by David Bach
For example, say you decide to convert a traditional IRA in which you’ve got a current balance of $50,000. In order to do so, you’ve got to declare that $50,000 as ordinary income earned during the year in which you’re making the conversion. Chances are, this will bump you up into a higher tax bracket.
Now, some financial advisors will suggest that if you have the money to pay the extra taxes, you should do it, because you’ll come out ahead in the end. The idea is that by paying a bit more now, your tax bite will be much lower down the road when you eventually take the money out of your Roth IRA. Unfortunately, what I find is that most people don’t have extra money sitting around. And if they do, they don’t want to spend it on income taxes.
Typically, what happens is that people pull money out of their IRAs in order to pay the extra tax they’ve incurred by converting to a Roth. And in most cases, that makes no sense. Take our $50,000 example. If you withdrew $20,000 from your retirement account to pay the tax bill resulting from the conversion, that would leave you with only $30,000 invested in your new Roth IRA. That’s a 40 percent reduction in your wealth. Is the Roth’s tax advantage worth that much? Probably not.
Keep the following thought in mind. Regardless of what everyone says, the government is not stupid! It created the Roth conversion option to generate more tax revenue for itself. I totally expect there are going to be future new tax rules to encourage Roth IRA conversions. Just remember who benefits first—the government.
That doesn’t mean converting is never a good idea. For example, if you know you are going to leave your money in a Roth IRA for at least 15 years and you have the extra cash (outside your IRA) to pay the extra taxes you’re going to face, you might want to look into converting to a Roth.
Also, if you are in your sixties or seventies, and you have a huge IRA, it can make sense for estate-planning reasons to do a Roth conversion. Let’s say you are not planning to live on your IRA money, but rather intend for your kids to inherit it someday. In this case, you can justify converting a traditional IRA to a Roth IRA. For one thing, unlike a traditional IRA, with its mandatory withdrawal requirement for people over 70½, you can leave money in a Roth IRA for as long as you live. For another, when your children inherit your Roth IRA, they won’t be forced to withdraw the money the way they would with a traditional IRA. Rather, they can leave the proceeds in the account and watch their money continue to grow, free of taxes, for decades. And then when they are finally ready to withdraw it, it will still be tax-free.
Whatever your situation, if you are thinking of converting your traditional IRA to a Roth, get professional assistance and check out www.rothira.com. It’s a great website devoted to Roth IRAs, complete with a calculator designed to assist you with conversion decisions.
WORKING TEENS CAN OPEN A ROTH IRA
Because of their long-term advantages, Roth IRAs are great for teenagers. And if you think involving teenagers in this sort of thing is unrealistic, think again. I believe strongly that everyone with teenage children or grandchildren should do everything they can to get them investing now. Teaching your kids about the importance of investing while they’re still in high school can make the difference between their eventually becoming rich or having to struggle.
I can’t think of a better gift parents or grandparents can give their children or grandchildren than a Roth IRA. I’m not talking just about the account and the money to fund it, but the knowledge and habits the child can acquire as he or she starts learning about the importance of saving for retirement.
Imagine the impact you could have if you helped your 16- or 17-year-old open a Roth IRA. Take a look again at the chart illustrating the power of compound interest. I include this chart in all of my seminars, and I tell my students, “Show it to your kids!”
SO HOW WOULD I DO THIS?
Obviously, your child can’t open a Roth IRA unless he or she has some earned income. Fortunately, most teenagers today do have at least part-time jobs that earn them at least a few thousand dollars a year.
The rules for Roth IRAs for teens are the same as for adults. So when you read this if the Roth IRA maximum is $5,500 a year for an adult under the age of 50, it’s the same for your teen. The only catch for teens is they have to earn the money. Under the law, if your teenager earns $1,000 during the year, he or she is allowed to contribute $1,000 to a Roth IRA. Now, don’t worry, I’m not crazy. I know that very few teenagers (if any) are going to want to take all their earnings and put them into a Roth IRA. So here’s what I suggest. Show the chart to your teenagers and tell them that if they’re willing to contribute to a Roth IRA, you’ll match their deposits dollar for dollar. In other words, if they put in $200 over the course of the year, you’ll add another $200.
The government doesn’t care where the money used to fund a Roth IRA comes from. All it cares about is how much the account owner happens to have earned that year. I have some creative clients with their own companies who’ve put their minor children on the payroll with a salary of $5,500 a year, which they then use to fund a Roth IRA. They have to report the $5,500 as income for the child, but as of 2016 a child under age 18 who is considered a dependent youth could earn up to $6,300 without owing any federal income tax.
Now watch this math. Ready? Take as an example a teen who is age 15. We’ll call him “Jack.” Invest $5,500 in a Roth IRA. Never add another dollar to the account. Stick the investment in a target dated mutual fund (like those I talked about on this page). If the investment grows at 7 percent annually (yes, I am being conservative), when Jack reaches age 65 it will be worth—ready for this?—$162,013. Tax-free. Now that is a gift!
Needless to say, being able to start building a retirement nest egg at such a young age is a great thing. But to me, even more important than the money your teen is getting to sock away is the fact that the child is learning about the importance of saving and is getting into the habit of funding a retirement account. If you can get a teenager or a college student in the habit of saving now, you will have done something absolutely fundamental toward helping him or her Finish Rich! As a parent, it’s a phenomenal gift to give to your children.
YOU CAN’T BUY AN IRA!
By now, I hope you’ve recognized the importance of contributing to a retirement account—and figured out which type of account makes the most sense for you and your partner.
As I noted earlier, how the two of you invest the money in your retirement accounts may be the most important decision you make concerning your financial future. Unfortunately, many people don’t really understand what they are doing when they make this decision.
All too often, here’s what happens. A couple gets motivated to open an IRA, so they head down to the local bank. There, they are introduced to the on-site financial advisor, who says, “Mr. and Mrs. Jones, do we have a great IRA opportunity for you! It pays 6 percent for 24 months.”
“Is it safe?” Mr. and Mrs. Jones ask.
“Oh, yes,” the advisor replies, “it’s very safe. In fact, it’s insured and guaranteed.”
So Mr. and Mrs. Jones sign the papers, write a check, and leave the bank smiling, thinking they have “bought” an IRA account that pays 6 percent for two years.
Well, that’s not really what happened. The fact is, you can’t “buy” a retirement account! What Mr. and Mrs. Jones did was open an IRA account. Once that was done, the bank’s representative put the money they gave him to fund the account into a 24-month certificate of deposit that pays 6 percent a year.
Remember, whether you’re dealing with an IRA, a 401(k), or any other kind of qualified retirement plan, the process is always the same: you open the account and then you decide where to invest the money. That’s what Mr. and Mrs. Jones were doing, even if they didn’t realize it. You have to tell the bank or brokerage firm that’s administering your account how you want your money invested! If you don’t, the money could wind up literally just sitting there, earning little or no interest!
I always explain t
his in seminars, and virtually every time I do, there are people who are stunned to hear it. Sometimes they get mad. I recall one seminar where an older fellow named Peter stood up and told me flat-out, “You are obviously new to the business, young man. My wife and I have been buying IRAs for years at our bank and the rates are great! We’re getting 7 percent.”*
“Terrific,” I said. “It sounds like you’ve invested your IRA contributions in a certificate of deposit with a 7 percent annual return.”
Peter shook his head angrily. “You don’t know what you’re talking about. I would never invest in a CD for retirement.”
“Really?” I said. “So what do you think you’re invested in?”
“I told you,” Peter replied. “A bank IRA account.”
At this point, Peter’s wife started looking concerned.
I went to the chalkboard and led Peter through the steps: you open an IRA account, your money goes into the account, you decide how it is to be invested.
Still, he wouldn’t give up. “I really don’t think that I invested in a CD,” he insisted.
“Well,” I said, “don’t you think you should make sure you know how your IRA money is invested? If I were you, I’d call your bank tomorrow and find out.”
The following day, Peter did just that. Needless to say, he found out that his bank had put his money in a certificate of deposit, just like I’d said. The good news for Peter was that he was in fact earning 7 percent. Often, people find out their money is sitting in an IRA earning nothing because they never instructed the bank or brokerage on what to do with it.
If you think this is dumb, you are correct—it’s really dumb. Unfortunately, there are probably millions of Americans with retirement accounts who have no idea how their retirement money is invested. Since you are a Smart Couple who plans to finish rich, I know this will not happen to you.
WHAT IF I OWN MY OWN BUSINESS?
First, let me say congratulations! I say this because I admire entrepreneurs and because, as a business owner, you are eligible for the best retirement accounts around. Second, let me urge you to avoid a mistake that too many business owners make—deciding that setting up a retirement plan is too much of a bother.
Remember, you are in business to build a financially secure future for yourself and your family—and how can you do that unless you pay yourself first? As a business owner, the best way to pay yourself first is by setting up one of the four types of retirement plans meant for self-employed people:
Simplified Employee Pension Plan (also known as a SEP-IRA)
Solo 401(k) plan
Defined-benefit plan
Savings Incentive Match Plan for Employees (known as a SIMPLE IRA)
Establishing one of these may take a little effort on your part, but, hey, you’re an entrepreneur—you should be used to going the extra mile. In any case, it’s more than worth it. While the regulations regarding distributions and early withdrawals are pretty much the same as the ones that govern IRAs and 401(k) plans, the rules on contributions to retirement plans for business owners are much, much better, allowing you to put away up to $55,000 a year, tax-deferred—possibly even more. How much more? A lot more. In 2018 you can put up to 100 percent of your compensation, not to exceed $215,000. Yes, you read that correctly. That’s huge! We’re talking big money here!
SIMPLIFIED EMPLOYEE PENSION PLAN (SEPS)
SEP-IRAs are very attractive to small business owners because they are easy to set up and require the least paperwork. If you run a small business, are a sole proprietor, participate in a small partnership, or are a Subchapter S corporation, this is probably the type of retirement account you’ll want to set up. These accounts are truly amazing. You can now contribute as much as 25 percent of your gross income to a SEP-IRA, up to a maximum of more than $54,000 (the amount is adjusted for inflation every year; always double-check the rules at www.irs.gov). If you are self-employed and don’t have any employees, run—don’t walk—to the nearest bank or brokerage and open a SEP-IRA today. Setting up a SEP-IRA can often be done in less than15 minutes, and can be taken care of online by most brokerage firms.
The downside to these plans is that if you have employees, you have to contribute for them. If your workers are over age 21 and have been on your payroll for at least three of the last five years, you also must include them in your SEP-IRA, contributing on their behalf the same percentage of their annual compensation that you do of your own. In other words, if you put in 10 percent of your compensation, you also must contribute an amount equal to 10 percent of theirs. (By the same token, if you decide not to put in any money for yourself one year, you don’t have to put any money in for them.)
One disadvantage of a SEP-IRA is that the contributions you make for your employees are immediately 100 percent vested (which means the money you put in for them is theirs to keep, even if they leave your employ the next day).
THE SOLO 401(K) PLAN
If you’re liking the SEP-IRA, you’re going to love this. The solo 401(k) plan was originally created in 2002. If you own a business and have no nonfamily employees, these accounts can be amazing for you and your spouse. Why? Because you can put more money more quickly into the solo 401(k) than you can into a SEP-IRA. Here’s how it works: to begin with, you can deposit 100 percent of the first $18,500 you earn in 2018 (or more later, depending on the rules). On top of that, you can use the profit-sharing portion of the plan to contribute up to another 25 percent of your income. The maximum combined total you could contribute in 2017 would be $54,000.
Now check out the math. Say you earned $100,000 as a self-employed businessperson. With a solo 401(k) plan you can put the first $18,500 you earned in the salary-deferred solo plan, and then later you can put $25,000 into the profit-sharing portion (i.e., 25 percent of your $100,000 salary). That’s a total of $43,500 tax-deductible into your plan—on $100,000 in income. With a SEP-IRA the most you could put away on $100,000 income is $25,000 (still a lot), but for a business owner looking to build wealth faster, this is a better plan that allows you to save more money faster. Most major full-service brokerage firms today offer these plans.
DEFINED-BENEFIT PLANS
Business owners over the age of 50 who have no employees and enjoy a high level of dependable income should consider setting up one of these plans. The reason: defined-benefits plans allow you to put away more money than any other plan around. If you can afford to contribute more than $55,000 a year and are confident that you can do this yearly until you reach age 59½, this plan is for you. How much more? A lot more. In 2018 you can put up to 100 percent of your compensation, not to exceed $220,000. Yes, you read that correctly! You can put up to $220,000 tax-deductible into a defined-benefit plan. That’s huge! We’re talking big money here! If you have a nice large income and you are over age 50 you should really look into these plans while they are still available.
This is not, however, a do-it-yourself kind of retirement plan. To set one up, you will need to hire a financial advisor who specializes in defined-benefits plans as well as a third-party administrator to write the plan document for you. You also will want to work closely with an accountant to make sure your plan conforms to all IRS guidelines and that you are filing the yearly reporting forms correctly. But don’t let this extra work scare you. If your income is sufficiently high, in just 10 years you could put enough into a defined-benefits plan to be able to retire! One caveat on this plan, if you have employees, there are huge liabilities. This is the ideal plan for a high-income family-run business or solo business.
THE SIMPLE IRA
The biggest disadvantage of defined-contribution plans is that they don’t allow your employees to put their own money into the plan. That’s not a problem with the new SIMPLE IRA (Savings Incentive Match Plan). Introduced in 1997, this plan is meant for small companies (those with less than 100 employees) looking for an easy and affordable retirement program—in other words, something simpler and cheaper than a 401(k) plan.
; As with a SEP-IRA, the employer must contribute to the plan on the employees’ behalf, and these contributions vest immediately. Then again, they are relatively small—limited to 3 percent of each employee’s total compensation. Employees are able to defer up to $12,500 in 2018. Unlike the SEP-IRA, the SIMPLE IRA has a required employer contribution. However, they are tax-deductible. All things being equal, if you have employees I recommend you open up a regular 401(k) plan for your company and pass on the SIMPLE IRA. These are not as simple as they sound. There are plenty of companies today offering 401(k) plans to small businesses.
FIGURING OUT WHERE ALL THIS MONEY GETS INVESTED
Now that we’ve covered how to save your retirement money, it’s time to think about where you’re going to invest it. Making investment decisions is really not that complicated. In fact, we can sum up everything you need to consider in what I call…
THE FINISHRICH RULES OF RETIREMENT INVESTING
RULE NO. 1
Know what your money is doing.
This may seem obvious, but I have to start with it. Don’t ever put money in a retirement account and then forget about it. You have to know exactly what your retirement funds are invested in. Don’t make the mistake of thinking you know. Pull out your statements and get familiar with what you own. Whatever you do, don’t keep your long-term retirement money sitting in a lazy investment like a certificate of deposit. In the financial-planning business, we call certificates of deposit “certificates of depreciation.” That’s because the return on CDs is usually so low that it doesn’t even keep up with inflation.