappy investment that loses 30% of it’s value? Now, on December 31, you have an account with $28,000 in it…but guess what? The IRS wants it’s taxes paid on the full $40,000 you converted.
Rotten deal, right?
Well, not-so-fast, my friend! The IRS allows you to “Re-characterize” those funds back to a Traditional IRA for whatever reason you please.
So if you converted $10,000 and it lost value, then you could “un-do” it and say, “Nah, I changed my mind.” No taxes. No penalties. Just some paperwork.
Here’s the Cooler Part
You have until your tax filing deadline plus extensions to undo your Roth Characterization. For most of us, we can file an extension until around October 15, instead of the normal filing day of April 15th.
Follow me here: you can perform a Roth Conversion on January 1 and have an “Un-do” switch available until October 15 the following year!
Motivational speakers will tell you that life is about making good use of time.
IRS rules allow you over a year and a half to change your mind.
Here’s what we do with that time
Let’s say you’re like most people without supernatural powers and have no idea how the financial markets are going to perform – nor do you know what asset class is going to be the big winner over the next year.
Convert your $40,000 and split the investment into four different asset class buckets:
If you do this on January 1 (or the middle of February, it doesn’t much matter) you’ll now have until October NEXT YEAR to make a decision on what you’d like to do. After the next 20 months have gone by, maybe your chart now looks like this:
If you keep the Small Cap section, (which grew from $10,000 to $20,000), you’ll pay taxes only on the original $10,000 conversion amount from 20 months ago! Then, you “re-characterize” the other three sections back into their original Traditional IRA bucket and viola! You have big bang for your buck.
You only recharacterized the portion that was sure to grow tax free. The remainder you waited until next year and did it again.
Less tax and more money. I know. I’m brilliant. You don’t have to tell people you read this and can claim it as your own personal strategy. It’ll be our secret.
There are Plenty-o-Caveats
1) You MUST pay taxes due by the normal tax filing day (around April 15th most years) on the conversion amount. If you converted all $40,000, you’ll owe the government a HUGE bill on tax day, BUT you’ll receive that money back when you file taxes by October 15.
2) You’ll need to file an extension on your taxes by the normal filing date. There are IRS failure to file penalties.
3) If you screw this up, there are no do-overs. The IRS has very specific rules and they are to be followed to the “T”. Don’t beg forgiveness for incompetence later. It won’t work.
4) If you use this strategy, you must wait at least 31 days before you “re-convert” these funds.
This strategy can be done with any amount, it doesn’t have to be the full $40,000. I recommend this approach regardless of dollar amount – if you decided to only convert $5,000 of your old 401k savings to a Roth it would make still make sense , why pay more taxes than you need?
With Tax Time Approaching, Know Your Options
If you did a Roth IRA conversion last year, you have the option of “un-doing” it until your tax filing deadline plus extensions this year. If you have old 401k money in an IRA – consider moving it out piece-by-piece to a Roth IRA.
Part two of this series will cover what happens if you make too much money and don’t have money to convert…that’s a good problem to have, but then what?
While I tend to do things the hard way, finding college savings isn’t one of the areas where I complicate a task. For some reason, my sixteen year old twins helps me focus on whether a 529 plan, Roth IRA, or savings bonds will treat me right.
So, even though I’ll generally remember to add softener to the washing machine just after it’s finished, I understand how college plans operate up and down.
If you’re saving for college, it’s important to categorically work through the details of each plan to determine which best fits your needs.
…because there IS A right way to save for college, and a wrong way to save.
The bad news? The BEST way to plan college savings differs depending on who you are and what your circumstances may be.
I know that sounds generic and evasive, but it’s true: the best way to save for college will depend on your own income, current savings and college goal, so the best course of action will be this:
Know what plans exist and how they’ll affect your ability for financial aid before investing a dime.
If you haven’t yet, you should read the pieces on:
– 5 Steps to a Successful College Plan – This will guide your plan of attack when creating a college plan.
– Narrow Your College Search – This will focus your college search to those schools which are the best fit, both financially and for your particular interests.
After reading these two thorough primers, you’ll be armed with an idea of the cost and feasibility of your favorite school.
Let’s now save for the goal: education.
Complicated Ways to Save For College
Some methods of saving for college are so fraught with risk that I’m reticent to ever recommend them to people. That doesn’t mean that these college savings plans are bad; on the contrary, they all have some huge upside potential, provided that all the right conditions exist. Here are a few:
In-State Tuition Reimbursement Plans – Many states offer plans which reimburse the cost of college credits at a later date. This can be a fantastic way to lock in the price of a college, provided that everything goes according to plan.
Upside: Paying today’s rates for in-state public institutions. Don’t have to worry about market conditions or returns on investment.
Downside: Have to worry about state plan solvency. More than one state has already notified participants that they might not be able to meet their obligation. In fact, some plans no longer guarantee that your dollars will lock in present rates. Instead, these plans invest your money with state funds. Who wants their state government as a money manager?
Life Insurance – Some life insurance plans, such as whole life and universal life are presented as attractive options for education savings vehicles.
Upside: These plans are financial-aid friendly. When completing a FAFSA application, money inside of life insurance policies doesn’t count against your savings, acting as a nice shelter. Also, if for some reason the insured passes away, money is available for education.
Downside: You may have to cancel your life insurance policy to withdraw education funds. What if you still need the policy? Also, do you really need life insurance? If the answer is yes, and you’re sure that you will no longer need coverage after this incident, then this might be a good option.
Watch out for fees, too. Not only will you pay for insurance, but often a policy which offers stocks and bonds are filled to the brim with fees to manager and (maybe more importantly) to withdraw funds.
Still want life insurance in your account? Read this good article at FinAid.org for a more in-depth argument: Variable Life Insurance Policies.
Annuities – Tax deferred savings may seem like a good option for education planning. Why save into an account that’ll be taxed every year when you can shelter your money?
Upside: These accounts are FAFSA friendly, meaning that they are not usually counted in the equation for financial aid. Many annuities offer some flexible savings options.
Downside: Too many to mention here, but mostly: fees and penalties. Make sure you’re going to be over age 59 1/2 before you remove money, because if not, there’ll be IRA penalties on top of whatever the annuity company may charge.
Taxes can be a bear. Here’s why: when you withdraw cash, dollars in the account are removed in a LIFO (last in-first out) accounting manner. This means that all interest on the account must be taken before principal is removed. Why is this a big deal? Taxes. You’ll pay taxes as if you earned the money in the year you remove the money. This income may also make your chances of receiving financial aid worse in the following year.
Less Complicated But FAFSA or Tax Return Unfriendly
Stocks or Stock Based Mutual Funds – These accounts can be used whenever you wish, assuming the dollars aren’t inside of a tax shelter. In some years there’s a chance of nice returns, too.
Upside: Returns. While there are no guarantees, over long periods of time the instability of a stock or stock-based exchange-traded fund or mutual fund can be countered with a high average annual return.
Downside: Risk. There is a chance you could lose a substantial amount of principal if you don’t monitor or manage your money. Also, this type of investing isn’t FAFSA-friendly. Dollars that aren’t sheltered count directly against your chances of financial aid.
Bonds or Bond-Based Mutual Funds – More stable than stocks, these types of funds have performed attractively over the last ten years.
Upside: Returns with generally less risk than stocks above. Because bonds throw off dividends as one of the main methods of creating returns, these investments often perform more consistently than stocks.
Downside: Taxes. Bonds often throw off an attractive dividend that savers often reinvest. This money, unless it comes from a special type of bond such as a municipal bond fund, is taxable every year, slowing down your return. While there has been tax reduction with capital gains taxes, these are taxed as income, which is a much higher tax bite. These are also FAFSA unfriendly investments, unless you use government savings bonds. These can be good to you tax-wise, as long as they’re titled correctly and cashed in the same year as you’re paying qualified education expenses.
The Easy Way To Save For College
Roth IRA Plans – A Roth IRA is generally a retirement savings vehicle. Money invested gives you no tax benefit today, but can be taken tax free during your retirement years. You’ll have to follow a few rules, but you are allowed to withdraw funds for college. You may also use nearly any time of investment you choose inside of a Roth IRA.
Upside: Tax shelter. This money can grow tax deferred for education, and if you end up not using it can be used later for retirement, tax free.
Downside: Retirement savings. The best use of a Roth IRA is clearly as a retirement savings vehicle. While money can be used for college, why miss out on the main Roth opportunities around retirement?
Coverdell Education Savings Accounts (ESAs) – These plans allow you to save not only for college, but also for earlier years of private school expenses.
Downside: Funding. Man, these accounts are small. Because you can only place $2,000 per year into this type of account, they often don’t make sense. I’d also meet people with very limited funds in a few different Coverdell IRAs. Who can manage all these little accounts effectively?
The IRS page on Coverdell ESAs is very helpful. Find more details here.
529 Plans – State sponsored education plans offer a good tax shelter, are somewhat FAFSA friendly, and eliminate taxation of dollars as long as funds are used for qualified education expenses.
Upside: Amounts of savings. You can pack tons of money into these plans. Most allow as much as $300,000 to be invested into a 529 account. These accounts can either be in self-directed fund options or can be in age-based options. If you don’t use the money for the primary beneficiary, funds may be used by siblings, parents, children or other close relatives. In these plans your choice of education institutions isn’t limited to a single state. You may use these dollars in any state and still receive the tax benefit.
Downside: Money earned in a 529 plan must be used for education expenses or you’re slammed with penalties. If you aren’t sure about saving for college, funding your Roth IRA first might be a better idea, because while these funds are flexible for college funds, money will be trapped here.
Of these, the savings option I like best is a 529 plan, because of its flexibility, range of schools that accept funds, and tax treatment. While it isn’t best for everyone, for the vast majority it’s where you should save for college.
Here’s How To Evaluation 529 Plans
Just like we’ve told you previously that Morningstar is the best way to evaluate mutual funds, I like savingforcollege.com to evaluate 529 plan options.
Here’s a link to savingforcollege.com. Have a look around to see how thorough this site is on investing for education.
The Good – Lots of information on FAFSA and college savings options. Great reviews on the fees associated with 529 plan savings accounts.
The Bad – While fees are certainly important, I’m about returns. Savingforcollege.com does a poor job of comparing how money managers work unless you’re willing to fork over some money for a premium membership. When compared to more robust money management sites such as Morningstar.com, there’s no reason to pay for this information.
Can I recommend a single-best 529 plan?
Check your state’s plan options at savingforcollege.com to see how they stack up. Always evaluate a few national plans to see how they compare against your own state’s options.
My favorite national plan is UPromise, though I also like the T. Rowe Price option.
I’ll attack this next week, but here’s a preview: not only is the plan managed better than most options available, but if you sign up your credit and debit cards, but using the Upromise Rewards program (which you can sign up for whether you use a Upromise 529 plan or not) you’ll receive points which can translate into extra money into the 529 plan later. Combine the benefits of low cost investing, good management and extra money, and you’ve found a plan that’s hard to beat.
If you want to compare Upromise with your state’s plans, here’s a link for more information: Upromise is the smart way to save for college!