401K and IRA Questions

July 7, 2007 5:17 AM

I've several tax-related questions. Background: (a) I just became eligible in my job to participate in the firm's 401K program--the firm makes a 3% contribution--since I'm over 50 (I'm 57), I'm told I can contribute a maximum of $20,500 during 2007; (b) I have a traditional IRA from the past; and (c) I also am self-employed in addition to working for the firm. My questions are: (1) Since I have ample assets, would it not make sense to immediately start contributing my ENTIRE salary into the 401K until I max out the $20,500 limit? (2) Related to #1, would it not make sense to change my withholding so that nothing is withheld, eg so that the entire amount of my gross is contributed to the 401K? (3) Is there any reason why I should not "roll over" my traditional IRA to the 401K? (4) Am I able to make a contribution to my IRA in addition to my contribution to the 401K? (5) If I don't roll over my IRA, should I convert it to a Roth?
posted by america4 to work & money (8 comments total)

So many questions. The first place to look for answers is in your plan. Find out who administers the plan (Fidelity, Vanguard, Putnam etc.) and go to the WQebsite. All of them have tools that you can plug in various numbers to predict future outcome. If your Plan does not offer these tools talk to your HR people about getting a better Plan administrator.

To answer at least one. Yes. If you can afford it go for the maximum allowed in the 401k. Although I'm sure the company will not 3% match all of it, it makes sense to take full advantage of free money. Converting to a ROTH may make sense if you believe you will be in a high tax bracket when you start taking money out, or if you believe that tax rates will go up when HilaryObama Clinton takes office.
NOTE: There are differences of inheritance between a 401k, regular IRA and Roth IRA. An estate tax planner would (should) know the implications.

Good luck.
posted by Gungho at 5:38 AM on July 7, 2007

Yes, you should put the max amount in your 401(k) and yes you should change your withholdings so that you can put the max amount. The only thing with withholdings, what I usually do is estimate how much my taxes are going to be at the end of the year, so that I make sure I come close to breaking even when taxes are due, or even owing a little. That's what I would recommend to you.

On number 3, I am not sure. Usually you would, but I am not sure what type of fund your current IRA is invested in and what kind of interest rate you are getting. If the interest rate in your new 401(k) plan is better, you should definitely move it over.

4) Contributions to your IRA - you cannot go over the pre-tax contribution max for the year. Any contributions after that amount are allowed but must be after-tax.

I don't know enough about ROTH IRA's so someone else will have to answer that question.

I would also suggest that you go talk to a financial advisor. My credit union offers a free session with one (even though they try to sell you stuff) it was good to have a conversation with one.
posted by hazyspring at 6:41 AM on July 7, 2007

Re (1): Be careful about putting money into the 401(k) too quickly. It's possible to hit the upper limit in a 401(k) without getting full advantage of the 3% matching, at least where I work. My employer does the 3% matching on a paycheck by paycheck basis. Which is to say, they'll match up to 3% of my salary from that particular paycheck. But, if my salary on the first paycheck of the year were $20,000 and I put all of that into the 401(k), I'd only get $600 from the matching and essentially be done with the 401(k) until next year. So, in this case, I have to make sure my 401(k) contributions are spread out over the course of the year or I'm leaving money on the table.
posted by HiddenInput at 7:52 AM on July 7, 2007

yes... seconding the match-per-paycheck problem. this happened to me this year with my new employer. strangely though, they kept up the match by deducting the full amount that i had specified as a post-tax contribution. if i had realized this was going to happen i might have spread it out, or reduced my contribution to the match percentage after i hit $15,500.

speaking of which, the total amount that can be deposited in a 401k (employer match + pre-tax employee contribution + post-tax employee contribution) for 2007 is $45,000.
posted by joeblough at 8:41 AM on July 7, 2007

Re: #5, Unless I'm missing something, no. As I'm sure you know, you paid taxes on the Roth $ before it went in and now can be withdrawn tax-free, which is not the case for the traditional IRA. So converting it seems to me that you then would pay taxes on it again... right? (But if I'm way behind you here and there's some advanced reason this would make sense, please explain!)
posted by salvia at 9:46 AM on July 7, 2007

For younger people I would recommend keeping your IRA separate from your 401k. I would also recommend using your self-employment income to contribute to a separate SEP IRA. The combined contribution to the SEP IRA and 401k would be the same, $20,500 for those over 50 years old. The reason for keeping the IRAs separate is that you have better control over the types of investments you can make. With the 401k you are at the mercy of whatever investments the plan makes available to you.

But in your case, if you don't like the investments available, you can withdraw some or all of your 401k investments and roll them into a personal IRA when you reach 59 1/2. Since this is only a couple years away in your case, the accounting is simpler if you don't bother with a SEP and just max everything in your 401k. I would not roll your existing IRA into your 401k. Just the opposite, I would roll your 401k into your IRA when you turn 59 1/2 so that you can invest in very low cost Vanguard index funds.

You can always make a contribution to an IRA. It is a completely separate plan from a 401k. The max is $5000 for someone over 50. The only consideration is whether you can do it tax deferred. If your adjusted gross income is less than $60,000 if single or $85,000 if married, then you can contribute tax deferred to a traditional IRA. If above that income, you would contribute to a Roth IRA.

Roth conversion is always a tricky issue. Basically, it boils down to whether you believe you will be in a higher tax bracket when you convert or later when you withdraw. This is tough to determine because is depends not just on how much you will spend in retirement but where that money comes from each year -- social security, taxable dividends, taxable capital gains, a traditional IRA, or a Roth IRA. In addition it depends on whether you believe that laws with change to make tax rates higher or lower in the future.

If you believe that you are paying a higher tax rate now, then you shouldn't convert and instead pay taxes later when your rate is lower. If you believe that you will be paying a higher tax rate in the future, then you should convert and pay your taxes now.

What some people do is wait until they retire and then do the Roth conversion in their first few years of retirement. The idea is that with your income decline you will be in a lower tax bracket and you can convert just enough each year that you aren't pushed into a higher marginal bracket. The cost of conversion depends on your marginal bracket when you do the conversion so it is best to do it at a lower tax rate. If you roll your 401k into an IRA, you have the option of converting all of your retirement savings into a tax free Roth.
posted by JackFlash at 11:08 AM on July 7, 2007

1) Yes, up to the limit of the 3% match or $20,500, whichever comes first. Just in general talk to HR to make sure that your plan will take full advantage of your company match. Otherwise you're throwing away free money.

2) Is this a Roth 401(k) or a traditional? If the latter, the answer is provisionally yes, except that your HR department will be annoyed and will probably screw it up. I wouldn't do it just on those grounds. (Since you're self employed, I'm assuming you have a handle on what you need to do about your personal tax situation.)

If it's a Roth 401(k), the contributions are taxable income.

3) Don't put all your eggs in one basket. Recall that the FDIC only insures the first $250,000 of each retirement account, per institution.

4) Yes.

5) The short answer is that this question has the same answer as the question, "Is my 2007 tax rate the lowest that it's ever going to be for the rest of my life?"

The long answer is, it depends on a couple of things. First of all you need to be aware that some companies now offer Roth 401(k)s. If the Roth IRA is a better deal for you, so is the Roth 401(k), so you should find out.

Second of all, there are income limits to adding to a Roth - MAGI $150K is where it starts to kick in - and rollovers into a Roth count against this limit.

Given the above, whether the Roth IRA is a better deal for you depends on a couple of things. First of all, money you put into a Roth has to remain there for 5 years, or else there is a penalty for early withdrawal. This probably doesn't apply to you right now due to your age, because there's also a penalty for withdrawal before age 59.5.

Second, you want to look at the differential taxation. If you put money in in 2007 and withdraw it in 2023, and your net tax rate in 2007 was 20% and in 2023 it was also 20%, *it doesn't matter* whether you are in a traditional plan or a Roth. Do the math if you don't believe me. (If you're able to contribute more than the limit to the traditional IRA, suddenly the Roth makes more sense because you can effectively cram more pre-tax income into it.)

However, if your net tax rate in 2007 is 28% and you're expecting your net tax rate in 2023 to be 15%, you do *much* better with the traditional account, because you defer paying taxes on that amount of income (and its earnings) until such time as your tax rate is much lower. The problem with this way of thinking is that it requires you to have a crystal ball to peer into the future tax code, but in general if you're expecting to retire without having a big unearned income stream, the traditional IRA makes more sense.

If America changes over to a VAT or Congress amends the tax code to make Roth withdrawals taxable (both unlikely but not impossible) obviously the Roth becomes much less attractive.

Don't forget to consider state taxes. If you're going to retire and move away from a place with a high state income tax, to somewhere that has no state income tax, and only then start making IRA withdrawals, suddenly again the traditional IRA gets more attractive.
posted by ikkyu2 at 11:24 AM on July 7, 2007

america4, we don't have enough information about you to know what the right answer is, but here are somethings to consider, most of which clarify or repeat :) comments already made.

You don't say how much you're making or if you're married, but there are some phaseouts to consider.

For instance, you are not allowed to convert your IRA to a ROTH if your MAGI is $100k or up, whether you're married filing jointly or not. If you're married filing separately you're not allowed to do it, period.

To clarify what JackFlash said, because you are participating in a retirement plan at work, your IRA contributions won't be tax-deductible if you make over a certain amount. (The amount you'll be allowed to deduct or not deduct changes with your AGI but, if you're married, start worrying about it when your AGI is $83k or up. If you're single, it's $52k and up.) If you were not in a retirement plan at work (and your spouse wasn't either), you could have a deductible IRA no matter what your AGI was.

You don't say where your IRA came from, but unless it's a rollover IRA from another pre-tax-contribution retirement account, and you haven't sullied it with post-tax contributions, generally you can't add it to your 401k.

FDIC only insures bank accounts. That is, Money Markets (not Money Market Funds), Checking accounts, Savings accounts, & CDs. Mutual Funds and securities are not protected. The FDIC covers $100k per type of account, and $250k for retirement accounts. Types of accounts are Individual Ownership, Trusts, Joint, and Retirement.

Gungho, I don't of any differences in the estate tax rules for Traditional IRAs, ROTH-IRAs, and 401ks. (If you know of so, please tell me what they are!)

I don't understand what you mean by withholding. Are you talking about the 401k withholding? Usually people mean tax withholding, but I could be misunderstanding.

A lot of the options that people mention with regards to 401ks may be legal, but may not be permitted by your particular 401k. As an example, many 401ks do not permit in-service withdrawals, even if you're over 59 1/2. (You have to quit first.)

If I'm understanding correctly, your HR department won't have anything to do with your ROTH. (You're talking about rolling your existing IRA- either a Rollover or a Traditional/contributory- into a ROTH-IRA, right? Not your employer 401(k) into a ROTH 401k?)

Finally, I am not a financial advisor. I recommend you buy an hour's time with one and have them look over your particular situation. Have everything in hand before you go. Better yet, send it to them beforehand. Just for your retirement questions, here are some things they will find useful:

Pay stub (a couple of them, even)
Account statements, especially for your IRA
A copy of the 401k options available to you (should be included in the plan summary they have to give you once a year)
Last couple of years' tax returns

If I think of anything else I'll post it.
posted by small_ruminant at 2:59 PM on July 7, 2007