My Retirement Blog

Snowflaking is a play on words off Dave Ramsey’s Snowball psychologically-driven debt busting technique and it refers to putting small amounts towards your debt, snowflakes, to help eradicate debt. One of the ideas of snowflaking is that you can find small alternative sources of income and then push it towards your debt but you could really put it towards anything. You’re snowflaking when you drop your loose change in the piggy bank, so why not apply this towards retirement?

Snowflaking won’t work for things like a 401(k) since it will be a payroll deduction, but you could use it to fund your IRA, Roth or Traditional. I recommend using the piggy bank approach, putting small amounts of money into your piggy bank and then making one deposit each month, hopefully in addition to your monthly Roth IRA contribution. If you’ve maxed out your retirement fund, that’s wonderful and you can skip this. If you don’t max out your contributions to your Roth IRA each year, consider using snowflaking to help get you even closer. Remember, the 2008 Roth IRA contribution limit is $5,000 if you’re under 50 and $6,000 if you’re over (it’s the catch-up provision).

If you’re retired and drawing payments from Social Security, you may be wondering if you could use those payments as contributions to a Roth or Traditional IRA. Unfortunately, Social Security is not considered earned income so it’s not counted towards what you’re allowed to contribute towards an IRA. Earned income is anything that is reported on a W-2 or something you put on a Schedule C, if it’s business income, or Schedule F, if it’s farm income.

This rule also applies for income you may derive from a pension, interest, dividends, rental income, or capital gains. So, all that interest you got from the bank doesn’t count as dollars you can put towards an IRA.

On my mainstream personal finance blog, Blueprint for Financial Prosperity, I penned an article today called How To Become A Millionaire (In 6 Easy Steps!) that begins with a two steps focused solely on retirement. For the retirement saving savvy out there, these two steps are obvious and a staple of retirement planning. Step 1 is to contribute to your company’s 401(k) plan and, hopefully, get yourself a nice employer match for your efforts. Step 2 involves contributing towards a Roth IRA so that you can diversify your tax profile, a little of tax-deferred to go with your tax-free retirement investments.

Becoming a millionaire isn’t difficult but it does require discipline. It’s extremely difficult to take some of your hard earned money and lock it up in a time capsule you won’t open for twenty, thirty, or forty years. It’s even harder if you have current financial demands such as children, bills, etc that are vying for your next dollar. If you have the discipline to do it, you should be handsomely rewarded with a more fulfilling retirement.

Fidelity, Vanguard, TD Ameritrade, Charles Schwab… there are just so many brokerages and mutual fund shops, which one should you sign up with for your Roth IRA? The answer is any of them. In fact, if you haven’t opened up a Roth IRA because you didn’t know which investment company would be best then you’ve made a big mistake. However, it’s not the end of the world because the day is young and you have plenty of opportunities to go open a Roth IRA right now.

Now, since you still are deciding where to go, there was a great CNN Money article that outlined what you should be looking for in an investment company. The article is pretty long but the bottom line is that you are really talking about the amenities a company offers. Can you get someone on the phone? Are you willing to pay a premium to talk to someone on the phone? Does it offer the types of funds you want to be invested in? If you only want index funds, then compare fees and expense ratios and see which one is the cheapest. If you are interested in a target retirement food, check out the investment companies that offer them like Vanguard and Fidelity. If you want to trade stocks, go with the ones that have the lowest fees (Vanguard’s brokerage side is not discount, it’s quite expensive! The mutual funds are top notch though).

First decide what you are investing in, then filter down that list. Then look at the amenities. If you want phone contact, check to see if your investment company has that. If it doesn’t, cross it out and move on. Eventually you’ll have a good list, now go open it and contribute. You have a few months left to contribute for 2007.

Source: CNN Money

In 2008 and 2009, you will be permitted to directly roll over/convert a 401(k) into a Roth IRA as long as you’re willing to pay the taxes for the conversion and if your annual income does not exceed $100,000 (in 2010, the $100k rule expires). In 401(k) official terms, this means that you can convert a distribution from an employer-sponsored plan directly into a Roth IRA. For those keeping score at home, this may come as a surprise since you couldn’t do this in the past and because you are basically throwing all the Roth IRA contribution limits out the window. Currently you can only contribute $5,000 a year to your Roth IRA, subject to income phaseout limitations, and so being able to convert from a 401(k) into a Roth is something that would circumvent that since the 401(k) limits are $15,500 a year!

What happens when you convert? Easy, the amount that you convert will be subject to your marginal income tax rate but then it’s tax-free at disbursement, since it is a Roth IRA at that point. Do you have to convert the whole thing? No, you pick how much you want to roll over, just as you would if it were to go into a Traditional/Rollover IRA, and you only pay taxes on that which converts into a Roth IRA. If you are willing to wait until 2010, you can convert as much as you want and spread out the tax liability over 2010 and 2011.

Now, before you jump at the opportunity to convert everything over to a Roth, I would investigate your tax diversification profile because having all your retirement assets in tax-free is just as bad as having all of your assets in tax-deferred accounts. Make sure you are properly diversified from this perspective so you don’t get sticker shock down the road.

When it comes to investing, the tax benefits of IRAs (both Roth and Traditional) and 401(k)s can’t be matched, as long as you use them properly. So, it always pays to make sure that you’re not putting tax advantaged investments into those accounts (unless that’s the only place you’re investing) because you generally can’t take advantage of them twice. While a little confusing, let me explain with an example.

Let’s say you invest in a bond that is federal income tax free. For our example, you are earning 3.9% APY from this federal income tax free bond and you invest a tidy little sum of $10,000. After the first year you have made yourself a nice $390 profit. If you kept this in a regular brokerage account and realized those gains, you wouldn’t owe any federal income taxes on those funds. In fact, if you are in the 25% tax bracket, you would’ve had to have earned 5.2% APY from a non-federal income tax free bond in order to get that equivalent yield.

Now let’s take the case in which you invested that money in a Roth IRA. After the first year, you get your $390 and you still pay no taxes on the realized gain. It’s the same thing right? Wrong because in the Roth case you could’ve invested in a 4.0% APY bond, non-federal tax free, and made more because of the tax advantaged status of the Roth IRA. See what I mean? Instead of being forced into finding a 5.2% federal income tax free bond because you have to pay taxes, anything above 3.9% is fair game in a Roth (you have to wait until retirement to withdraw it penalty free though).

So, be sure to take advantage of the tax advantaged nature of IRAs and 401(k)s in your investment decisions.

It’s not very often you hear someone touting the benefits of a Traditional IRA over a Roth IRA, but today it happened. Roland Manarin, founder of Omaha, Nebraska based investment firm Manarin Investment Counsel, says that the bigger pot you work with in a tax-deferred account will result in greater earnings than a tax-free account.

“To put $4,000 into a Roth, you have to effectively earn $6,000,” because of taxes, Manarin said. “To put $4,000 into a regular [deductible] IRA, your take-home pay goes down by $3,000. What a huge difference,” he said. “Let’s turn it around: You put $4,000 in a Roth, that’s the equivalent of putting $6,000 in a regular IRA. There’s just no comparison.”

Then, “you compound that difference over 20, 30 years. Now I’m facing retirement, I’m going to be in a lower tax bracket, I’ve got three times the money in my regular IRA versus the person in the Roth,” Manarin said.

While I applaud the “going against the grain” idea, because it spurs thinking, I think this guy has a few flaws in his reasoning.

Assuming a lower tax bracket in retirement may be dangerous. Who knows what taxes will be in the future, that’s why I personally advocate tax diversification (a mix of tax-free and tax-deferred retirement accounts) so that you can hedge a little.

Assuming everyone can invest tax-deferred in a Traditional IRA is even worse. You can only deduct your contributions to a Traditional IRA if you satisfy certain rules, one of which is whether you’re an “active participant” in another in a company sponsored retirement plan. For example, if you’re single, participate in a company 401(k) and earn more than $50,000, you cannot deduct your Traditional IRA contributions! (more rules here) That throws the whole idea of deductible IRAs being better out the window.

It’s an admirable try at it and a great way to get yourself and your firm in the papers but I think it’s deeply flawed.

You can only contribute to a Roth IRA if you have earned income, so one wonders what counts as earned income? Does Social Security count? What about rental income? How about interest from bank accounts or capital gains from the sale of stock? Actually, none of those count as earned income. Earned income is, in general, that income which you receive as a result of working. Whether that’s reported on a W-2, reported on a Schedule C (where business income is reported), or on a Schedule F (that’s for farming), it has to be earned. In addition to those things that appear on those two schedules and a W-2, union strike benefits, alimony, and long-term disability benefits received prior to minimum retirement age also count as earned income.

In a few short months it’ll be 2008 and with a new year comes new retirement account contribution limits.

For Individual Retirement Accounts (including Roth and Traditional IRAs), the contribution limit for 2008 is $5,000 if you are 49 and below. If you are 50 and above, you can contribute an additional $1,000 as a catch-up contribution. As for 2009 and beyond, those increases are indexed to inflation.

For 401(k) and 403(b), the contribution limit for 2008 will remain $15,500 (the same as 2007) for those 49 and below. If you are 50 and above, the limit will again remain at $20,500 (the same as 2007). The limits for 2009 and beyond are again indexed to inflation.

Enjoy!

If you’re currently not eligible to contribute to a Roth IRA because you’re being phased out, you should consider starting a Traditional IRA so that you can convert it to a Roth IRA in 2010, when income restrictions for those eligible to convert are lifted. Right now, if you earn more than $100,000, you are not eligible to convert any of your Traditional IRA into a Roth IRA. When President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005, it lifted the restriction and so starting in 2010, you can convert. Those Traditional IRAs that are converted in 2010, you can spread the tax payment out across 2011 and 2012.

So, the plan would thus be to contribute to the Traditional IRA, deduct it from your taxes, then wait until 2010 when you can convert the sum over to a Roth IRA. If you currently are participating in your employer’s 401K, then your Traditional IRA contributions may not be tax deductible so you won’t even have to pay the tax when you convert.

Please check with a tax professional before making decisions regarding this as I may have my facts wrong or my interpretation is inaccurate.