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An IRA and a Variable Annuity

Question: I'm 61 and will work until 65 or 66, unless my employer decides otherwise. My financial advisor is recommending that I put my IRA into a variable annuity for about 4 years, as I can get a guaranteed 5% return if the Market goes down and a better return if it goes up. The fees of the annuity plus the 1.3% fee the advisor is charging now would raise the annual management fee to 2.8%. I ran the numbers and his suggestion makes seems to make sense if the Market does go down for the next 2 years or more and I start taking money out at retirement.

The IRA is about 37% of my current retirement savings, I'm putting 19% of my income into my 401K at work, and pension and social security are expected to replace ~34% of my current income (no adjustments for inflation) if I stay employed until 66. Does a variable annuity make sense for me? Gary, Omaha, NE

Answer: I can't stand this tactic. The fundamental reason I dislike it is that an IRA is a tax sheltered account. A variable annuity is also a tax sheltered account. Therefore, you're wasting valuable tax shelter with this maneuver--and taking on huge fees at the same time.

The Financial Industry Regulatory Authority (FINRA), is the largest non-governmental regulator for all securities firms in the U.S., overseeing more than 5,000 brokerage firms, about 172,000 branch offices and more than 676,000 registered securities representatives. It periodically issues "Investor Alerts" and one was on variable annuities. In its typically cautious language, here's what FINRA has to say about the recommendation to mix together a variable annuity and an IRA:

"Investing in a variable annuity within a tax-deferred account, such as an individual retirement account (IRA) may not be a good idea. Since IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA, while generating fees and commissions for the broker or salesperson."

You can read the whole investor alert at www.finra.org/InvestorInformation/InvestorAlerts. It's called "Variable Annuities: Beyond the Hard Sell." The bottom line: Don't do it.

03/31/08 by Chris Farrell

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Roth vs Pay Down Debt

Question: I'm 26 years old, and have no credit card debt, no car loans, no student loans. I max out my 401(k), and have a six-month emergency fund. Pretty good, right? But I also have a mortgage and a $40,000 second mortgage (which is structured as a home equity line of credit).

Over the past year, I've saved up about $5,000. My question is, should I put this money into paying off the home equity line of credit, or should I start a Roth IRA? I know the Roth IRA has higher returns over the long-term, but in my gut, I REALLY want to knock off that home equity line of credit. What should I do with the $5,000. Seattle, WA

Answer: First of all, I admire your financial acumen. I know that I was nowhere near as financially savvy as you are at your age. You're saving for retirement. You have a nice emergency stash. And no debt other than your mortgage and home equity line of credit. It's great.

If I were you, I would pay attention to your instincts: Go ahead and tackle that home equity line of credit. It's a smart move.

05/06/08 by Chris Farrell

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Emergency savings?

Question: I'm a 28 year old full-time graduate student, married, and proud parent of one son. I receive stipend from school which is not much and is our sole source of income, but with (super!) tight budget we make our ends meet.

One of the things that we'd love to do is to save, even if it's a very small portion of our income. I've heard a lot of good things about the Roth IRA and I think you recommended it to some folks who dialed in to your show. From what I've read about the Roth IRA so far, my understanding is that the Roth IRA allows us to contribute up to $4000 / calendar year and be able to withdraw from our contribution (but not the interest earned) in that same year.

Now, one "wild" idea I had is that since we don't have much of a savings yet but do want to start getting in the habit of doing so, AND also be able to have some level of liquidity with our savings, could I treat my Roth IRA account like a $4000 savings account from which I can withdraw in case of emergencies? I'm attracted to this idea because I'm told that IRA's (mutual funds) typically yield much better returns than conventional savings accounts. Do you think this is wise or am I missing overlooking something fundamental?

Thanks in advance for kindly sharing your wisdom! -John, Baltimore, MD

Answer: Congratulations on your money management skills. And I like your "wild" idea. It's an approach I promote it a lot.

You're absolutely right: A big advantage of a Roth IRA is that it is both a retirement savings plan and an emergency source of savings.

To briefly touch on the basics, Roth contributions are paid with after-tax dollars. The limit for 2008 is $5000. (a $5,000 maximum in 2008 if you're 49 and under and $6,000 if you're 50 and older.) Your investments gains will be tax free when you take the money out during retirement.

Still, in a pinch you can withdraw your Roth contributions without paying a penalty or taxes to Uncle Sam. The key is to leave the investment returns alone. You only tap your contributions. For example, let's say you contribute $3,000 into the Roth and in a pinch you need $1,000. You can take out that $1,000 without penalty or taxes.

09/09/08 by Chris Farrell

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Are IRAs safe?

Question: "Is our IRA account in UBS Financial Services Inc. safe during this wall street crisis?"..." If not, would you recommend taking the money out and putting it into treasury bonds or treasury money markets with an FDIC approved bank?" Thank you for your assistance Lynette, Chico, CA

Answer: There are two answers to this question. First, your IRA account is safe. Even if UBS got into trouble, another financial services firm would take over the account. Second, the value of the account depends on what assets you're invested in. To take an extreme example (just for the sake of illustration) lets say all the money had been invested in Bear Stearns and Lehman Brothers. You'd be wiped out. In sharp contrast, if all the money were in T-bills, you'd be sitting (relatively) pretty.

09/24/08 by Chris Farrell

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No income and an IRA

Question: I have a Roth IRA and traditional IRA, both with Vanguard. I am not employed at this time but I would like to contribute to an IRA or somehow take advantage of the down market with indexed mutual funds. Can I do this without having earned income? Lynn, Mooresville, NC

Answer: You need to have earned income in 2008 to contribute to an IRA of any kind. (If you were employed earlier in the year, however, you got a wage or salary and you can then contribute to an IRA even though you aren't employed at the moment.) The important exception to this general rule is the so-called spousal IRA. A stay-at-home Mom or a stay-at-home Dad can put money into an IRA even if they haven't earned an income during the tax year. (They've certainly worked, however!)

By the way, even if you don't qualify for an IRA and you want to put some money into index funds to take advantage of a down market, why not do it in a taxable account? The annual tax bite of a broad-based equity index mutual fund like the S&P 500, the Russell 3000, and comparable indexes (assuming that's what you are interested in) is relatively small since there isn't a lot of churn with the portfolio by design. You can always tap the money when you need it without paying the 10% penalty that comes with a premature withdrawal of money from a retirement account.

12/08/08 by Chris Farrell

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Convert an IRA?

Question: I am considering converting a Traditional IRA to a Roth IRA. My reasoning for this is: 1.The markets are depressed right now. If I convert now, the tax hit on conversion will be smaller, since my IRA has lost 25% of it's value. I have money outside the IRA which I will use to pay the taxes. Furthermore, I am expecting the market to rebound long term, and when it does, I will eventually get to withdraw the appreciation tax free.

2. I am self-employed, and so my income varies. This year my income is low, so I am in a low tax bracket, so I feel it would be advantage to convert at this time.

Is there any reason to not do this? Any other information I should be aware of?

At one point, McCain was talking about allowing people to withdraw from Traditional IRA's tax free. This would annul the main benefit of a Roth IRA. Do you think this could actually happen? Andy, San Francisco, CA

Answer: For many people, converting a traditional IRA into a Roth-IRA is a smart way to take advantage of the bear market. The gain is that the upfront tax hit on conversion is relatively small and should be dwarfed by the benefit of tax free withdrawals in retirement. Remember, a traditional IRA is funded with pre-tax dollars; you pay your federal income tax rate on withdrawals during retirement. The Roth is funded with after-tax dollars, but when you take the money out you don't owe Uncle Sam anything.

I think you've thought this through well. You're right, you will have to pay taxes on the conversion, but the tax hit will be minimal with the sharp drop in market values and your low income. The finances of a conversion get better if you have savings to tap outside the IRA money to pay the tax bill.

Your modified gross income has to be less than $100,000 to make the conversion, but that doesn't seem a problem in your case. (That rule will be scrapped starting in the 2010 tax year.) And added benefit of the conversion is that unlike the traditional IRA there is no mandatory withdrawal schedule beginning at age 70 ½ with the Roth.

Speaking of withdrawals, the two main law changes that I am aware of involving IRAs is first, allowing retirees to skip their mandatory withdrawals in 2009 and, second, extending the rule allowing each spouse to make a charitable distribution from his or her IRA account of up to $100,000.

To be sure, there are many tax cut proposals floating around fiscal-stimulus Washington at the moment. But it seems unlikely that Congress would let people withdraw money from Ira's tax free--at least not for any lengthy period of time.

01/09/09 by Chris Farrell

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Convert to Roth

Question: Given the current Federal deficit, and the way the U.S. Government is currently burning through money, it seems like a sure bet that tax rates will have to eventually start going up in the future. Because of this I've been thinking of converting my current 403(b) into a Roth IRA. And given that value of my retirement account has gone down (like everybody else's) it seems like a good time to make the conversion. In my particular case, if I were to convert the entire amount, according to the calculators I've tried, I would still be able to pay the taxes and penalties for the conversion entirely from current savings. And again, given how little these savings are currently earning, it seems like good timing. What are your thoughts on doing such conversions? Bill, Durham, NH

Answer: Your basic insight is sound. A lot of people are rightly running their calculators to see if conversion into a Roth is a good financial move for just the reasons you mentioned. For many, the answer is coming out yes.

Problem is, you may not be eligilble. If this is an active 403(b) at work you can't convert it into a Roth. You can do it if you're no longer on the job but simply left the retirement plan alone with your former employer and the plan allows you to roll the money over into an IRA. (Before 2008 you had to roll a 401(k)-type plan into an IRA and then roll that over into a Roth. The law has been changed so that you can go straight to a Roth.) You're also eligible If you're over 59 1/2 and your company allows an in-service distribution.

Remember, before 2010 your adjusted gross income has to be below $100,000 to make a conversion. The same $100,000 limit applies to the overall income of couples filing jointly as singles. Those who are married but file separately can't convert at all. (I don't make these rules up; I'm just reporting on it).

I'm glad to see that you have other money to put toward the taxes owed on a conversion. That's an important test to pass to see whether conversion makes sense.

The IRA laws are not simple. You can see if you even qualify for conversion at the Fairmark website. The Roth information is here ( www.fairmark.com/rothira/index.htm.)

02/05/09 by Chris Farrell

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I-bonds for Roth?

Question: I was told by my bank that it is not possible to put I-Bonds in my Roth IRA. If not, why not? I want to make a contribution that will not shrink like my mutual funds. Suzanne, Los Angeles, CA

Answer: That's right. There are technical and legal reasons why it's almost impossible to do. For instance, the U.S. Treasury rules say you can't open an account to buy savings bonds electronically through Treasury Direct in the name of an IRA.

Here's the thing: I don't think you should do it anyway. It isn't a good idea even if you could convince a bank to go through contortions to do this transaction for you. In essence, you're wasting a valuable tax shelter with the I-bond. You buy an I-bond with after-tax money. The savings compounds tax free. That is, until you cash it in and then you pay ordinary income tax rates on the gain. The I-bond is like a non-deductible IRA.

By the way, I-bonds are a terrific fixed income investment for most people. I like owning I-bonds, just not in an IRA.

Another inflation-indexed security is the Treasury Inflation Protected Securities, better known as TIPS. These default-free securities are also designed to hedge the value of your money against the ravages of inflation. The big drawback with TIPS is that Uncle Sam requires owners of TIPS in a taxable account to pay income taxes on the inflation-adjusted gains before getting any of the inflation-adjusted money at maturity. That's why TIPS work best in a tax-sheltered account, like an IRA or Roth-IRA.

It would be a better idea to use TIPS in your Roth.

You do need to go through a broker if you want to own the TIPS directly. A number of brand-name mutual fund companies sell funds made up exclusively of TIPS, too.

You could also buy short-term CDs insured by the FDIC at your bank for your Roth. You wouldn't have any credit risk with the FDIC insurance. You'd earn a decent rate of interest. And by keeping the CD terms short you could always be earnings something around the prevailing rate of market interest rates.

04/10/09 by Chris Farrell

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A Roth-IRA conversion in 2010

Question: As I understand it, Congress has lifted the income limits for Roth IRA roll-overs starting in 2010. How likely do you think it is that Congress will leave that tax change in place? Paul, Seattle, WA

Answer: My best guess--and it's just that, a guess--is the shift in the Roth-IRA conversion rule will hold for 2010. After that it all depends on whether the Obama Administration pursues dramatic tax reform and manages to get Congress to agree to a major overhaul of our Byzantine tax code. The Administration has appointed a tax reform commission headed up by former Federal Reserve Board chairman Paul Volcker, but with everything that is going on in the economy and markets it hasn't had much traction.

For the moment it looks like 2010 is fast becoming the equivalent of a conversion gold rush. Here's why: Up until now, you could only convert a traditional IRA into a Roth-IRA if your modified gross adjusted income was under $100,000. The income limit lifts in 2010. What's more, when you convert from an IRA to a Roth you owe income taxes on the amount converted. The reason is a traditional IRA is funded with pretax dollars while a Roth is funded with after-tax dollars but withdrawals are tax free in retirement. Well, the 2010 conversion amount may be included as taxable income in 2011 and 2012. That helps spread out the tax bite. It's a one-time perk.

To convert or not to convert, that is the question. There are many factors to consider, but for many people the answer will be yes. The benefit of tax free withdrawal is huge. The argument for converting strengthens the longer your money can compound after conversion and before retirement. It's also important to have other savings on hand to pay the tax bill. Another advantage of the Roth is there is no required minimum distribution at age 70 ½ as there is with a regular IRA. For those with substantial assets converting to a Roth may make financial sense simply from an estate planning perspective.

There are many twists and turns to this conversion story. For instance, should you pay the tax tab in 2010 or spread it out depend on whether you believe the money you make off the delayed payment will offset the risk of a higher tax bill. What will happen to your income in 2012? Maybe your income will plunge in which case you'd probably elect to pay the tax over two years. But if there's a chance of a big bonus in 2012 you'd get rid of the tax liability in 2010.

One place to get started researching the economics of conversion for your household is at web-based calculator, like this one.

04/28/09 by Chris Farrell

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A loss on a closed Roth

Question: I recently closed a ROTH account, feeling that the money could best be used elsewhere, since I still have a fair amount in other retirement funds, even after all the recent market trouble. I had been contributing $100 per month for about seven years, yet the cash out value, even before 10% government withholding and surrender fees, was less than the total of my contributions by several hundred dollars. What is my tax liability? Can I claim a loss on this year's taxes? Can I expect to get my 10% withholding back at some point? Thanks! Joe, Milwaukee, WI

Answer: There is nothing simple about Roth-IRAs and taxes. Yes, under certain conditions can claim a tax deduction for the loss from closing the Roth-IRA account. But there are a number of twists and turns in the tax code about liquidating a Roth. My best advice is to strongly urge you to consult a professional advisor.

That said, if you're in a similar position as Joe in Milwaukee you can stop reading this post right now. Go get professional help.

Here's a brief overview of the basic rules for those of you that remain curious. In order qualify for a tax loss from closing a Roth you must liquidate all your Roth-IRAs. The amount of money you have at liquidation must be less than your "basis." A basis is defined as the amount of money you contributed to the Roth; plus any money you may have added to it by converting a traditional IRA into a Roth; and subtract any sums of money you've withdrawn. (From Joe's email it looks like he has a loss by this definition.) You must itemize on your taxes to claim the loss. The amount that can deducted is limited to 2% of adjusted gross income. By the way, the 10% penalty doesn't apply if the Roth is made up from annual contributions.

There are a few more wrinkles, but you get the basic idea. And you see why I say work with a tax pro.

06/05/09 by Chris Farrell

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Inflation and an IRA

Question: I'm interested in finding a good investment for inflationary times. This would be about 7% of my retirement portfolio; around 10,000 in cash languishing in 2 different IRA accounts. I am 42, and will probably have to work until I croak. I am guessing I'll retire at 75 or so. I considered purchasing some I Bonds in an IRA account. I'd like to be able to sweep the proceeds of a dividend-yielding investment into the bonds once a year. I contacted my stock-trading account - no dice on holding I Bonds in my account there. I contacted Treasury Direct and they told me I needed to find a bank that would hold the bonds in an IRA and also contact the IRS. Do I need to call all the banks in town to see if anyone will do this? Is there a kind of bank that I should focus on? A directory that would help? Am I trying to do something completely wacko and ill-advised? Jill, Northfield, MN

Answer: I wouldn't say "wacko". But ill-advised? Yes. For a number of technical and legal reasons you can't get I-bonds into an IRA. More importantly, you wouldn't want to do that anyway. In a sense, an I-bond acts like an IRA. The money you put into an I-bond compounds tax deferred until you cash it in. At that point you owe ordinary income taxes on the gain. With an IRA, your investment grows tax deferred until you pull it out in retirement and pay ordinary incomes taxes on the withdrawal. You'd be wasting the tax shelter if you could invest it in an IRA.

That said, I like I-bonds. I would just buy them directly from the Treasury.

Inflation isn't much of a problem right now. The government reported this morning that the Consumer Price Index for the 12 months ending in May was down 1.3%, the biggest decline since 1950. I'm not very concerned that the Federal Reserve extraordinary actions to shore up the economy will end in a bout of hyperinflation, either. The formidable combination of an intensely competitive global economy and a competent central bank will keep inflation around its target level of 1% to 2%.

Of course, that forecast could be horribly wrong and a reprise of the inflationary '70s awaits us. Even if I am right low levels of inflation erode the value of a dollar over time. Long-term savers should worry about inflation a lot. That's why I like Treasury Inflation Protected Securities or TIPS. It's an ideal security for an IRA, although you'll have to buy them from a broker. I've written a fair amount about TIPS elsewhere on the Getting Personal site. The best overall source of information for investing in TIPS and similar securities for safety and security is Worry Free Investing by Zvi Bodie, finance professor at Boston University. You can check it out here.

06/17/09 by Chris Farrell

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IRA contributions

Question: My 18 year old daughter is graduating high school and going on to college. She has had odd jobs, but has earned no more than $600. I would like to open an IRA for her to get her thinking and planning for her future. Can I open an IRA for her for more than what she has earned? Thank you. Olga, Hasbrouck Heights, NJ

Answer: I think it's a wonderful idea for her to open up an IRA. The contribution limit to an IRA if you're under 50 is $5,000 (and its $6,000 if you're 50 or over). However, the law says she can't put more into an IRA than her earned income. So her limit is around $600. By the way, I would set up a Roth-IRA. When she retires several decades from now she can withdraw the gain with no tax liability. What's more, the contributions are a stash of emergency money. She can always tap the contributions without penalty or tax.

06/24/09 by Chris Farrell

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The 60 day IRA rule

Question: This past quarter, I made a series of small withdrawals from my IRA to keep the mortgage and other bills paid. I returned the first draw within the 60 day period, but when I went to return the second I was told I could only do 1 "rollover" per year! Help! How do I get my money back in without the penalty? The irony is that I am only 4 months from being 59.5 yrs. old. Chris, Gypsum, CO.

Answer: Ouch. It's a little known rule, but you can take money out of your traditional IRA penalty-free and tax-free so long as you put it back within 60 days. In essence, you're making an interest free loan to yourself for a brief period of time. The 60 day limit is strict. If you're under 59 ½ and you don't get the money back within the 60 day time period you'll owe taxes on the withdrawal and a 10% penalty. The other restriction is that you can only do this only once within any 12-month period. I don't see any way around it.

This article from Investopedia lays out some exceptions, but I doubt you qualify. Still, it offers a lot of good detail.

07/20/09 by Chris Farrell

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IRA withdrawal

Question: If I borrowed amount $x from my IRA and invest it and make $x + 10% and return $x back into my IRA within the 60 day limit, what is the status and treatment of the 10% profit? Treated as ordinary income? Paul, Bethesda, MD.

Answer: Yes, short-term gains are taxed at your ordinary income tax rate. But for a whole host of reasons it's a really bad idea to take money out of your IRA and try this strategy.

08/06/09 by Chris Farrell

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Early withdrawal from 401(k)

Question: Is it possible to move the majority of my balance in my company's 401k to a self-directed IRA without penalty (or quitting my job)? I'm not happy with the investment alternatives available in my company's 401k plan. David, Lewis Center, OH

Answer: In most cases the answer is no. The general rule is that employers aren't supposed to let you take money out of the 401(k) and roll it over into an IRA. You can only do that when you leave the company--voluntarily or involuntarily.

However, there is one important wrinkle (hey, legislators can't make saving for retirement simple, can they?). By law, companies can offer their employees 59 ½ or older the option of rolling over their contributions into an IRA. It's called an "in-service" distribution. In other words, you're still working for the company, you're 59 ½ or older, and you can roll the money over into an IRA. It's legal, but it's up to management whether they offer the option. A majority of large companies seem to allow it.

To learn more about the twists-and-turns in the in-service distribution world, check out this detailed article in Forbes: The Great 401(k) Escape.

09/10/09 by Chris Farrell

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Required minimum distribution

Question: What exactly is involved in "distributing" your IRA'a by / at age 70 ½? Beverly, Flagstaff, AZ

Answer: In the calendar year following the year you turn 70½ you must start withdrawing a minimum sum of money from your tax-sheltered regular IRA. (You don't have to with a Roth-IRA; it doesn't require minimum distributions.) The jargon term is "RMD" for required minimum distribution. Of course, you can take out more money than the RMD if you want to or need to.

The basic formula is composed of two parts: The adjusted market value of your IRA as of December 31 of the prior year divided by your life expectancy taken from the Uniform Lifetime Table published by the IRS. But most major financial institutions that are in the IRA business offer calculators to figure out your RMD. If your IRA provider doesn't offer one you can turn to calculators at websites such as dinkytown.net.

The exact amount of your RMD does change from year to year.

10/13/09 by Chris Farrell

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Rollover IRA

Question: I was recently laid off and told that because my 401k balance was below 5k I would need to move the money. I do not want to cash out and would like to avoid paying any taxes on the funds. I currently have 3 other 401k accounts with previous employers. What are some of my options for these investments? Natalie, West Chester, OH

Answer: You'll want to do what's called a "rollover IRA." There are no tax consequences or penalties so long as the money is transferred from your former employer directly into the rollover IRA account. Check with human resources before you do anything to make sure you understand any requirement the company may have about a rollover. The same goes with the company you've chosen to place your rollover IRA. And if you put the money into a comparable investment you shouldn't take much of a hit on the transfer, either.

Now, as to your other 401(k) accounts at 3 previous employers, why are you keeping the money there? If it's because you really like the plan options offered by these employers, fine. But my bias is for you to take control of the money through a rollover IRA. "It's great anytime you can take control of your money and take it out of your company plan," says Ed Slott, head of his eponymous company and a leading IRA expert.

You're no longer working for these companies. It's your money and if it's under your control you'll watch it carefully. Plus, you get to chose the investment company and investment options, not your former employer.

10/21/09 by Chris Farrell

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Roth conversion

Question: My wife has a combined income that is over the limit for a traditional IRA tax deduction or for contributing to Roth directly. We both also have employer sponsored retirement plans. Since there is no income limit for conversion from a traditional IRA to a Roth in 2010, I want to establish a traditional IRA now so that I can convert it to Roth next year. My question is, because I will be contributing to my traditional IRA after tax (or without any tax deduction), how I will be taxed when I convert my traditional IRA to a Roth coming 2010? Thanks. Andrew, Norman, OK

Answer: What you're planning on doing can be a smart move. Let me just give a bit of the background behind your question.

The Roth-IRA is a terrific retirement savings vehicle, probably the best available. The main reason is that all accumulated investment gains are free from Uncle Sam's clutches when withdrawn during retirement. The other attraction of the Roth is that it offers unusual flexibility for managing finances. For instance, there is no required minimum distribution at age 70 ½ with a Roth as there is with a 401(k) or a traditional IRA.

In the past, you could convert money stashed in a traditional IRA into a Roth, but you could only do it if your adjusted gross income was under $100,000. That earnings cap on conversion disappears next year. That's why the Roth conversion equivalent of a gold rush is about to be unleashed in 2010. Conversion calculators have sprung up all over the web. (The contribution limits to a Roth and the income phase-outs all remain essentially the same in 2010 and on. What have changed are the rules with conversion.) There are a lot of twists and turns to the Roth conversion question in 2010 and after. But it's an issue well worth researching.

Now, to your question. Many financial planners I've talked to are advising folks that earn too much to contribute to a Roth and a traditional IRA to open up what is called a non-deductible IRA. This is what you're planning to do. The non-deductible IRA is funded with after-tax dollars. The gain is tax-sheltered over the years and the earnings are taxed at your ordinary income tax rate on withdrawal during retirement.

But you're not going to wait that long. You'll convert the non-deductible IRA into a Roth in 2010. The only tax you will owe on conversion is on whatever gain you've earned in the meantime--in other words, not much. You won't owe anything on the contribution since you've already paid the tax tab on that money. And, of course, with this maneuver you won't pay any taxes on the investment earnings when you withdraw the money in your retirement years.

As I said, it can be a savvy move.

10/22/09 by Chris Farrell

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Military thrift plan

Question: Hi, I recently left active duty military service and am trying to decide what to do with my Thrift Savings Plan. I've got about $40k saved in it right now.

When I look at the options for withdrawing, it seems like I'll be paying either 10 or 20 percent penalty fee.

I was thinking about starting a ROTH IRA. Should I take the penalty and roll it over into a ROTH IRA? Or am I better off just letting the money sit in the TSP until I retire? Thanks, Spencer, Humble, TX

Answer: You have a number of good options to think through. And you shouldn't pay a penalty or taxes with them. The one exception on taxes is the Roth option. I'll explain in a moment.

First of all, the Thrift Savings Plan is a really good, low-fee plan. It's hard to beat. You might want to simply leave your retirement savings in the plan.

If you still want to move your savings out of the Thrift Savings Plan you can roll it over into another tax sheltered plan. For instance, if your current employer's savings plan allows it you could transfer the money into your new 401(k). Alternatively, you could roll it over into an IRA. In both cases you don't take the money out. You'll make an institution to institution transfer of the money, preserving its tax-sheltered status. No penalties will be imposed, either.

You could put the money into a Roth-IRA. Since the Thrift Savings Plan was funded with pre-tax dollars and a Roth is funded with after-tax dollars you'll owe taxes on the money your transfer into the Roth. However, when you pull the money out during retirement the gain is free of Uncle Sam's levy. By the way, in most cases it does not make sense to Roth if you have to use your retirement savings money to pay the tax levy. It reduces the amount that can grow, free of tax, in the Roth.

I'm not sure which branch of the military you served in. But the Navy offers a clear brief explanation of your choices.

10/28/09 by Chris Farrell

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ETFs

Question: I've just opened a Roth IRA to start saving for retirement. However, as a graduate student, the amount I'm starting with and able to contribute monthly is well below the minimum investments for various mutual funds. I've been looking at ETF's, which seem to have the same diversification with lower expense ratios. Is there a reason to prefer one over the other that I'm not seeing? Thanks much. Drew, Atlanta, GA

Answer: The exchange traded fund (ETF) is a genuine innovation. ETFs are investment vehicles that track indexes but an ETF is traded like a stock. The most popular ETFs are based on broad stock indexes such as the S&P 500 and the Dow Jones Wilshire 5000. There are also a number of broad-based socially responsible ETFs. It's also another way for the small investor to take a plunge in windmill energy, solar and other energy alternatives.

Problem is, there has been an explosion of ETFs that slice and dice the market into smaller and smaller and smaller pieces. Intrigued by patents? There's an ETF for you. Think the Austrian economy is poised to rebound? Yes, there's an Austrian ETF. That's why I'm cautious with ETFs in general. It's a product increasingly designed for speculation, not investing.

That said, an ETF is fine if you want to buy a broad-based index all at once. You pay the brokerage fee, and then hold on to the investment. An ETF works for a buy-and-hold strategy. But a no-load equity index mutual fund is better if you're adding to the investment in small increments over time, say, $100 a month or a similar investment disciple.

11/02/09 by Chris Farrell

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