An ongoing series of articles on taxes has elicited many letters from readers with tax questions. Here are answers to two of them. If you have more, please send me an email.
If you can't deduct IRA contributions because you have a 401(k) and your income is too high, are there still circumstances where it might make sense to put money away in an IRA even though you don't get the deduction? Also, would there be any tax advantage that comes from investing in stocks vs. bonds in an IRA?
If at all possible, you should try to put away money in an IRA (as opposed to a taxable account) because of the tax advantages you'll receive.
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You say you aren't eligible for a deduction on contributions to a traditional IRA. In that case, you can choose between investing in a traditional IRA without the benefit of the deduction, or investing in a Roth, which never allows for a deduction. The Roth wins, hands down.
With a Roth, you invest post-tax dollars now in exchange for making tax-free withdrawals when you take out the money. Once you've paid taxes, the money can grow in your account, compounding over time, for as long as you want. You can start taking withdrawals at age 59¿ if you've held the account for at least five years. But some investors never cash out their Roth IRAs at all, simply leaving them to heirs.
By comparison, a traditional IRA allows you to defer taxes only until withdrawal, at which point you do pay taxes. Meanwhile -- in your case, at least -- you're shut out of enjoying the deduction for your contribution.
While the Roth is clearly the better choice for you, your income may be too high for you to participate. Click
here for an earlier
story detailing the eligibility requirements for both kinds of IRAs, based on your income, marital status and access to a retirement plan at work.
Assuming you do invest in an IRA, here's a tip that could save you money: Since you can't take a deduction on the traditional IRA, and you won't get a deduction for investing in a Roth, you should max out deductible contributions to your 401(k) before doing anything else. By shielding the maximum sum possible in your 401(k) -- currently $11,000 -- you'll reap the biggest tax advantages.
As for your second question, if you're deciding whether to fund your IRA with stocks or bonds, the choice should be based primarily on your risk tolerance and asset allocation strategy, not on taxes.
That said, though, you don't want to fritter away the tax breaks offered by an IRA. In other words, you shouldn't fund an IRA with
municipal bonds or
Treasuries because they already offer some tax advantages. Dividends in municipal bonds aren't taxed by the federal government, and in some cases escape state taxes as well, while Treasuries aren't subject to state taxes.
You should invest those securities in taxable accounts to minimize your tax hit. "When you put
them in an IRA, it's wasted," says Nicholas Kaster, senior pension and IRA analyst for CCH, a provider of tax law information and software. "You don't want to put any tax-shelter instrument inside an IRA."
The bottom line: Equity mutual funds or taxable bonds make sense for funding an IRA. But keep muni bonds or Treasuries in a taxable account to take full advantage of the tax benefits available to you.
Rollovers From Previous Jobs
K.C., I want to roll my 401(k) from a previous employer into a Roth IRA. How does this work, and is there any issue with regard to the high-income limitations? My current income would likely preclude me from contributing new dollars to a Roth on a stand-alone basis, but do the same limitations apply when rolling from a traditional IRA to a Roth?
It's a great instinct to want to convert to a Roth IRA. It sounds smart to pony up for taxes now in order to avoid having to pay them when you withdraw the money, by which time your account will have had plenty of time to fatten up. Yet a conversion may not be as sensible as you think.
Before we get into that, though, a few quick notes on the nitty-gritty of a conversion: First, you have to convert your 401(k) to a traditional IRA (a somewhat annoying middle step); then you can convert the traditional to a Roth IRA. In the process, you'll have to pay taxes on the money in your account that had been allowed to grow tax-deferred in your 401(k). Remember, a Roth IRA must be funded with post-tax dollars.
To be eligible for a conversion in the first place, your income must be less than $100,000. If you convert an account in the middle of the year and end up unexpectedly earning more than the limit by year-end, you won't be able to keep the Roth. In that case, you'll have to roll the money back into a traditional IRA, but you'll be able to recover any taxes you paid for the conversion by filing an amended return for that year.
But as noted earlier, converting your 401(k) to a Roth isn't a slam-dunk decision. That's because taxes can eat up such a large chunk of your capital, especially if you're in the 31% or 35% tax brackets. It may not be worth it.
For example, say you want to convert a 401(k) worth $50,000 to a Roth IRA, and you're in the 35% income tax bracket. After paying the taxman, you'll be left (sullenly) holding just $32,500. It's going to take a painfully long time to earn that money back.
Specifically, assuming compounded annual returns of 8%, it will take six years before you get back to your starting point (at which point you'll have $51,573). If you're within 20 years or so of retirement, you may not have six years to spare.
"Because the conversion comes with a big tax cost, you need a longer period of time and investment results to outweigh that upfront tax cost you pay," says Dennis Cohen, chair of the tax department for Cozen O'Connor, a Philadelphia law firm.
For that reason, it's easier to justify a conversion if you're relatively young, in a low tax bracket and are converting a fairly small sum. (And since you're writing in with a fairly complicated question to a tax column, it's likely that none of those factors apply to you.) By the time you're in your 40s, a conversion becomes an iffy proposition.
Another point worth considering: Taxes might be lower in the future. As it stands, the tax legislation passed last year will steadily force down income tax rates through 2006. "If you believe there's a trend toward lower taxes -- so that 40 years from now, taxes may be lower yet -- it's a bad idea to pay tax today," Cohen says.
If all this seems unnecessarily complex, take comfort in the knowledge that in a few years, you'll be able to treat all or part of your investment in a 401(k) as a Roth contribution -- regardless of your income. As with a Roth, you'll pay taxes on the contribution upfront, in exchange for being allowed to make income tax-free withdrawals on it after age 59¿.
"You could end up with a huge amount of money in a tax-free vehicle, even more than with a Roth IRA, because the contribution limits are much higher," says CCH's Kaster. But that provision, part of the Bush tax overhaul, won't go into effect in 2006.