Monday, January 19, 2015

Retirement Plans for Young People: Know Your Choices

A primary concern of a young person starting to save for retirement is the ability to access his or her retirement savings, if needed, for other purposes. It's nice to have a retirement nest egg, but when you are in your 20s, 30s, and 40s, you predictably will need money for other stuff, too, such as buying a house and educating your children. But the Tax Code puts a block on most retirement plan withdrawals in the form of an extra 10% tax on income-taxable distributions taken prior to age 59 1/2 (sometimes called the "premature distributions penalty"). So when you have a choice, it's wise to save for retirement in a way that minimizes exposure to that penalty.

Of course, if you participate in an employer-sponsored plan that is entirely funded by the employer, you have no choice about participating...and even if you can't access that money until many years from now, it's nice to have such a plan! But beyond the totally-employer-funded plan, you do have choices:
The first choice to consider is an employer-sponsored cash-or-deferred plan (such as a401(k) plan) where the employer matches some or all of the employee's contribution. Even if the employee's contributions are going to be out of the employee's reach for many years, it is considered advisable to take advantage of that match and contribute to the 401(k) plan as much as needed to secure the matching contribution. Otherwise you're giving up "free" money.

Once that's done, where should you put the rest of your retirement savings contribution for the year? The next best retirement plan for younger people is undoubtedly the Roth IRA. With a Roth IRA, the individual can always withdraw his or her own annual contributions tax-free and penalty-free. Only the earnings that hopefully will accrue on those contributions are subject to income tax and the premature distributions penalty, but you don't need to worry about that unless you have to withdraw more than what you contributed. So the Roth IRA contributor is not putting that money out of his or her reach, which is a very nice feature when you are looking at several decades ahead before you attain retirement age. Even though a traditional IRA contribution is sometimes tax deductible (see below), it may be worth giving up an immediate tax deduction (depending on how much money it actually saves you) to go for a Roth IRA rather than a traditional IRA if you are eligible to contribute to a Roth IRA (see below for that, too).        

The second-best type of plan from this perspective is the employer-sponsored 401(k) plan. Though distributions from these plans are generally subject to income tax and the 10% penalty, it is possible under some employer plans for the employee to borrow from his own plan account. A loan would not be subject to income tax or penalty, provided various rules are followed and the loan is timely repaid. The maximum loan is generally 50% of the employee's vested account balance (a higher percentage if the vested account balance is under $20,000), but never more than $50,000. Though borrowing is not a helpful solution for desperately needed funds you know you can't repay, it is helpful for getting a downpayment on a house or funding some other capital-type need you expect you can repay gradually. Your interest payments go right back into your own pocket (inside the retirement plan). Borrowing from your own plan account is neverpossible with any type of IRA, including an employer-sponsored SEP-IRA.

In the employer plan, the question may arise: Should the employee direct his contributions to a "regular" 401(k) account (employee's contributions excluded from employee's income for income tax purposes) or to a "designated Roth account" (DRAC), if the plan offers DRACs? This would involve an exercise in number crunching. How much current income tax does the traditional 401(k) contribution save (usually a lot) vs. how much will be saved later when taking tax-free distributions from the DRAC. Although the rules are not as favorable as for Roth IRAs, DRAC contributions withdrawn prior to age 59 1/2 would not be subject to the 10% penalty.

The worst type of plan for the young person is the traditional IRA. Even if your contributions to the plan are not tax-deductible, once they go into the IRA, you cannot withdraw them (with one exception--you can change your mind and withdraw an IRA contribution tax-free for a limited time after making it). Rather, every withdrawal you make from a traditional IRA will "carry out" with it proportionate amounts of taxable income (i.e., the deductible contributions you made plus all the accrued earnings on all your contributions) and the after-tax money (i.e., your nondeductible contributions, if you made any). Further, the calculation will not just consider the particular account you withdraw from, but all your IRAs collectively if you have more than one--even rollover IRAs! Generally you can view money in a traditional IRA as "trapped" until you reach age 59 1/2...unless you do a Roth conversion or find an escape hatch.

So consider carefully the choice between contributing to a traditional IRA and a Roth IRA, if you have a choice. The deadline for 2014 IRA contributions of any type is April 15, 2015. Here are your choices:

The young individual generally can contribute $5,500 a year from his/her compensation to either a traditional IRA or a Roth IRA, but:
An individual cannot contribute to a Roth IRA for 2014 if his/her adjusted gross income (AGI) exceeds $129,000 (single) or the spouses' combined income exceeds $191,000 (married filing jointly). For 2015, these limits increase to $131,000 and $193,000, respectively.
A 2014 contribution to a traditional IRA will be tax-deductible if the individual is unmarried and either (1) does not participate in an employer-sponsored retirement plan (such as a 401(k)), or (2) does participate in such a plan but has AGI of less than $70,000. The contribution to a traditional IRA will be tax-deductible if the individual is married and either (1) neither spouse participates in an employer-sponsored retirement plan, or (2) one or both of them do participate in such a plan but they jointly have AGI of less than $116,000. For 2015 these limits will increase to $71,000 and $118,000, respectively.

If high income prevents the individual from directly contributing to a Roth IRA, he or she can still contribute to a traditional IRA, then later convert that IRA to a Roth IRA. The tax on the conversion may be low enough to make this worthwhile. The tax on the conversion would be zero, if the traditional IRA contribution that was converted was nondeductible, has not appreciated since it was contributed, and the individual does not have any other pretax money in this or any other traditional IRA. A low- or no-tax Roth IRA conversion would be a good investment because it creates the possibility of years of tax-free future earnings and the possibility of a later tax-free and penalty-free withdrawal of that conversion contribution if the individual does need to take money out before age 59 1/2.

Note, however, that if a young person does a taxable Roth conversion, then withdraws the conversion contribution less than five years later, the withdrawal would be income tax-free but it would be subject to the 10% penalty. In other words, taxable Roth conversions can be a good long-term investment for the young person but are not a way to get fast penalty-free access to IRA funds