When the calendar passed from December to January, we bid a not so fond adieu to 2009 as well as the rollover income limitation associated with transitioning a traditional IRA to a Roth IRA. This is a good thing if  converting to a Roth IRA makes sense for you.

The Roth IRA is one of the best retirement and estate planning tools available, and with the recent change in restrictions and tax payment scheduling, 2010 is the year of the Roth. Quite simply, if the Roth makes sense for you then 2010 is likely the year to make it happen.

Here are 8 ways not to screw it up.

1. Just Do it.

As many experts look at the mounting federal deficits and growing number of states in danger of bankrupting themselves, they see no choice but for taxes to skyrocket. Maybe, and maybe not. I’m not going to get on a political riff on the subject of reckless spending and taxes. I just want you to be aware that the chances are slim that tax rates will stay at their current rates, which are historically low.

So, the question for long term investors is not whether to fund a Roth, but how to fund a Roth IRA. Regarding a rollover from a traditional IRA, your choices are essentially:

1. Convert your IRA all at once.
2. Convert your IRA in stages, or segments.

Either way, if you don’t at least start to convert now, and you wait to do it later it may cost you dearly in terms of taxes. If you’ve decided that a Roth isn’t for you, then… why are you reading this article? Besides, since January 2010, all income limitations have been removed.

2. Understand the tax consequences.

Deciding to wait and do a conversion after taxes rise is a costly mistake, but so is jumping into a conversion without understanding the full tax implications.

For example, if you’re in a 15% income tax bracket today and you rollover a $250,000 IRA you will not pay 15% in taxes. You will end up paying quite a bit more because that $250,000 distribution can be counted as income, according to Barry Picker (who recently served as the technical editor of “100+ Roth IRA Examples and Flowcharts,” by Robert Keebler) and that will most likely bump you into a higher income tax bracket.

3. Know the direction of your tax bracket.

If you are the sole breadwinner today, but your spouse is likely to re-enter the workforce in a year or two, then you’re better off converted at today’s lower tax rate. On the other hand, if your spouse is considering staying at home with the baby that’s due in a few months, you’re better off waiting until she leaves the workforce and your combined income drops. Likewise if you file solo, but you’re thinking of tacking a pay cut to switch careers. Time your conversion when your tax rate is likely to be on the low side.

4. Don’t pay taxes with money from your transaction.

Paying the taxes with money you have withheld from the rollover transaction is a bad idea for a number of reasons, including:

Every penny you take out of the transaction is less that goes to work for you in the Roth.

The amount withheld goes to the IRS as an advance payment, and also reduces the total conversion amount. Hence, the amount withheld is considered a distribution and not part of the conversion and can impart further tax liabilities. For example, if you have a $100,000 IRA that you convert to a Roth IRA and withhold $20,000 (20%) for taxes, then the $20,000 is treated as a distribution and may be taxable in itself.

If you need to reverse the conversion (called a re-characterization – more on that below), then you can only reverse the amount actually converted. In the example above, you could reverse the $80,000 conversion, but you’d be out that $20,000 permanently – and you would still owe taxes on the $20,000.

The amount withheld for taxes is also subject to the 10% early distribution penalty, unless you are 59 1/2 when the conversion occurred.

5. Be a good judge of re-characterization.

If not converting is a mistake, not paying attention to your Roth after you’ve converted is a huge mistake. Here’s why – and incidentally, here’s one of the greatest aspects of the Roth IRA conversion. It’s called “re-characterization” and here’s how it works.

Re-characterization allows you to undo a conversion if the market value falls below your conversion amount. It’s the mulligan of the Roth world. Here’s an example:

You have $100,000 in your traditional IRA when you convert it to a Roth IRA. After a while, the your Roth is worth only $50,000. If you left your Roth alone, you’d owe taxes on the full amount at the time of conversion – $100,000. But, if you re-characterize your Roth (i.e. undo the conversion, you get your $100,000 back in a traditional IRA and you would owe taxes on the $50,000 re-characterization amount.

Of course, you have to do it before the next tax filing deadline after your initial conversion and if there are fees involved, you might want to makes sure you’ve lost enough value to make it worth your trouble.

6. Divide and conquer.

Besides the income limitations being dropped, you also get an extension on when you have to pay the taxes if you convert in 2010. For this one year only, you can spread your payment of the taxes you owe on the amount converted over the 2011 and 2012 tax periods; meaning you don’t have to actually pay them until 2012 and 2013!

7. Catch the early bird special.

If you convert early in 2010 and the market resumes its bull run, as some analysts think may happen, then you would have more time to catch those tax-free gains, while splitting the payment of the taxes owed over two year’s.

8. Hedge your bets.

You can split your conversions up into multiple conversions, by asset class for example. That way if your stocks perform well, but your bonds tank, you can re-characterize your bond conversion back into a traditional IRA and lessen the tax hit. In fact, many experts recommend slicing your IRA up into as many Roth IRA accounts as possible to gain maximum control over your taxes. This is probably only beneficial for very large accounts however.

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Target date funds have been in the news quite a lot over the past few years, though the nature of the news seems to have gone from great to bad over that time. Consider that when target date funds were first introduced they were heralded as the pinnacle in the evolution of investment vehicles. They were the ultimate in “set it and forget” investing!

These funds were so universally praised by the investment community and politicians alike that when congress passed the Pension Protection Act (PPA) allowing companies to automatically enroll employees in 401(k) accounts, it was target date funds that were chosen most often as the default fund, or “qualified default investment alternative” (QDIA) in the lingo of the PPA.

Then the crash of 2008-2009 happened.

2010 Target date funds performed horribly in that crash. This gave target date funds a lot of bad publicity. After all, the idea of a 2010 target date fund was that it would be invested in less risky assets as 2010 got closer, right?

Maybe.

See, the problem isn’t really that these funds lost as much as the average stock fund, or even that they were tilted too heavily in the direction of stocks. There are really two problems at the root of all this:

1. The crash of 2008 was not a garden variety stock market crash.
2. People’s perspectives on retirement savings is skewed.

Problem One: The crash of 2008.

The crash of 2008 was a once in a lifetime kind of phenomenon, one in which almost every investment asset lost value. The problem for target date funds regarding this kind of crash is: where should the majority of assets held in a 2010 target date fund be allocated?

In a garden variety stock market crash, or correction of say 10-15% or even 20% loss in stocks, a hefty bond allocation is usually enough to provide proper ballast to limit the total losses for the fund. But in 2008, just about the only safe place was cash, or gold and in any normal investment environment a majority of holdings in cash or gold would be a money loser.

Problem Two: Investor perspective.

This problem affected target date funds because investors simply did not expect a 2010 fund to lose 35% -40% of its value so close to the target date. But I think this is really the result of an underlying mistake in expectation on the part of the investor.

Too many investors have it in their mind that they will be taking all their money out of the stock market when they retire.

Maybe it’s the way these funds are marketed, but I know a lot of investors think that the clock stops when they retire and that what they have in their investment account is what they have for the rest of their lives. This is simply not true. The average retiree today can expect to live another 15-20 years. The fact is that they will still need to be invested in stocks in order for their savings to last as long as they do.

Solutions.

I think just about the only solution one can have for the first problem (the unusual market crash) is to have a sizeable sum of cash saved up for immediate access if you have just retired or are about to retire when such a crash hits. Something along the 9-12 month of expenses range, maybe more if you tend to panic about finances. This ought to allow the investor to weather the crash and not have to deplete his investment account while it is suffering heavy losses.

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Morningstar has a terrific article (available to free members) titled Three Tips to Make Your 401(k) Work for You and I love it! Here’s a brief sample of why:

It’s surprising there aren’t many calls in the press to ditch the automobile. After all, think of all the dumb things people do with them. They drive much too quickly and sometimes after drinking lots of alcohol. They even drive while sending text messages, putting on makeup, and reading the newspaper. The consequences can be dire: More than 40,000 Americans die in auto-related deaths each year, with nearly 3 million suffering injuries of some kind.

Few things in the financial media annoy me more than the recent calls to 86 the 401(k) plan. And the above paragraph illustrates the absurdity of the move to end 401(k) plans quite nicely.

The article goes into greater detail about the push to eliminate the plan, but it also offers some real actions that investors can take to help get their 401(k) balances back on track, or to keep them on track so that they will function as intended – as a means to save for retirement, not get rich in the stock market (as too many seem to think).

Tip #1. Save More.

Yeah, I know, this sounds trite but it’s important not to simply gloss over it. My 401(k) balance dropped by about 30-35% from its 2008 high by the time the market bottomed in March of 2009 – and this was also at a time when my company canceled 401(k) matches! Things looked not so good, to say the least. But I didn’t get discouraged and start blaming the system. Partly because I have over 20 years left until I need that money, and partly because I know the stock market ebbs and flows. True, the market doesn’t usually drop by as much as it did by early 2009, but that also meant that there was near unprecedented opportunity for big returns in the coming months.

So, I looked at what I could do to change my situation and decided to increase my contributions. I knew that this would maximize my ability to buy more stock at those low levels, and also help offset my employers decision to break their promised benefit to me (i.e. contribution match).

I saved more. And the result was that my balance was over its pre-crash value in September, 2009.

Tip #2. Invest Wisely.

Most 401(k) plans are quite limited in the options open to investors, but that doesn’t keep them from screwing it up! For example, some employees “play it safe” and put all of their money in the money market equivalent. That’s stupid, unless you’re looking at retiring in the next 2 year, but even then you shouldn’t have all of your money in cash equivalents because you’re not going to suddenly withdraw all of your saving upon retirement. You need to keep some of it in stocks for long term growth so you don’t run pout of money in retirement.

So, basically, examine the options open to you in your plan, and diversify properly according your time away from retirement and other factors such as other assets available upon retirement – ex: home equity, pension plan, etc..

Tip #3. Be Flexible.

The best laid plans can often fall short due to factors beyond your control, so while it’s important to have a plan and stick to it, it’s also important to remain flexible and be ready to adapt to new realities as the economy (both U.S. and global) enter uncharted territory. This may mean working longer than you originally thought, or working part time jobs in retirement. Regardless, don’t get caught up in the way you think things ought to be and lose sight of the way things are.

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Here’s a freebie for your Friday…

Open an IRA & invest for FREE in 2010!

ING Direct is offering a year’s worth of investing credits if you open an IRA with them before April 15, 2010.

Here are the details:

• no-fee IRA
• free Automatic Investment Plan (AIP) credits to use all year long, if you open your account before April 15, 2010.
• ING IRA accounts offer more than 7,000 stocks and ETF’s
• Automatic investment plans can be scheduled on a weekly or monthly basis
• Online AIP investments only occur on Tuesdays
• Real-time trade fees apply to all sales. (i.e. automatic buying is free with the credit all year long, but all sales with cost you)

An IRA is a great way to grow you retirement savings tax-deferred, and this promotional mean that even more of your contribution goes toward your investment, instead fees.

To take advantage of this ING Direct IRA promo, visit: www.sharebuilder.com/2010ira

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This is a friendly reminder for anyone with retirement savings who is concerned about paying higher taxes in retirement: new tax rules remove earnings limits on Roth IRAs.

Prior to the start of 2010, you could not open a Roth IRA if:

• Your individual adjusted gross income was $120,000 or more
• You and your spouse’s adjusted gross income was $176,000 or more
• You are a married taxpayer who filed separate returns from your spouse

But all of that changed on January 1, 2010. Those limitations have been permanently removed.

This opens the doors to millions of IRA and 401(k) account holders to convert those accounts to a Roth.

Reasons to convert.

Taxes.

Unlike IRA and 401(k) contributions (which are pre-tax), Roth IRA contributions are after tax. But withdrawals from Roth IRAs are tax-free, where IRA and 401(k) withdrawals are taxed at your income tax rate.

Required distributions.

There are none!

You can keep your savings in a Roth IRA as long as you want – and even leave them to your heirs upon your death.

Benefits for heirs.

If you leave your Roth IRA to your children, they don’t pay taxes on that money either!

You may be on the fence about whether to fund a Roth or traditional IRA, but here are two things to consider.

• First, if you’ve been smart with your money, and invested well you will likely be withdrawing more money than you think you will in retirement. This is especially true if your savings are in an IRA or 401(k) or similar plan that requires mandatory distributions after a certain age.

• Secondly, taxes will most certainly be higher in the future than they are today. Even before the current crop of politicians in D.C. quadrupled the deficit, tax cuts were set to expire and rates to return to higher levels. The recent spate of uncontrolled spending in Washington only sets the stage for even higher taxes down the road.

Source

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401(k) plans can be a great way to save for retirement and let your savings grow tax-free. But the plans are chosen by employers and managed by 3rd parties and don’t always have the best options. IRAs give you the entire universe of investments to choose from, but most employers offer a free match on a percentage of contributions to the 401(k) plans by the employee. So what’s an employee to do when the 401(k) plan has lousy investment options?

Here are 5 options, though there may be more.

1. Be an index hugger.

If your 401(k) plan offers index funds, then you can still get broad-based exposure and diversification at a low cost. You won’t be beating the market, but you won’t under perform the market either.

2. Take the best and move on.

If your 401(k) plan has one or two excellent funds and a dozen other mediocre funds, take the one or two and skip the others. This may seem like you’re not properly diversifying, but you should consider your entire collection of assets when diversifying, not just a single account.

For example, say your 401(k) plan has one excellent blue chip stock fund, and an equally excellent small cap stock fund, but the bond funds are lousy. You should invest in the stock funds offered by your 401(k) and invest the overall bond allocation in some other account, like an IRA account or maybe your spouse’s 401(k). Each individual account will be non-diversified, but when taken together your total assets will be diversified.

3. Look into the “window”.

More and more large employers are offering 401(k) plans with a “brokerage window” or “self-directed accounts.” These options allow the employee access to hundreds or thousands of other mutual funds, ETF’s and even individual stocks that aren’t part of the standard 401(k) plans options.

Be sure to investigate the details and learn about any additional fees or transaction costs that may be associated with the use of the “window”. There may be additional work on your end as well, since this option is unlikely to be available for automatic contributions like the standard 401(k) options. You may need to fill out additional paperwork or make other such declarations.

4. Talk to HR.

If you think your 401(k) plan stinks and you can get other coworkers to join you, you can petition your HR department to change the plan, or go with a new plan provider altogether. The more employees unhappy with the status quo, the more likely you can get your employer to change things.

5. Check out other options.

If all else fails, you can always go it alone with an IRA account. But if you get a company match on your contributions, then pick the best fund that’s offered and contribute at least enough to get the full company match and put the rest in an IRA. There’s no point in passing up free money, no matter how lousy the fund options are.

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There was a time when only the wealthy and well connected could invest in the stock market. Then IRAs and 401(k) plans ushered in a new era of the “common man” investor. Flash forward a bit more, to the Internet age, and we have a grand democratization of the stock market.

Not too long ago, you had to be one of the aristocracy to have access to what the power elite could dabble in: options, shorts, foreign exchange (forex), margin, commodities futures, to name a few.

But thanks to the Internet and the information age bringing investing to the masses, all that has changed. You can buy stock options through dozens of online brokerages like TD Ameritrade, Charles Schwab and ShareBuilder. Similar availability exists with foreign exchange markets, shorts and commodities futures.

When retail investors began purchasing shares in mutual funds in the 1970s, Forbes magazine was able to print the returns and expenses of every fund available. But now there are over 9,000 mutual funds on the market. When ETFs were first available in the 1990s, there were a handful and most were simple index tracking funds. Now there are over 700, many with elaborate weighting algorithms and some are straight actively managed funds.

But just because you can make use of these tools and techniques, doesn’t mean you should.

When it comes to saving for retirement, college or building your estate to pass on to future heirs, the tried and true stocks, bonds and mutual funds (and index ETFs) work just fine. The key isn’t how fancy or esoteric your investment vehicle is, but how you allocate your assets.

Take trading on margin for example. Margin is simply investing with borrowed money, usually from the brokerage. You borrow the money at a specified interest rate, and agree to pay it back with interest – hopefully once you’ve earned more from your investments than the cost to borrow. Margin amplifies returns, but it also magnifies losses, and you could end up owing more than you have. For this reason, it’s best left alone by the individual investor.

Another needlessly risky technique is shorting. Shorting is a bet that an asset will go down in value. At least in terms of individual stock, shorting puts the investor at odds with management. Knowing a particular stock is a dog, and not worth its trading price is one thing, but timing when the market will realize this is quite another.

But the real reason short selling is so risky is that you have virtually limitless amounts to lose. Consider this:

“You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold.

Your broker buys 300 shares at $35 per share and deducts $10,500 from your account to pay for the shares. The broker replaces the borrowed shares and you have a profit of $3,000 ($13,500 – $10,500 = $3,000). I have ignored commissions and so on to keep the math simple.”

Sounds great, you pocket a quick and easy 3k in profit. But here’s what happens when you guess wrong:

” You short 300 shares at $35 for $13,500. However, instead of falling like all reason and logic suggests, the stock rises and rises fast.

Before you know it, the stock is at $55 per share. You get a call from your broker, who is getting nervous. Your account for short selling is a margin account and if the stock goes too high, you will have to deposit more money or cover the short by buying the stock.

You decide to cut your loses and cover the short by buying the stock at $55 per share for $16,500. Since you only have $13,500 in your account, you have to come up with another $3,000 out of your pocket to make things right. You suffer a $3,000 loss. “

But what if the stock rockets past $55 a share. A stock can only lose so much money, and most stable companies don’t go to 0. But a share price can rise a long way before it starts to turn, and that can add up to big losses when you’re short.

For these reasons and more, you’re probably better off sticking to the simpler approach of The Simple 7 or the super simple One Minute Portfolio.

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There’s been talk about the “coming stock market crash” for years now, and one of the presumed causes is retiring baby boomers suddenly selling their stocks en mass. The reason seems sound enough. Baby boomers are no longer working and saving for retirement, and once their golden age arrives they take the money and run. But there are a few problems with that line of reasoning.

Here are 5 of them.

The top 1%.

According to the CBO (Congressional Budget Office), about 1/3 of all U.S. financial assets are held by the wealthiest 1% of the population. Think Soros and Buffett. These people don’t need to sell their assets to retire, they can live quite well on the interest and returns generated by their portfolios.

Longevity.

Retirees are realizing that retirement can be almost as long as their working life. Because of this, they get cautious and become wary of selling their assets in case they might need that money later in life. Many people think of retirement as the end game, a point where they take their savings off the table and live out the rest of their lives in happiness. But the reality is that they still need to invest in stocks so that their saving will continue to grow and be there for them 15 or 20 years into retirement.

Inheritance.

Some retirees want to leave something for the next generation, by way of bequests. If they cash out their portfolio, they won’t have as much left over for the next generation to inherit.

Foreign demand.

We’ve all heard stories about China owning America, or funding the U.S. deficit and the like. Hyperbole aside, there is a certain amount of truth in that sentiment. The world is a much smaller place than it once was, and that’s certainly true in the stock market. Foreign investors will continue investing in the U.S. stock market, even if some boomers decide not to.

Working longer.

One of the most consistent pieces of financial advice given to prospective retirees who realize they haven’t saved enough is to continue working. The longer you can defer retirement, the less money you’ll need. This effectively spreads out the retirement dates of boomers even more than they would otherwise be, lessening the likelihood of a mass exodus from the stock market.

Photo © by dan paluska

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Most people think they’ll be in a lower tax bracket when they retire, but this isn’t always true. And if you make the right financial moves during your working years, it almost certainly won’t be true.

The case for the Roth.

When you stop and consider the many tax breaks you’re likely to lose later in life, you can see why:

Tax breaks you’re likely to lose in, or close to, retirement:

• Deduction of mortgage interest
• Tax deferred 401(k) contributions
• Tax deferred 529 account contributions
• Tax credits for child dependents
• Deduction of Student loan interest

There are many other examples, but you get the idea – you’ll be paying more taxes later in life even if tax rates remained unchanged.

Speaking of tax rates, here’s why tax rates are certain to be higher in the future than they are now:

• The current income tax rates are very low from an historical stand point.
• Federal and State deficits continue to grow at alarming rates.
• The already record Federal deficit is only expected to continue growing for the foreseeable future, as Congress continues to spend money they don’t have.

In addition to paying more taxes, you’ll also have required distributions from 401(k) and similar retirement accounts that may push you into higher tax bracket.

All of this serves as a terrific recommendation for a Roth IRA, because in a Roth IRA, it’s the contributions that are taxed, not the withdrawals. So you’re paying taxes at today’s rates, and when you withdraw your money at a later date, you avoid the crushing tax burden. Also, there are no required distributions, which means if you don’t need the money you can leave it to grow, or leave it to your heirs as an inheritance.

Converting a traditional IRA to a Roth IRA.

You can convert a traditional IRA to a Roth IRA, but there are tax implications and income limitations you should know about. You will owe taxes on the amount you are transferring, so be sure to have cash on hand to pay for the tax bill – if you pay for it out of the IRA balance, you might incur an additional 10% penalty for early withdrawal.

For 2009, you must have a gross adjusted income of less than $100,000 to open a Roth IRA, but those income limits disappear in 2010. So, if your AGI is higher than $100k, it’s best to wait a few months.

A perfect marriage?

Often times discussion about the Roth vs traditional IRA is an either-or proposition, but it may be beneficial to have both.

Here’s why:

You can keep the traditional IRA and open Roth IRA, max out your Roth first, then your traditional IRA. Then, in retirement, you take your mandatory distributions from the traditional IRA as your base income. This is taxed as income, but you can then supplement your income with Roth IRA withdrawals that are tax-free.

This strategy also gives you the flexibility to keep your money in the Roth to continue growing if you don’t really need it as income at that time.

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Retirement is a time of great financial uncertainty and worry for many people. The common thinking is that you spend less in retirement than you did when you were working. Once you’ve retired, you no longer have the expenses associated with a commute, eating lunch out, new suits and career upkeep like training and so forth. But the reality is that many retirees spend more in retirement, at least in the first few years. New retirees like to catch up on home maintenance and feed their pent up thirst for travel. And don’t even get me started on greens fees!

So what’s a prospective retiree to do. Put your retirement plan to the test of course. A dry run in the years leading up to your target retirement date can help you see what kind of lifestyle you’re actually in for while you still have time to adjust.

Here’s a simple, 3 step approach:

1. Track spending. Get an idea of what your expenses are that will carry over into retirement. You want to track your cable bill but not what you spend on lunch with the guys from work or bridge tolls, for example.

2. Create a budget and stick to it for a year or two. Once you have an idea of what you think will be your expenses in retirement, create a budget and limit yourself to living on that amount.

3. Invest the money you’re not using into your retirement account. Take the difference between your budgeted expenses and your income and invest or stash it in a savings account. This will let you see what retirement will be like while increasing your retirement savings – a win-win!

The end result of this process is an emotional preparation as well as financial test drive. You will see if you really are ready to retire or not. If you are, then you’ve gotten some practice and some extra savings. If you’re not, then you’ve got some work to do. Get your financial house in order, minimize expenses, maximize savings and investigate other options like working longer, or part time in the early years of retirement. Whatever the outcome, you want to become aware of any problems before you’re on that fixed income and have less options.

Photo © carlos170691 (is busy with his assignment)

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