4/18/2011 12:12 PM ET|
4 money rules you should break
Low interest rates and a rebounding economy make now a good time to ignore a few old-school financial axioms – and reap benefits such as more savings and less debt.
Never borrow against a 401k. Avoid credit cards. Make a bigger down payment on your house or apartment to avoid paying extra mortgage interest. These are among the financial rules consumers have been told to live by for years. But now -- with interest rates still low and credit staging a comeback -- might be a good time to break them.
This solid financial advice isn't suddenly all wrong, but many of these axioms no longer result in higher savings or less debt. That's because the economic recovery has opened up more exceptions and loopholes to standard advice, says David Peterson, the president of Peak Capital Investment Services, a financial planning firm.
Advisers, for example, typically discourage clients from taking a loan from a 401k -- but this is now the cheapest way to borrow money, with the average rate at 4.25%, lower than most personal loans. As some parts of the economy have improved -- equities are once again outperforming fixed income, banks are slowly returning to lending and consumers are spending more -- the rules for making and saving money are changing, at least temporarily.
Here are four traditional money rules you can break -- at least for now.
- Old-school advice: Avoid taking one at all costs.
- Now: The most affordable loan available.
For decades, borrowing from a 401k plan was synonymous with derailing retirement savings. But right now, the cheapest bank for many borrowers -- especially those who feel secure in their job -- is their own 401k. Average interest rates on credit cards are 14% and on home-equity lines of credit 5.22%. But a 401k loan charges a fixed average of prime (currently 3.25%) plus 1%, according to the Profit Sharing/401k Council of America. Approximately 90% of employers offering 401ks permit employees to borrow from them, according to the PSCA, and the loans can last for up to 15 years.
These loans make most sense for consumers stuck with high-interest credit card debt. In a year, a borrower can save around $800 in interest with a loan that eliminates a $5,000 balance on a card with a 20% interest rate.
And the money the borrower pays back goes into the 401k -- not to a bank. Repaying can also be easier than it is with a regular loan, says Olivia Mitchell, professor at the University of Pennsylvania Wharton School, who recently coauthored a study on 401k loans. About 60 million people contribute to a 401k, according to the PSCA; once a loan is taken out, any contributions made via automatic payroll deductions first go toward paying down the loan.
- Calculator:How much will your 401k provide?
But, there are still some pitfalls: If you lose your job or leave it voluntarily and can't pay the loan back within 90 days, you'll be hit with federal income tax on the outstanding amount, plus a 10% penalty if you are younger than 59 1/2. And you'll need to reallocate some of what remains into higher-yielding equities until the account is made whole, to avoid missing out on potential gains, says David Wray, the president of the PSCA.
- Old-school advice: Convert a traditional IRA into a Roth to save on taxes.
- Now: Stick with the IRA.
The appeal of the Roth IRA has always been that contributions, rather than withdrawals, are taxed, shifting the tax burden to pre-retirement instead of years down the road when taxes could be higher. Roth IRAs became even more user-friendly last year when taxpayers were allowed to convert from a traditional IRA regardless of income (the limit for conversions had been $100,000 modified adjusted-growth income). But in many cases, staying put in a traditional IRA will lead to bigger savings -- especially for people five to 10 years away from when they plan to withdraw their money, Peterson says.
Here's why: It can take years of tax-free growth to make up the taxes incurred during the conversion. For example, someone who converts $100,000 from a traditional to a Roth IRA and pays $30,000 in taxes will need at least five years to make that money back -- assuming a 7% rate of return. And that doesn't address the loss of compounding that would have occurred if that money didn't go toward paying taxes, says Sheryl Garrett, a fee-only certified financial planner.
- Calculator:Should you convert to a Roth IRA?
There's also less time to pay taxes on this conversion now. Savers who converted from a traditional IRA to a Roth IRA last year were able to spread the income from that conversion over 2011 and 2012. But now, all of the income from a conversion made in 2011 (and after) is taxable at once.
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Please read my post again, but carefully this time. Notice I said IF you can roll the money at a tax rate that was equal to or less than the tax bracket you expect to be in when you take the money out later. That is key, and when you figure things that way, the Roth IRA never loses.
You make a good point about tax laws changing - that's a big risk. One should hardly trust the tax-and-spend'ers not to renege on the "tax-free forever" promises they've made.
But let's assume you can. There are other advantages to rolling into a Roth. Medicare is means-tested (and surely will get worse). If one takes money out of a regular IRA, one's Medicare premiums will rise. But money coming out of a Roth IRA is NOT a taxable event. Ditto for the taxes on SS benefits. Right now (and I'll phrase this badly to save space), 85% of SS is taxed if your income is over $24K/year. That means that withdrawing from a regular IRA may also generate taxes on SS. Not so with a Roth.
There are more considerations. If you pay the tax on rollovers with savings outside of tax-sheltered accounts, it means that you won't be paying taxes on the earnings you would have made on those savings/investments. That money has effectively been put into the Roth where it will never be taxed again (if you can trust the government).
Another consideration is estate taxes. If you have already paid the taxes on your (Roth) IRA, then the size of your estate is smaller than if your money is in a traditional IRA. The estate tax bill is smaller. (The Federal estate tax may miss most readers, but in my state, the estate tax starts at roughly $335,000.)
Getting back to actually rolling money into the Roth. The strategy should be to roll only as much each year as you can to avoid paying the higher marginal rates. Furthermore, one doesn't need to roll everything into a Roth. After all, depending on one's situation, one can make a few 10's of thousands of dollars per year and pay no Federal income tax.
The average individual income in the US is $32,140 latest I could find putting you in the 15% tax bracket. Lets say you are 55 and have saved up $100,000 in an IRA. To roll it over into a Roth, you would have to pay taxes on that $100,000 which would move your income to $132,140 which is the 28% tax bracket. You would pay 15% on the IRA income from 32,140 to 34,000 then 25% tax on 34,000 to 82,400 then 28% from 82,000 to 132,140. Total tax = $26,306. Assuming a 7% return in both the IRA and Roth IRA, you would turn 65 and retire with $196,715 in the IRA or $144,967 in the Roth.
Now lets assume you continue to make 7%, you expect to live for 25 years (90 years old), and your income from Social Security, pensions, 401k, IRA/Roth, etc will still be 32,140. With a balance of $193,605 earning 7% and lasting 25 years, you could pull out $16,880 taxed at the 15% tax bracket. You will pay $2,532 in taxes each year for 25 years totaling $63,301. Ok so yes $63,301 is in fact greater than $26,306 BUT that doesn't necessarily matter. So $16,880 - $2,532 in taxes = $14,348 in income after taxes.
With a balance of $142,675 in the Roth, earning 7% and lasting 25 years, you could pull out $12,439.68 in tax free income.
Last I checked, $14,348 after tax income is greater than $12,439 tax free income ($1,909 more to be exact) and thus you would be better off paying a small amount of taxes over 25 years than paying $26,306 all at once. PLUS you can't ignore inflation. If I pay $26,306 today in taxes vs $2,532 from year 10 through year 35. Adjusting for inflation (assumed 3%), that $63,300 in taxes is only $32,807 in today's dollars.
Yes, you still pay more in taxes but by delaying it for 10-35 years instead of paying it today, you increase your income by $1,909. Everyone is different and everyone needs to do their own math. Yes, there is risk that tax rates will go up. The risk is small for low earners and very high for the "rich". Of course there is always the possibility that income tax disappears and go to a national sales tax instead. There is also a risk that the government will change the tax rules on the Roth IRAs as well (i.e. require taxes on the earnings portion). The government never leaves things alone for 35 years so to assume the Roth will be unchanged for 35 years is just silly. No one knows for sure what taxes will be like in 2045. You just have to do the best you can. In some cases that might mean converting to a Roth. In other cases, stick with the IRA.
It can take years of tax-free growth to make up the taxes incurred during the conversion
People with this bad an understanding of middle-school math shouldn't be allowed to give financial advice. Or at least call the site, "DumbMoney.com".
It completely ignores that if you don't convert to a Roth IRA, you have to pay taxes when you take the money out of the IRA later, but not if you convert it to a Roth. (After all, before-tax money in a traditional IRA may generate a prettier statement, but you can't spend it unless you pay tax on it.)
Here's the good advice: If you can pay the taxes on the conversion out of non-sheltered money, and if the marginal tax rate you pay is equal to or less than what you expect to pay in retirement (and does anyone think taxes aren't going up?), then convert to a Roth.
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