Smart Couples Finish Rich, Revised and Updated

by David Bach

  WHAT HAPPENS TO MY 401(K) MONEY IF I CHANGE JOBS?

  Recent surveys indicate that most of us will work for 10 or more different employers over the course of our lifetime. Talk to someone in their thirties, and chances are they have already held half a dozen different jobs. In the midst of all this job changing, many people leave their 401(k) money behind, in their old employer’s plan, when they go to a new company or, worse, they cash out their plan. This is a huge mistake. What they should do in most cases is “roll it over” into their own Individual Retirement Accounts (IRAs).

  Here’s why.

  Money you leave behind in an old employer’s plan is out of your control. Once you’re gone, your former employer can legally move your money without your permission. For instance, say your old 401(k) plan had been managed by Charles Schwab but now your company decides to move the plan to Fidelity. If the company can’t find you, it will move your money into its new Fidelity plan automatically. However, since the company is not allowed to make investment decisions for you, your money will be put into a money-market account, where it will sit until the company hears from you. Which may not be for years. In the meantime, your money is earning a lot less than it could or should be. Trust me, you want to keep control over your money. So take it with you.

  By not rolling over your 401(k) money into an IRA, you’re limiting your investment options. With an IRA, there is almost no limit to the sort of investments you can make. You can put your money into stocks, bonds, mutual funds, or just about any recognized investment vehicle that strikes your fancy. This is generally not true of 401(k) plans.

  An IRA may offer you better beneficiary options than a 401(k). Most 401(k) plans allow you to name only a spouse as your beneficiary (that is, the person who will inherit your account if you should die). You may, however, want to do more elaborate estate planning, in which you name a trust as a contingent beneficiary. Generally speaking, you can’t do this with a 401(k) plan. Also, most 401(k) plans don’t allow you to make your kids contingent beneficiaries. Why does this matter? Because in the event you and your spouse die together, if your children aren’t contingent beneficiaries of your retirement account, the money might have to be distributed and they could have to pay income and estate taxes on the proceeds. That could cost them as much as 70 percent of what you managed to put away.

  To be fair, there is one advantage to leaving your money in a former employer’s 401(k) plan: you don’t have to make any decisions or think about any of these issues. But that’s not how a Smart Couple operates—not if you want to finish rich.

  IF YOUR COMPANY DOESN’T HAVE A RETIREMENT PLAN…

  In my view, companies have a moral obligation to offer employees 401(k) or similar retirement plans. I find it incredibly sad when I meet people who have worked for the same company for decades and don’t have any money for retirement because their bosses never bothered to put a self-directed plan in place.

  The fact is, there is simply no excuse. Setting up and administering a 401(k) plan is both simple and inexpensive. Indeed, for a company with fewer than 100 employees, it shouldn’t cost more than a few thousand dollars a year.

  If, for some reason, your current employer does not have a 401(k) plan in place, I strongly recommend that you and your fellow employees make it known—in writing—that you are concerned about your future and feel that the company’s unwillingness to offer a retirement plan puts your financial future in jeopardy.

  I also recommend that you make it as easy as possible for your employer to do the right thing. Do the basic research for him or her. Contact a few of the many companies that offer “turnkey” 401(k) plans for small businesses and get them to send you some information about how the process works. Then pass it along to your boss. Among the companies that can help you with this are Insperity (reachable at 877-516-8977 or www.insperity.com), Fidelity Investments (at 800-343-3548 or www.fidelity.com), the Vanguard Group (877-662-7447 or www.vanguard.com), and T. Rowe Price (800-422-2577 or www.troweprice.com) and America’s Best 401k (great option for small companies; call 855-905-4015 or www.americasbest401k.com). This is only a starting point, but by doing some of the groundwork you stand a better chance of getting your company to set up a plan. In addition, you may even end up impressing your boss with your initiative.

  IF THERE IS NO WAY YOU CAN GET YOUR EMPLOYER TO OFFER A 401(K) PLAN…

  If all your efforts are in vain, and your employer simply won’t (or, for some reason, can’t) set up a 401(k) plan for you and your fellow workers, then you have no choice—you must open an Individual Retirement Account.

  Fortunately, opening an IRA has never been simpler. As a result of the massive Taxpayer Relief Act of 1997 and the IRS Restructuring and Reform Act of 1998, it is easier than ever to become eligible to open a traditional tax-deductible IRA or a Roth IRA.

  THE TRADITIONAL IRA

  The IRS permits you and your spouse to contribute up to $5,500 annually to an IRA if you are under the age of 50 and $6,500 for people over age 50 (they call it a “catchup-provision”). When you open an IRA, you first decide how much to put in, then how to invest it. Depending on your tax situation, your entire contribution may be tax-deductible. Your money, though, will grow tax free until you withdraw it.

  WHO’S ELIGIBLE TO USE A TRADITIONAL IRA?

  Anyone under the age of 70½ who earns income from a job (as opposed to interest or investment income) or is married to someone who earns income from a job can open and contribute to a traditional IRA.

  HOW MUCH MONEY CAN I DEPOSIT IN A TRADITIONAL IRA?

  By law in 2018, an eligible individual is allowed to invest up to $5,500 a year in a traditional IRA if you are under age 50 and up to $6,500 if you are 50 or older. Depending on your income and whether or not you participate in a company-sponsored retirement plan, you may be able to deduct your entire contribution. Visit www.irs.gov for updates.

  WHAT ARE THE TAX ADVANTAGES OF A TRADITIONAL IRA?

  There are two big tax advantages to a traditional IRA. Depending on how much you earn and the extent to which you participate in a company-sponsored retirement plan, part or all of your IRA contributions may constitute a pretax investment (that is, one that is tax-deductible). In any case, regardless of whether your contribution is deductible, the money you invest in an IRA account grows tax deferred—meaning that if you keep your nest egg in the account, you don’t have to pay any income or capital gains taxes on any dividends or investment profits it may earn. This ability to defer taxes allows your money to grow much faster than it otherwise would—and makes it possible for you to finish rich!

  CAN A SPOUSE WHO DOESN’T WORK INVEST IN A TRADITIONAL IRA?

  Yes, if you work and participate in a 401(k) plan, your nonworking spouse can still contribute up to $5,500 a year to a traditional IRA account or $6,500 if age 50 or older. How much the working spouse can deduct depends on their adjusted gross income. Again, check IRS.gov for the most up-to-date phase-in rates based on the year you read this.

  WHAT IF I USE A 401(K) PLAN?

  Even if you participate in a 401(k) plan at work, you can still fund an IRA if you wish. Depending on your marital status and income, your contribution may even be tax-deductible. Things get a bit more complicated if you are married and filing separate tax returns. If this is your situation, I suggest you consult a tax advisor. In addition, you can read IRS Publication 590 (“Individual Retirement Arrangements”) or visit the IRS website (www.irs.gov).

  WHAT’S THE DEADLINE FOR FUNDING A TRADITIONAL IRA?

  The deadline for making contributions to a traditional IRA is the date your tax returns are due for that year—April 15 of the year following the one for which you’re making the contribution. However, don’t wait until the last minute to fund your IRA. The sooner you take care of it, the more time you’ll have to take advantage of the tax-deferral benefit.

  WHEN CAN I TAKE OUT MY MONEY?

  The basics of withdrawing money from a traditional IRA are quite simp
le. To begin with, the money you put into the account is supposed to stay there until you reach the age of 59½. At that point, you can start taking out your contributions without incurring any penalties. You will, of course, have to pay income taxes on the money you withdraw. If your contributions were after-tax contributions (that is, if they weren’t tax-deductible), you’ll owe tax only on any gains your original investment may have made, not on the original investment itself.

  WHAT HAPPENS IF I TAKE MONEY OUT OF MY TRADITIONAL (DEDUCTIBLE) IRA BEFORE I REACH 59½?

  If you take any money out of a traditional (deductible) IRA before you reach 59½, in addition to paying income tax on the withdrawal, you may have to pay a penalty fee amounting to 10 percent of whatever interest or investment earnings your initial deposit generated over the years. For example, say you invested $10,000 and it grew to $15,000. If you withdrew this $15,000 prematurely, you would have to pay income taxes on the entire $15,000, plus a penalty of 10 percent of the $5,000 gain ($500). However, no taxes or penalties are due on a premature withdrawal if you put the money back into an IRA within 60 days.

  ARE THERE ANY OTHER EXCEPTIONS TO THIS 10 PERCENT PENALTY RULE?

  Yes, you can make penalty-free withdrawals to pay for certain special expenses. These include higher-education bills for you, your spouse, your children, or your grandchildren, as well as up to $10,000 of the cost of your first home. You can also take money out of your IRA without penalty to cover medical expenses due to long-term illness or disability, to pay for health-insurance premiums, and to affect a property separation in the case of a divorce. Of course, in all these situations you will still have to pay income tax on the money you withdraw.

  ARE THERE ANY OTHER EXCEPTIONS?

  There is one other way you can avoid the early-withdrawal penalty—although to qualify for it, you must be in your early fifties and planning to retire early. According to an obscure section of the tax code known as Internal Revenue Service Rule 72(t) 2(A) iv—generally referred to as “72T”—you don’t have to pay the penalty if you take your money in what the IRS defines as “substantially equal and periodic payments that are based on life-expectancy tables.” In plain language, the IRS allows you to take a fixed amount of money out of your IRA early without penalty provided you work out a withdrawal schedule in advance and then stick to it. This is an extremely complicated undertaking that you shouldn’t attempt without professional guidance. Done correctly, however, it can be hugely valuable to prospective early retirees. So if early retirement is a possibility for you, make a point of finding a financial specialist who knows the ins and outs of rule “72T.” It could save you a bundle in tax penalties.

  CAN I LEAVE MY MONEY IN A TRADITIONAL IRA AS LONG AS I WANT?

  No. With a traditional IRA, you must start taking money out when you reach the age of 70½. IRS Publication 590 (“Individual Retirement Arrangements”) explains how to calculate your Required Minimum Distribution (RMD)—that is, how much you are required to take out and when. This can be a complicated procedure, and so once again I recommend that you get a financial and/or tax advisor to help you figure things out. If you have older parents, make sure they are doing the same because if you fail to make your mandatory withdrawal, or if you get it wrong, you can get hit with a penalty amounting to 50 percent of the total you were supposed to withdraw. The RMD rule, by the way, is a financial ticking time bomb of tax penalties. If you don’t begin taking your RMD at age 70½ you could be penalized by the government up to 50 percent on the amount you don’t withdraw. Couple that with taxes, and you could literally lose up to 90 percent of your money on this IRS tax trap. So, please, make sure you don’t forget, and please check with your parents and grandparents to make sure they are taking care of their RMDs from their IRA accounts. You can blame me—tell them, “David told me to ask.”

  THE ROTH IRA

  When the Roth IRA was introduced in 1997, many experts were skeptical that it would really be worthwhile for the average American. In the years since then, however, skepticism has been replaced by enthusiasm.

  The Roth IRA—it’s named for the late Senator William Roth, who sponsored the legislation that created it—is quite similar to the traditional IRA, except for two things. The first difference is that with a Roth IRA, your contributions are not tax-deductible. Once your money is in the account, however, it grows tax-deferred, just as it would in a traditional IRA. And when you take it out, you encounter the second big difference: provided you’re older than 59½ and the money has been in the account for at least 5 years, it’s totally tax-free! That’s right—you pay no income taxes, no capital gains taxes, nothing!

  If you are at all like me, you’re probably wondering, “What’s the catch?” Why would the government give us this incredible tax break? Well, remember, contributions to a Roth IRA are not tax-deductible, and that deductibility is what originally made the traditional IRA so popular. If you’re one of the many people for whom the tax deduction is important, a Roth IRA may not make sense for you. But before I discuss which kind of IRA may be right for you, let’s go over the specifics of the Roth.

  WHO IS ELIGIBLE FOR A ROTH IRA?

  As with a traditional IRA, you need to have earned income in order to be eligible to open a Roth IRA. But you can’t earn too much. For singles, the cutoff point starts at a modified adjusted gross income (known as a “MAGI”) of $63,000 for single filers and $189,000 for married filers. Below that level, you can contribute up to $5,500 a year to a Roth IRA. Above it, the maximum allowable contribution begins to drop. Depending on what year you read this book these rules could change, so go to IRS.gov (always go here for tax information related to rules like this) and plug in “Roth IRA Contributions Limits” in the search bar. Bam!, you will have the latest rules. Don’t just Google this stuff. Too often there are mistakes online in outdated articles. For tax limit rules assume the IRS website is the source to go to.

  IF I PARTICIPATE IN A 401(K) PLAN AT WORK, CAN I STILL OPEN A ROTH IRA?

  Yes! I love pointing this out at my seminars because so few people are aware of it. My suggestion is that you and your partner first make sure that the two of you are maxing out your contributions to your 401(k) plans. Couples who maximize their 401(k) plans and then contribute to Roth IRAs are setting themselves up to Finish Rich! I strongly recommend this if you can pull off the extra savings and you qualify based on your income.

  WHAT ARE THE TAX ADVANTAGES OF A ROTH IRA?

  As I’ve explained, your contributions to a Roth IRA aren’t deductible, so they will not reduce your current taxes. On the other hand, the money you put in a Roth IRA will grow tax-deferred. Most important, when you take it out, it’s totally tax-free—provided it’s been in the account for at least five years and you are over the age of 59½. It’s this tax-free withdrawal that makes the Roth IRA such a good deal.

  WHAT’S THE DEADLINE FOR FUNDING A ROTH IRA?

  The deadline for making contributions to a Roth IRA is the same as the deadline for a traditional IRA—the date your tax returns are due for that year (April 15).

  SO WHICH WOULD BE BEST FOR US—A TRADITIONAL IRA OR A ROTH IRA?

  Without knowing your personal situation, it’s hard to say which plan might make the most sense for you. Keep in mind that many investors have both types of plans. But there are some general guidelines you might consider.

  GUIDELINES FOR FUNDING ROTH VS. REGULAR IRAS

  The first priority for both of you should always be to max out your contributions to a 401(k) or similar tax-deductible company-sponsored plan.

  If you’re not eligible to participate in a 401(k) plan and you are more than 10 years away from retirement, my personal recommendation is that you go with the Roth IRA. The reason is that in the long run, the benefit of being able to make tax-free withdrawals from your retirement account is enormous.

  If you don’t like worrying about things like the cost basis of your IRA contributions or whether they were pretax or after-tax, then go with the Rot
h IRA. Why? Because none of these things matter with a Roth, since there won’t be any tax to calculate when you take the money out after you reach retirement age.

  If you don’t intend to touch your IRA money and you want to leave it to your heirs, go with a Roth IRA. With a Roth, you are not forced to make mandatory withdrawals.

  If you feel strongly that you need the tax deduction in order to justify funding an IRA, then use a traditional IRA.

  WHAT ABOUT CONVERTING OUR TRADITIONAL IRAS TO ROTH IRAS?

  Over the last few years, many tax and financial consultants have been advising their clients to convert their old traditional IRAs to new Roth IRAs. The reason, of course, is the fact that once your money has been in a Roth IRA for five years, it can be withdrawn tax-free. But while this is a great selling point for converting your traditional IRA to a Roth, there’s a big catch here. When you convert a traditional IRA to a Roth IRA, you’ve got to pay income taxes on the money in the account.