Why Alan Didn’t Rollover his 401(k)

Posted On July 1, 2014 By Admin In Retirement Planning /  

Couple at Golden GateAlan and Lois began investing in the 1990’s when their tax preparer suggested the young couple establish a Roth IRA to begin saving for retirement.  They each deposited $2,000 into a Roth, the maximum contribution back then.  As the contribution limits increased, they continued to fund their Roth IRAs, and as their careers flourished, they were able to contribute to their 401(k) plans at work as well.

This worked for more than a decade, until 2006, when their joint income exceeded the income limitations to contribute to a Roth IRA.  At that point, they ceased making contributions.  They could have funded a Traditional IRA, but it would have been non-deductible.  Luckily, I met Alan and Lois two years ago and I was able to determine they were eligible for a Back Door Roth IRA.

Prior to 2010, in order to convert a Traditional IRA into a Roth, you had to have a joint income under $100,000. When this income restriction was abolished in 2010, it created a new opportunity.  Now, anyone can contribute to a Traditional IRA – which does not have income limits – and convert those funds into a Roth IRA.  If you fund the Traditional IRA with a non-deductible contribution and immediately convert the account, you will have zero taxable gains and the conversion will be tax-free.  The strategy is called the “Back Door Roth” since it bypasses the Roth’s income restrictions.

Here’s the crucial piece to understand: the IRS considers you to have one Traditional IRA, regardless of the number of accounts or types of IRAs you own (Traditional, Rollover, SEP, or SIMPLE).  This means that you cannot convert just the new non-deductible contributions.  If you have multiple accounts or multiple contributions, the IRS will consider any conversion to bepro rata, meaning proportional from all sources.

Luckily for Alan and Lois, their retirement accounts consisted solely of 401(k) accounts and Roth IRAs, so they were eligible fund the “Back Door Roth IRAs” and pay no taxes.  We deposited $5,500 into a Traditional IRA for each of them and converted the account into their existing Roth IRA.  It’s a great way to add $11,000 a year to tax-free account, and yet many people don’t realize they are eligible for the Back Door account.

This spring, Alan changed jobs and asked me about rolling over his 401(k) into an IRA.  If we did rollover his $350,000 account into an IRA, he would be giving up the ability to do the tax-free Roth conversion in the future.  The IRS will look at his accounts as of December 31, so if he did rollover his 401(k) this year, the Roth conversion we did in January would now be more than 95% taxable.

After explaining this to Alan and Lois, we decided that it did not make sense to rollover the 401(k) into his IRA and give up the opportunity to fund the Back Door Roth for the next 15 to 20 years.  He could leave his 401(k) in its current location or roll it to his new 401(k), which is acceptable because it is not going to an IRA.  The rules on Roth conversions apply only to your IRAs, and not to 401(k), 403(b), 457, or other ERISA-type plans.  Alan’s new 401(k) plan had extremely low fees and access to institutional share classes of mutual funds.  So, we rolled his old 401(k) to the new plan and will still be able to take advantage of the Back Door Roth IRA each year.

There are a number of reasons to not roll a 401(k) into an IRA, and that’s why it can be highly valuable to have a financial planner who is completely familiar with your individual situation.  If you’re looking for this kind of personalized advice, please give me a call.

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Who’s Going to Pay for Your Retirement, Freelancer?

Posted On June 26, 2014 By Admin In Retirement Planning /  

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A regular employee has a steady paycheck which makes planning and budgeting easy.  For a freelancer, your income may fluctuate greatly from month to month and be very difficult to predict from year to year.  You may not know what work you will be doing six months from now and that’s likely to be a more immediate concern than retirement which could be 20 or 30 years away. 

It’s often impractical for a freelancer to save up a large lump sum investment each year.  What does work for freelancers is to “pay yourself first” by setting up a monthly automatic investment program into an Individual Retirement Account (IRA).  This forces you to budget for retirement savings just as you would do for any other bill, such as your car payment or rent. It is easier to plan for smaller monthly contributions and this creates the same regular investment plan as an employee who is participating in a 401(k).

The maximum annual contribution for an IRA in 2014 is $5,500, which works out to $458 per month.  If you aren’t able to contribute the maximum, that’s okay, there are mutual funds that will let you invest with as little as $100 a month.  The most important thing is to get started and not put it off for another year.  You can always increase your contributions in the future as you are able.  If you are over the age of 50, you can contribute an additional $1,000 a year into an IRA, a total of $6,500 a year, or $541 per month. 

If you can use a tax deduction, open a Traditional IRA.  If you don’t need the tax deduction, and meet the income limitations, select a Roth IRA.  Additionally, there is another reason the Roth IRA is very popular with freelancers.  Many freelancers worry about hitting a slow patch in their business and needing to tap into their savings.  A nice benefit of the Roth IRA – which may help you sleep well at night – is that you can access your principal without tax or penalty at any time.  So if you do have an emergency in the future, you would be able to withdraw funds from your Roth IRA.  (Principal is the amount you contributed; if you withdraw your earnings (the gains), the earnings portion would be subject to income tax and a 10% penalty if you are under age 59 1/2.)  

If you are able to contribute more than $5,500 (or $6,500 if over age 50), the SEP-IRA is your best choice.  You could contribute as much as $52,000 into a SEP this year, if your net income is over $260,000.  The contribution for a SEP is roughly 20% of your net profit each year, so it works great for freelancers who want to save as much as possible.  Why not just recommend a SEP for all freelancers?  The challenge with a SEP is that it is impossible to know the exact dollar amount you can contribute until you actually prepare your tax return each year.  That’s why most SEP contributions are not made until March or April of the following year.  For freelancers who are getting started with saving for retirement, your best bet is to first maximize your contributions to a Traditional or Roth IRA through automatic monthly deposits.  Then if you want to make an additional investment, you can also fund a SEP at tax time.  A lot of investors assume that you cannot do a SEP if you do a Roth or Traditional IRA, but that is not the case, you can do both. 

Being a freelancer can be very rewarding and fulfilling, but it does carry some additional financial responsibilities.  You don’t have an employer to pay half of your social security taxes or to provide any retirement or insurance benefits.  Unlike traditional employees, however, many freelancers don’t go from working full-time one day to completely retired the next day.  What I often see is that many freelancers choose to keep working but reduce their schedule and select only the projects which really interest them.  In this manner, they are never fully retired, but still stay active and have multiple sources of income.  Regardless of your plans or intentions for retirement, my job is to help you become financially independent, so you work because you want to and not because you have to.

 

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