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I have a friend (ahem) who is starting her 401k in her new job. A family member has offered to start an IRA for her this spring. My friend is worried about putting money in these two different retirement plans. Are taxes going to be a problem or will there be a deferment of some kind? Anybody have a similar concern? Thanks for your help--silverhair
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Well, you can't deduct the contribution to a traditional IRA, if your participating in a 401k.

But, you could contribute to a Roth IRA, if your income level isn't over the limit.

Or I think you can also contribute to a traditional IRA, but you won't be allowed to deduct the contribution.

The Dreamer.
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I have a friend (ahem) who is starting her 401k in her new job. A family member has offered to start an IRA for her this spring. My friend is worried about putting money in these two different retirement plans. Are taxes going to be a problem or will there be a deferment of some kind? Anybody have a similar concern?

I don't know about taxes so this may be no good to you...From what I've read on different websites (i.e. Transamerican Goaltender, Merryl Lynch)you should try to max out the 401k before contributing to an IRA. I think the reasoning behind it is the 401k's are usually matched.

Just an idea!
R
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The Dreamer

Your statement:
<Well, you can't deduct the contribution to a traditional IRA, if your participating in a 401k.>

is not completely correct.

The income limits for a deductible IRA are very low if eligible for a 401K. It is eligibility not participation that changes the income limits. It is still possible she would be eligible to make deductible contributions.

Debra
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There are no tax problems about contribution to a IRA and 401K at the same time.

The income limits are low for deducting a traditional IRA. The income limits are much higher for a ROTH IRA and no reporting of contributions is required on her federal tax return and probably not for state. The administrator reports contributions to the IRS.

If she is ineligible for a ROTH then there is no income limit for non-deductible traditional IRA contributions. An additional form is required with the tax return to account for non-deductible contributions.

Debra
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As another post indicated, being eligible to contribute to a 401(k) greatly reduces the income level at which you can no longer deduct contributions to a Traditional IRA. But if your friend's income is low enough, she can certainly contribute to both and enjoy the tax deductions to both (the 401(k) contributions, if pre-tax, reduce the income reported on W-2, box 1; she would have to show deduction for a Traditional IRA on form 1040 or 1040A).

Many people find that if they have a 401(k) avalable, they cannot deduct contributions to a Traditional IRA because of their income level. If that is the case, a Roth IRA is generally better than making non-dedictible contributions to a Traditional IRA. But if your income is too great to contribute to a Traditional IRA, you can still contribute to a Traditional IRA if you have earned income and you aren't turning 70.5 years old in the current year.

The general advice is usually:

1. Top priority for retirement funds is to contribute to an employer's plan (401(k), 403(b), or the like) up to the matched amount. This is like an instant return on investment or like free money--actually it is part of one's compensation package--so it is usually good to make use of the employer's match.

2. Next priority for retirement funds is usually to contribute to one's Roth IRA. Since your friend can open a Roth IRA with just about any financial institution, she isn't restricted to what her employer provides in the 401(k) or 403(b), so she could pick the best place to hold the IRA to get the best investments or savings instruments one wants that is consistent with one's investment plan. Often this means one can find a place with lower expenses and thus better returns, or be able to bring in diversity that one doesn't have in the employer's plan.

3. The next priority for retirement funds is to consider whether to contribute more to the employer's plan (401(k), 403(b), or the like). Some plans are pretty expensive (high fees, high expense ratios) that may swamp the tax advantage in the long run, but even with high expenses it might make sense if one is planning on leaving that employer in a few years, at which point (i.e., at separation of service), one can roll over the employer's plan to a "rollover IRA" (a Traditional IRA funded with strictly 401(k) or 403(b) money).

4. If one still has money to invest for retirement (beyond #3 or having skipped #3, or even want some assets that could be used before retirement), one may consider whether to invest in a personal (taxable) account or, if one owns a home, pay down the mortgage. One doesn't get the immediate tax advantage of #1 or #3, nor the tax free growth of #2, but one does have the flexability of putting that money in almost any investment in the investment universe, no contribution limits, no withdraw restrictions (other than what the particular investment might impose).

The above should be considered no more than a general rule of thumb--individual situations may suggest different priorities. For example, if one is in an occupation that tends to attract lawsuits, one might reprioritize based on creditor protection, and 401(k) and 403(b) plans generally have ERISA protection (protected from creditors, except for IRS back taxes and domestic order decree from a divorce), whereas protection for IRAs (Roth and Traditional) vary based on state law. Or one might make a Roth IRA top priority because one can withdraw regular contributions from a Roth IRA at any time for any purpose, no tax, no penalty. (My preference is to have a separate savings for emergency and keep the Roth IRA money invested for its intended purpose: retirement.) Or if one expects one's retirement tax rate to be lower than one's working tax rate, one may want to prioritize all employer plan contributions before Roth (so taxes get deferred on the 401(k) & 403(b) until retirement), provided that the expenses aren't too high.

Here are a couple links that may be of additional help:

"All About IRAs" <http://www.fool.com/money/allaboutiras/allaboutiras.htm?REF=PRMPIN>

IRS Publication 590: Individual Retirement Arrangements <http://www.irs.gov/pub/irs-pdf/p590.pdf>
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Debra,

There's one statement you wrote that I wanted to elaborate on, It is eligibility not participation that changes the income limits.

Actually, eligibility and participation are the same thing for a 401(k) under IRS rules. An employer may allow you to contribute to a 401(k) plan next year; but under IRS rules, if you don't contribute you weren't eligible.

This is true for any defined contribution plan your employer may offer. This is to give you some measure of choice so that you're not forced into some poorly designed plan offered by your employer. This is not true of defined benefit plans such as a conventional pension plan. If you are eligible to acrue a benefit from a pension any time next year it may affect your eligibility status and may potentially make any contributions to a conventional IRA non-deductible.

- Joel
I hope that made sense.
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You are considered an eligible participant if you meet the definition as defined by the plan sponsor in the Summary Plan Document (SPD) which the employer must give to each plan member.

You are an active participant for the IRS if you have either made any contributions, or have had any funds otherwise accrue to your account.
Through forfeitures of company matches by former members who weren't vested, for example.
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In the view of the IRS it does not matter whether you actually participate or not as long as you are eligible. The fact that you are eligible for a 401k or other Qualified Defined Contribution Plna will affect your ability to deduct contribtuions to a Traditional IRA. Please refer to the excellent post (as usual) by MarkOYoung for the details. The IRS is notified of your eligiblity status each year on your Form W-2. I believe it is box 13 on the w-2 that indicates if you are eligible. Whether you participate is not a factor to the IRS.

Bill
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W401K,

You wrote, In the view of the IRS it does not matter whether you actually participate or not as long as you are eligible. The fact that you are eligible for a 401k or other Qualified Defined Contribution Plna will affect your ability to deduct contribtuions to a Traditional IRA. Please refer to the excellent post (as usual) by MarkOYoung for the details. The IRS is notified of your eligiblity status each year on your Form W-2. I believe it is box 13 on the w-2 that indicates if you are eligible. Whether you participate is not a factor to the IRS.

Reference Page 12 of Publication 590. ( http://www.irs.gov/pub/irs-pdf/p590.pdf )

The right-hand side of this page defines the rules that govern who is covered and who is not. Even if the IRS goes by what your employer reports in box 13 of your W-2, under what condition they can report you as covered by a Qualified Defined Contribution Plan is spelled out here. To quote publication 590:

Defined contribution plan. Generally, you are covered by a defined contribution plan for a tax year if amounts are contributed or allocated to your account for the plan year that ends with or within that tax year.

Pub 590 goes on to define the difference between Defined Contribution and Defined Benefit Plans and the difference in coverage. It also points out that even an unvested employer contribution will make you covered under your employer's plan.

If neither you nor your employer contribute to your 401(k) during a plan year that ends in the current year and your employer still lists you as covered on your W-2, you should fight it. It doesn't matter what it says in the company's plan documentation because reporting you as covered violates IRS guidelines.

- Joel
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Joel,

You quoted the proper passage in Pub 590, but you went on to say that...

If neither you nor your employer contribute to your 401(k) during a plan year that ends in the current year and your employer still lists you as covered on your W-2, you should fight it.

But the rule also talks about funds that are allocated to an employee's account. In plans that have a company match, for instance, the match is often vested over three years or so. If a plan member leaves the employer before being fully vested in the match, that portion that is not vested is allocted to all other plan members, whether they've made contributions in that year or not.

So, you could rightly come across a situation where the employee, having not made any contributions, sees the box for retirement plan checked on the W-2 for no other reason than there was an allocation of non-vested company matches. The employee will insist that the company is wrong, but in most cases the W-2 is correct.
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Joel,

Thanks for the info!!
I had not read through Pub 590. I have seen numerous instances (my wife included) where there was no active participation in teh plan whether it be employee money or employer money and the box on the w-2 was checked as being covered by a qualified plan. Since the W-2 is reported to the IRS the assumption was the payroll company or whoever prepared the W-2 was following the IRS regs. Thanks for the clarifying for me. This is the best part of the Fool!!
I'll read the referenced pages of Pub 590 in more detail


Thanks Joel.


Bill
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Or if one expects one's retirement tax rate to be lower than one's working tax rate, one may want to prioritize all employer plan contributions before Roth (so taxes get deferred on the 401(k) & 403(b) until retirement), provided that the expenses aren't too high.

How is one supposed to know what the tax rates will be when one retires much less figure out what your tax rate will be upon retirement? That is the problem I am trying to figure out as to whether or not to cut down on the max 401k contribution and put it into a ROTH.

buylower
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BuyLower,

You wrote, How is one supposed to know what the tax rates will be when one retires much less figure out what your tax rate will be upon retirement? That is the problem I am trying to figure out as to whether or not to cut down on the max 401k contribution and put it into a ROTH.

Like any good plan, it's just an educated guess... Probably one you'll have to revise from time to time.

- Joel
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buylower,

<<How is one supposed to know what the tax rates will be when one retires much less figure out what your tax rate will be upon retirement? >>

If you are very near retirement then an estimate is possible, otherwise a crystal ball would be the only way to make an accurate estimate.

It is unlikely that tax rates are going to go down. The general rule is to contribute at least the minimum the company matches to a 401K then consider others plans.

Would you decrease the 401K contributions by the amount contributed to the ROTH or will it be by the amount contributed to the ROTH plus taxes? If it is the later then I would continue with the 401K contributions. You should do what makes you feel the most comfortable. Both are good decisions and there is not sufficient information to make a perfect decision.

The decision can not immediately be changed but is not completely unrevokable. Once a 401K is rolled into an IRA it maybe an option to convert it to a ROTH.

Debra
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Thanks for the replies. I figured I'd have to get a crystal ball, but wanted to be sure I'm not overlooking something obvious.

I currently contribute 16% to my 401k and 1.5% to a pension plan which is matched 100%, but I'm not sure that I'm enthralled with the choices of funds we get from Fidelity. I would probably reduce the 401k to the point of being able to max out a ROTH with the additional after tax income (which I would be able to choose any investments in).

This seems like a good course of action but I guess I'll check with my tax preparer to see if this would bump us up a bracket.

buylower

I have another old 401k that I never rolled over, I have contemplated conversion to a ROTH but was leary of the potential tax bill.
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BuyLower,

I thought I'd add a little more to the discussion of tax rates in retirement.

Let me generalize about individual income levels for a moment. Statistically, when you're young (in your 20s and early 30s), your income level and tax rate are actually relatively low. Once you settle into your career, your income will rise until it peaks within a range near the maximum for your chosen field/profession. As you near retirement, these levels may drop off for many workers, though not for all.

In retirement, your income level will be lower than at any other time if you depend solely on social security. Beyond that, you may have more or less income in retirement depending on how well you planned during your working years. But as a practical matter, most people that actually plan shoot for some level that's somewhere between 60 and 80 percent of their peak income.

But if you're still young, you don't know what that peak income is going to be. This is the main reason I think funding your ROTH IRA is a good idea when you're young; or in any year you think you won't have much income to report to the IRS. Once you settle into your career and your pay raises start settling down to more normal, inflationary increases you should probably switch your savings to tax-deferred accounts -- assuming you still have room to contribute tax-deferred.

Let me put this another way, and I know it may sound a little strange... But the very best time in your life to contribute to a Roth account is when you may feel you can least afford it. And the worst is probably when you can most easily afford it. The trick is in knowing which is which.

Finally, let me point out a little corrolary to this observation. If you're down on your luck financially -- say you've been out of work most of the year -- now is probably the best time in your life to considering converting a conventional IRA to a Roth IRA because of the tax implications.

- Joel
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<I have another old 401k that I never rolled over, I have contemplated conversion to a ROTH but was leary of the potential tax bill.

A 401K must be moved to a traditional IRA before it can be converted to a ROTH IRA. The IRA conversion does not have to be the entire amount of the IRA.

Debra
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