Hack your Roth for tax-free short-term savings (Re-thinking the Roth IRA – Part 2)

You may remember my admonitions that ‘retirement savings are for retirement!’, but today I’m going to show you how to use your Roth as a sort of savings ‘hybrid’: you can use the Roth as short-term savings vehicle AND get the benefits of tax-free interest for retirement.  Before we get any further into this, make sure you understand how the Roth IRA works.

You may have decided that investing in a Roth IRA isn’t the best move for your retirement (opting instead for a 401k perhaps.)  Contributing to a Roth may still be a smart move, even if you want to use the money sooner rather than at retirement.  (Anyone with earned income whose modified adjusted gross income is less than $105,000 can contribute to a Roth IRA, regardless of age or participation in other retirement plans, like a 401k.)  Before we delve into the details, I want to let you know that this is an ADVANCED (though not hard) technique.   Make sure you understand all the details before deciding to use it.  (Post a comment with any questions you have.)

Recall that a Roth IRA lets you contribute after-tax dollars to a variety of investments including index funds, individual stocks and bonds.  The benefit over a ‘normal’ taxable account is that the money then grows tax-deferred, meaning you don’t pay interest on reinvested dividends or interest.  Plus, if you take out the gains AFTER age 59 1/2, you don’t pay any taxes on those either!  The catch is that if you DO take out any gains before turning 59 1/2, you generally must pay a 10% penalty on top of regular income taxes.  BUT, because you’re contributing after-tax money already, you can pull out amounts up to the value of your contributions with NO penalties/taxes at any time you want!

For example, say you contributed $2,000 to a Roth IRA in 2007, then another $4,000 in 2008.  You can take out up to $6,000 with no penalties/taxes.  IF however, your account increased to $7000 in value due to appreciation, you can still only take out up to the $6,000.  The extra $1000 gain must remain in the account until you’re 59 1/2 to avoid penalties (with a few exceptions detailed here.)

Since your money accumulates tax-free, you earn a higher after-tax rate of return in a Roth than in a taxable account.  If you’re earning say, 6% interest on $5000 and you’re in the 25% tax bracket, your after-tax return is only 4.5%  ($225 per year) in a taxable account.  If you had that money in a Roth IRA instead, you’d earn the full 6% ($300), which equals 33% more money per year.  Over time, small differences in interest rates make a huge impact on your wealth due compounding interest as shown by the below graph.*

After 5 years, your Roth IRA will have $400 (7.5%) more in it, in 10 years, about $900 (15%) more.  When we combine the two facts above, being able to take out contributions at any time plus tax-free growth, we get a great way to use the Roth IRA as BOTH a short-term savings vehicle AND a way to earn higher returns on that money.

First, open a Roth IRA account that is completely SEPARATE from any Roth IRA account you might have designated for retirement.  This is because you do NOT want you to think of any Roth money you set aside for short-term savings as retirement money.  This makes it easier to keep track of your contributions that you plan to take out.  I have two Roth IRA accounts at Vanguard, one for retirement (invested 100% in stock index funds) and one for short-term savings, like emergencies, invested 100% in a diversified bond index fund.  Here’s how it looks:

Next, use an Excel spreadsheet, like the one I developed here, to track your Roth IRA contributions.  Your spreadsheet should have at least two columns: one that shows the amount of money you either contributed or took out of ANY of your Roth IRA accounts and one that shows the date of the transaction.  To find past contributions, the financial institution where you have your Roth IRA should keep records of these transactions for a few years (or check all Form 5498’s that you might have received from your financial institution(s) over the years.)  Make sure you never take out more than you’ve contributed, or you’ll likely face taxes or penalties.

Next, fund your separate, non-retirement Roth IRA with money that you need in the short (or long) term.  If you’re saving for the short-term, like an emergency fund, choose a relatively safe investment like a bond or money market fund.  The beauty of using a Roth for an emergency fund is that you get the benefits of easily-accessible principle (your contributions) with the added bonus of tax-free growth that can be used for retirement.**

This is great because your emergency funds might be invested for a really long time, if you’re lucky enough to avoid costly emergencies.  In light of this, you’d like to maximize your gains by avoiding taxes while the money sits there.  You can use a similar strategy when saving for a down payment on your first home.  If (and ONLY if) you’ve had a Roth account open for at least 5 years, you can use up to $10,000 of Roth IRA gains towards a first-time home purchase tax- and penalty-free.  So in this special case, you can even use the earnings (plus all the contributions) from your Roth IRA.

(Remember, you must have opened a Roth IRA account and deposited money into it at least 5 years ago to use this exception.  There is a similar exception for qualified education expenses, except the earnings withdrawals are NOT tax-free, only 10% penalty-free.  However, there are better ways to save for education.)

As a final note, remember that the IRS doesn’t care which IRA accounts you deposit to or take money out of, all that matters is your total contributions & distributions from all your Roth IRA accounts combined.  (Even so, I strongly recommend keeping Roth accounts you intend to use for short-term events separate from retirement-designated Roths.)

Start using this strategy today by opening a Roth IRA online at a reputable mutual fund house like Vanguard, Fidelity or T. Rowe Price.  With minimum initial deposits as low as $50 for T. Rowe Price, there’s no excuse for not starting a Roth.

* The graph is inflation-adjusted because we always want to talk about ‘real dollars’, aka purchasing power.  Another way of saying this is that we don’t really care about how many dollars we have, but how much stuff we can buy with them.  If we didn’t factor in inflation, we would actually understate how valuable the tax-savings from a Roth are.

** If you really want to optimize your investment performance, you could periodically (perhaps annually) move the gains on your non-retirement Roth into a Roth you’ve designated for retirement.  You would do this in order to move these gains (which shouldn’t be taken out until retirement) into a more volatile long-term investment, like a stock index fund, rather than having them sit in a stable, but lower expected return, short-term investment.

Start a retirement fund with fifty bucks (it’s that easy…)

… thanks to T. Rowe Price’s Total Equity Market Index fund (ticker: POMIX.)  Most funds require a few thousand dollars to open an account.  T. Rowe Price lets you open, say, a Roth IRA, with as little as $50 as long as you sign up for minimum automatic monthly contributions of $50 as well (taken right out of your checking account.)  With this particular fund, you get a low-fee, broadly diversified, US stock market index fund.  It’s the kind of thing you can invest in regularly and forget about until you’re within 10 years of retirement.

(If you invested the bare minimum of $50 per month for 30 years at 7% interest, you’d have over $58,000.   Plus, you would only have invested $18,000 of your own money [= $50 * 12 * 30]. That’s an extra 40 grand in your pocket just for 50 bucks a month!)

POMIX’s expense ratio is a low 0.40% (not quite as low as Vanguard’s 0.18%, or Fidelity’s approaching-absolute-zero Spartan fund ratio of 0.10%.  Unfortunately, they require $3000 and $10,000 to open an account, respectively.)

Bottom Line

If you’re not saving for your retirement (or for whatever long-term goal you have), and you don’t have a few thousand laying around to open an account, you can still start with $50 today!

Re-thinking the Roth IRA – Why the Roth IRA may NOT be the best retirement vehicle for you

In this article we’re going to discuss why the Roth IRA may NOT be your best retirement vehicle (and why it certainly shouldn’t be your only one.)  If you’re not already familiar with a Roth IRA and how it compares to a Traditional IRA, please read this.

(Quick refresher: Traditional IRAs and 401ks allow you to avoid paying taxes on contributed income in the current year, but when you take the money out in retirement, you must pay taxes on it at your regular income rate.)

So, which one is better for you?  If you expect your marginal tax rate to be higher in retirement than currently, it may make sense to put some of your money into a Roth IRA (Only after you max out your employers matching contribution on your 401k; never refuse free money!)  Say you’re a student with a part-time job, and your marginal tax rate is 10%.  Assuming you’re significantly wealthier when you retire, you might be in the 25% tax bracket at age 60 and beyond.  Thus, it doesn’t make sense to save 10% on  taxes today, when you may pay 25% on your marginal income at retirement.

On the other hand, if you believe your retirement tax rate will be lower than your current tax rate, then a 401k or Traditional IRA may make the most sense hands-down.  (Imagine that you and your wife are fully employed and are supporting kids or a mortgage.  In retirement, you may not have those expenses, and thus can live on less income, which might reduce your tax bracket.)

Either way, the best retirement plan for you is likely to have some money in both types of accounts (if not all of it in a 401k.)  Let me explain why:

Fill up those low brackets!

1) The first reason (other than employer-matching) to funnel money into a 401k is to ‘fill up’ your lower tax brackets.  This concept (and many others  in this article) is excellently described here at ‘The Finance Buff’s’ site.  I highly recommend your read his article as well, especially if you have any questions about the below.  His graph (see below) illustrates what I mean:

Because the United States tax system is progressive, the first dollars of income you have are taxed at a lower rate than the last (or marginal) dollars.  In 2008, a married couple filing jointly could take 2 exemptions and the standard deduction and not pay ANY taxes on their first $17,900 of income.  Then, they’d pay 10% on their next $16,050 (“taxable income.”)  After that, they move into the 15% tax bracket and pay that rate on their next $49,050.

For simplicity, let’s assume that a 401k is your only source of income and that when you retire, the tax brackets will remain the same as they are in 2008*.  If you withdraw less than $83,000 (adding up all the amounts in the 10%, 15% and “0%” brackets above), you’ll pay only 15% at the marginal dollar of income.  If you and your spouse make, say, $100,000 combined today, you’re in the 25% bracket.  Thus, it would make sense for you to contribute to a 401k and save the 25% now, paying the 15% later (rather than a Roth which would save you the 15% later, but cost you 25% today.)

In addition to filling up your retirement low tax brackets with 401k income, there’s another reason why a 401k might be a better choice than a Roth IRA.

Like a Ford Explorer, it’s easy to rollover a 401k

2) You can rollover a 401k into a Roth IRA (after leaving your employer), paying the taxes in the year you convert the Roth.  What this means is that you effectively (but not really) cash out your 401k into a Traditional IRA, then, you convert the Traditional IRA into a Roth IRA.  You have to pay regular income taxes on the value of the conversion (because you were never taxed on the 401k contributions.)  Why might you want to do this?  Let’s look at an example:

Say you’re currently in the 25% tax bracket and expect to remain in that bracket in retirement.  Because you’ve read this article, you contribute to your 401k to fill up your lower brackets for retirement.  This year however, you’re fed up with the rat race.  Maybe you quit your old job to take a sabbatical, go back to school, or start your own business.  If your new marginal bracket is low (say 15%), you could rollover some money from your 401k/Traditional IRA to a Roth IRA, only paying 15% tax to do so.  If this chunk of your 401k represented money you would’ve paid 25% on in retirement, you’ve just saved yourself 10% (=25% – 15%)!

In closing…

There are other reasons that I’ll let you read about in the above-mentioned article by The Finance Buff (including avoiding phase-outs and the dreaded Alternative Minimum Tax.)  For most people though, I believe the above two reasons, especially the ‘filling lower brackets’ strategy, are the most important.

Don’t get me wrong, there are still some great reasons for using a Roth IRA for retirement.  Like ‘hedging’ against higher future taxes and not being forced to take the minimum distributions at age 70.5 that you have to with a Traditional IRA/401k.  There are also some non-retirement Roth IRA usages that I’ll discuss in the next column.

Bottom-line: For most people, the 401k/Traditional IRA should make up the bulk of their retirement contributions.  I see entirely too many personal finance sites that recommend putting your money into a Roth IRA as soon as you max out your employer matching.  This is dangerous, blanket advice, which I think is dead WRONG for many people.

Even if you determine the Roth isn’t the best thing for your retirement money, check out how to ‘hack your Roth’ for use as a tax-free, short-term investment vehicle.

Note: I’m not an accountant, so please review your personal tax situation with one, or make sure you understand it when planning for your own retirement.  As always, if you have specific questions about the above, please comment on this article or email me.

* This would be a good approximation if real dollar (inflation-adjusted) tax brackets stay the same.  However, it may be that tax rates increase in real dollars.  This could be due to, oh, I don’t know, our MASSIVE and increasing federal debt in the US.

All about the Roth IRA – your key to tax-free retirement!

If you’ve read my primer on retirement, you should have a good idea of the benefits of investing in a Roth IRA. If you haven’t read it, let me give you a quick rundown before we get into the gritty details:

Meet the Roth IRA

Unlike a Traditional IRA (“Individual Retirement Account”), with a Roth IRA you have to pay taxes on the income that you invest. (The money you put into a Roth IRA is called a “contribution.”) However, instead of that money (plus all the growth) being taxed when you take it out at retirement (after age 59 1/2), with a Roth IRA you get to make the withdrawal tax-free (The money that you take out of a Roth is called a “distribution.”)

Also, like a Traditional IRA or 401k, all the growth and reinvested dividends in a Roth IRA grow tax-free while they remain in the Roth account.

That’s the Roth IRA in a nutshell. Now let’s look at some of the details below that might also sway your decision on where to put your retirement money. (And for a complete look at those details, you can check out IRS publication 590. I’ll warn you though, it’s as dry as the name suggests.)

The Roth IRA has “rules and $#%&” too…

Contributions

In order to contribute money to a Roth IRA, you must have “earned income” that amounts to at least as much you’re going to invest. Thus, if you want to put in $2500 into your Roth IRA in 2008, you must’ve received at least that amount of earned income in the same year. This then begs the question, “what the heck counts as earned income?”

Earned income (or “compensation”) is defined as wages, salaries, tips or professional fees. Essentially, it’s what shows up on your W-2 as “wages, salary, tips” etc. This does NOT include money from investments like interest, dividends, or capital gains. Also NOT included as compensation are payments from social security, disability, pensions, annuities or income from property.

The most you can contribute in one year to a Roth IRA is $5000 for 2008 (that is, if you ONLY contribute to a Roth IRA for retirement.) This amount will be adjusted in $500 increments, when required, to keep pace with inflation. There is one exception to this maximum IRS limit: if you’re 50 years old or older prior to 2009, you can contribute an additional “catch up” amount of $1000 to your Roth IRA, for a grand total of $6000 in 2008.

In 2008, in order to contribute to a Roth IRA, you also must have an Adjusted Gross Income (AGI) of less than $116,000 if you’re filing single ($169,000 for those married filing jointly.)  Also, the amount you can contribute to a Roth IRA is “phased out” for those filing single whose AGI is between $101,000 ($159,000 if filing jointly) and $116,000 ($169,000 filing jointly.)

One nice thing about the contributions to a Roth IRA is that for a given year (say, 2008), you have until the tax deadline in the following year to make contributions. Therefore, for most people, April 15th 2009 would be the last day you could make Roth IRA contributions for 2008.

Distributions

If the idea of receiving tax-free income in your golden years isn’t enough, the Roth IRA also has some other benefits when it comes to receiving distributions.  These benefits give you some flexibility and liquidity that is usually reserved for taxable accounts.

Distribution of your regular contributions – You can take out the amount you’ve contributed to a Roth IRA tax-free at anytime (I recommend only doing this if you really have to; chant the mantra: “Retirement savings are for retirement!”) For example, let’s say you’ve contributed $5000 per year for 4 years to your Roth IRA. Then, at age 42, you lose your job and need to tap your IRA in this emergency situation. You could take up to $20,000 worth of distributions from your Roth IRA tax-free, since you made an equal amount of contributions over the years.

Qualified Distributions – With a Traditional IRA, you can generally only take the money out without penalty if you’re over 59 1/2, and then you still have to pay normal income tax on that money. With a Roth IRA, some of the ways in which you can take out money tax and penalty-free are known as “qualified distributions.”

“A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:
   1. Made on or after the date you reach age 59½,
   2. Made because you are disabled,
   3. Made to a beneficiary or to your estate after your death, or
   4. One that meets the requirements listed under First home under Exceptions in chapter 1 [of IRS publication 590] (up to a $10,000 lifetime limit).”

If you receive a distribution that is not a qualified distribution, you may have to pay the 10% additional tax on early distributions.

Item D means that if you’re a first-time home-buyer, you can take a distribution of up to $10,000 in earnings (after using all the contributions) for the purchase of this home (as part of a down-payment, for example.) If your spouse has a Roth IRA and is also a first-time home-buyer, she could use $10,000 of her Roth IRA in the home purchase as well (for a total of $20,000 between the two of you.) Note that you can also use your Roth IRA distributions in the same way for a child, grandchild, parent or other ancestor that is a first-time home-buyer.

Additionally, should you kick the bucket early, your beneficiaries can use your Roth IRA distributions tax-free. This makes a nice life insurance bonus out of the Roth IRA (for your sake, a benefit that hopefully won’t be used!)

You can also use Roth IRA distributions penalty-free (but not tax-free) for up to the amount required to pay for your qualified higher-education expenses (as long as you paid for those expenses with savings, loans, wages, a gift or an inheritance, and NOT through a tax-free scholarship or grant.)  Even though your Roth earnings withdrawals are not tax-free for qualified higher education expenses, you may be able to used tuition deductions or education credits to offset the taxes from that income.  (However, there are much better ways to save for eduction.)

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

This means that if you want to start a retirement fund but think that in several years you might decide to buy a house (for the first time) or go back to school, a Roth IRA may be a good place for your money in any event.  However, I would caution that if your plan is to use a Roth IRA to fund something other than your retirement, you can’t really count that Roth IRA money as part of your future retirement.

As stated in my article on retirement, I believe that funds set aside for retirement should ONLY be used for that purpose. So, make sure you keep your “true” retirement money separated (at least in your mind) from your “maybe-for-school-or-a-house, maybe-for-retirement” money.

Conversion – You can also convert a Traditional IRA or 401k/403b into a Roth IRA. Keep in mind that you’ll have to pay the taxes in the current year at ordinary income rates on the basis amount of Traditional IRA that you’re converting.

Ready, set, Roth!

Now you should have a deeper understanding of the Roth IRA, a powerful retirement vehicle that could save you a bundle in taxes after you retire. If you combine the over-59 1/2 tax-free distributions with the additional distribution flexibility of funding your first home purchase or higher-education costs with your Roth, this IRA might be the right investment vehicle for you.

(To find out why the Roth IRA may NOT be the best retirement vehicle for you, read this.)