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Can You Double-Count Earnings for IRA and 401(k) Contributions?

A reader writes in, asking:

“My spouse is retired, and I recently began semi-retirement, working just a few days each month. Because of a pension and paid off house, we won’t be spending from our retirement savings. My question regards contributions to retirement accounts with a small amount of income.

My employer offers a 401k. Let’s say I earn $10,000 in 2016. Can my wife and I each contribute the maximum to a Roth IRA? Essentially what I’m asking is can we each count the $10,000 as income? And does that change if I contribute to the 401k?”

First let’s back up a step for readers unfamiliar with this topic. In addition to the normal IRA contribution limits, there is also a rule which says that your IRA contributions for each year are limited to your compensation for that year (i.e., wages, commissions, self-employment earnings, alimony, and nontaxable combat pay).

There is an exception to this compensation-related limit for married people, but for the moment let’s focus on the simpler situation of an unmarried person.

Contributing to a 401(k) and IRA

Your IRA contribution is limited to your compensation for the year. For people earning wages (as opposed to self-employment income) the relevant amount is the amount reported in box 1 of Form W-2. Of note, that figure has already been reduced by any pre-tax (i.e., “traditional”) 401(k) contributions that you make for the year. In other words, if your earned income is low enough, contributing to a pre-tax 401(k) would reduce the amount of IRA contributions that you can make.

Example: Beth earns $5,000 this year. If she doesn’t contribute anything to a retirement plan at work, she can contribute the entire amount to a Roth IRA.* However, if her employer offers a 401(k) and she decides to make pre-tax contributions to that plan, those contributions would reduce the amount of wages that show up in box 1 on her W-2, thereby reducing the amount she can contribute to her Roth IRA.

Things work differently, however, if it is a Roth 401(k) to which you are contributing at work. Specifically, the amount of wages reported in box 1 on Form W-2 is not reduced by the amount of Roth 401(k) contributions that you make. In other words, you can essentially “double count” your earned income by contributing to a Roth 401(k) and a Roth IRA.

Example: Beth earns $5,000 this year. If she contributes $5,000 to a Roth 401(k), she can still contribute $5,000 to a Roth IRA.

Spousal IRA Contribution Limits

As mentioned above, there is an exception to the rule that your IRA contributions for each year are limited to your compensation for that year. Specifically, in a married couple, for the spouse with the lower amount of compensation for the year, the compensation-related limit is calculated as:

  1. The compensation of the spouse in question, plus
  2. The compensation of the other spouse (i.e., the one with higher earnings), minus
  3. Any IRA contributions the other spouse (the higher-earning one) has made for the year.

Example: Bob and Jane are married, both age 60. Bob is retired. Jane still works part-time, earning $20,000 per year. Jane does not contribute to a retirement plan at work. She does, however, contribute $6,500 to a Roth IRA for the year. Despite having zero compensation for the year, Bob can also contribute $6,500 to a Roth IRA, because Jane’s compensation is sufficiently high for both of them to make contributions.*

A key point here is that spousal IRAs do not allow for “double counting” of income. For example, if Jane in our previous example only earned $5,000 for the year and she contributed $5,000 to a Roth IRA, Bob wouldn’t be able to make any Roth IRA contribution.

*For the sake of simplicity, we are assuming here that the MAGI-related income limits are not an issue.

Transferring an IRA and 401(k) in a Divorce

A reader writes in, asking:

“My divorce was finalized a few weeks ago, and I am supposed to receive a portion of my ex-husband’s IRA and 401k. Are there any specific rules to follow as far as how to move the money from his accounts to my IRA? Or does he just take the money out, write me a check for the appropriate amount, and I deposit the money in my IRA?”

Yes, there are specific rules to follow. And it’s important to note that the rules are different for IRAs than for employer-sponsored retirement plans. Let’s talk about IRAs first.

Transferring IRA Assets in a Divorce

Publication 590-A speaks to transferring an IRA after a divorce. There are two key points here.

The first key point is that there are two ways to do it:

  1. Change the name on the account (in cases in which the entire account is being transferred to you), or
  2. Move the money via a direct trustee-to-trustee transfer, in which the money is sent directly from one financial institution to the other.

A check written to you is a problem, because it does not fall under either of these options. That is, it is not possible to do a “rollover” in which the money is sent to you, then you put it into your own IRA. It has to be a direct transfer from one financial institution to the other (i.e., from the custodian of your ex-spouse’s IRA to the custodian of your IRA).

The second key point is that the divorce decree (or a written document incident to such decree) must specifically state that you are supposed to get this interest in your ex-spouse’s IRA.

Transferring 401(k) Assets in a Divorce

The rules for an employer plan — such as a 401(k) or 403(b) — are different.

First, rather than the divorce decree needing to state that you’re supposed to get an interest in the account, it has to be a “qualified domestic relations order” (QDRO) that states that you get an interest in the account. Also, it’s critical that the order includes certain specific pieces information in order to qualify as a QDRO.

Second, with an employer plan, a rollover is possible. That is, as long as there is a QDRO ordering that you get the part of the account in question, the plan can make out a check to you, and you can then deposit it (i.e., “roll it”) into your IRA — though you only have 60 days (from the date you receive the distribution) to do so.

Can I Take a Loan from my IRA?

A reader writes in, asking:

“A friend recently told me that he took a loan from his IRA so he could take money out for a short time without having to pay penalty. I had never heard of that, so I called Vanguard and asked about it. They said that only 401k accounts have loans, not IRAs. Is that true? Was my friend wrong?”

The Vanguard representative is correct that IRA accounts do not have loan provisions, whereas many 401(k) plans do have such an option. (For more on 401(k) loans, see this MarketWatch article from Elizabeth O’Brien.)

Perhaps your friend was talking about the ability to “borrow” from an IRA by using the 60-day rollover provision.

To back up a step, there are two ways to move money from one IRA to another:

  1. Via a direct “trustee-to-trustee transfer,” in which you never have possession of the money, as it goes directly from one financial institution to the other, and
  2. Via a “60-day rollover.”

With a 60-day rollover, the first financial institution sends the money to you, and as long as you deposit an equal amount of money into an IRA within 60 days from the day you receive the distribution, it will be treated as if the distribution did not occur.

The 60-day rollover option exists so that you can move money from one retirement account provider to another. But it can also be used as a sort of short-term “IRA loan” mechanism, because it’s possible to simply deposit the appropriate amount of money back into the same account (rather than into an IRA with a different financial institution).

There is, however, one very important point to be aware of: You can only do one such 60-day rollover per year. So if you have executed such a rollover within the last year, you cannot “borrow” from your IRA in this manner, because you would not be able to put the money back into an IRA. (That is, the distribution would simply count as a normal distribution, potentially subject to the 10% penalty.) Similarly, if you do “borrow” from your IRA in this manner, you won’t be able to do so again within the next year, nor would you be able to do a normal 60-day IRA-to-IRA rollover during that period.

Of note, the one-per-year limit does not apply to:

  • Roth conversions (i.e., rollovers from a traditional IRA to a Roth IRA),
  • Direct trustee-to-trustee transfers, or
  • Rollovers involving an employer-sponsored plan (e.g., from a 401(k) to an IRA or vice versa).

Also, the one-per-year limit is no longer one rollover per IRA per year as it used to be, but rather one rollover per year regardless of how many IRAs you have.

Should I Still Contribute to a 401(k) if I Plan to Retire Early?

A reader writes in, asking:

“If I plan to retire well before age 59.5, should I still be contributing to my 401-K? In case it matters, I am in my late 20’s and the goal is to retire around age 40.”

For a few reasons, even if you plan to prior to age 59.5, it is still probably a good idea to contribute to a 401(k) account.

First, in order to retire very early, you’re probably going to have to save more per year than your maximum 401(k) contribution limit, so you will probably also have money in a Roth IRA and in taxable brokerage accounts, each of which can be accessed prior to age 59.5 without penalty. (At least, contributions made to the Roth IRA can be accessed prior to age 59.5 without penalty. For earnings, one of several exceptions to the penalty would have to be met.)

Second, there are several ways to get money out of a 401(k) account prior to age 59.5 without having to pay a penalty. For example, there is an exception to the 10% penalty for any distributions that are part of a “series of substantially equal periodic payments” taken over your life expectancy. The rules are complicated, and I would urge you to work with a tax professional if you plan to take advantage of this option. But if you follow the rules correctly, you can get access to (some of) the money as early as you want.

Finally, even if you retire at age 40, there will still (most likely) be many years after 59.5 for which you will need savings. According to the Social Security Administration, the average total life expectancy for a 40-year-old is approximately 80.5 years. In other words, on average, there would still be more than two decades of post-age-59.5 spending that must be funded.

In short, the 10% additional tax that applies to certain early distributions from 401(k) accounts shouldn’t necessarily be a big problem, even for somebody who plans to retire early. And it is unlikely that that drawback overwhelms the benefits of contributing to a 401(k) account (i.e., tax-deferred growth, potential for shifting income from high-tax-rate years to low-tax-rate years, and potentially an employer match).

The Age 55 Rule for 401(k) Accounts

A reader writes in, asking:

“I recently heard that if I am laid off at age 55, I can get money out of my 401K before turning 59.5 without having to pay the 10% penalty. Is that true, and if so could you elaborate on how that works?”

This rule comes from Internal Revenue Code 72(t)(2)(A)(v), which states that the 10% additional tax for early distributions does not apply to any distributions that are “made to an employee after separation from service after attainment of age 55.”

In reality, however, the rule is slightly more lenient than that. IRS Notice 87-13* states that “a distribution to an employee from a qualified plan will be treated as within section 72(t)(2)(A)(v) if (i) it is made after the employee has separated from service for the employer maintaining the plan and (ii) such separation from service occurred during or after the calendar year in which the employee attained age 55.”

In other words, you can take money out of a qualified plan account (such as a 401(k)) without having to pay the 10% penalty, if:

  1. You have left the employer in question, and
  2. You left that employer in or after the calendar year in which you reached age 55.

A Few Points of Clarification

There are several points about this rule that often trip people up, so let’s go through them one by one.

First, it doesn’t matter how/why the separation from service occurred. Quitting counts. Getting laid off counts. Getting fired counts.

Second, it is the separation from service (not just the distribution) that must occur at the age in question. For example, if you left your employer at age 53, even if you are now age 55, distributions from your 401(k) with that employer would still be subject to the 10% penalty, unless you meet one of the other exceptions.

Third, you don’t have to be retired to qualify for this exception to the 10% penalty. For example, if at age 56 you leave Employer A and take a job with Employer B, your 401(k) account from Employer A is now accessible penalty-free — even though you’re not retired.

Fourth, it doesn’t have to be your most recent employer. For example, if, at age 56, you leave Employer A and take a job with Employer B, then you retire from Employer B at age 58, your 401(k) accounts from both Employer A and Employer B are now accessible penalty-free (because in each case, you separated from service in or after the calendar year in which you reached age 55).

Fifth, this exception does not apply to IRAs, and that’s true even if the money in the IRA came from a 401(k) that would have met the requirements. For example, if you leave your employer at age 57 and roll your 401(k) into an IRA account, distributions from that IRA would still be subject to the 10% penalty, unless you meet one of the other exceptions. (And yes, in some cases, this is an excellent reason to wait to roll over a 401(k) until you have reached age 59.5.)

*Unfortunately, the only place I can find this notice online (it is from 1987, after all) is in the Internal Revenue Cumulative Bulletin 1987 [Part 1], available here. (Be prepared to wait a while for the download. The relevant wording is on page 441.)

Why Do Expensive 401(k) Plans Exist? And What Can You Do About It?

A reader writes in, asking:

“My daughter works for a company that provides relatively high cost investment options in her 401K plan. I’ve encouraged her to speak with senior management to encourage them to add low cost funds (such as Vanguard) so that every employee could realize these potential savings while employed there.

It seems only logical that management would want to have low cost funds available since they probably have 401K savings as well. What I don’t know and understand, is does a business or HR office benefit in various ways by only offering funds that are higher costs?”

There are two primary reasons why an employer might use a 401(k) plan with expensive funds.

First, the decision makers might simply be unaware of the importance of costs when it comes to investment performance. Perhaps they’re choosing funds based on past performance or based on the recommendation of a salesperson.

Second, the decision makers might have chosen to go with a plan that was inexpensive for the employer. In many cases, a plan is inexpensive for the employer precisely because it is expensive for the plan participants. That is, rather than making money by charging the employer, the plan provider charges administrative fees directly to the participants and/or offers funds that have substantial 12(b)-1 fees.

How to Get Less Expensive Funds in Your 401(k)

I’ve heard from many readers who have tried to get big changes made to their 401(k), such as switching from a provider with expensive actively managed funds to a provider such as Vanguard. Unfortunately, such attempts are usually (though not always) unsuccessful. There are several possible reasons why employers might be reluctant to comply with this request:

  • It sounds like a lot of work.
  • It may mean higher costs for the employer.
  • It appears risky. What if they anger a plan participant who likes the current investment options? Would they have to worry about a lawsuit?
  • It may mean having to “fire” a salesperson whom they’ve come to trust (and who, in some cases, may even be a family member or friend).

In addition, if the decision makers are using the current plan provider because they personally subscribe to an investment philosophy that involves using relatively expensive actively managed funds, you would have to convince them that they’ve been making poor decisions with their own money in order for them to see the wisdom of switching. That’s a big barrier to overcome.

Conversely, I’ve heard from several readers who have had success with a much simpler approach: Ask the employer to add one or two low-cost index funds. Phrase the request as a simple favor — a relatively easy way to make an employee happy. Something along the lines of, “I personally really like to use low-cost index funds. Would it be possible to add a stock index fund to the plan, such as Vanguard’s Total Stock Market Index Fund or Fidelity’s Spartan Total Market Index Fund?” Then follow-up as necessary.

With this approach:

  • You’re making a request that’s much easier (i.e., less work) to satisfy.
  • There would (likely) not be any additional costs for the employer.
  • There’s little risk of making any employees unhappy, because they wouldn’t be removing any investment options.
  • There is no need for a discussion in which you have to convince anybody of the merits of your investment philosophy (or the lack of merits of their philosophy).

Unfortunately, even this method isn’t foolproof. For example, in some cases, the plan provider will be unwilling to include lower-cost investment options. And in other cases, the salesperson representing the plan provider may talk management out of adding low-cost funds when asked about doing so.

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