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Contributing to an IRA and a 401(k)
Dear Dollar Diva,
I'm 27 years old, and will contribute the maximum $10,500 I'm allowed
to my company's 401(k) plan this year. I would also like to open
an IRA, but don't know how they work. Can I invest in stocks and
mutual funds through an IRA? And are they all the same regardless
of which financial institution I use? Would there be contribution
limitations based on my income? I earn $120,000 a year.
Mike
Dear Mike,
You've discovered the magic formula for accumulating wealth: Make
systematic deposits in tax-deferred or tax-free investments -- and
start early.
Plug your 401(k) contributions into Bankrate.com's "Simple
savings calculator," assume a 10 percent return and watch
your $10,500 annual contribution grow to more than $1 million before
your 53rd birthday.
Better yet, if you're in the 30 percent tax bracket, it will only
cost you $7,300 to have that $10,500 working for you year after
year. Is this a great country, or what?
Saving comes before investing
The Diva is going to explain the ins and outs of IRAs, but first,
a word of caution. One day, without warning, the cosmos will decide
that it's your turn to take a financial hit. When that happens,
you'll need to cushion it with savings. You don't want to add insult
to injury by having to tap retirement money and pay the taxes and
penalties to get through a period of financial distress. Downsizing
and re-engineering have become ways of life; only the boss's son-in-law
gets immunity.
Make a list of your bare-bones expenses (exclude trips
to Cancun, Bally loafers and dinners at Ruth Chris Steak House).
Set aside enough cash to keep you afloat for six months, and include
an allotment for emergencies, such as a dead transmission or a wounded
roof; tuck these savings away in U.S.
Treasury Series I bonds, and then move on to investing.
How does an IRA work?
IRA is an acronym for Individual Retirement Account. Only people
who receive compensation, or have spouses who receive compensation,
can open an IRA account. Compensation is money earned for personal
services, such as wages, tips, fees and bonuses. Taxable alimony
is also considered money earned for personal services; read more
about it in the Diva's "Can
I have a spousal IRA?"
An IRA is a savings or investment account that is
set up at a bank or other financial institution, such as Vanguard,
Fidelity
Investments, TIAA-CREF,
or T.
Rowe Price.
An IRA account can be used to buy certificates of
deposit, money market accounts, mutual funds, stocks, bonds, REITs
and most other types of investments. It cannot be used to buy collectables,
such as stamps, coins and vintage wines, but it can hold investments
in gold and silver. The rules are the same regardless of the financial
institution you choose. See IRS
Publication 590, Individual Retirement Arrangementa (IRAs) for
more details.
Financial institutions want your IRA account; they
will help you with the paperwork to open the account and accept
lower minimum initial deposits than usual. For example, Vanguard
normally requires a $3,000 minimum investment to invest in its Vanguard
500 Index Fund; the IRA investor gets to play for $1,000. Janus
wants $2,500 as a minimum initial investment in its Janus Balanced
fund; the IRA investor gets in for $500.
Contribution limitations
Depending on the IRA, there are two ways that contributions and
deductions can be limited:
1. If you are covered
by a retirement plan at work
2. If you make too much money
The three kinds of IRAs and how they are affected
by the limitations are as follows:
- Traditional IRA (nondeductible): If you work and
have modified adjusted gross income of at least $2,000, you can
make the full $2,000 IRA contribution in 2001; even if you make
a million dollars and are covered by a 401(k) plan at work. This
is the least desirable of the three IRAs, but it's better than
nothing.
- Traditional IRA (deductible): The deduction for
a contribution to a traditional IRA phases out if you make too
much money. What's too much? Here are the phase-out ranges for
the various filing categories for 2001 if you're covered by a
retirement plan at work:
Single and head of household: $33,000 - $43,000
Married filing jointly: $53,000 - $63,000
Married filing separately: $ 0 - $10,000
Unless you have some huge deductions to bring down your adjusted
gross income, your $120,000 salary makes you ineligible for a
deductible IRA.
- Roth IRA: This is the Diva's favorite; especially
for young people. Contributions are not deductible, but earnings
can grow tax-free for as long as you live, and the Roth passes
on to your heirs, tax-free. Here are the contribution phase-out
ranges for 2001:
Single and head of household: $95,000 - $110,000
Married filing jointly: $150,000 - $160,000
Married filing separately: $ 0 - $10,000
If you file married filing jointly and your wife doesn't
make a lot of money, you might each be eligible for a Roth. If you
are, jump-start your investment by contributing $2,000 for 2001
and $3,000 on Jan. 1, for 2002. Together you can start the New Year
with $10,000 growing tax free in the investment of your choice.
For more details on contribution limits, read the
IRS
Publication 590, Individual Retirement Arrangements (IRAs).
What other options do you have?
Once you start making those big bucks, you need to be vigilant about
hanging onto them. The Diva suggests other ways to grow money without
paying a big chunk of it to the tax collector in "When
you're ineligible for tax deferral, seek out tax-friendly."
Investing is a serious business: If you want to earn
at least market returns, you need to do your homework. Start your
journey to financial freedom by reading the Diva's "401(k)
allocations for twenty-somethings," "How
does a new grad start investing?" and "Debtless
and happy."
-- Posted: Nov. 26, 2001
 DOROTHY
ROSEN has a master's degree in finance, with a specialization in
accounting, from the Kellogg Graduate School at Northwestern University
in Evanston, Ill. Rosen has more than 15 years of experience in
the financial arena, serving in Illinois and Florida as a certified
public accountant, financial consultant, expert witness and educator.
She is owner of Dorothy Rosen, CPA, a public accounting firm that
serves individuals and small businesses.
-- Posted: Nov. 26, 2001 |
