No Money for Your IRA Contributions?

With those tax benefits, you’d think that most people would  be aggressively contributing to their IRAs. However how many people actually maximize their contributions (currently it’s $5000/year)? Why is that the case?

One of the biggest obstacles I hear from people about why they are not contributing money into an IRA is that they don’t have the extra money in their budget. With budgets already tight, they feel like retirement contributions are out of the question.

The good news is that you can make some adjustments to your budget that will help you save for later without drastically sacrificing your budget now.

Finding Money in Your Budget

If you’re looking to jump start or increase your retirement contributions, here are some big ways to find money in your budget.

• Proper Withholding on Paychecks: If you haven’t reviewed your w-4 in awhile, you may want to look at it again. When it comes to withholding on your wages, you could optimize your finances by simply adjusting to what could work best for you. For some, being conservative with their withholding means they can get a bigger refund come tax time, which they can immediately use to fund their IRAs in one swoop. For others, getting more money in their paychecks throughout the years can be the right choice as they set up automatic contributions to keep them on point.
• Take a Week to Shop Insurance: Sometimes we can get into a comfortable habit of staying with the same insurance company simply because we’re used to dealing with them. There’s nothing wrong with being loyal to a good company, just make sure you’re getting value for your loyalty. For us, switching car insurance has cut our premiums by almost half. For my mother, calling around got her current insurance company to lower her bill.
• Consolidate Student Loans: If you qualify for lower rates with a student loan consolidation, you should seriously check it out and run the numbers. The money saved can then be redirected towards your IRA.

None of these adjustments will hamper your budget now, yet they can save you a good amount of money. If possible, once you make the change set up an automatic contribution to your IRA so you can stay on target.

Thoughts on Funding an IRA

I’d love to hear from you about your retirement contributions. How did you find money to contribute to your IRA? What has been the easiest adjustment you’ve made? What has been the hardest?

Retirement

On the road to retirement, there are some decisions you’ll have which can impact your taxes along the way. Your 401(k) and IRA accounts – should you choose the traditional pre-tax flavor or Roth?  The Roth plan requires post-tax contributions, but allows tax free growth and distribution, in most cases.  If the distribution is the result of a conversion or certain rollover in under 5 years after conversion and you are under 59-1/2, you may have to pay an additional 10% tax penalty.  With pre-tax plans, you contribute to the plans with your funds without any taxes deducted so the distributions are taxable.  So which one do you choose?

One approach to consider is to look at your marginal tax rate, and see how far into that bracket you are. For example, a single filer will be in the 15% bracket from $8,500 of taxable income right until $34,500. If you find that after deductions, exemptions, credits, etc, your taxable income is $38,000, it may not make sense to be in pre-tax retirement accounts for all your retirement savings. Since only the amount above $34,500 is taxed at 25%, by putting exactly $3,500 into a pretax 401(k) or IRA, you’ll reduce your taxable income so the last dollar is taxed at 15%, and none at 25%.

If your company offers a 401(k) with a company match, see if they also offer a Roth 401(k). If not, at least be sure to deposit enough to get the match, and then use a Roth IRA to top off your savings. If the Roth 401(k) is an option, you are usually able to change between this and the standard pre-tax 401(k) on a pay cycle adjustment. The process can be fine tuned a bit by using a traditional IRA and converting some of it to Roth, as needed. A bit of attention to your taxable income and your paystubs and you should be able to take advantage of the difference between these two tax rates.

On the retiring side, you can implement a similar strategy. As a single retiree, finding yourself with a mix of pre and post tax investment accounts, by choosing the pre-tax 401(k) and IRA to make withdrawals right up to the taxable income of $34,500, and Roth or other post tax money for anything above this, you can aim to live right on the edge of 15% through retirement.

With the 2011 standard deduction ($5800) and exemption ($3700) adding to $9500 right off the top, this is about all the median earner needs at retirement. If your withdrawals are a bit lower than this, consider the strategy of converting just enough IRA money to top off that 15% bracket.

It’s not as difficult as it might appear. By looking at last year’s return and adjusting slightly for this year’s numbers, you should have a good idea where 2011 will put your taxable income. Underestimate a bit, and convert just enough IRA money to Roth to hit your goal.

If in April, your return tells you went over, just recharacterize enough to get the taxable income number dead on. This strategy for the just-retired person will help bring that IRA balance down over time to avoid some potentially large RMDs (Required Minimum Distributions) after reaching 70-1/2.  Please note: once you make contributions to a designated Roth account, you cannot later change to a pre-tax account.

Note – the rates I discussed are for the single filer. Take a peek at the page I linked above for the tax table for other filing status, the idea works the same with the numbers adjusted for status.

Contributions to Your 401(k)

The 401(k) plan contributions you elect to make come directly out of your salary. Since the contributions are made with pre-tax dollars, your employer does not include these amounts in your taxable income for the year. At the end of the year, when you receive your W-2 form that shows your earnings, you will notice that your wages subject to federal income tax are lower because of your 401(k) plan contributions. Since the wages are not counted in your taxable income to begin with, you do not take a deduction when you file your return. However, when you prepare your tax return, it’s possible to calculate how much income tax your 401(k) contributions saved you. For example, if you contribute $8,100 to your 401(k) during the year and that amount would be taxed in the 33 percent bracket if included in taxable income, then your tax savings is $2,673.

Increase in Your Take-Home Pay

Your 401(k) plan contributions also reduce the amount of your income tax withholding. Each time you get paid, your employer withholds money for your federal income taxes based on your expected taxable income. However, if you make 401(k) plan contributions, the amount of money subject to withholding will decrease since your taxable income is less than your actual salary. The result is more money in your take-home pay each pay period.

The Savers Tax Credit

In addition to the tax savings available for your contributions to a 401(k), the IRS also offers the Savers Credit if your Adjusted Gross Income (AGI) doesn’t exceed certain maximums. This credit offers a dollar-for-dollar reduction of your federal income tax bill. In 2010, single taxpayers whose AGI doesn’t exceed $27,750 can receive a credit up to $1,000 and married taxpayers with an AGI of $55,500 or less can receive up to $2,000. If your AGI doesn’t exceed these thresholds, you are at least 18 years of age and are not a dependent to another taxpayer, then you need to prepare IRS Form 8880 with your tax return to claim the tax credit.

Misconceptions About 401(k) Contributions

The contributions that you make to a 401(k) plan only reduce your income taxes, not your Social Security and Medicare taxes. These two taxes only apply to your earned income, but you do not get to claim any deductions before these taxes are assessed. For example, if your gross wages for the month are $2,500 and you contribute $400 to your 401(k) plan from it, there is withholding on the full $2,500 for Social Security and Medicare even though for federal income tax purposes, there is withholding on $2,100.

Length of Retirement

The first thing you’ll need to consider is how long you expect to rely on retirement income. Time plays one of the largest roles in determining the size of your nest egg. Somebody working until they are 70 needs far less in the bank than somebody planning to retire early at age 60. Not only that, but early retirees may not have the benefit of receiving Social Security or Medicare for a few years which can significantly increase the amount of money needed.

So, take a look at what you plan on doing. Things may change, but you have to start with some sort of expectations. If you’re assuming you’ll retire at age 65 and plan on living to 85 that will at least give you a starting point. Now you know that at the very least your nest egg should cover about twenty years of income.

The Kind of Retirement

What you actually do in retirement will ultimately dictate how much money you need. If you will retire debt-free, no mortgage, and don’t plan on doing any traveling or buying a new home or anything, your retirement expenses may be very low. On the other hand, if your retirement vision consists of buying a new condo on the beach in Florida and traveling to Europe every summer, well, that’s another story.

You need to sit down and actually think about what you want to do in retirement so you can create a better picture of what your income needs will be. Obviously, the younger you are, the more these dreams and costs can change, but you can still create a ballpark figure by looking at what things cost now and adjusting for inflation. A good inflation rule of thumb is an average of 3 percent per year. Another way to think about it is the cost of something doubling every 25 years.  So, if your projected annual income in retirement would be about $30,000 in today’s dollars, know that in 25 years that means it will probably cost you roughly that.

Putting it All Together

After you’ve determined how much your annual retirement will cost and figured out roughly how many years you’ll need to rely on that money it’s time to create your magic number. Using the information above, let’s say I’m 30 years old today, plan on retiring at age 65, and expect my retirement income to be about $30,000 a year based on today’s dollars. Adjusted for inflation, that means my retirement expenses when I retire will likely be about $80,000. Then if I plan that money has to last another 20 years in retirement, I end up with a figure of $1.6 million.

Don’t be shocked at the number just yet. It may sound like a lot, but let’s look at how you can get there. In the same example, that leaves me 35 years to save up to this goal. So, utilizing my company 401(k) or IRA I can start putting money aside and let it grow. Remember, there are tax breaks here as well that will ease the pain. It won’t actually require putting aside the entire $1.6 million since we have time and compound interest on our side.

Assuming I already have $25,000 tucked away for retirement, I could reach my nest egg number by saving $12,000 per year and earning a somewhat conservative 6 percent average annually. Depending on your situation and how much you already have saved or need to save that may still seem like a lot, but remember that we’re basing it off of needing to fund our entire retirement ourselves. Whether you like the direction Social Security is headed or not, chances are you’re going to receive some retirement income there as well, and that will cut into how much of your personal money you need to use. But when planning, I feel it’s always best to plan for the worst and assume it won’t be there at all and if it is, that’s just a bonus.

Get Started Today

If this example has done anything, hopefully it illustrates the importance of saving for retirement. I know young people feel there’s no money to be saved and there’s plenty of time to catch up, but you really need to get started as soon as possible. Maybe you can’t put away enough each year right now to meet your goals, and that’s okay. As long as you’re saving something you’re on the right track. Besides, what seems like a lot of money today might feel like a drop in the bucket in 20 years and you may be able to comfortably save double or triple what you need to each year. So stop kicking the tires on your retirement plan and start putting some money away. A little bit goes a long way over time.

I’d like to see an article about the tax and long-term financial implications of using 401k loans or early withdrawals to pay off debts (credit cards, student loans, mortgage, etc.). Does it make sense to be paying a higher interest rate on debt than I’m making in my retirement investments?

Deciding to raid one’s retirement plan for debt repayment is not a decision to be taken lightly. I’m glad you took the time to ask for help before taking money from your future.

A 401(k) plan is a retirement plan and the government gives us some pretty big incentives to use it exclusively as one. Consequently, my bias is to avoid taking money from a 401(k) plan at all costs. Of the examples you mention, only the existence of significant high-interest credit cards would cause me to consider making an exception. (Student loans and home mortgages are “good debt” and are typically at a low cost. The negatives, discussed below, of pulling money out of your 401(k) greatly exceed the benefits of more aggressively reducing relatively low-cost “good debt.”)

On the other hand, credit card debt can be extremely expensive. For example, if you’re paying 20% or more APY on a sizable credit card balance, it might take you a very long time to pay back your debt. As such, if you could borrow from your 401(k) plan and pay off all (or nearly all) of your credit card debt, I’d consider it. Yet even in such a situation, it’s still not a no-brainer to do so to borrow from your 401(k) plan. Here’s why:

A 401(k) loan is risky. Should you terminate employment for any reason (e.g., lay-off, spouse gets a job in a different city, you get really irritated at your boss one day, etc.) your loan is typically due, in full, within 60 days. When you can’t pay it back (and you won’t be able to – if you could, you would have paid it back already), the entire outstanding loan is considered a distribution. As such, you’ll be subject to income taxes, plus a 10% early distribution penalty if you’re under 59 ½. This potentially large sum will be due no later than the following April 15. Will you have the money available? Unlikely, making matters even worse.

An outright distribution from a 401(k) plan is no better. After all, you permanently reduce the amount available to you at retirement.

Furthermore, keep in mind your retirement plan money is typically unavailable to debt collectors, even in bankruptcy. While I believe people should pay what they owe, one needs to be wise to all the angles.

Taking money from your 401(k) plan should be a last resort and, in my mind, done only a very specific situation: as a loan to immediately and aggressively attack high-interest credit card debt by a person with a good deal of job security who is willing to make the significant commitment necessary to ensure the debt does not recur once more credit is available. Otherwise, steer clear and pay off your debt the old fashioned way – by spending less than you earn and using the difference to pay down debt.

What do you think? Have you taken a 401(k) loan or distribution? Glad you did or still paying for it?

Taxes on Your Retirement Saving . . . While You’re Saving

When you save money in a workplace retirement plan such as a 401(k) or 403(b), you receive a tax deduction for your contribution.  Consequently, by putting money away for your future in a 401(k), you also save tax dollars today.  A regular IRA might work the same way, but it also might not. Depending on whether you have a workplace retirement plan available and your modified adjusted gross income (also known as “MAGI” which is IRS-speak for your income, more or less), your regular IRA contribution might be deductible. Learn more about the 2010 rules.

The rules for a Roth IRA are much simple— no tax deduction is permitted for any contribution.

Taxes on Your Retirement Saving . . . While You’re Working

You’ll of course hope your retirement plan money grows during the many years between when you save it and when you take it out to enjoy during your golden years.  As the last few years have unfortunately demonstrated, there’s no certainty such growth will happen. Nonetheless, over the very long term, intelligent investors ought to see significant growth over the decades.

How do taxes affect such growth? Thanks to a concept known as tax-deferral, none of your retirement plan money is taxed while it grows. Said another way, you’ll pay no tax on the money your 401(k) or regular IRA earns during your working career.  Furthermore, there’s no limit to how much it earns; you’ll still pay no tax on the growth.  However, should you take out even a single dollar from your plan prior to retirement, you’ll owe income tax. You might even owe a penalty tax on such an early distribution.

Keep in mind you can get some of your money out of your Roth IRA without paying income tax.  However, because of the long-term upside of Roth IRAs discussed in the next section, you’ll want to avoid doing so. (Retirement plans are for saving for retirement—the government gives you pretty big incentives to use them that way. Take advantage.)

Taxes on Your Retirement Saving . . . While You’re Retiring

I’ve heard spending one’s retirement plan funds is much more enjoyable than putting money in them.  Makes sense; after all, it’s why you’ve saved all along. If there’s a downside to the “harvesting” on your retirement plans, it’s that during retirement is when you begin to start paying for those tax breaks you received earlier.  Still, there are a few very important distinctions between how the various retirement plan distributions are taxed.

Distributions from regular IRAs and 401(k)s are taxed as ordinary income. In English, this means you’ll pay normal federal income tax (state income tax too, depending on the rules for the state in which you live), based on the amount you take out of your accounts.  Once you reach age 59 ½, you can take out as much as you want without any early distribution penalty. However, you do not need to start distributing money from your regular IRA and 401(k) plan at that time. In fact, not until after you reach age 70 ½ must you begin to take from those accounts From that point forward, you must take your required minimum distribution from your qualified retirement plans or face a significant penalty.

One retirement plan really shows its dramatic upside during retirement. Recall how a saving contribution to a Roth IRA provides no upfront tax deduction.  In retirement, however, distributions from Roth IRAs are not subject to federal income tax.  Consequently, the potentially enormous growth over the many years between saving and retirement is never taxed.  Furthermore, Roth IRAs are not subject to required minimum distributions, so you can leave your money in the plan until you need it.

Who says you can’t get something for nothing?  Now, let’s just hope the rules don’t change between now and when you retire.

Get more tax tips about retirement.

Here are some year-end moves you should make now:

Boost your retirement account

By making pre-tax contributions to your 401(k) or 403(b) you’re not only reducing your adjusted gross income and overall tax bill, but you’re building up your savings, too. In 2010, you can contribute $16,500 to your 401(k) plan; those age 50 and over can pitch in an additional $5500. If you’re slightly below these limits, consider ratcheting up your contribution by Dec. 31st.

Start spending your benefit dollars

If you’ve set aside money in a flexible spending account (FSA) for medical expenses, find out how much you have left in the account, how long you have to use the money before you forfeit the balance (While you may have until mid-March 2011 to use up the funds, many accounts expire at the end of December–check with your plan administrator) and start spending it. Schedule an appointment to have your teeth cleaned, for example, and buy things like prescription glasses, contact lenses, and various medicine-cabinet stock (For a complete list of expenses that are eligible for reimbursement, go to http://www.wageworks.com)

Estimate your income and deductions

While year-end tax planning typically involves finding ways to defer income and accelerate deductions, this year is different. We are about to experience the biggest tax increases in nearly 17 years (and the first increase in capital gains taxes in 24 years), so if ever there was a time to do the reverse – accelerate income and postpone deductions – 2010 is the year to do it.

Review your portfolio

Before the end of the year, take your losses off the table (You can deduct up to $3000 of losses against ordinary income), and consider selling winners, too, because while the top rate is currently 15%; next year, it is scheduled to rise to 20%.

Put the AMT on your radar

The AMT, a parallel tax system with its own set of rules, does not allow for deductions for state and local taxes, home equity interest and other things – like personal exemptions. And it’s complicated – you have to figure your taxes under two sets of rules – the regular tax code and the AMT – and pay whichever is higher. TurboTax can help you figure this out, but chances are, if you paid the AMT last year, you’ll be caught again, so plan accordingly.

Consider coverting to a Roth

This is a big year for Roth conversions, and anyone can do it this year (the restrictive income limits that frustrated high-earning taxpayers has been lifted). There are considerable advantages to doing this – your assets grow tax-free, you don’t have to pay taxes when you withdraw this money, and there’s no minimum distribution requirements once you turn 70 1/2. Now, you will have to pay taxes on the conversion, but you can spread these payments out over the 2011 and 2012 tax years.

Take advantage of tax credits

If you buy energy efficient products or systems for your home – things like water heaters, boilers, heat pumps, air conditioners, windows and doors – you may be eligible for a federal tax credit that can put as much as $1500 in your pocket. For details, go to www.energystar.gov (and click on “Tax Credit for Energy Efficiency” on the bottom left-hand side of the screen).

Be giving

If you plan to contribute to your favorite qualified charities, make sure you do it by December 31st, and that you have receipts to prove it! You might also want to think about giving shares of winning stocks to your low-earning children (specifically, kids 19 or older and out of school or 24 or older if they are still in school). Reason being, if they earn under $34,000, their long-term capital gains rate for 2010 is 0%. Zilch!

If you have a 401(k) available to you it’s still one of the best and easiest ways to put money away for retirement. It’s easy because it’s done at the payroll level, meaning you don’t have to worry about making deposits or calculating tax deductions at the end of the year. It’s beneficial because it significantly reduces your current taxable income and grows tax-deferred. If you think getting a tax refund is great, consider this. At the 25% tax rate, every $1,000 you put away for retirement, you will pay about $250 less in federal taxes. It’s still your money, but instead of directing it into your bank account you’re just tucking it away in an account earmarked for retirement but paying fewer taxes in the process.

More Than the Stock Market

The biggest objection I hear from people is that they don’t want to put money into their 401(k) because they don’t trust the stock market. To be honest, that’s a pretty lame excuse. That’s because virtually every 401(k) out there gives you a variety of investment choices, some of which have nothing to do with stocks. From money markets to bonds, you’ll almost always have an option to invest your money somewhere that doesn’t involve stocks if you choose to do so.

So, don’t use the recent stock market volatility as an excuse to not save for retirement. You can probably still put money away into a 100% guaranteed fund if you want. Dust off your 401(k) investment options brochure and look at what’s available to you if you have some reservations about putting money into your 401(k).

Don’t be Afraid of Withdrawal Restrictions

After complaining about the stock market the next thing I usually hear is something to do with how the money is tied up. It’s true that the money isn’t going to be as easy to get your hands on as the money you have in a savings account, but it’s not supposed to be easy. If people could tap into their retirement funds with an ATM card, nobody would ever be able to retire.

That being said, the restrictions aren’t all that bad and your money isn’t locked up forever. Money can generally be withdrawn from a 401(k) on six different occasions:

• Termination of employment
• Disability
• Reaching age 59 ½ (or 55 in some cases)
• Retirement
• Hardship
• Death

Usually, when you find yourself in a position that forces you to look towards your retirement plan for money, it’s one of these reasons. Sure, you might be bummed to learn that you can’t dip into it whenever you want to buy a new car or take a long vacation, but that’s what your other savings accounts are for.

Finally, there’s often the ability to take a 401(k) loan. More than 65 percent of all plans have a loan provision, so you have one more way to access your money if you really need it. While you still don’t want to tap into retirement savings if you don’t have to, a loan is usually a better option than a straight distribution because you aren’t assessed a penalty (as long as it’s paid back) and you actually put money back into the account to repay the loan.

Taking Advantage of Your 401(k) in 2011

As the new year approaches, you should consider how to take advantage of your company’s 401(k) in 2011 if you have one. If they offer a match, it’s a no-brainer and you should contribute enough to at least get the match. That’s free money and in most cases it’s like getting an instant 50 or 100 percent return on your money. Even if they don’t have an employer match it’s still a good idea to save. You’ll only help build your nest egg while receiving some tax breaks in the process. For most people, the contribution limit should be $16,500 with a $5,500 catch-up provision for those over 50. This is a generous limit considering the annual IRA contribution is just $5,000.

First, we have to understand the fundamental differences between these accounts. First, the Traditional IRA, Roth IRA, and 401(k) plans fall into two broad categories: pre-tax and after-tax. The Roth is the only one of the three that operate on an after-tax basis. What this means is that contributions to a Roth IRA are made with after-tax dollars, thus there’s no tax deduction on these contributions. Because of that, the Roth allows you to make tax-free withdrawals in retirement. Both the Traditional IRA and 401(k) type plans are pre-tax, meaning your contributions are made before taxes are calculated. These contributions therefore reduce your taxable income in the year they are made which means a lower tax bill. Unlike the Roth IRA, distributions in retirement are then taxed as ordinary income.

While taxes are the big difference here, there are a few other things to consider. IRAs have annual contribution limits of just $5,000 while the 401(k) allows up to $16,500 each year. There are also differences with each plan in terms of investment options, withdrawal rules, and so on. But for this exercise we’re going to focus mainly on the taxes.

To Roth or Not to Roth

Most experts agree that younger adults are the best candidates for the Roth IRA. This is because younger workers tend to make less than they will in the future, therefore they are in a lower tax bracket now than they might be a few decades from now. If you’re a single filer earning $50,000 a year, that puts you at the 25% tax rate. The argument here is then assuming that because tax rates are at a historical low point, you’ll probably be paying taxes at a higher rate in thirty years once you do retire. So, you’re basically giving up a 25% tax break today in order to see a greater tax break in the future.

If your tax rate does indeed increase in retirement, then the Roth is going to allow you to see the biggest net gain in terms of income tax paid. But what happens if you find yourself in a lower tax bracket when you retire? We have no idea what will happen to taxes over a long period of time or even know what our income will be, so it’s a real possibility. Then, the benefit of a Roth IRA isn’t as significant. You could be giving up a 25% tax break today only to see a 15% tax break in retirement.

Of course, there are some additional benefits to a Roth IRA such as the elimination of the Required Minimum Distribution (RMD) and no age limit on contributions, but looking at the tax situation alone leaves a lot of unanswered questions and anything can happen over the course of a few decades.

Since changes took place in 2010 that also allow people who didn’t qualify for a Roth IRA in the past because of income to now convert their Traditional IRA into a Roth IRA, it’s worth mentioning that this conversion isn’t right for everyone. A lot of experts are urging people to make the conversion, but what a lot of people ignore are the taxes due on the conversion. In fact, paying tax on the Roth IRA conversion with account assets can actually be worse than not doing the conversion at all, so keep that in mind if you are thinking of doing a conversion.

Beyond Taxes

While calculating your tax burden is the primary factor in deciding what retirement account to use, there many other things you need to consider. First and foremost are contribution limits. Whether you choose a Roth IRA, Traditional IRA, or both, your limited to just $5,000 per year total. While that’s a great start, you’re likely going to want to save even more as your budget and time allows. So, the most likely scenario is utilizing a few accounts. For example, you may want to contribute $10,000, so you may contribute $5,000 to your employer’s 401(k) and $5,000 to your Roth IRA each year. This accomplishes two very important things.

First, it allows you to save more money for retirement. Second, you’re diversifying your tax burden. Just like you diversify your investments, you also want to diversify your taxes. By having your nest egg divided up into both a taxable and tax-free account you’ll hedge your bet somewhat regardless of how tax rates turn out in the future, plus you will have the flexibility to plan your withdrawals from each account so that you can maximize your income and minimize taxes in retirement. Finally, it’s also giving you a bit of a tax break today while you’re still putting funds aside that will give you a tax break in the future.

As you can see, there’s no silver bullet account. While the Roth IRA will generally provide the most benefit to a younger employee making less now than they expect to in the future, we’re also grappling with a lot of unknowns that can transpire over the next thirty years. So, just like you wouldn’t put all of your eggs into one investment basket, it’s also a good idea not to put your whole nest egg into one type of retirement account.

Still, even with penalties, some people may need to pull from their 401(k) in dire cases. For those few instances, here are the instances where a person can withdraw from their 401(k):

Penalty-Free Withdrawals

1. Tax-deductible medical expense. If you have such qualified medical expense, defined as the part of your total medical expenses that exceeds 7.5% of your adjusted gross income, you can make early withdrawals up to that amount without paying the 10% penalty. However, income tax is normally imposed upon withdrawals, unless the contributions have been made after tax to a Roth 401(k), which became available in 2006. Contributions can also be made on a after-tax basis to a regular 401(k), if so elected, where the after-tax contribution amount is not taxable when withdrawn, but the growth on the contribution is.

2. Having entered retirement at 55 or older. If you’re no longer working at or after 55, because you are permanently laid off, terminated from work, or quit to retire early, your withdrawals become qualified.

3. Having already retired as of March 1, 1986. If still in retirement currently and having elected to start receiving substantial equal periodic distributions of your 401(k) balance, all withdrawals are qualified but must last at least 5 years or until 59 and half, whichever is longer. Previously scheduled withdrawals can be altered thereafter.

4. Having become totally and permanently disabled, which demands 401(k) to be an immediate income source.

5. Domestic relations court order. The court has ordered fund withdrawals to give to your divorced spouse, a child, or a dependent.

These measures apply only in those special circumstances and understandably are not practically useful for people with a financial hardship but in different situations.

401(k) Loans

What is generally available to account holders wishing to withdraw funds penalty free is the so-called 401(k) loans. Such a loan allows the account beneficiary to withdraw funds with the promise of paying it back later to the same account. Loans are not subject to penalty nor income tax, except in the event of a default. The term of a loan is normally less than 5 years unless used for a home purchase. Interest must be charged and later becomes part of the 401(k) balance when paid back. Payments on the loan are made with after-tax funds and the repayment plan must have substantial equal periodic payments for at least once every quarter over the term of the loan, meaning repayment starts almost as soon as the loan is taken out.

A 401(k) loan in a significant amount with a longer term disrupts the plan’s investment process, losing potential long-term investment earnings. In the case of changing employment, the borrower must repay the loan in full within 6 days. Failing to do so would be considered a default, causing the assessment of both penalty and tax.

Hardship Withdrawals

To be able to withdraw any funds under the hardship withdrawals as prescribed by law, one has to first meet the conditions and also qualify under the acceptable fund uses.

Conditions

1 – The financial need is immediate and severe. 2 – No other funds or ways to meet the need. 3 - Other distributions and loans have been first obtained under your 401(k) plan. And 4 – The amount withdrawn is not exceeding the amount needed.

Qualified Fund Uses

1. Non-tax-deductible medical expenses that are not reimbursed for you.

2. Payments related to the purchase of one’s principal residence.

3. Funds used to prevent eviction or foreclosure.

4. Higher educational costs, i.e. tuition and room and board.

5. Expenses for the repair of damage to one’s principal home.

Remember that the 10% penalty is not waived for hardship withdrawals. And once the withdrawals are made, they can not be returned to your 401(k) account, unlike paying a loan back to the account balance. Withdrawals like these reduce account balance and therefore forever forgo the tax-deferred growth that could have been generated by those assets. The loss of growth can be a huge opportunity cost, especially when considering the power of compounding on those tax-deferred growth over a long period of time. Moreover, no contribution is allowed for 6 months following such a withdrawal, effectively reducing investment principal further.

As such, a 401(k) withdrawal must be used as the last resort even in an emergency situation. An emergency fund would be a better way to prepare for life’s unexpected occurrences. Contrary to common perceptions, building an emergency fund takes very little effort if you start small and continue to save small and have a reasonable goal of covering only 3 to 6 months of living expenses, as an emergency fund is not intended to be a golden egg.

You 401(k) may look like a nice amount of money to pull from but its there for a reason – to fund your retirement.

Shouldn’t you be working to be financially fit as well? Or, if you resolved to do so, what are you waiting for?

Here are 13 things you can do in 20 minutes to get financially fit in 2010:

1. Open Up A High-Yield Online Savings Account. Brick and mortar banks pay almost nothing these days. With most online savings accounts you can actually see your money growing and earning interest. This added incentive helps keep you going on your path to savings.

2. Re-Allocate Your Retirement Accounts. Check up on your IRAs and 401(k)s and any other accounts you may have to make sure you are sticking to an allocation plan. Many companies will let you set up an email alert when your accounts exceed a specified percentage and remind you to re-allocate your retirement plan. This helps you you retire well.

3. Up Your 401(k) Contributions to the Company Match. The company match is free money for your retirement. Really. Think your salary isn’t enough? Add the company match to it, it’ll look better. And your contributions are pre-tax which means if you are taxed at say, 25%, a $100 contribution really only costs you $75 in your paycheck.

4. Set Up an Automatic Savings Plan. Create a savings goal. Now divide that number by 12 months. Set up your online high-yield savings account (see item #1) to withdraw that amount every month. Voila! Automatic savings. Too often we say we are going to save but by the end of the month the money is spent. Make it automatic to make sure your savings happen. Don’t even give yourself a chance to get your hands on that pre-set amount, send it straight to savings.

5. Call Your Credit Card Company to Lower Your Interest Rate. How is your account? Have you been paying on time? Are you carrying a balance? If so, give your credit card company a call and ask to have your interest rate lowered. Most times they will oblige, especially if you tell them you have an offer for a better rate with another card. This could easily save you hundreds, if not thousands, on your credit card balance as well as help you pay it off sooner.

6. Contribute to An IRA. Try to contribute the maximum that you can. If done before April 15th you can still contribute for 2009. A Traditional IRA means you get tax breaks now. A Roth IRA gives you tax breaks when you retire. TAX BREAKS!

7. Donate Old Books and Clothes. Man, do our closets pile up with stuff we don’t use anymore. You too? Head to the local library and donate your old books. Ask for a receipt so the books can later be written off at tax time. Take your clothes to the Salvation Army or another charity. Get a receipt there too – donations are deductible.

8. Set Up A Bill/Pay Calendar. Late bill payments not only cost you cash but they can beat up your credit score too. Use a free application like Google Calendar to set up bill due date reminders for all of your bills. This can help you stay on top of your bills and can remind you if a bill got lost in the mail. Or, free budgeting software like Mint.com can send bill reminders for you, while also helping you easily set up budget, with alerts for when you overspend on clothes, food, or wherever you want to save money.

9. Use Tax Software (like TurboTax) for Your Taxes. When I started filing taxes I used to do them myself (ok, computers weren’t used as much either but that’s another issue). It would take my quite a while making sure I had every form and reading through all of the instructions then I started using tax software. Like butter! It was so much easier and quicker than doing my taxes on my own. Plus, you can save almost $200 by choosing tax software over an accountant.

10. Adjust Your W-4. Do you get a big tax refund every year? You know that’s a tax-free loan to the government right? And you could have that money in your paychecks instead? Adjust your W-4 withholding so your tax refund is less and you get more money in your paychecks now! Know what? You can put the difference in your online savings account (Item #1) as part of an automatic savings plan (Item #4).

11. Get Your Free Credit Report. You are allowed to get one copy of your credit report for free from each reporting agency once a year (three agencies). Mark your calendar in four month intervals and check one report each time to make sure all of the information on it is accurate. Mistakes on your credit report can cost you big time on your credit score, which can affect everything from loan rates to insurance costs to getting a job.

12. Collect Your Loose Change In A Jar. Toss your daily pocket change in a jar. When it fills up cash it in (look for a free service). You may find you saved up over $100 with very little work!

13. Make a List Before Food Shopping. Ever go food shopping with an idea for what you need then come home with $300 of groceries and still forgot stuff? I have. Write a list and keep to it. It will keep you focused on buying what you need and keep you from getting the extra. It also helps to cut down trips to the grocery store when you forget something and start the whole process of getting what you don’t need all over again.

There you have it – 13 things you can do in 20 minutes to get you financially fit in 2010.

What else can you think of?

NOTE: If you make a contribution in 2010 before the April 15th deadline, be sure to tell your broker that you want the contribution to be for the 2009 tax year. By default, they will put it towards 2010 unless you tell them otherwise.

Roth IRA vs Traditional IRA

When it comes to IRAs, there are two major flavors – the Roth IRA and the Traditional IRA. With a Roth IRA, your contributions are not tax deductible but the account balance grows tax free. When you begin withdrawing money in retirement, you are not taxed on the disbursements. With a Traditional IRA, your contributions are tax deductible but you are taxed when you begin withdrawing money in retirement. You either pay the tax today, with a Roth, or you pay a tax in retirement, with a Traditional IRA.

The general idea is that a Roth IRA is valuable if you believe your income tax rate in retirement will be higher than your current rate. If you believe the reverse is true, then you would prefer a Traditional IRA because you get tax benefits immediately. Another school of thought argues that since it’s impossible to determine where the tax brackets will shift, it’s most important to diversify your tax profile. Finally, given the contribution limits on Roth IRAs, it might make more sense to take advantage of it today because you might not be able to tomorrow.

IRA Contribution Limits

IRA contribution limits are the same for Traditional and Roth IRAs. For 2009, you can contribute up to $5,000 total. If you are age 50 and above, you can contribute a maximum of $6,000. This amount is shared between the two types of accounts, so if you want to contribute to both then the sum can’t be greater than your limit.

Roth IRAs have an additional income restriction. If you are single filer, you can contribute the maximum as long as your adjusted gross income is under $105,000. If you earn between $105,000 and $120,000, your contribution maximum will be adjusted based on how much above the lower limit you earn. If you earn over $120,000, then you cannot contribute to a Roth IRA.

For example, if you have an AGI of $110,000, or 33.3% into the phaseout, then you can only contribute 66.7% of the $5,000 limit – or $3,340. (it is always rounded up to the next higher $10 increment, or $200 if the amount is less than $200)

For married filing jointly, the two limits are $159,000 and $169,000.

2010 Roth IRA Conversion Loophole

Starting next year, anyone will be able to convert a Traditional IRA to a Roth IRA. Today, that conversion is only permitted for individuals earning less than $100,000. This is a big deal for people who can’t contribute to a Roth IRA because of the income restriction. If you are one of those individuals, read up on the Roth IRA conversion rules to be prepared.

Jim writes about money at his personal finance blog Bargaineering.com.

Not necessarily.

There’s nothing to report on your tax return if your investment lives — like most everyone’s does — in a 401(k) or an IRA. These are special no-taxes zones, where you can buy and sell securities and mutual funds without having to report the capital gains and losses on your tax return. When you eventually take your money out, however, you’ll have to pay income taxes on some or all of it (unless it’s coming from a Roth IRA.)

Stocks/Investments

But what about the investments you own outside of your retirement accounts?

Let’s say your 200 shares of the Bank of What Was I Thinking have fallen by 50 percent.

You can’t deduct your loss, however, if you haven’t sold those shares. Until you sell, you have what’s known as a “paper loss,” not an actual loss.

Now then, even if you sold your shares after watching them lose half their value, you still might not get to claim a loss. Let’s say you bought the shares at $50 each, they climbed to $140, then fell to $70 at which point you decided to sell them. However, you don’t have a loss. You have a gain of $20 per share. And you need to report that on your tax return.

Here’s another puzzler. You might have a taxable gain even if you didn’t sell any of your investments. How is that possible?

Because a mutual fund you own sold some stocks and bonds it had in its portfolio. Here’s what happens when the markets climb steeply then fall precipitously, as they did in recent months:

When the markets were booming, your mutual fund held stocks that had shot up value. And when the markets fell, some investors decided to bail. The managers of your mutual fund had to pay those investors, so the managers sold highly appreciated stocks to raise the cash. That generated capital gains for the mutual fund, which are passed on to you as capital gain distributions.

Unless, of course, your mutual fund is in your retirement account. You don’t have to report your “gain” to the IRS.

For more information on about taxes and your investments, read Capital Gains and Losses.

7)  401(K)

These days, you’re lucky if you’re working for a company that provides you with a 401(k) plan. A 401(k) is a retirement plan that you can contribute to so you have money when you’re old and gray—and who knows if there will be any social security left over for you?  If you’re a teacher, it’s called 403(b) plan.   Also, if your income is less than $26,500 you might get a retirement saver’s credit of up to $1,000 for contributions to your 401(k) or 403(b). You can’t be a full time student to get this credit.  This type of retirement plan is fantastic because it gives you some input into how the money you’re contributing is being invested and growing.  Talk to your human resources department if you want to get more involved in where your money is going.

5)  Individual Retirement Agreement (IRA) Deduction

This is a double-whammy in a good way.  You could save for your retirement AND reduce your taxes.  How?  Read on:

If your income is less than $26,500 you may get a retirement saver’s credit of up to $1000 for contributions to an IRA.  The catch here is that you can’t be a full time student to get this credit.

If your income is under $63,000 and you’re eligible for a retirement plan with your job, you can make a contribution of up to $5000.  However, if your income is $63,000 or more, you won’t get to deduct it.  See http://turbotax.intuit.com/tax-tools/ and click on the IRA Calculator to figure out how much you can deduct on your tax return (not a shameless plug—just a freakin sweet tool).

A final word on IRAs: If you aren’t eligible for a retirement plan, it doesn’t matter how high your income is—you can contribute and deduct up to $5000.  The nice thing about this is—deductions reduce your income.  And deducting your income reduces the amount of taxes you have to pay. Not to mention the fact that having a retirement fund might work out better for you than working at a burger joint when you’re 80.

Stay tuned for my next installment.  I’ll be talking about what paperwork you’ll want to have with you when you actually sit down to file.