Traditional IRAs
What it offers
Who's it best for
Best Investments
Inherited IRAs

ROTH IRAs
What it offers
Who's it best for
Best Investments

Plan Limits for 2001

Offered by many employers, these provide tax-deferred investing and have the benefit of lowering your taxable salary by as much as $14,000 a year in 2005. Once you begin withdrawals, the money - both contributions and profits - is taxed as ordinary income based on your tax bracket. The income is ordinary in nature regardless of whether any of the profits came from capital appreciation.

401(k) plans are typically restricted in their investment options, based on the employer's selection and that of the 401(k) fund manager.

     Who's It Best For

Because of the high contribution limits a 401(k) is a valuable retirement tool for any taxpayer whose employer provides such a plan.

In the cases when the investment options do not meet the employees acceptable options, most plans to offer a money market fund option or one with little risk. In those cases, a taxpayer may want to weigh the advantages of increase contribution limits with the reduced flexibility.

   Best Investment Options

401(k) plans offered by employers often have few investment options. Options typically include a low risk money market or CD based fund, a bond fund and one or a few stock funds.

In general, the longer the period between contribution and retirement, the higher the risk that should be contemplated by the employee. For short periods of time, dictated either by age or job security, lesser risks are suggested.

You have a 401(k) plan with your current employer -- but you're thinking about changing jobs. What do you do with your 401(k) money after you change employers? You have a number of options.

One option we hope you don't elect is taking a distribution of your 401(k) funds. It's just not a good deal. If you're under age 59 1/2 (age 55 in some limited cases) and take a distribution, you'll not only owe taxes on it, you'll also owe a 10% penalty tax. So, we don't see this as a viable option. In fact, it should be avoided at all costs... it's a real last-resort type of thing.

That said, let's look at your other real options:

Leave 'Em
Many employers will allow you to leave your 401(k) money in their plan after you leave the company. Additionally, you should know that an employer generally can't force you take your money out of their 401(k) plan when you leave, unless your balance is $5,000 or less. This option works well if you are satisfied with the investment choices and the investment returns provided by your prior employer's 401(k) plan. Additionally, since some plans allow you to take a loan from your 401(k) account, leaving the money in the plan, as opposed to rolling it into an IRA, allows you to take advantage of this rule should the need arise.

But, there are disadvantages. One is leaving money in the former employer's 401(k) plan if the plan investments are limited to only the former employer's stock. In this situation, since all of your 401(k) money is in one investment, you run the risk of losing that money if there is a decline in the value of the stock. Another disadvantage of leaving the 401(k) funds with your prior employer is that it will not allow you to invest Foolishly. You can likely do a much better job with your 401(k) money in a self-directed conduit IRA account than you could with the mutual fund choices in the 401(k) account.

Move 'Em
If your new employer has a 401(k) plan and permits transfers from other employers' 401(k) plans (it's not mandatory for them to do so), you can transfer the money from your former employer's 401(k) plan to your new employer's 401(k) plan. This option is only advantageous if the investment choices offered by the new employer's plan are better than those offered by the former employer's plan. It also preserves the opportunity to take a loan from the plan if the need arises (and if the new employer's plan offers that option). But, again, if the mutual fund choices offered by your new employer's plan won't likely perform to your expectations, consider Foolishly investing your funds by moving the 401(k) funds to a conduit IRA account.

Transferring your money to a new employer's 401(k) plan generally can be done in one of two ways. You can take a distribution of the funds from your prior employer and deposit it (roll it over) into the new employer's plan. Second, if the new plan permits it, you can make the transfer through a trustee-to-trustee transfer.

The trustee-to-trustee transfer option is always preferable, because the IRS requires that, if you take a distribution, even one that you will roll over to another 401(k) plan, the employer must withhold 20% of the amount distributed for tax purposes. You won't be able to get this money back until you file your tax return for the year in which the distribution took place, and claim that amount as taxes withheld. Additionally, if you aren't yet 59 1/2 and don't deposit the distribution check and/or the amount withheld -- which must be obtained from sources outside of the distribution -- within 60 days of the distribution, those amounts will be subject to income taxes and the 10% early distribution penalty. More about this later.

IRA 'Em
The final option available to you is to transfer the money to an IRA. If you choose a self-directed IRA brokerage account, you can completely control your entire investment and can use the funds to buy any investment offered the brokerage -- including stocks, bonds, and/or mutual funds. You aren't limited to the (potentially) crummy investment choices provided by either your old or new employer. But, if you do make the transfer to an IRA account, you'll lose the opportunity to take loans, since loans against an IRA account are strictly prohibited.

Be careful, though, because as with a transfer to a new employer's 401(k) account, how you make the transfer is critical. If you take a distribution and then open an IRA account, you'll find that the required 20% withholding will reduce your distribution. And, if you don't roll over the entire amount of the distribution (including the 20% withheld), you'll get hit with taxes and potential penalties on the amount that wasn't rolled over. This means you'll have to dig into your pocket to roll over the appropriate amount.

Example: In May 2005, John, age 45, left his job. He had $100,000 in his employer's 401(k) plan. John decided to take the money from the plan and open a self-directed IRA account. However, John never filled out the paperwork to make a trustee-to-trustee transfer. As a result, on July 1, 2005, John's former employer sent him a distribution check for $80,000 -- John's $100,000 account balance, less 20% withholding. To avoid all income taxes and penalties, John must not only deposit the $80,000 check by September 1, 2005, (i.e., within 60 days of the distribution), he also must deposit $20,000 (the amount withheld by his employer) by that same date. The $20,000 must come from sources outside of the distribution. If John does not have $20,000 from other sources, that amount will be treated as a distribution and will be subject to income taxes and penalties.

Sure, John will get this $20,000 back in the form of taxes withheld when he files his tax return, but that will take a number of months. Why go through this hassle when a trustee-to-trustee transfer will avoid the 20% withholding and will not make you scramble to find funds to cover the withholding amount?

Undecided?
What if you are undecided whether to transfer your 401(k) funds to your new employer's plan or to a brokerage IRA? Or, what if you are between jobs and don't know who your new employer will be, or if it will have a 401(k) plan? In these cases, you'll likely want to transfer the money to an IRA until the decision is made. An IRA can act as a holding account until you decide what to do with the money. If the decision is, ultimately, to transfer the money to a new employer's plan, you can direct the broker to do just that.

But, if you want to keep this option open, you must remember that this "conduit" IRA account must not receive any other IRA distributions or contributions from any other sources. So, if you are interested in keeping your options open, make sure to open a completely separate Rollover IRA account for these 401(k) funds, and keep them completely separate from all of your other IRA transactions (e.g., Roth, traditional, SEP, etc.).

Ready for Retirement?
Remember, these are your retirement funds. The better you can protect them and invest them, the farther along the road to a glorious retirement you'll find yourself.

Speaking of retirement, did you know that we've developed the first-ever Motley Fool retirement planning seminar? Roadmap to Retirement is just that -- a guide to help you with retirement planning whether you're just now starting out or are ready to retire tomorrow. According to recent census statistics, only one out of every ten people of retirement age is financially able to fully retire. 

Traditional IRAs

Traditional IRAs, and rollovers of retirement accounts into traditional IRAs provide tax-deferred investing, like a 401(k), but offer a much broader range of investment choices, including all mutual funds and individual securities.

Rollover IRAs are money from a 401(k) or other employer-sponsored retirement plan. This typcally occurs when an employee retires or changes jobs.

Traditional IRA contributions are much more limited than 401(k) contributions. A taxpayer can contribute up to $2,000 or their earned income, whichever is smaller, per year. A couple can contribute up to $4,000, even if only one spouse has earned income (this changed in 1998). Contributions to an IRA may be tax deductible for the year the contributions are made for, depending on whether the taxpayer or spouse is covered by a retirement plan at work, and depending on their adjusted gross income.

Withdrawals from a traditional IRA are also treated as ordinary income, regardless of whether any profits came from capital appreciation.

  Who's It Best For

Traditional IRAs offer an immediate tax benefit in return for a future tax. In other words, you defer your taxes until distribution.

For a taxpayer that will be in a lower tax bracket when retired than currently, the immediate tax break may be more beneficial than tax-free earnings. Also, for an older taxpayer with limited future contributions a traditional IRA may be better.

Any taxpayer whose income levels exceed the maximum for a Roth IRA should choose a traditional IRA rather than not make any IRA contribution.

   Best Investment Options

A traditional IRA grows tax deferred. The distributions are taxed at the owners tax rate at withdrawal. There are few limits to investment options with either a traditional IRA or a Roth IRA.

If you also own an 401(k), use your IRA investments to complement your 401(k) investments. If your 401(k) is invested in high risk funds or individual stocks, IRA investments should take the form of lower risk securities, funds, or possibly bond funds. Conversely, if your 401(k) is not invested aggressively, aggressive IRA investment may be in order.

As with all retirement investments, the longer the time period between contribution and withdrawal, the higher capacity to absorb risk, especially as it pertains to stock investment.

   Inherited IRAs

IRAs are among the largest assets left to heirs and beneficiaries, and deciding what to do with an inherited IRA is among the most important decisions facing many heirs. So, let's discuss the decisions you'll want to ponder if you find yourself on the receiving end of an IRA account from a loved one who has passed away.

You can, of course, elect to receive the entire balance immediately in a total distribution... but is that really what you want to do? Unless you need the money immediately, it's generally better to leave it in the IRA as long as possible to defer taxation and prolong the period of tax-free growth.

Did you even know that you have choices if you are the beneficiary of an IRA account? Well, you do. But, the IRA distribution options available generally depend on whether the IRA owner dies before or after April 1 of the year following the year in which he or she turned age 70 1/2. That's when the owner would have been required to start taking minimum distributions from the account and, for the remainder of this article, we'll refer to that date as the "required beginning date."

Options for the Estate

If the IRA owner made the mistake of not naming a beneficiary or of naming his estate as beneficiary, there is little room for distribution planning. If the IRA owner dies before the required beginning date, the balance will be distributed to his estate (or other beneficiary, as prescribed in the will) according to the five-year rule.

The five-year rule basically requires the entire amount in the IRA be distributed no later than December 31 of the fifth year after the IRA owner's death. In this case, the only question is when and how to take the distributions during the five-year period, as waiting until the end maximizes the tax deferral, but spreading them out over all years avoids bunching income for the recipient.

On the other hand, if the IRA owner dies after the required beginning date, the balance must be distributed over the remaining term elected by the IRA owner. Or, if the owner elected to recalculate his life expectancy, the balance must be distributed by the end of the year following the year of his death.

Options for the Non-Spouse Beneficiary

Assume that you're not the surviving spouse of the deceased IRA owner, but this person was kind enough to name you as the beneficiary of the IRA. Now what happens?

IRA Owner Dies After Required Beginning Date
If the IRA owner had already begun to receive minimum required distributions, the remaining distributions generally must be paid out at least as rapidly as they would have been under the method of distribution in effect before his/her death.

This means that the options available to you are limited, because you generally can't lengthen the distribution schedule selected by the IRA owner on his required beginning date. Instead, with a few exceptions, if the IRA owner was receiving distributions over your collective life expectancies on the required beginning date, you must continue to take distributions over this period. If the IRA owner was recalculating the life expectancy each year, you must take the distributions over your own life expectancy (since the life expectancy of the IRA owner is now, sadly, zero).

If, on the other hand, the IRA owner was receiving distributions over his own single life expectancy (whether or not recalculated), the IRS has ruled that you can take distributions over your own life expectancy.

IRA Owner Dies Before Required Beginning Date
If the IRA owner dies before the required beginning date, you have a few more options. The general rule is that the entire balance of the IRA must be distributed under the five-year rule discussed above.

But, you can take advantage of an exception to the five-year rule and elect to receive distributions over a period not exceeding your life expectancy -- a better option for most people. If you decide to take this option, it's vital that you elect a method of distribution and that you take the initial distribution by the end of the year following the year of the IRA owner's death. Why? Because, unless the IRA agreement provides otherwise, distributions to a non-spouse beneficiary must be made under the five-year rule if no election is made. If you fail to make the election and take the appropriate distribution at the appropriate time, you'll lose this option and will be required to take distributions using the five-year rules. In effect, if you snooze, you lose.

One option not available to non-spouse beneficiaries is rolling over the inherited IRA account into an existing IRA they own. (Only spouses have this option, and we'll discuss it in a bit more detail below.) If a non-spouse beneficiary does roll over the inherited IRA into his or her own existing IRA, the rollover is treated as a distribution, and the proceeds must be included in the beneficiary's income in the year the rollover occurs.

Using Separate Shares for Multiple Beneficiaries

Multiple beneficiaries of an IRA can elect individually to apply the five-year rule or one of the exceptions when the IRA owner dies before beginning to receive distributions. In other words, each beneficiary can decide how quickly to receive distributions. That's the good news.

The bad news is that generally the individual having the shortest life expectancy must be used to determine the required distribution amount. Given this restriction, there may be little advantage to naming multiple beneficiaries if there are vast age differences among them. The younger beneficiaries will be required to take distributions based on the life expectancy of the oldest beneficiary.

But, there's a way around this. If separate IRA accounts or segregated shares are maintained for each beneficiary, each beneficiary can take his or her own distributions based on his or her own life expectancy.

The separate shares or accounts can be set up in two ways. First, the IRA owner may set up separate IRA accounts, naming different beneficiaries for each. This is advisable, but can't be done retroactively after the death of the IRA owner. But, the account can be segregated after the IRA owner's death, as long as the necessary actions are taken no later than the time by which distributions are required to begin, and the division is retroactive to the time of the IRA owner's death.

The separate shares are created by having the IRA trustee or custodian set up sub-accounts within the original IRA, and then account for gains, losses, and distributions separately for each sub-account. This division does not affect the tax-deferred status of the IRA and is not treated as a taxable distribution to the beneficiaries. The individuals can then, if they wish, have the sub-accounts transferred in a trustee-to-trustee transfer to separate IRA accounts, as long as the accounts remain in the decedent's name.

The result, according to several IRS rulings, is that each individual's distribution is calculated using each individual beneficiary's account balance and life expectancy. So, even if you discover you are one of many beneficiaries, don't overlook the possibility of creating sub-accounts and controlling your own destiny.

Options for Surviving Spouses

A surviving spouse who is named the beneficiary of an IRA generally has the same options available to non-spouse beneficiaries... and then some. A surviving spouse has an additional option -- he or she can avoid the post-death minimum distribution rules completely by electing to treat the inherited IRA as his or her own IRA.

If this election is made, the surviving spouse is treated as the IRA owner for all purposes and becomes subject to the minimum distribution rules only after reaching age 70 1/2. The surviving spouse also has the opportunity to name another beneficiary and receive distributions based on the joint life expectancy with the new beneficiary, under the general rules applicable to all IRA owners. Sweet.

Surviving Spouse Strategies

The election to treat your spouse's IRA as your own after his/her death should probably be made when the IRA owner is receiving distributions under the recalculation method. Why? Because, if you, the surviving spouse, don't elect to take the IRA as your own, the IRA will have to be distributed in a lump sum if you die before the entire balance is distributed. This could cause a real hardship to your beneficiaries.

In addition, this election should be made whenever the surviving spouse is much younger than the deceased IRA owner. Why? Because it allows the surviving spouse to leave the funds invested tax-deferred until after he/she reaches age 70 1/2. If the election is not made, the surviving spouse will be required to receive distributions based on the deceased IRA owner's age.

Obviously, on the other hand, a surviving spouse who is much older than the deceased IRA owner generally should elect to receive minimum distributions beginning after the decedent's death or after the decedent's attainment of age 70 1/2, whichever is later. Nevertheless, even an older surviving spouse can use the election to treat the decedent's IRA as his or her own to name a new beneficiary and begin receiving distributions over their joint lives. This might well lead to a longer payout period.

The election to treat an inherited IRA as one belonging to a surviving spouse can be made by filing an election on a form supplied by the IRA trustee or custodian. But, the election can also be made without filing any forms -- by simply by not taking required distributions, or by making a contribution to the IRA.

Another option for a surviving spouse is a rollover. Unlike other beneficiaries, a surviving spouse can roll over an inherited IRA into an IRA of his or her own. This has the same result as the election to treat the IRA as belonging to the spouse -- in fact, many IRA trustees and custodians prefer or even require the surviving spouse to change the ownership of an inherited IRA by rolling the account over to a new account.

Disclaimer Option

The beneficiary named by the decedent may be able to disclaim an interest in an inherited IRA, resulting in the distribution going directly to the next beneficiary in line. The disclaimer is effective for both income tax and estate tax purposes, so that the original beneficiary will not be taxed on the IRA and the recipient will be treated as receiving the IRA directly from the decedent. This can be a complicated issue and is well beyond the scope of today's discussion. It also could have both estate- and income-tax consequences -- both positive and negative -- for the beneficiary. Just know that this option is available and discuss it with a qualified estate planning pro before you decide to disclaim your interest in an inherited IRA.

Paperwork and Administrative Issues

Whatever option the beneficiary selects, he or she needs to take care of some administrative details. First, a non-spouse beneficiary must make sure that both the decedent's name and the beneficiary's name are on the account. If the account title is modified to reflect only the beneficiary's name, this modification is treated as an immediate distribution of the account and all the proceeds will be included in the beneficiary's income. In addition, the account should reflect the decedent's date of death and the beneficiary's Social Security number. It is safest not to assume that the IRA custodian will take the necessary steps to ensure that the information on the account is complete and correct.

Final Thoughts

Does this all look a bit complicated? Well, it certainly can be -- which is why, if you inherit an IRA account, you'll likely need some help to review your options from a qualified tax and/or financial professional with experience in this area of the tax code. Taking a "do-it-yourself" approach really might not be in your best interests. You may overlook or not completely understand some of the options available to you. Or worse, you could make the wrong decision and end up paying unnecessary tax dollars to Uncle Sammy. So, use the information above as nothing more than a starting point, and then do the additional research required to see exactly where you stand. 

thanks to fool.com for the above information.

ROTH IRAs

The Roth IRA was introduced in 1998, and thus provides a new approach to retirement savings.

In a nutshell, contributions to a Roth IRA are not tax-deductible, but earnings grow tax deferred and can be withdrawn tax-free in retirement after age 59 1/2 if the account has been in place for at least five years. In addition, the Roth IRA permits certain early withdrawals without penalty, sets no maximum age limit for contributions and imposes no schedule for withdrawals. The one key limit the Roth IRA adds is a maximum income level; joint filers may contribute the lesser of $2,000 or 100% of their compensation (earned income) into a Roth IRA, as long as their combined annual income is below $150,000.

Above that figure, the allowable contribution decreases and is phased-out completely at $160,000. For individual filers, the $2,000 maximum allowable contribution begins to phase-out at $95,000 and reaches zero at $110,000. Roth IRAs can be opened starting January, 1998. Taxpayers may contribute to a traditional IRA, a Roth IRA, or a combination of both, but an individual's maximum allowable total annual IRA contribution remains at $2,000

A Roth IRA also incorporates a few other options. Both traditional and Roth IRAs allow withdrawals after age 59 1/2, but unlike the traditional IRA, a Roth will permit contributions after age 70 1/2 and does not require withdrawals on any particular schedule.

After five years, a Roth IRA allows tax-free withdrawals for a first-time purchase (up to $10,000), disability or certain emergencies without penalty, up to the amount deposited. Larger withdrawals i.e., including some or all of the interest earned in the account, will be subject to tax.

Who's It Best For

A taxpayer that will have a higher or equal tax rate at retirement than when contributions are made should highly consider a Roth IRA.

Taxpayers with many years before retirement should also highly consider a Roth IRA over a traditional IRA. This is because the more years between contribution and retirement, the higher the potential value appreciation. Since the appreciated value will be withdrawn tax free at retirement, or at a later date, this increases a Roth's advantage over a traditional IRA.

Finally, a taxpayer that considers the need to make IRA withdrawals at age 70 1/2 an unnecessary burden should consider the option of a Roth. 

Best Roth Investment Options

Most investment advisors agree that contributions to a Roth IRA can be a taxpayer's most aggressive investments. The rationale is that the Roth, since it is not taxed at withdrawal, can absorb the most growth of all the retirement account options.

Pension Plan Limits for 2005

On October 20, 2004, the Internal Revenue Service announced cost of living adjustments applicable to dollar limitations for pension plans and other items for Tax Year 2005.

Section 415 of the Internal Revenue Code provides for dollar limitations on benefits and contributions under qualified retirement plans. It also requires that the Commissioner annually adjust these limits for cost of living increases.

Many of the pension plan limitations will change for 2005. For most of the limitations, the increase in the cost-of-living index met the statutory thresholds that trigger their adjustment. Furthermore, several limitations, set by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), are scheduled to increase at the beginning of 2005.

 

401k Plan Limits for Plan Year	2005	2004	2003	2002	2001	2000
401k Elective Deferrals	$14,000	$13,000	$12,000	$11,000	$10,500	$10,500
Annual Defined Contribution Limit	$42,000	$41,000	$40,000	$40,000	$35,000	$30,000
Annual Compensation Limit	$210,000	$205,000	$200,000	$200,000	$170,000	$170,000
Catch-Up Contribution Limit	$4,000	$3,000	$2,000	$1,000	n/a	n/a
Highly Compensated Employees	$95,000	$90,000	$90,000	$90,000	$85,000	$85,000
Non 401K Related Limits
403(b)/457 Elective Deferrals	$14,000	$13,000	$12,000	$11,000	$8,500	$8,000
SIMPLE Employee Deferrals	$10,000	$9,000	$8,000	$7,000	$6,500	$6,000
SIMPLE Catch-Up Deferral	$2,000	$1,500	$1,000	$500	n/a	n/a
SEP Minimum Compensation	$450	$450	$450	$450	$450	$450
SEP Annual Compensation Limit	$210,000	$205,000	$200,000	$200,000	$170,000	$170,000
Social Security Wage Base	$90,000	$87,900	$87,000	$84,900	$80,400	$76,200