Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective
401k tip jar

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A reader writes:

“Due to current economic trends I have suffered a rather costly loss and one of my 401K’s dropped below the minimum of what they need to be to stay open.  I got a letter in the mail with options of what I can do with it. I was wondering what you would do in this situation?”

While the loss of value in your 401k is unfortunate, this situation forces you into a beneficial situation.  Generally 401k plans have fewer investment options and sometimes more restrictions on how frequently you can move into and out of those options.  Moving your retirement money to an Individual Retirement Account (IRA) opens up a lot of investment options.

The major question is what type of IRA to use: Traditional or Roth.  A Traditional IRA is very much like a 401k in that money is put into it pre-tax.  Money and earnings in a TIRA grow untaxed as well, and only withdrawals are eventually taxed.  A Roth IRA uses post-tax money.  Earnings and withdrawals from a Roth are non-taxable, and you can also withdraw principal (but not earnings) from a Roth IRA at any time without penalty (though this practice is not recommended by this blogger).

The question of choosing one type of IRA over the other can be very complicated, but the general rule of thumb is to consider whether or not you have yet reached your full earning potential, and therefore whether you are yet at your highest tax burden.  If the answer is “yes”, then a TIRA is probably your best bet, since you will likely have a lower tax burden in retirement, and therefore you want your earnings taxed then.  If the answer is “no”, then a Roth is probably a good choice because your retirement earnings will likely be higher than they are now, so you want your contributions taxed now.

With all that said, I think there are a few questions that you have to ask yourself to make the best choice:

1. How much money is in the 401k that you are about to roll over? My presumption is that it’s not that much, otherwise the plan custodian would not be closing your account.  In the grand scheme of things, this probably means that it will not make that much difference one way or another which option you choose.  However, the amount you have to invest may have some effect on what fund options are available to you in the particular option you choose.

2. Are you currently contributing to an IRA and/or do you plan to contribute to one soon? Related to Question 1 above is the issue of how much money you have to invest.  The fund option availability issue can be mitigated very quickly if you’re already contributing to an IRA or plan to do so soon.

3. How much money do you make? Your income determines your eligibility for TIRA and Roth IRA contributions, which relates directly to Question 2 above.  If you’re covered by a 401k plan at your current employer, then your Adjusted Gross Income (AGI — income after tax exempt deductions such as 401k contributions and Health Savings Accounts) has to be less than $53,000 if filing singly or $85,000 if filing jointly (there’s another pesky marriage penalty…) to be eligible to contribute to a Traditional IRA.  The AGI limits are $99,000 for single filers and $156,000 for joint filers for Roth IRA contributions.  Both types of IRAs allow up to $5,000 per person in contributions in 2008.  There are a number of little nuances to these rules, so you should check the link at the top of this paragraph to see the relevant tables pertaining to your particular situation.

With all that said, here is how I see your options:

1. Roll your 401k straight to a Traditional IRA.  This is the most common and straightforward move you can make.  The biggest problem that you could run into is not being able to meet the minimum amount required to buy into a particular mutual fund.  I’ll talk more about this in my next post on this subject.

2. Roll your 401k to a TIRA and then recharacterize it to a Roth IRA.  This may be a good option if your AGI is less than $100,000.  The downside to this option is that you will have to pay taxes on the money you have invested as if it were income, and you will have to file some additional paperwork with your tax return next spring.  Since it’s not a lot of money, the taxes won’t be that great.  You can pay the taxes out of the principal or out of pocket.  The latter option is preferred so that you keep the greatest amount of money working for you, but means you may have to come up with the cash in April if you’re expecting a refund but it doesn’t cover the taxes owed on the conversion.  Example: If you have $3,000 in the plan and you’re in the 25% tax bracket, then you’ll owe $750 in taxes.  You can reduce your principal balance to $2,250 to cover this, or you can come up with $750 on your own.  The bonus to the 2nd option is that you get to keep that extra $750 in the plan and growing tax free for the next 30-40 years.

3. You can take a distribution on the money.  This is probably the worst option (I like nuance, otherwise I would have said, “This is, by far, the absolute worst thing you can possibly do with this money.)  If, for example, you happen to have a credit card that is currently charging an exorbitant interest rate, like in the 30% range, then it may be in your best interest to use this money to help get out of that pickle before refocusing on retirement.  The downside to this option is that not only will you have to pay taxes as in Option 2, but you will also face a 10% penalty on the early withdrawal of 401k funds if you are under 59 1/2.  So that $3,000 turns into $1,950 just like that (imagine fingers snapping).  Just to be clear: Option 3 is nearly always a bad idea.

In my next post on this topic I will cover how to pick a new custodian for this money, how to set up an IRA, how to move the money from the 401k to the IRA without incurring expenses or taxes, and some thoughts on good fund options to get you started.

What would you do if you found yourself in this reader’s shoes?  Do you prefer to use Traditional or Roth IRAs for your non-401k retirement investing?  Let’s hear your thoughts in the Comment Section!

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