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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

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.

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'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?

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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

-- Posted: Nov. 26, 2001

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See Also
Can I have a spousal IRA?
What's a REIT?

Can I contribute to an IRA and a 401(k)?

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