The Roth IRA was introduced as a retirement investment option back in 2007. The New Year, 2010, has brought changes to the Roth IRA rules that are making this retirement investment vehicle better for some investors than ever before. In order to fully understand how a Roth IRA can be more beneficial than a traditional IRA you first have to understand the logistics of each retirement account option.

Traditional IRAs

Traditional IRAs allow account holders to deposit up to $6,000 per year if you’re over 50 years old and up to $5,000 per year for those younger than 50. Whether or not the contributions you make to a traditional IRA are tax deductible depends on the amount of your income and if you have another retirement account such as a 401(k) through an employer.

If you withdraw money from a traditional IRA account before you turn 59½ you are typically charged a 10% early withdrawal fee. Otherwise, you can begin taking distributions from the account when you turn 70½ and pay income tax on the amount of the withdrawal at your current tax rate.

The good news for retirement account holders that are 70 or older is the federal government is offering a temporary reprieve. Minimum distributions from tax-deferred retirement accounts (IRAs, employer sponsored retirement plans, inherited IRAs and inherited Roth IRAs) are not required this year, which helps to offset some of the major losses these accounts saw because of the floundering economy.

Roth IRAs

A Roth IRA works a little differently than a traditional IRA. The first difference is that you pay income taxes at your current income tax rate when you make your contributions to the account. The other difference is that you are not taxed again when you make your withdrawals. You are also not required to start making your withdrawals at the age of 70½ as you are with a traditional IRA. If you make early withdrawals, as long as you are at least 59½, you do not pay a tax penalty for early withdrawals.

The downside of a Roth IRA was that if you have a 401(k) or IRA Rollover and your annual income exceeds $100,000 per year, then you are not eligible for a Roth IRA.

As of January 1st 2010 this changes. Households converting an existing traditional IRA to a Roth IRA account can do so because there is no longer an income restriction. The minor setback of the conversion is that you pay income taxes on the amount of money you convert at your current income tax rate.

Roth IRA conversions that take place in 2010 allows you to deduct half of the income when you file your 2011 tax returns and the other half of the income when you file your 2012 tax returns.


Questions to Answer to See if a Roth IRA is Right for You

• Will my tax rate change in the future? If you expect your tax rate to decrease then paying to convert to a Roth IRA may not make sense when you can pay less money on your income later in life. This is especially true as you near retirement and withdrawal age.

On the other hand, if you have significant assets, it may be worth paying for the conversion because financial experts predict tax rates will increase in the future.

• Do I have the money to pay for the tax conversion? If you do not have the cash to pay for the Roth conversion, then it doesn’t make sense to do so. If you have to use the money in your retirement account to pay for the conversion, you will be penalized the 10% early withdrawal fee and lose the tax-free growth status on the money in the account.

You can convert a portion of the money into a Roth IRA, which should be the portion you can afford to pay the taxes on, and convert the rest into a Roth IRA in the future when you can afford to pay the taxes on this amount.

According to the results of a recent survey conducted by USAA, only nine percent of those surveyed with household incomes of more than $100,000 and 27 percent of all those surveyed (who own an IRA) plan on turning their tax-deferred savings into tax-free retirement income. This means for the most part that the new Roth conversion rules may go to waste for investors that would benefit most.

People make a lot of mistakes when it comes to IRA and 401(k)-related decisions. And I can’t blame them. The tax code is obscenely complex. That said, there’s no need for you to make these mistakes.

1. Converting to a Roth when it makes no sense Just because you can convert your traditional IRA to a Roth IRA doesn’t necessarily mean you should do it. Generally speaking, if you expect your tax bracket in retirement to be lower than your current tax bracket, converting isn’t a good idea.

2. Thinking tax rates won’t change between now and 2040 Of course, if you won’t be retiring any time in the next few decades, it’s nothing short of impossible to say what your retirement tax bracket will be. Tax brackets change as a function of both economic and political circumstances. Since we cannot easily predict what tax rates will look like 20 or 30 years in the future, it may be a good idea to tax diversify. That is, put some of your retirement savings in tax-free accounts (like a Roth IRA) and some in tax-deferred accounts (like a 401(k) or traditional IRA).

3. Not understanding how a Roth IRA works Sometimes, people neglect to make an IRA contribution because they don’t want to tie up the money until they’re 59½. What many investors don’t know is that contributions to a Roth IRA can be withdrawn at any time–free from tax and free from penalty. It’s only for distributions of earnings (and amounts converted from a tax-deferred account) that the various Roth IRA withdrawal rules have to be met.

4. Missing out on the Retirement Savings Contribution Credit It doesn’t get much press, but the Retirement Savings Contribution Credit can be a real boon for middle-class investors. In short, if your Adjusted Gross Income is below a certain level ($55,500 for married couples in 2009), you may qualify for a tax credit equal to a percentage of contributions you made to a retirement account. Tip: Investors who are just barely ineligible for the credit may be able to contribute to a traditional IRA, thereby reducing their income to the point where they’d qualify.

5. Funding your IRA just before the deadline every year You have until April 15, 2011 to make your 2010 IRA contribution. Of course, if you make your contribution as early as possible rather than as late as possible, you give your money more time to grow. Giving each of your contributions an extra 15.5 months of growth can make a startlingly large difference in your account balance when you finally retire.

6. Missing out on your catch-up contribution Once you reach age 50, you’re allowed to make an additional “catch-up contribution” to your IRA. It’s all too easy to forget about this for the first year or two that you’re eligible–especially if you make your IRA contributions via automatic monthly deposits.

7. Thinking you can’t contribute because only your spouse is employed Many one-income families think that they can only contribute to an IRA for the working spouse. That’s not true. In most cases, as long as one spouse is working and earns more than double the current IRA contribution limit, each spouse can contribute to an IRA. (Note: Reductions in contribution limits for high-income taxpayers still apply.)

8. Forgetting to take advantage of your self-employment income Between the popularity of blogging and other online businesses, it seems like everybody has a “side hustle” these days. What many people overlook is that their self-employment income qualifies them for additional types of retirement accounts. By opening a SEP IRA, SIMPLE IRA, or solo 401(k), you may be able to significantly increase the maximum amount you can contribute to retirement accounts this year.

9. Having your previous significant other listed as your IRA beneficiary No explanation needed–though you’d be surprised how often this happens.

What mistakes have you made (or avoided)? It’s always good to learn from mistakes. Especially when they’re somebody else’s. Have you made any IRA or 401(k) mistakes that you’d be kind enough to warn the rest of us about?

About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor.

Reverse mortgages were the topic of a post several weeks ago in which we promised to take a look at the downsides of seniors using a reverse mortgage in retirement. Here are some of the disadvantages of using a reverse mortgage to borrow against the equity in a home.

Builds up Debt

Traditional mortgages allow you to purchase a home using financing. As you make monthly payments on the mortgage, you start to pay down on the principal balance you owe. Over time, this decreases your debt amount. A reverse mortgage, however, is the direct opposite. It takes a home that you own free and clear of any debts and creates a new debt on the home.

Significant Upfront Costs

All mortgages have some types of fees and costs associated with establishing them. Most reverse mortgage adversaries claim that the fees and costs of establishing a reverse mortgage are significantly higher. Since many retirees establish a reverse mortgage to provide them with more income, having to pay what potentially adds up to thousands of dollars to establish a reverse mortgage may negate the benefits of the intended purpose of a reverse mortgage.

Decreases Assets to Heirs

If you have children, grandchildren or others you want to leave your assets to, a reverse mortgage may not be for you. A reverse mortgage decreases the amount of equity you have in your home, which directly affects the overall value of your estate. A reverse mortgage does not remove the possibility of leaving your home to your heirs, but your heirs are left with the responsibility of refinancing or paying off the reverse mortgage debt. The other option is for them to sell the home, pay off the existing reverse mortgage debt, assuming they can sell the home for at least the amount owed.

Can Make You Ineligible for Low-Income Assistance

Income from a reverse mortgage can affect your eligibility to receive low-income assistance from the federal or state government such as Medicaid. Check with the agency you’re receiving support from to see if the income from a reverse mortgage may adversely affect this income. Generally, this does not apply to Social Security income and Medicare coverage, but if you receive other types of income, make sure you’ll continue to receive this money if you take out a reverse mortgage.

Restricts Options to Move

A reverse mortgage uses your home as collateral for the mortgage. Since a reverse mortgage requires the home is your primary residence, this restricts your ability to move out of the home while you have a reverse mortgage. Reverse mortgages used as a short-term loan option may end up costing you more than you gain. With the high upfront closing costs, if you move out of the home soon after establishing a reverse mortgage, then you typically do not recoup the upfront costs–meaning you’re losing more than you’re gaining.

Can reverse mortgages be beneficial? Yes. Can reverse mortgages leave you with disadvantages that outweigh the advantages? Absolutely. Be sure to consider the disadvantages of a reverse mortgage carefully before choosing to use one as part of a retirement strategy for you or your parents.

Reverse Mortgage Guide
If you want to know more about reverse mortgages you can also check out a report by Quicken Loans, a branch of Intuit (the companies that creates the software products TurboTax, Quicken, and QuickBooks), that goes into much more depth about who reverse mortgages are right for.

The free guide answers covers topics and questions such as who qualifies for a reverse mortgage, the different types of reverse mortgage options, how a reverse mortgage works, and how much money you can get. Get the free report

If you or your parents have lived in your home for many years and have built up a lot of equity in the property you may have heard about or considered a reverse mortgage as a potential source of income during retirement. There seems to be a wide divide in opinions on whether reverse mortgages are a wise way to leverage equity in a home or a detrimental financial move for living out the golden years.

According to financial advisor Paul Escobar of U.S. Wealth Management, when it comes to reverse mortgages, “Seniors and their advisors should consider them, especially when their sole income and asset is their house.” Today we’ll take a look at how a reverse mortgage works and the benefits they have to offer retirees and seniors.

What is a Reverse Mortgage

A reverse mortgage is the direct opposite of a traditional mortgage because the mortgage lender makes monthly payments to the homeowner. A reverse mortgage is an option available to homeowners that are 62-years of age or older that own a primary residence free and clear of any mortgages or liens. The home also has to have a sufficient amount of equity—what is deemed as sufficient varies by the lender.

There may be other requirements from the lender but credit does not play a role in the qualification process. When homeowners qualify, the mortgage payments can be taken as a lump sum or in monthly installments. Since the amount of the reverse mortgage is based on the amount of equity, interest rate and the borrower’s age, the amount of the mortgage can vary.

Reverse Mortgage Benefits

While all reverse mortgage holders have their own reasons, there are some popular reasons that seniors opt for a reverse mortgage. Jason Roberts of Frost Lending Group points out that the fees for a reverse mortgage are similar to a conventional loan and the interest rates for reverse mortgages are generally lower. He’s helped a range of clients with reverse mortgages—some couldn’t pay for their basic needs, while others had a decent amount of savings but wanted to eliminate their mortgage payment. 

Retirement

Medical Expenses 

Increased cost of living, rising healthcare costs and a decreasing income do not necessarily work in harmony, but is the situation that leads many retirees to a reverse mortgage. Rather than forcing retirees to choose between paying their living expenses and paying for medicine and healthcare, the extra money that reverse mortgage provide allow seniors to pay for all of their needs—medical and daily living.

Home Accommodations

Some retirees use the money from reverse mortgages to make necessary modifications to their home. It may be widening doorways to accommodate the use of a walker or wheelchair or building a ramp to get up and down the stairs. Reverse mortgage payments can cover these costs.

Extra Money

With more time to travel and participate in leisurely activities, money from a reverse mortgage can provide extra spending money. It pays for trips, vacations or activities such as golf and days at the spa. It is an added bonus that allows them to enjoy some of the luxuries in life.

Go Debt Free

With another source of income for normal living expenses, many retirees use reverse mortgages to reduce or deplete debt. Without debt, the reverse mortgage money becomes additional cash flow that can be applied to other expenses.

After a discussion in her own mind and with her daughters, 77-year-old Francine Trevins opted for a reverse mortgage on her Manhattan loft. Francine says she has a wonderful life now because she is relieved of the “burden of a mortgage.” Her only concern is outliving the mortgage amount.

When it’s Right

Whether a reverse mortgage is right is different for each person. Talk with your financial advisor, tax consultant and estate attorney to go over the specifics of your situation. Don’t make a decision on what someone else has done because situation-specific reasons why reverse mortgages work or not vary too much.

Some of the questions you want to answer:

• Is there family you want to leave the home to?
• Do you have sufficient income to live out your retirement years?
• What plans do you have for retirement? Continue to work part-time? Travel?
• How old are you?
• Is there equity in the home? Is your home paid off?
• Do you have other sources of income?

Reverse Mortgage Dangers

Even the experts agree that there are drawbacks to reverse mortgages in some situations. In this article on reverse mortgage disadvantages we take a look at the potential dangers of reverse mortgages and what to look out for.

You can also check out a report by Quicken Loans, a branch of Intuit (the companies that creates the software products TurboTax, Quicken, and QuickBooks), that goes into much more depth about reverse mortgages.

The free guide answers covers topics and questions such as who qualifies for a reverse mortgage, the different types of reverse mortgage options, how a reverse mortgage works, and how much money you can get. Get the free report

Do you ever ask yourself why you’re being such a stickler with your money? We save and invest money for “the future” but how do we know when that future we’ve been preparing for becomes the present?

My Grandmother’s Apartment

My kids and I paid an evening visit to my grandmother this week, just so they could spend a few hours hanging out with her.  The memory of my grandfather, who passed away last year, still fills her relatively new apartment.  She moved into the independent living community after he died and as I walked in the front door I realized how people know when “the future” has arrived.

The place she’s living is wonderful. They have a computer room, a chapel, a game room, a workout room, a movie theatre, shuttles to drive the residents around town, a great dining facility, and most importantly… a nice community.  The people that live there congregate for meals, movies, games, worship, and just to visit.

The Future is Now

Of course all of these amenities aren’t cheap but it’s okay because “the future” that my grandfather saved for all those years has arrived.  As I mentioned in my memorial to him, my grandfather was tight with money, and proud of it.  Now all that saving and investing is paying off. Providing for his wife when he’s not there to care for her is EXACTLY what that money was meant for. 

He probably couldn’t visualize exactly how the money would be spent at the time of earning and saving it but he knew he was investing in the security of his family.  He didn’t know what the future held but he knew that it would eventually come and that he wanted to be ready when it did.

Condolences

One of the reasons I wanted to write this was because of Jason over at Frugal Dad who sadly lost his mother last Sunday. My visit to my grandma and his loss of his mom really got me thinking about where my parents and someday my wife and I will end up. 

I don’t know when that future will be. I don’t know what it will look like. But I’m glad that my parents and my wife and I are saving for the day when it arrives so that we can provide the rest of our family the security that we won’t be there to give.

The Roth IRA conversion rules are changing in 2010, here are a few things to consider if you’ve been thinking about converting your traditional IRA to a Roth IRA.

Roth IRA Conversion Limits

The current IRS rules only allow you to convert your traditional IRA to a Roth IRA if your modified adjusted gross income is $100,000 or under. Next year that income limitation will be removed so you can convert to a Roth IRA regardless of your income in 2010.

IRA Conversion Taxes

Converting from a traditional IRA to a Roth doesn’t allow you to skip out on the taxes you owe.  You still have to pay income tax on the amount you convert into your Roth IRA.

However, if you convert your traditional IRA in 2010 you can delay reporting of the income over a two year schedule.  The rules allow you to defer 50% of the income to 2011 and the other 50% until 2012.

If you don’t have the money to pay the taxes you’ll owe, it’s probably not worth it to convert your traditional IRA to a Roth IRA until you have the funds. If you pay the taxes with funds from your IRA you’ll be missing out on the tax-free growth of the funds you withdraw.  In addition if you’re under 59 1/2 you’ll proably also have to pay a penalty.

Retirement Tax Brackets

If you think your tax bracket will be lower in retirement than it is now then the taxes you would pay when converting to a Roth IRA next year could be higher than what you would pay when widthdrawing from a traditional IRA if you decided not to convert it.

Of course no one knows for sure what their income will be in retirement so this decision has to be made based on assumptions about your financial situation in the future.

Retirement planning can be daunting. You make a lot of assumptions about where you’ll be financially decades down the road.  You assume that the tax laws won’t do anything crazy and that the financial markets will continue to operate as they have for decades.  You also debate whether Social Security funds are going to shrivel up and blow away by the time you’re ready for them.

Although retirement planning is not simple it’s still very necessary to help give you some financial security in your later years.  The Obama administration made some proposals in their weekly address that are intended to help with retirement savings and education.  Here they are:

1) Allow employees of small businesses to automatically enroll in a 401(k) or an individual retirement account.

2)  Offer the option to receive your federal tax refund as a savings bond.

3) Enable employees to put payments for unused vacation and sick days into their retirement plan if they wish.

4) Retirement Planning Education. The IRS and the Treasury Department are working on a simplified guide and website to help translate the financial rules into a format that’s easier to understand.

I think finding ways to allow small businesses to let their employees automatically put money into a retirement account is a good idea.  The savings bond for your tax refund sounds good, I wonder how many people will actually do it?  I would love to put my unused sick days towards my retirement plan but I wonder how much that will cost companies and what impact that will have on them.  I don’t think financial education is a bad idea but I wonder how many people will make use of the site and how much it will cost to build and promote it.

What are your thoughts on the retirement savings and education proposals?

Traditional IRA or a Roth IRA, which should you open? This is a common question that comes up with many people looking to open an individual retirement account (IRA). I’ll try to make this as concise as possible, and let you decide for yourself which IRA is best for you.

Traditional IRA

Definition: A traditional IRA is a tax-deferred retirement fund, and the contributions may be tax deductible depending on your income and tax filing status. The contributions are made on a pre-tax basis.

Income Restrictions: There are no income restrictions for the traditional IRA. Everyone can contribute to a traditional IRA, but not everyone can deduct the contributions on their taxes based on your level of income.

Withdrawals and Distributions: Withdrawals can be made starting at age 59 1/2, but they cannot be made before that without incurring a penalty. Distributions are required to be made at 70 1/2 years old. This is the FAQ from the IRS about required minimum distributions.

Advantages: The advantages all depend on how much you plan on being worth when you are in your retirement years. If you think that you will have more taxable income during your working years or you make too much money to qualify for a Roth IRA, then a traditional IRA is the right choice for you. The biggest advantage is that you can reduce your taxable income during your working years.

Disadvantages: If you are a great saver, and your IRA distributions end up becoming higher than the income in your working years, then you could end up spending more in taxes during retirement than the money you saved in taxes from your contributions.

Roth IRA

Definition: A Roth IRA is a tax-exempt retirement fund, and contributions are made with after-tax income. Contributions are not tax deductible, but the distributions in retirement are tax free.

Income Restrictions: Single tax filers cannot earn a gross income of more than $95,000 and married tax filers cannot earn more than $150,000.

Withdrawals and Minimum Distributions: Like the traditional IRA, the minimum age to start wthdrawing funds is 59 and a 1/2 years old. The principal amount can be withdrawn at any time, if you take out earnings early you will incur a steep penalty. The Roth has no minimum distribution requirements.

Advantages: The biggest advantage is not worrying about taxes during retirement. If you will earn more in retirement distributions than you do during your working years, then the Roth IRA is for you. Also, not being required to make minimum withdrawals is a very nice thing.

Disadvantage: Contributions are not tax deferred so you don’t lower your income taxes for the year you make the contribution. Not everyone qualifies for the Roth IRA, so high-income earners don’t have the option of opening one.

Traditional IRA or Roth IRA? Not only should you calculate how much income you think you’ll have in retirement vs today, you also have to consider how tax laws will change over time.  It’s hard to know what the tax code will look like decades from now when it’s time for you to retire.  There’s been a lot of talk about tax reform lately but no one really knows when or if it will happen.

Some people think that taxes will inevitably be higher across the board in the future to help fund social programs like Social Security, Medicaid, and Medicare.  Others believe that the US government will keep tax rates relatively low and won’t adopt the high tax rates that many European countries use.

Opening an IRA

Whichever you decide, be sure to talk with your financial advisor about the advantages and disadvantages before you open an account.

Below are a few good places to open an IRA:

• Vanguard
• Etrade
• TradeKing

Death. No one wants to think about, especially a newly married couple. However, thinking about the worse case scenario is an essential trait for maintaining a sound financial plan. There’s no scenario worse than the death of you or your spouse, and that is why you need to prepare for it.

When Should You Buy Life Insurance?

Here are some scenarios where you might want to protect your family with life insurance:

• If you buy a house together as a couple, buy life insurance. If one of you dies, then the other can take the death benefit and either pay off the house or invest it and pay the payment with the monthly interest that it earns.
• When you have kids. If you both die together in a car accident, you need to leave money behind for your children to live a happy and fulfilling life.
• When one spouse is a stay-at-home parent. If the primary income earner dies, the other spouse MUST be left with a death benefit to cover monthly expenses.

What Type of Life Insurance Should You Buy?

For a younger couple in these situations I would recommend level term life insurance. I think cash value life insurance such as whole life, variable life, and universal life insurance are horrible products for the consumer.  They attach a cash value account with a death benefit.  The problem with these products is that the investment accounts attached to these policies typically yield low returns and come with VERY high management fees. 

Honestly, these products only make life insurance agents richer, not you.  This is why many financial advisors and life insurance agents recommend these products, because they offer a higher commission than term life products.  Term life insurance is only a death benefit of a specified amount for a level amount of time, and the premium is VERY cheap for healthy individuals. 

For instance, I just looked on Zander Insurance for an instant term life quote, and I can purchase a 20 year policy for $750,000 for $342 bucks a year!  Don’t use a life insurance policy for your retirement investing.  Designate mutual funds, index funds, and real estate for your retirement nest egg.

How Much Should You Buy?

Buy 8 to 10 times of your yearly income. So, if you make $50k a year, then you should buy $400k to $500k in term insurance. The idea here is that your spouse could take that money, invest it in good mutual or index funds, and replace your monthly income with the monthly interest from the lump sum death benefit.

Where Should You Buy It?

You could try and inquire separately with companies like Met Life or Zander Insurance or you could check with your local insurance agent or financial advisor that you trust. Another option is to check online with an established company for life insurance quotes.

I told you this would be a topic that you didn’t want to read about! It’s okay. The only things certain in life are death and taxes. Face reality and prepare for the worst. You owe it to your family.

If you think your family needs a life insurance policy and are looking for ways to pay for it check out the marriage budgeting tips and coverage of joint bank accounts for married couples to help make a plan and work together towards it. 

This coverage of buying life insurance in marriage is part of the Marriage Money Guide.

A reader sent the following response to yesterday’s post on avoiding Social Security payments.  I asked them for permission to share it because the email reminded me that Social Security is a safety net for many people and asks some interesting questions about keeping the Social Security program viable:

Reader Response:

Why would your wife forfeit her Social Security contributions?  My wife taught for a year under the Missouri Educators’ Retirement System.  We converted her contributions and earnings to an IRA when we left the state. 

During her last six years as a teacher in South Dakota, and previous years teaching in Kansas and Iowa, she contributed to Social Security, as most public educators do.  Her annual Social Security update lists her record of contributions in these states and forecasts her benefits upon retirement, which I fully expect she will someday receive. 

Why would you have any more confidence in the survival of Missouri’s retirement system over Social Security?  Both can go bust.  One in fact might argue that a program that has been around since the late 1930s and has the backing of the Federal Treasury has a more secure future than a relatively new program from a midsized Midwestern state. 

It all comes down to political and public will.  Will we allow Social Security to fail or embrace obvious remedies toward solvency?  Why not raise the cap on payroll taxes past $96000 (maybe even tax investment income), consider raising the retirement age for full benefits, or demand politicians quit raiding the Social Security Trust Fund for other expenditures? 

For the past seventy years, Social Security has been an essential part of the safety net for millions of Americans, particularly among the lower and lower middle classes.  Its benefits not only help retirees, they assist disabled workers and their families as well as spouses and children of deceased bread winners. 

For example, my wife’s grandmother, a former housewife widowed in her mid-sixties, could not have survived into her mid-eighties without her survivor’s monthly Social Security check.  There are millions of more just like her today as there will be tomorrow. 

Frankly, the question shouldn’t be how do we avoid paying into Social Security but rather can we find the moral and political courage to protect this vital program for future generations.