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ACap Asset Management
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April 2012: ACap ReCap

1. I don’t qualify for a Roth IRA and my employer doesn’t offer a 401k. What are my options?

The question itself show that you realize that if your income exceeds a certain amount, depending on your marital status, you no longer qualify to contribute to a Roth or Traditional IRA. Many professionals and dual income households find themselves in this situation –making good money, yet falsely assume that they cannot tax-efficiently save for retirement. If your income precludes you from contributing to a Traditional or Roth IRA, and you don’t have a 401k, you can contribute to a non-deductible IRA regardless of your income. A non-deductible IRA functions just like a traditional IRA in that the annual contribution limit is still $5,000 and the money grows tax-deferred. However, your contribution is not tax-deductible. A non-deductible IRA can also be used as a backdoor entrance to a Roth IRA (click here for related article). So just because your income is too high to contribute to a Roth or Traditional IRA, and you don’t have a 401k, doesn’t mean you cannot still save for retirement in a tax-efficient account.

2. Can I buy real estate using the money in my IRA?

The short answer is yes, but before you go hunting for that ideal investment property, there are some key restrictions you must be aware of. You don’t have to work at Bain Capital or be a Mitt Romney to invest in non-traditional assets within your IRA. However, you do have to understand the complex rules that apply to self-directed IRAs – the vehicles which allow you to invest in assets beyond stocks, bonds, mutual funds, and ETFs. Not all custodians will allow you to open a self-directed IRAs, so you have to find one that is not only willing to service your self-directed IRA, but also permit you to invest in assets you want rather than their proprietary products. You should also use a custodian that understands the IRS prohibited transactions rules and has procedures in place to prevent (to a reasonable degree) you from engaging in such activities. Some examples of prohibited transactions include: guaranteeing the mortgage loan in your IRA, using personal funds to pay expenses because there is insufficient cash in the IRA, using the property for personal use (including during retirement), or having a recourse loan. According to the IRS, “if you engage in a prohibited transaction, the account stops being an IRA as of the first day of that year.” Bottom line: you can buy real estate in your IRA, but make sure you do your homework first so that you don’t disqualify your IRA status.

3. What should I do with my old 401k after I’ve left my employer?

Most people really don’t know that their 401k is their money and is portable. Worse, some people have simply forgotten that they even have a 401k from a previous employer. Just because you left your job does not mean you have to keep your 401k with your old employer’s custodian; in fact, you may be doing yourself a disservice if you leave it there.  Once you leave, you can transfer (aka “rollover”) your 401k balance into an IRA. By transferring into an IRA, you can reduce your cost and expand your investment options. 401k plans cost money to administer which is either borne by the company directly, the plan participants, or a combination of the two. Most plan costs are paid by the plan participants, which means if you have left your company, you are still paying for the administrative cost of that company’s 401k (you are paying higher fees within your investment options.) In addition, 401ks usually have very few investment options to choose from. When you transfer your old 401k to an IRA, you can invest in almost anything, and can easily control your costs.

4. How much emergency cash should I have?

Emergency cash reserves are a vital aspect of financial planning because they protect you in case of well…emergencies. It’s bad enough to have to deal with a sudden job loss, leaky roof, medical need, or car repairs, but having a cash reserve to help you get through that ordeal helps minimize the stress. It’s important to note that the emergency fund is not meant for vacations or shopping sprees, but for a bona fide emergency. I generally advise my clients to have between 3 and 18 months of living expenses saved in a very safe and liquid account (i.e. short-term CDs, savings account, or short-term bond fund). Why the wide range? Because the amount you should have saved depends on your personal circumstances and profession. For example, if you are a physician at an established medical group with a set salary and good job security, you don’t need to maintain a large emergency cash reserve. On the other hand, if you are a realtor who works strictly on commissions, your income is more unpredictable. As a result, I would recommend a larger cash reserve to withstand months of little or no income. Furthermore, factors such as the ability to borrow from family members, ample home equity, or known health issues can justify maintaining a larger or smaller emergency reserve. If you don’t have an emergency fund, start small by saving a little bit every month until you have built up your fund. Then don’t touch it until you have an absolute emergency.

5. I know about Roth IRAs, but what is a Roth 401k? My company just started offering a Roth 401k, should I start using it?

This is a great question. Roth 401ks (can also be a 403(b) or 457(b)) are relatively new, and a growing number of employers are offering them. If you’re fortunate enough to have a Roth 401k offered by your employer, I would recommend you seriously consider it. The annual contributions limits are the same for the regular 401k – $17,000 for 2012. But one of the biggest benefits of a Roth 401k is that there are no income restrictions. So unlike a Roth IRA where your income determines your eligibility, you can contribute to a Roth 401k regardless of your income. However, whereas contributions made to a regular 401k reduces your taxable income and grows tax deferred, contributions made to a Roth 401k do not reduce your taxable income, but rather, grow tax-free like a Roth IRA. So if you are in a high income tax bracket now and need the lower taxable income from the regular 401k, you might be better off continuing with the 401k versus the Roth 401k. In addition, you can also split your deferrals and put some in your regular 401k and some in your Roth 401k. As an added benefit, you can still contribute to a Roth IRA (if your income qualifies). Lastly, if you employer matches your contributions, the matching contributions can only go into your regular 401k and not your Roth 401k.