By Jon L. Ten Haagen, CFP ®
Years ago many companies offered a pension. Unfortunately, these are disappearing and being replaced by 401k – if at all.
The former was funded by the company, the latter is funded by the employee. Some companies offer a match –they’ll put a certain amount of money into your plan when you contribute, too. These usually range in the 3- to 6-percent range. If your company offers a ‘match,’ you should at a minimum contribute at least up to the company match. These are free monies to you.
The first thing you have to look at are the sub-accounts offered to you in the plan. Over the years I have seen too many plans with mediocre investment choices. Funds with not enough diversification or funds with poor management and therefore sub-par returns. In these situations I advise my clients to invest only up to the company match and then look outside to an IRA or ROTH IRA for additional investments. If there is no match ignore the plan.
The basics of an IRA are that you invest your funds and your contribution is tax-deductible if you qualify (see the IRS tables on income amounts and filing status because this can be confusing and complex). Your investment then grows tax-deferred. If you withdraw your funds before age 59.5 you will incur taxes and a 10-percent early withdrawal penalty. If you withdraw your monies after you reach age 59.5, then there is no penalty but the withdrawn funds are taxable at your current income rate. Next, when you attain age 70.5, you are obliged to start withdrawing funds based on an IRS life expectancy table. These are called RMD (Required Minimum Distribution).
The ROTH IRA is a bit different. The monies you contribute to a ROTH go in after tax so no deduction benefit here. Be aware that there is a five-year rule on Roth IRA withdrawals. You cannot take interest and dividends out of your Roth until you are age 59.5 and the monies have been in the plan for five years from the January of the first contribution. There is also a 50-year holding period on withdrawals of money that were part of a Roth conversion, so think about the possibility you might need these monies prior to five years. The monies do grow tax deferred and there is no penalty on the funds you contributed if you withdraw them because they were already taxed before being contributed. There is no age at which you must start withdrawing funds and at age 70.5 you do not have to withdraw. You do not have to ever withdraw these monies and they can be left to your heirs. If and when you withdraw these funds after the age of 59.5, there is no tax, so the entire amount is yours to keep.
One idea is to convert some or all of your IRA and convert it to a ROTH IRA. The monies coming out of the IRA will be taxed as ordinary income, however, once converted, when you take distributions in the future they will be tax free. A good idea would be to do these conversions in a low income year so your tax rate will be lower. The new tax law allows these conversions from an IRA to a ROTH IRA, however, now you cannot reverse this process going forward, so check with your CFP and CPA before proceeding.
An idea for your RMD is to consider a charitable contribution. If you donate your RMD to a charity you will incur no taxes. The funds must go from your IRA directly to the charity. If you touch the monies first they will be taxed. The maximum allowed per year and person is $100,000, which can help reduce a taxable estate.
As you can see, these are very complicated situations and you should get expert advice up front so things do not come back to bite you.
We are here to give you guidance with any of these situations. Feel free to contact us at firstname.lastname@example.org or 631-425-1966.