Lynn Brenner's Family Finance

Can I Withdraw My Principal From A Roth IRA in Less Than Five Years Without Triggering a Tax?

Q: I really appreciated your timely AARP magazine article "Roth Mania" . I have a question on one of the rules. You wrote: "Roth IRAs allow tax-free withdrawals of earnings after you're 591/2 and have owned the account for five years." Does this five-year rule refer to the principal and the interest earned, or just to the interest earned? -- PS via email
 
A: This rule is often misunderstood!  It applies only to the interest earned.

You can't withdraw the Roth IRA's earnings tax-free until you're over 59 and a half AND have owned the account for five years. 

But you can withdraw your principal anytime without triggering a tax or a penalty.

There is one exception: If you do a Roth conversion and you're under 59 and a half, you'll owe a 10% early withdrawal penalty -- but no income tax -- on converted principal that you withdraw within five years of doing the conversion, says Barry C. Picker, a New York City tax accountant and IRA expert.

If you do a Roth conversion and you're over 59 and a half, you can withdraw the converted amount tax-free and penalty-free at any time; but you can't withdraw earnings tax-free until the account is over five years old. 

The reason you can withdraw Roth IRA contributions tax-free anytime is that you've already paid taxes on them. If I contribute $2,000 to a Roth IRA, for example, I get no tax deduction for the contribution. The $2,000 is included in my taxable income for the year.

But of course, there's a major downside to tapping the account: If you withdraw your principal, the Roth IRA can't earn anything.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.

Why Can't I Contribute to a 401(k) Plan And Also to Both a Traditional IRA And a Roth IRA?

Q: Everyone including my tax accountant says that you may contribute the maximum amount to a 401(k) plan, and then also contribute to a Roth IRA. If your employer does not offer a 401(k), you may contribute a much smaller maximum amount to a traditional IRA, but you may NOT then also contribute to a Roth IRA.

Is it true that you can contribute to both a 401(k) and to a Roth IRA, but not to a traditional IRA and a Roth IRA?  And if that is true, what possible rationale is there for such apparently illogical and unfair rules? JC via email

A: You expect tax rules to be fair and logical?

Actually, there is a rationale for these rules, but you'll probably find it less than compelling.

Like most of us, you lump IRAs and 401(k) plans together as `retirement accounts'. But legally, they're in two distinct categories.

A 401(k) is a `qualified' retirement plan, which means that it meets the requirements of Internal Revenue Code Section 401(a), and is governed by the 1974 federal law known as ERISA.

An IRA is not a `qualified' retirement plan -- which simply means that it doesn't have to meet 401(a) requirements, and it's not subject to ERISA.

The annual contribution limits are per category, not per account. You can invest the category maximum in one account, or you can divide it between two accounts within that category. But you can't inflate the annual limit by contributing the maximum to two accounts in the same category.

Or to put it another way, you can contribute the maximum to both a 401(k) plan and a Roth IRA because the two are in different categories. The 2010 maximum 401(k) contribution is $16,500 ($22,000 if you're 50 or older.) The maximum 2010 Roth IRA contribution is $5,000 ($6,000 if you're 50 or older.)

Theoretically, that means you can save up to $21,500 (or $28,000) by contributing to both. But in real life, even if you can afford it you can't salt away that much.

In the first place, most employers cap the amount their highest-paid workers can contribute to the 401(k)  to less than the law allows. That's right: A 401(k) plan can never be more generous than the law; but it can always be more restrictive.

(Why the cap? So the plan will be sure to pass a federal anti-discrimination test. A 401(k) flunks the test if a company's higher-paid workers save disproportionately more of their pay than its lower-paid workers. If that happens, the employer must either return some of the higher-paid workers' contributions or dig into its own coffers to add to the lower-paid worker's contributions.)

In the second place, you may earn too much to contribute the maximum to a Roth IRA. In fact, if you can afford to contribute the maximum, you probably do earn too much:

If you're single, you can't contribute the maximum to a Roth IRA if you earn more than $105,000 a year. If you're married filing jointly, you can't make the maximum contribution if you earn more than $167,000. If you earn over those limits, the rules gradually 'phase out' the size of your permissible contribution until it disappears. If you're single and make more than $120,000, or are married filing jointly and earn more than $177,000, you can't contribute to a Roth IRA at all.

I know what you're thinking: What about all the hoopla advertising how Roth IRAs are now finally available to everybody regardless of income?

All that hoopla is about converting a traditional IRA to a Roth IRA, which you couldn't do until this year if your household income exceeded $100,000. Roth IRA conversions are now available to everyone. But the limits on Roth IRA contributions haven't change.

You can contribute to both a traditional IRA and a Roth IRA, provided you meet their respective age and income requirements.

To contribute to a traditional IRA, you must be under 70 and a half, and you must have earned income. (Whether or not the contribution is tax-deductible is a subject for another day. It's based on a fiendishly complex rule that depends both on your annual income and on whether you or your spouse participates in an employer-sponsored retirement plan.)

You can contribute to a Roth IRA at any age; but you must have earned income, and it can't exceed the limits. (See above.)

If you're fully eligible for both accounts, you must split the maximum annual IRA contribution between them. In other words, your total 2010 combined contributions to a traditional IRA and a Roth IRA cannot exceed $5,,000 ($6,,000 if you're 50 or older).

A combined limit rule also applies to Roth 401(k) contributions, which federal law has permitted since 2006. In other words, if your company's 401(k) plan allows both regular and Roth contributions, your combined limit for both would be $16,500 (or $22,000) -- subject to your employer's restrictions, of course.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.

Does a Roth IRA Conversion Really Make Sense?

That's the subject of my article in the March/April issue of AARP Magazine, titled 'Roth Mania!'

You can read that article here. 

The answer obviously depends on many variables, and I think that one of them doesn't get enough attention:

How soon will you have to spend the money you convert from a traditional IRA to a Roth IRA?

(Given my druthers and more space, I'd have devoted a couple of additional paragraphs of 'Roth Mania!' to that question alone.)

A Roth conversion has a price tag -- the income taxes you pay on the money you transfer from your traditional IRA into the new Roth IRA.

You won't come out ahead unless your new Roth IRA earns more than enough to cover that initial cost. That's going to take time -- and a decent investment return. Sure, a Roth IRA's earnings are tax-free. But even tax-free, an abysmal return is abysmal.

Some of the articles I've read quote financial advisers who suggest -- or at least imply -- that five years may be long enough.

I think that's much too optimistic. 

In 'Roth Mania!' I wrote that it's going to take at least ten years for your Roth IRA earnings to exceed the cost of the conversion, and I wish that the words at least had been italicized. 

If you believe that's overly cautious, consider the stock market's performance over the ten years that just ended. From the end of 1999 to the end of 2009, stocks traded on the New York Stock Exchange lost an average of 0.5% a year. It was the worst calendar decade for stocks in the past 200 years.

Many investors still haven't recovered from the shock. After all, in the previous decade --from 1989 through 1999 -- stocks earned an average 17.6% a year. And no matter how often we heard (and in my case, wrote) that those splendid annual returns were much higher than the long-term average, they grew to seem normal.

I'm not suggesting that this decade will be as bad as the last one. (God forbid!) I'm just pointing out that the market can deliver considerably less than its historic average annual return of about 10% to 11%.

When you calculate whether or not a Roth conversion is worthwhile, I wouldn't assume more than a 10% average annual investment return going forward -- and if you want to play it safe, figure on a more modest 6% to 8% return.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

Taxes on IRA Withdrawals: Which State's Tax Laws Apply When I Tap My Account?

Q:  Let's say I worked and contributed to my retirement account in a state that gives seniors a small tax exemption on their distributions from retirement accounts. Then when I retire, I move to a state that offers retirees a much more generous tax exemption for these distributions. Which state's tax exemption applies to me -- the one where I earned my pension, or the one where I now reside? -- AP, via e-mail


A: The laws of the state you live in are the ones that apply to you. Isn't that one of the reasons you moved to that taxpayer-friendly state in the first place?

Money you take out of tax-deferred retirement accounts is always subject to federal income tax; but some states let you exclude part of your withdrawal from your taxable income.

In my own home state of New York, for example, people who are over age 59 and a half pay no state income tax on the first $20,000 of their annual pension income. You get that $20,000 exemption no matter where you earned your pension or contributed to your IRA. For the purposes of this particular law, 'pension income' means money that comes out of your employer-sponsored retirement accounts, such as an IRA, 401(k), or 403(b) plan, and from tax-deferred annuities. It doesn't include Social Security, which has its own exemption from both state and federal income tax.

IRA beneficiaries who live in New York state get the same tax break on inherited accounts, regardless of their own age, provided the retirement accounts' original owner was at least 59 and a half years old. But this state tax exemption applies per decedent, not per beneficiary. In other words, three beneficiaries of one decedent can only inherit one $20,000 annual exemption.

For more information about which states are the friendliest when it comes to income taxes, check out this excellent article from the Washington Post.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved