Roth IRA

This Tax Mistake Will Cost You a 50% Penalty

April 11, 2018 By Jackie Cohen Leave a Comment

Tax penalty on required minimum distributions

You may have until April 17 to figure out contributions to retirement plans, but don’t confuse it with the deadline for mandated withdrawals known as required minimum distributions (RMDs). That ship has already sailed for the 2017 tax year and if you are late or miscalculate how much you owe, you get hit with a 50% penalty on the owed amount.

Let’s back up: The money you put into a 401(k), 403(b) or other defined contribution retirement plan is not tax exempt. It’s tax deferred.

Your time to pay up comes when you take RMDs — annual withdrawals from your IRA that are taxed as income, not capital gains.

RMDs Are Annual

RMDs aren’t a one-off type of tax. They happen annually, once you turn 70.5 years old — or if you inherit an IRA and do not intend to liquidate it within five years.

Fortunately, RMDs don’t kick in on a Roth IRA during the lifetime of the original accountholder — but after a person’s death, the beneficiary who inherits the Roth would have to start taking distributions.

And no, the estate tax exemption doesn’t apply to IRAs because, again, these are tax-deferred — even though the heir isn’t the one who did the deferring, someone still gets to pay the postponed taxes.

Timing of Distributions

The first year you take the distribution, you have a bit more time to do it than in subsequent years. The deadline is April 1 following the year you turn 70.5 or inherit the IRA.

Heirs have some additional wiggle room, since they effectively have five years to decide whether to liquidate the whole IRA or change it to a beneficiary IRA.

Liquidating an entire IRA puts you into a whole new income tax bracket for the year, which usually makes annual RMDs look like a better choice by comparison.

Wait and You Pay More

Heirs who choose to wait a year or more before taking their first RMD you still have to make up for the previous year(s)’ distributions by taking care of them all with the first distribution.

Thereafter, heirs and retirees take the distribution by the end of the respective tax year, December 31`. Unfortunately, the RMD amount isn’t a static figure every year — it involves similar math to what insurance companies do.

Fortunately, you don’t need to be an actuary to get the math done — just use one of the free online calculators available on these websites:

Ask Your Financial Institution

Or if you don’t feel like messing with a calculator, you might be able to get the issuer of your IRA or your financial advisor to do the math for you every year.

Vanguard, Fidelity and other fund families offer to calculate the correct amount and notify you about it. These free services also let you opt to have the annual RMD deposited into a bank account or another non-retirement account — and you may be able to set up income tax withholding on the transactions as well.

You can also choose to have the RMD distributed in multiple payments throughout the year if you want more of a payroll type of effect, which can help you budget better.

Understand the Math

Speaking of budgeting better, you can do exactly that when you develop an understanding of what RMD math involves.

It requires you to refer to the IRS or Social Security‘s estimates to determine your remaining life expectancy — grim as it may be to consider, take the figure you arrive at from either link above and divide it into your retirement account balance as of the end of the tax year in question.

If you have more than one retirement account, you have to take a distribution from each of them, following the same formula.

Which Accounts?

However, the IRS does allow you to aggregate accounts that are of the same type — like if you have two different 401(k)s — and then you can take the distribution from one or the other if you find it easier to do so.

Double check with your accountant or financial planner before you only take a distribution from one account, because apparently this is a common type of mistake that the IRS penalizes at the 50% rate.

However, one thing you can’t do is rollover the RMD money into another retirement account — although you can put it into a taxable investment account.

You Can Start Earlier

If you want to reduce the amount of income tax you have to pay on RMDs in retirement, you could try taking distributions once you reach age 59.5.

Although you’d still owe income tax, you wouldn’t owe the penalty fee that’s normally charged on early withdrawals. This would enable you to reduce the size of the tax burden later on.

Indeed, taking withdrawals from retirement plans involves more complexity than contributing to them in the first place — but it’s worth it when you consider that your pre-tax money appreciated in value for around four decades, give or take.

And while people who inherit IRAs might find RMDs frustrating, there’s a lesson here: If you want to leave a legacy for heirs, IRAs aren’t the ideal investment product for that objective — they’re for funding retirement expenses that the ever-diminishing pool of Social Security funds can’t meet.

Readers, what issues concern you the most about planning for retirement?

Reconsider Roth IRA Contributions Over the Next Decade

March 14, 2018 By Jackie Cohen Leave a Comment

Roth IRA contributions require different decisions under the new law. Between the recent slide in the stock market and the enactment of the Tax Cuts and Jobs Act, you may want to rethink whether Roth IRA contributions make sense.

Contributions to Roth IRAs are not tax exempt but there’s no taxes on withdrawals from these accounts if they’re made at age 59.5 and up — the exact opposite of when taxation kicks in for all other types of retirement accounts.

As such, the Roth IRA primarily appealed to the young — and to an extent directly proportionate to the amount of time you had until retirement.

Rethink Roth IRA Contributions

The other rationale for contributing to a Roth IRA has gained wider relevance under the new tax law: if you anticipate having a higher tax burden in retirement than you do presently.

Most people now fall into that category because the tax cuts that just went into effect begin to sunset in 2025, at which points higher tax rates take effect.

That means that from now through 2024, you can save money on taxes by maxing out the allowed contributions to a Roth IRA — $5,500 annually for those under 50 and $6,500 for those 50 and up.

About Roth IRA Eligibility

However, eligibility to directly contribute to the Roth IRA starts to phase out among higher income brackets, making ineligible for direct contribution those who file as single earning $133,000 a year or more, married filing jointly with $196,000 annual income and married filing separately with at least $10,000 in annual income.

Notice the use of the word “direct” before “contribution” — that’s because it’s possible to make what some call a “back-door” contribution to a Roth, where you first put the money into another type of IRA and then you convert it to a Roth. These conversions are limited to the same amounts — $5,500 for people under age 50 and $6,500 for those 50 and older.

Conversions from other types of IRAs to Roth gain appeal whenever stocks in value following your original contribution — and with the markets becoming more turbulent since 2018 began, the prospect of converting other types of IRA contributions to Roth starts to look appetizing.

Last Year To Change Your Mind

If you convert another type of IRA contribution to a Roth, you have until mid-October of 2018 to change your mind and recharacterize it as the original type of contribution; this is the last year you have the ability to make this type of change.

The mid-October 2018 deadline also applies to any other type of IRA contribution you wish to reverse — something you might want to do if you see a prolonged slide in stock prices.

The ability to make this type of recharacterization also ends this year — assuming the Tax and Jobs Act doesn’t undergo additional revisions.

Meanwhile, you still have until the day that tax returns are due this year, April 17, to complete contributions to any type of retirement plan.

Talk to an Accountant

If all of this sounds confusing, ask your accountant or financial planner whether to switch any of your IRA contributions to Roth. And check out what the IRS has to say on the subject of Roth IRA contributions:

Readers, what issues have you found confusing or challenging this tax season? And do you have any concerns about whether to contribute to a Roth or other type of IRA as the stock market becomes more volatile? Please don’t hesitate to share in the comments section any questions you might have about retirement plans or taxes — we just might use them as the basis for blog posts over the next six weeks.

If you want to learn more about how tax filing has changed, be sure to check out the following articles from our archives:

What You Should Know About Roth IRA Conversions

April 21, 2017 By Doug Carey Leave a Comment

There is a lot being written about converting to a Roth IRA these days. With so much money being tied up in IRAs, it is becoming a very important question.

When thinking about converting from a traditional IRA to a Roth IRA, not only do you have to figure out how much to convert, but you also need to think about when and over how long of a time period.

When using a traditional IRA, you contribute your dollars pre-tax, and you will pay taxes only when you withdraw later in retirement. Roth IRAs are a bit different. You cannot deduct the contributions from your taxes, but when you withdraw later on, nothing is taxed.

In general, the goal is to minimize your taxes. But it’s a bit more complex than that. It also depends on the timing of the tax savings.

The Roth IRA vehicle was only created 20 years ago. It is just now starting to become mainstream. Although most people should probably not convert to a Roth IRA, it is worth it for nearly everybody to at least find out if it makes sense for them. The tax savings could be enormous.

Moving Tax Brackets

If you think you will be in a higher tax bracket when you retire, or if you know you will have very lot tax years coming up, you should definitely look into whether or not a Roth conversion makes sense.

One reason many people cite for wanting to convert a traditional IRA to a Roth is the lure of early retirement. Let’s look at a case study. We have a person, John, who wants to retire when he’s 50. The problem here is that John cannot use his IRA money (without a 10% penalty) until he’s 59.5.

This is one case where a Roth conversion can be very helpful. Here is what John can do:

Transfer all IRA money to a Roth IRA.
Pay the taxes on the transfer (you will be your marginal income tax rate on this). If possible, pay the taxes out of taxable accounts and not out of the IRA itself.
Wait at least five years and then begin to withdraw from the Roth IRA, tax-free and penalty-free.

This strategy will allow John to begin using his retirement money at age 55 rather than age 59.5 and he won’t pay the 10% penalty.

Now let’s look at running some actual numbers to see when a conversion makes sense.

Running The Numbers

Let’s look at another case study. John and Jane are 54 years old. They plan on retiring next year. They will be start receiving large pensions at age 62 and social security at age 67. Currently their federal tax rate is only 10%, but that will increase dramatically at age 62 when their pensions kick in. This is a perfect example of a couple who should probably do a Roth conversion.

With their current plan where they keep their traditional IRA as-is, they only have a 62% chance of never running out of money, according to the WealthTrace Monte Carlo simulator.

But what if they convert their entire $600,000 IRA to a Roth over a seven year period when their tax rate is low? I ran this scenario and it helps them quite a bit. The results are below:

Their probability of never running out of money jumps by 9%. Part of the reason is that their tax burden would decline by nearly 30%, as you see in the table above.

A Roth conversion is not for everybody, but for some it could be a life-saver in retirement.

Photo: CafeCredit.com

The Completely Tax Free Roth IRA: Strange Ways to Save

June 9, 2010 By Jennifer Derrick 10 Comments

SavingAdvice is starting a new column that’s going to look at strange, offbeat ways to save and make money. Anything that’s a little odd, uncommon, or contrarian is fair game – as long as it’s legal.

You probably already know about Roth IRA’s. These are IRA’s that you fund with after tax dollars and then, when you retire, your withdrawals are tax-free. In contrast, regular IRA’s are funded with pre-tax/tax deductible dollars but you pay taxes on your withdrawals when you retire. The big draw of a Roth IRA is that you pay your taxes now, at what is likely to be a lower rate than will be in effect when you retire, and then during retirement you don’t have to worry about taxes. But what if you could figure out a way to avoid taxes on both ends? Is it possible to create a Roth IRA that carries no tax burden whatsoever?

I have a friend who is trying just such an experiment. He is funding a Roth IRA with money that is not subject to taxes. He’s putting in all his gifts, money found in the street, rebates, credit card cash back, and other money that isn’t taxable income into this Roth IRA. He’s funding the account with money on which no taxes have been taken out. When he retires, he will not pay taxes on his withdrawals, either,
making this account completely tax free. So far he’s managed to accumulate about $5,000 in this IRA, including the interest he’s earned from his investments. With about twenty years to go until retirement, he could have a nice chunk of money in this tax-avoided account.

Is such a thing ethical? You could argue it both ways. You could say that he is cheating the system by operating against the spirit of the Roth rules. However, I would say he is being smart. He is careful to make certain that the money he puts into this account is not subject to taxes, so he’s not breaking any laws to my knowledge. He’s putting his gifts and found extra money to good use. Rather than dropping this non-taxable money into a regular savings account where the earnings are subject to taxes, he’s using it to best advantage, protecting any earnings from future taxes.

Now, obviously my friend does not intend to retire on just this money alone. It would be nearly impossible to gather together enough tax-free money to provide a comfortable retirement. Unless you have a lot of people giving you big gifts, you need another plan. My friend has other retirement accounts that will provide the bulk of his income. This is merely his attempt to “stick it to the man” by avoiding taxes on his retirement income as much as possible. When he retires, he will have a least a small amount of money on which he has never and will never pay taxes.

Dave Ramsey Financial Peace University Review: Week 10

April 22, 2010 By Maggie Ellis 2 Comments

This week we moved on to Baby Steps Four and Five, which are saving for retirement and saving for your kids’ college education. Baby step four was on deck first, which is to save 15% of your household income in tax-advantaged plans. Dave points out that, at the time this class was filmed, 53% of all workers had less than $25,000 in retirement vehicles. Further, when asked how they plan for retirement, 44% said that they guess at the amount they’ll need and the investment products to use. Those are some scary numbers. Most people figure retirement’s too far away or they’re too busy living for today that they “forget” to take care of their future. Big mistake. Since pensions are almost a thing of the past and Social Security cannot be counted on, most of these people are going to have a hard time making ends meet in retirement.

Dave spends the first part of the lesson discussing the most popular retirement products, including the 401(k), IRA, SEPP, and other speciality plans like 403(b)’s and 457’s. The most commonly used are the 401(k) and the IRA (and it’s cousin, the Roth IRA). The point of any of these plans is to use tax-favored money to save for your retirement. You’re either putting in pre-tax money and allowing it to grow tax free (IRA, 401(k)), or you’re using post-tax dollars that will grow tax free and not be taxed when you withdraw the money (Roth IRA).

Dave strongly advocates for the Roth IRA. In a Roth IRA, you invest after-tax money but your earnings grow tax free and you are not taxed on any withdrawals when you retire. There’s also a little more flexibility with a Roth in terms of early withdrawals without penalty. Dave argues that you have more investment choices with a Roth, also. That’s probably true when compared to a 401(k) that offers only a few funds, but you can open a traditional IRA at any brokerage and have access to thousands of funds and stocks, just like with a Roth. The ability to withdraw money tax free after you retire is the big draw. If you’ve saved a lot of money, you’ll likely be in a higher tax bracket when you retire since most of your deductions will be gone and you may be pulling in more per year than you did when you were employed. If that’s the case, tax free withdrawals are great news.

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Dave Ramsey Financial Peace University: Week One

Dave Ramsey Financial Peace University: Week Two

Dave Ramsey Financial Peace University: Week Three

Dave Ramsey Financial Peace University: Week Four

Dave Ramsey Financial Peace University: Week Five

Dave Ramsey Financial Peace University: Week Six

Dave Ramsey Financial Peace University: Week Seven

Dave Ramsey Financial Peace University: Week Eight

Dave Ramsey Financial Peace University: Week Nine

Dave Ramsey Financial Peace University: Week Ten

I have nothing against the Roth, but I don’t believe in it as strongly as Dave does. I just cannot imagine that in the thirty years I have until retirement that the government will not find some way to tax those withdrawals. I cannot see them letting that large pool of money remain untouched. I think it will be at a low rate, but I think it will be taxed. There was a time when Social Security earnings were tax free and that is no longer the case, so the government has proven to go back on its promises. I prefer to hedge my bets and use a regular IRA. Yes, I’ll have to pay taxes when I withdraw the money, but at least for now I’m able to reduce my taxable income each year. Since I hover right on the brink of a higher bracket, that reduction in taxes now is worth more to me than a promise that might not be honored by the time I’m retirement age. You might consider using both types of IRA’s and taking some deductions now, while hoping for tax free withdrawals later.

After discussing the types of retirement plans, Dave offers a reminder to roll your retirement money directly into another qualified plan if you leave your job. Never touch that money or you’ll have to pay taxes and penalties on it. You want it to roll seamlessly into another plan. He also counsels us to never borrow against retirement money. Not only do you lose out on the compound interest, but any loans must be repaid within 60 days of leaving your job. If you can’t repay it, you’ll be taxed and penalized on that money.

As far as what to do with the 15% of your income that you’re saving, Dave suggests this order:

1. Fund your 401(k) or other work plan up to the amount that your company will match.

2. Above the matched amount, or if the company does not match at all, fund Roth IRA’s up to the amount you’re allowed by the tax code.

3. If you still haven’t hit 15% of your income yet, go back and put the remainder into your employer’s plan.

His plan isn’t a bad one. It gives you a good distribution of your assets in plans that use both pre- and post-tax dollars and which have different tax structures for the withdrawals. If you don’t have a plan at work, I would suggest putting some money into a regular IRA and some into a Roth. That way you get the same type of tax structure.

Dave then moves on to saving for college. This part of the lesson is very short. He advocates using an Education Savings Account (ESA which is like an IRA for education. You invest pre-tax money into the account and the money is taxed when it’s withdrawn. If you can’t use an ESA, then Dave recommends a 529 plan. Just make sure that you stick with one that gives you complete control over the money and does not make any type of automatic adjustments based on the child’s age. Dave does not recommend using any other savings products including insurance, savings bonds, or pre-paid college tuition plans. Most of these simply don’t make the returns you’ll need to adequately grow your money. Some are also ripe for scammers.

You should do Baby Steps 4 and 5 concurrently, which is why Dave caps the retirement savings at 15% of your income. Ideally that leaves you with some left over to put away for college. Dave does not say this, but I will. If you are older and need to really catch up on your retirement savings, I say skip the college savings and put as much as you can into your retirement. Kids can find work, scholarships, and financial aid to pay for college. You can’t find aid to pay for retirement. Similarly, if you don’t have kids and don’t plan to, go ahead and funnel as much extra as you can into retirement. Don’t just accept the 15% cap. The more you can save, the better off you’ll be.

In small group we talked a little bit about our fears for retirement. We have several people in our group who are in their late forties and fifties, so this is a topic that scares them. Several of them admitted to being below even the reported average of $25,000 in retirement, with no pensions to pick up the slack. A couple of them admitted that they just never gave it much thought until now. They were so busy raising kids, working, and building a life that they let time slip away. They are like the people Dave brought up in the beginning of class who just live for today without much conscious thought for the future. They’re worried now that they won’t be able to retire or, if they can, that they won’t be able to have any fun. They mentioned that, having gone through this class, they are committed to saving from this time forward, but they worry that time has run out and that they’ll never be able to save the kind of money that will give them a good retirement.

From there we talked about what motivates you to get serous about retirement. Every single person in the room listed total fear as their primary motivator. Fear of having to work at Wal-Mart until they die, fear of living on state assistance, fear of not getting the health care that they need, fear of eating Alpo in their old age, and fear of not being able to do anything that they want to do. Fear is a powerful motivator, no doubt. Now that many people in the class are considering this seriously for the first time they are realizing just how far behind they are and how the safety nets they assumed would be there (pensions, Social Security) just aren’t going to be there. It’s scary stuff. Our group leader suggested we try to think of some positive motivators for planning for retirement, just so that terror isn’t the only reason. We came up with wanting to have fun, wanting to give to good causes, wanting to be able to help grandchildren, and wanting to leave a life changing amount of money to our heirs.

We also talked about why it’s a bad idea to borrow from or cash out a retirement vehicle to pay off debt, no matter how much you may want to be out of debt. One man in our class took out a 401(k) loan and used it basically as a debt consolidation tool. He paid off all his credit cards and high interest loans with it to the tune of about $40,000. This worked well until, two months later, he was laid off from his job. That loan was due within 60 days or he was going to have to pay the taxes and penalties on about $38,000. Ouch. He tried all he could to raise the money, but given that he was already living on the financial edge, he couldn’t do it. That 38K was considered income by the IRS and he had to pay the tax bill, plus the penalties for early withdrawal. He ended up losing a big chunk of his money, not to mention the amount of compound interest he lost by moving the money out of the account in the first place. It was an expensive lesson to learn; one from which he is still trying to recover.

As most of the people in the class are older with grown kids or no kids, we didn’t talk much about the college saving aspect of the lesson. However, we did wonder about the amount of guilt people feel if they don’t save for college. Many people put college savings before retirement because they feel so bad about it. But we talked about how a kid can work through school, or get loans or scholarships, whereas a parent has to fund his or her own retirement with no help from outside sources. The parents have to take care of themselves, first.

If you remember, last week we had to do the worksheet that showed how much money debt is robbing from retirement (or other long term goals). The results came up in group and they were eye opening. A quick calculation (using Dave’s charts) of the average in my class showed that debt has cost each person in that room about $2 million dollars in retirement money. The numbers will continue to grow until all of the debt is paid off so the total in the end will be much higher, assuming that it takes most of them several years to get out of debt. One woman said that this exercise motivated her to get out of debt more than anything else in the class so far. She’s probably in her mid-forties, so retirement isn’t that far off. once she saw how much she’d lost over the years, she got very scared and then very serious about paying off debt. Good for her!

This was one of those weeks where we had a really good discussion. Retirement is one of those things that everyone has an opinion on. It’s also something that scares and intimidates many people. I think this weeks’ discussion ended up being like a therapy session for many. It gave them a chance to air their fears and talk with others who are in the same boat. Maybe it made it seem a little less scary.

Homework roundup: This week we have to complete the monthly retirement and college planning forms to determine how much money we should be saving towards these goals. This is to give us a definite number to shoot for instead of just guessing, which is most people’s method of calculation. I don’t have kids so I skipped the college funding worksheet.

The first step in this exercise is to determine what sort of annual income you want to generate in retirement. I shot high and said $100,000. I’d like to travel a lot and I know that medical care and inflation are going to eat away at any income I have, so I aimed high. I doubt I’ll really need that much but I’d rather aim higher than lower.

We then divide that number by .08. The .08 comes from the idea that you are saving at a 12% return, but inflation is 4%, giving you a net gain of 8%. (As I said last week, I think his returns are high, but since this is homework I’m using his numbers.) Using this formula, my target number is $1,250,000.

To figure out your monthly savings amount, Dave has you multiply your target number ($1,250,000) by an 8% factor that matches your age (he provides a table that lists the factors at every five years of age, starting with age 25). Since my age falls slap in between two factors, I did this calculation twice. I need to be saving between $838 and $1,313.75 per month to reach my target number. The higher figure assumes the older age, while the smaller figure assumes the smaller age. Turns out that, according to Dave’s formula, I’m right on target. I currently save $1,227 per month in tax-advantaged accounts (the maximum I’m allowed by law based on my compensation) and another $300 per month in regular investment accounts for long term savings. So I’m at just over $1,500 per month or ahead of Dave’s calculation.

Lastly, if you aren’t interested attending the course yourself, consider picking up the Dave Ramsey Financial Peace University DVD Home Study Kit (9 Week Course) 2012 Release. It sells for between $185.00 and $200.00 on Amazon. This is pretty good deal when you factor in the time savings relative to attending the full course.

Next: Dave Ramsey Financial Peace University Review: Week Eleven

This is a series of posts about what you will find in Dave Ramsey’s Financial Peace University course. You can find the previous posts here: week one — week two — week three — week four — week five — week six — week seven — week eight — week nine