IRAS Archives - Finance Memos

The Individual Retirement Account Quiz

Eighteen True/Fales Questions: Topics include – advantages of investing in IRAs, differences between conventional and Roth IRAs, permissible investments for IRAs, conversion strategies, state taxes and the choice between Roth and conventional IRAs, rules governing inherited IRAs, and the Secure Acts.

Question 1: True or False: The sole tax advantage of conventional IRAs is the tax deduction in the year the contribution is made, and the sole tax advantage of Roth IRAs is the tax savings in retirement.

FALSE: People can trade inside both a conventional and Roth IRA without paying any federal or state income tax on capital gains, interest, or dividends in the year the of the trade. The tax deferral provision inside retirement accounts allows investors to take profits and reallocate assets without paying tax.

Question 2: True or False: An extremely successful investor that earns spectacular returns on their investment should choose a Roth IRA over a conventional IRA.

True: There is no limit on the future balance of an IRA, hence successful investors should use a Roth account. Disbursements from a large conventional account will be fully taxed while disbursements from a Roth will not be taxed during the lifetime of the owner of the account and for the first 10 years of the inherited account. Investors receiving spectacular returns will be in a high tax bracket when they are forced to distribute funds. Peter Theil provides the prime example of why successful investors use Roth accounts.

Question 3: True or False: Municipal bonds are an excellent investment to hold inside an IRA.

False: Since the interest on municipal bonds is not taxed at the federal level and may not be taxed at the state level the yield on municipal bonds is less than the yield on federal or private securities of equivalent risk. (On January 5, 2024, the interest rate on three-month AAA municipal bonds was 3.67 percent while the interest rate on the three-month T-bill was 5.1 percent.). The IRA investor does not gain from the tax advantages of the municipal bond so the IRA investor should purchase the bond with the higher pre-tax yield.

Question 4: True or False: A middle-income married couple where both spouses work should plan on putting a higher percent of retirement wealth in a Roth than a married couple with identical income where one spouse does not have a career outside the home.

True: One of the tax advantages of Roth IRAs is that the distribution is not included in AGI and therefore does not impact the amount of Social Security benefits subject to federal or state income taxes. The savings from the use of Roth IRAs from this provision is larger for the married couple with two working spouses than for the married couple with one working spouse.

Question 5: True or False: Both IRAs and 401(k) plans allow account holders to invest directly in Treasury bonds, corporate bonds, CDs, or agency bonds.

FALSE: The investment options of 401(k) plans are determined by the plan sponsor and are usually if not always limited to a small number of equity and fixed income funds. By contrast, a worker or retiree can roll over a 401(k) plan to an IRA at a firm like Fidelity, Vanguard, or Schwab and directly purchase fixed-income securities. This is a huge advantage of IRAs because the lack of a maturity date on fixed-income funds will result in large losses during a period of rising interest rates. The bond investor can always hold the asset to its maturity. The fund investor does not have this option.

Question 6: True or False: Series I savings bonds and Series EE bonds can be purchased inside an IRA.

FALSE: I read an article saying this was possible, but the article appears wrong because IRA contributions involve cash followed by investments and firms sponsoring IRAs do not allow for purchases on Treasury Direct, the primary place where Series I and Series EE bonds are purchased.

Question 7: True or False: The optimal disbursement strategy between spending from assets in brokerage accounts, conventional retirement accounts and Roth retirement accounts remains constant after retirement.

False:

The appropriate disbursement strategy depends on the age of the retiree, whether the retiree is claiming Social Security and whether the retiree is attempting to maximize the wealth of an heir.

Early in retirement, prior to claiming Social Security, live on funds in brokerage accounts while converting traditional retirement assets to Roth assets.
Delay claiming Social Security to age 70 if possible.
After claiming Social Security distribute assets from the Roth account to both avoid tax on the distribution and reduce the amount of Social Security benefits subject to tax.
Older taxpayers with heirs in a high tax bracket should spend from the conventional account to reduce tax burden on heirs.

This question pertains to Tip #7 here. Go here, for an interesting discussion of reasons to convert traditional assets to Roth assets early in retirement.

Question 8: True or False: A 62 year-old retiree with a very small amount of liquid assets outside of her retirement plan, around $1,000,000 of assets in a traditional retirement plan and no assets in a Roth account is well positioned to convert the traditional retirement assets to a Roth.

False: Since the retiree has little in the way of liquid non-retirement assets, she must distribute funds from the conventional asset to fund current consumption. Both the funds she uses for consumption and the funds that are converted to the Roth are fully tax as ordinary income. The incremental costs of the conversion are high because the person is in a relatively high tax bracket. By contrast, a person with liquid assets outside of her retirement account will only be taxed on the capital gain and the capital gains tax rate is lower than the tax rate on ordinary income.

The cost of converting traditional retirement assets to Roth assets is substantially higher for a person who must use traditional retirement assets to fund current consumption.

Question 9: True or False: A person who graduated college, works four years, puts $20,000 in her traditional 401(k) and leaves the workforce for two years for graduate school should convert her assets in her traditional retirement account to a Roth account while in school?

True: Converting traditional retirement assets to Roth assets is probably the last thing on the mind of person a person in their twenties returning to school but it is a great move.

Any conversion by a person with AGI less than the standard deduction is taxed at the 0 percent rate. Even conversions at a 10 percent rate (taxable income less than $11,000) or 12 percent (taxable income less than $44,725) will prove profitable.

Bottom line, as discussed here, is that costs of converting traditional IRAs to Roth IRAs are low when a person leaves the workforce.

Question 10: True or False: The total rate of return on a conversion of a traditional retirement asset to Roth by a 62-year person prior to claiming Social Security and who distributes funds in a Roth IRA after five years will be around 8.0 percent

False: The total return from this transaction, under reasonable assumptions, will be around 30 percent.

Key features of the transaction:

Person relies on liquid savings and no Social Security benefits at age 62.
Converts around $35,000 in traditional retirement assets to Roth and pays an additional $1,975 in tax.
Assets in Roth earn 6.0 percent per year for five years.
Roth assets grow to slightly over $46,000.
Person lives off Social Security and Roth assets instead of conventional assets after five years.
Tax savings from the use of Roth instead of conventional assets after five years is
The use of Roth assets instead of traditional assets would reduce tax by $7,000 after five years and $700 after six years.
The return on this investment calculated with XIRR is 30.7 percent.

A detailed discussion of this calculation and the regulations governing Roth conversions can be found in this Tax Notes article.

Question 11: True or False: A workers who resides in California one year and Florida the next year should wait until moving to Florida before converting conventional retirement assets to Roth assets.

True: The cost of conversion, the tax paid on the amount converted, depends on both federal and state income tax. California will tax the conversion to a Roth. Florida, which lacks an income tax will not.

Question 12: True or False: All else equal people who reside in California throughout their working and retired life should contribute to a conventional retirement account while people in Florida should always contribute to a Roth account.

False: Benefits of tax deduction from the contribution to the conventional retirement plan are higher in California, the state with a state income tax but benefits from distributions from the Roth account in retirement are also larger in the state with the income tax. All taxpayers should seek a mix of conventional and Roth assets regardless of the state where they are domiciled.

Question 13: True or False: The rules governing the tax and penalty on the distribution of funds contributed to a Roth IRA and funds from a conversion of traditional to Roth assets are identical.

False: All distributions from a converted IRA are subject to a penalty for five years from January 1 of the year of the conversion.

This penalty applies even if the taxpayer is over age 59 ½ at the time of the distribution.

A taxpayer who distributes funds on the converted Roth prior to five years from January 1 of the year of the distribution will pay both tax on the amount converted and a penalty.

There also exists a five-year rule on contributions to a conventional IRA but it appears to only restrict access to investment earnings on funds that have been in the account for less than five years.

Go here for a discussion of different aspects of the five-year rule.

Question 14: True or False: The Secure Act 2.0 requires the owners of all inherited IRAs to distribute all funds over a 10-year period after the death of the original owner.

FALSE: There are two exceptions.

Non-spousal beneficiaries who inherited IRAS prior to 2020 can stretch payments over their expected lifetime.
All spouse beneficiaries can spread payments out over their expected lifetime.

This article by TheStreet is a good resource.

Question 15: True or False: The increase in the age for required minimum distributions will substantially reduce the number of people who are likely to outlive their retirement savings.

FALSE: Most people who are in danger of outliving their retirement savings are distributing sums earlier than 73, the new age where RMDs start and are distributing sums greater than the minimum once distributions become mandatory. The RMD is only 3.8 percent of retirement assets at age 73. Go here for a useful RMD calculator.

Bottom line, the new RMD rules benefit the relatively affluent retirees and firms managing IRAs and 401(k) plans, not people struggling to survive in retirement.

Question 16: True or False: Some IRAs allow for alternative often non-liquid investments including real estate and private equity.

True: But they are complex and entail risk. Go to this nerdwallet article for some information.

Question 17: True or False: An IRA is an excellent vehicle for investment in a vacation home.

False: You can purchase real estate in a self-directed IRA, but it can’t be used as a vacation home, a second home or a place for your parents. The IRS is very strict about this. This Investopedia article is a good resource on this issue.

Question 18: True or False: The recently enacted Secure Act 2.0 substantially expands the ability of IRA and 401(k) owner to distribute funds prior to age 59 ½.

True: Although the increased access to funds prior to age 59 ½ is much larger for owners of conventional retirement plans than owners of Roth retirement plans because Roth accounts already allow for early disbursements of contributions.

The Secure Act 2.0 allows for additional penalty-free withdrawals including – (1) one withdrawal per year up to $1,000 for unforeseeable financial needs, (2) withdrawals for permanent disabilities, (3) victims of domestic abuse, (4) medical insurance when unemployed, (5) qualified education expenses, and first-time home purchases.

This Wall Street Journal article has a more complete list of expanded penalty-free disbursements.

My view is that these liberalized disbursement rules will result in an increased number of people retiring with insufficient retirement income. Go here for my empirical research on the issue of early disbursements from retirement plans.

Question 19. True/False: When tax rates are certain and identical in working years and in retirement a person will be indifferent between saving X dollars in a conventional deductible IRA and (1-t)*X dollars in a Roth where t is the tax rate that would have been applied to the funds placed in the deductible IRA.

True: The easiest way to check this is true is to plug in some numbers

Tax rate 10 percent,
$2,000 contributed to a conventional IRA,
$1,800 contributed to a Roth IRA,
8.0 percent annual return for 30 years,
Amount available for consumption in Roth after 30 years is $18,113

(1.08³⁰ * 2000),

Amount available for consumption in conventional account also $18,113.

0.90*(1.08³⁰ * 2200),

Note the tax savings from Roth distributions instead of conventional distributions will be much larger than 10 percent for most workers who have some working-years in the 10 percent tax bracket because they will be in a higher marginal tax bracket based on lifetime earnings or high expenses and disbursements in a particular year and tax savings from the exclusion of Social Security benefits from AGI.

Question 20: True or False: A spouse who is not in the workforce cannot contribute to a retirement account.

False: A non-working spouse can create and contribute to a spousal IRA, if he or she files a joint return and satisfies the IRS contribution limits, income limits, and federal deduction limits. Even if the joint return has a high AGI the non-working spouse will be able to create and fund a non-deductible IRA, which is legally owned by the non-working spouse. Go here for more information.

Question 21: True or False. A person with adjusted gross income over the income limits for Roth IRAs cannot add to a Roth IRA

False: The income limits on Roth IRA contributions are easily circumvented through a procedure called a backdoor IRA. The steps used to create a backdoor IRA involve:

Create and funds a non-deductible IRA.
Immediately convert proceeds in the non-deductible IRA to a Roth account.

Since the funds in the non-deductible IRA were fully taxed you will not owe any tax on the amount converted. Conversions from a deductible IRA or a traditional 401(k) plan would be fully taxed, hence, people using the backdoor IRA should use funds from a non-deductible IRA to fund the conversions. Additional conversions from deductible IRAs and 401(k) plans could occur when household earning is low.

As noted in this Smart Asset article,

“If your income leaves you locked out of the Roth option, you can simply contribute to a non-deductible IRA and then convert that IRA to a Roth IRA. Voila! You’ve got a Roth.”

Question 2: Tax and penalties on early distributions from a conventional and Roth IRA

Info on tax and penalty from early distribution on different types of IRAs.

Question 2: What is the tax and penalty on the withdrawal of all funds from both a conventional deductible IRA and a Roth IRA prior to age 59 ½ five years after an initial contribution of $3,000 assuming a 6 percent return on invested assets, and a marginal tax rate of 20 percent?

Answer: The entire distribution from the conventional IRA is subject to tax and penalty while only the investment income portion of the distribution from the Roth IRA is subject to tax and penalty. The calculations below assume a tax rate of 20 percent and a penalty rate of 10 percent on the relevant amount.

Total funds in both IRAs after five years is $4,015.
The penalty and tax on the conventional IRA is $1,204.40.
The penalty and tax on the Roth IRA is $304.40

Also, note the owner of the Roth IRA could have limited her withdrawal to $3,000, kept the investment return in the Roth and paid no penalty and tax.

The lack of penalty or tax on the distribution of the initial contribution makes the Roth IRA the better choice for people starting their careers or for people with limited liquidity. For more information on the choice between a Roth IRA and a conventional IRA look at the first two financial tips here.

A 2024 Retirement Security Agenda

Pension and Social Security reform are inextricably linked because many retirees are highly dependent or Social Security, many workers nearing retirement are not in good financial shape and young adult are spending retirement funds early in their career. The recently enacted Secure Act 2.0 does very little to assist workers who are having the hardest time saving for retirement. Republicans and Democrats are far apart in their ideas on how to fix Social Security and neither party recognizes that meaningful enhancements in private retirement savings are essential to a successful Social Security reform. This post discusses ways to fix both the private retirement system and Social Security.

Introduction:

Many American workers are not preparing well enough for retirement.

Around half of older workers do not have any funds in a defined contribution plan (401(k) or IRA.)

The median amount of retirement assets for people with retirement plans is around $109,000.

Around 13.7 percent of the 65-and-over population lives in poverty.

More older workers are entering retirement with mortgage debt or consumer debt.

Many older workers cannot remain in the workforce because of poor health.

Economic downturns tend to result in a larger increase in unemployment for older workers than for younger or middle-aged workers.

Around 40 percent of older Americans are entirely dependent on Social Security.

Current law links future Social Security payments to the balance in the trust fund. Projected decreases in the trust fund would lead to a 20 percent in Social Security benefits in 2035, barring changes to the trust fund or current law.

Nearly 60 percent of young workers between the ages of 18 and 34 have already taken funds out of their retirement accounts to maintain current spending. Early disbursements from retirement plans by young adults are especially high for people with high levels of student debt.

The traditional 60/40 portfolio held by many retirees loses substantial value in a period where the stock market falls, and interest rates rise.

Congress and the Administration have not prioritized retirement income issues and are not close to addressing the looming Social Security problem.

Documenting the lack of progress:

Our leaders are not moving us forward on efforts to increase private savings for retirement or on efforts to fix the looming Social Security problem.

Congress has passed some legislation, most recently, the Secure Act 2.0, impacting savings through 401(k) plans and IRAs. Unfortunately, the recently enacted law does more to benefit investment firms and high net-worth savers than the workers who are struggling the most to save for retirement. A more complete description of the Secure Act 2.0 can be found here and some of its shortcomings are listed below.

Delays in implementation of Required Minimum Distribution do not assist retirees with low levels of retirement assets, people who tend to deplete their retirement accounts early in their retirement. Provision increases fees received by investment firms.

Shorter waiting period for participation in 401(k) plans does not shorten vesting requirement and may benefit relatively few workers because many part-time workers do not stay at the same firm for a long time.

A provision clarifying that employers can contribute matching funds to 401(k) plans for student loan payments does not assist workers at firms without a 401(k) plan or firms with a 401(k) plan that do not match employee contributions.

The automatic 401(k) enrollment provision and automatic increases in contribution will reduce savings through other vehicles and will lead to relatively little additional savings if funds are distributed prior to retirement.

Around 40 percent of retired households are totally dependent on Social Security and many more are highly dependent on Social Security. Expansion of private retirement spending is important by itself and has major implications for Social Security reform efforts.

The implementation of some Social Security reform proposals that would lead to abrupt changes in benefits could not be applied to workers nearing retirement without causing large increases in poverty among the elderly.

The Social Security trustees project that automatic benefit cuts to Social Security could occur in 2035 and that automatic Medicare benefit cuts could occur as early as 2028.

Democrats and Republicans are wide apart on what needs to be done to prevent automatic cuts to entitlement programs. Democrats stress the need for additional revenue. Republican proposals often call for large benefit cuts, many of which are applied to workers nearing retirement.

One proposal that could receive some bipartisan support inside a larger package involves increasing the cap on wages subject to Social Security taxes. Current rules apply Social Security taxes to the first $160,200 of wages. Go here for a discussion of proposals to eliminate or modify the cap on Social Security taxes.

Republicans tend to favor plans to reduce benefits, raise the retirement age, and create private accounts to replace all or part of the current Social Security system. Some of the Republican proposals discussed herewould result in quick changes impacting potentially impacting workers close to retirement. For example, a proposal to increase the retirement age for full Social Security benefits by 3 months per year until 2040, when the full retirement age reached 70 would result in substantial poverty among the elderly because private retirement savings could not be increased in this time frame.

Timely changes to Social Security are essential to prevent automatic benefit cuts that would lead to large increases in poverty because of the lack of private retirement savings.

Reforming private retirement savings:

Reforms of private retirement savings that expand savings for low-income and middle-income households are a prerequisite for meaningful Social Security reforms because so many households are dependent on Social Security.

There are six problems preventing workers from accumulating sufficient retirement savings prior to retirement. Steps must be taken to address each problem.

First, workers are free to disburse all entire savings from their 401(k) plans prior to retirement. Around 60 percent of young workers have tapped part of their retirement savings prior to age 34. Steps must be taken to restrict pre-retirement disbursements from retirement plans and to incentivize workers from reducing retirement savings prior to retirement.

Proposed policy changes to address pre-retirement leakages from retirement accounts include:

Prohibit pre-retirement distributions from retirement plans for 25 percent of all contributions. The prohibited distributions could be used to purchase an annuity that would not pay out until the retiree reaches a certain age.

Require automatic rollover into IRAs for all workers making a job transition with 401(k) balances less than $50,000. (Current law allows but does not require automatic rollovers.)

Prohibit loans from 401(k) plans. Replace loans with limited tax-free and penalty-free distributions from the newly created emergency funds inside a 401(k) plan.

Second, workers reliant on Individual Retirement Accounts (IRAs) have less generous saving incentives than workers with access to employer-based 401(K) plans. Workers dependent on an IRA without access to a 401(k) have a lower contributions limit, do not have access to an employer match, and do not have access to retirement incentives for student loan payments.

Proposed changes to rules that reduce or eliminate discrepancies between savings through IRAs and savings through 401(k) plans include:

Create automatic contributions to IRAs for people without access to employer-sponsored 401(k) plans, patterned after the rules that are currently applied to automatic enrollment into 401(k) plans.

Change tax law to allow for employers to make matching contributions to worker contributions to IRAs like the ones currently allowed for 401(k) plans.

Equalize IRA and 401(k) contributions limit and deductibility limits on IRA and 401(k) contributions.

Change tax law to allow tax-free contributions to IRAs by firms hiring contractors or gig workers instead of direct employees.

Third, the current tax preference for contributions to 401(k) plans and deductible IRAs favors higher income people with higher marginal tax rates. Tax savings from expenditures from Roth IRAs in retirement also disproportionately benefit higher-income taxpayers. Income related gap in subsidies could be altered by changes to the tax code.

Replace existing tax exemption for contributions to traditional 401(k) plans and the tax deduction for contributions to deductible IRAs with a tax credit.

Create a tax credit for first $2,000 contributed to a retirement plan and allow tax deduction for additional contributions up to a cap.

Fourth, many workers are now diverting retirement savings to health savings accounts and flexible savings accounts to pay for health expenses that are no longer covered by health insurance. This is a growing problem due to the growing use of high-deductible health plans.

Proposed policy changes to offset the loss of retirement income due to the growth of cost-sharing between insurance companies and insured households include:

Allow for the use of health savings accounts for people with lower deductible health plans to reduce the need for large contributions to health savings accounts.

Change rules governing flexible savings account to allow people to place unused flexible savings account funds in a 401(k) plan or IRA rather than lose the unused funds. It would be appropriate to tax funds transferred from a flexible savings account to a retirement account.

Fifth, fewer than 15 percent of retirees have an annuity inside their retirement plan. The primary reason for the low level of annuity income is the cost of annuities.

Mandate that 25 percent of funds contributed to a retirement plan be used to purchase an annuity.

The source of funds for the mandatory annuity purchase could be the funds the person is not allowed to disburse prior to reaching retirement age.

The rule requiring all workers make an annuity purchase would lower annuity prices because voluntary annuity purchases are favored by healthy people with long life expectancy.

Sixth, retirees often suffer when inflation erodes the value of bond and stocks. Many workers cannot afford to save much outside their retirement plan and current tax law does not allow individuals to purchase series I bonds inside a 401(k) plan or an IRA. Many assets inside a 401(k) plan that proport to be inflation hedges lose value in an inflationary or high interest rate environment.

The most effective way to prevent reduction in retirement plan wealth in a period when inflation and interest rates rise, and stock prices fall is to allow and encourage the purchase of Series I savings bonds inside a 401(k) plan or IRA. Series I savings bonds never fall in value and have substantial upside in an inflationary environment. Go here for a discussion of advantages of Series I Savings Bonds.

The primary effect of the current restrictions on Series I Savings bonds is to increase the demand for financial assets and ETFs that are less effective in protecting investors from inflation than Series I Bonds.

Reforming Social Security:

The expansion and improvement of private retirement savings options will reduce dependence on Social Security by future generations and allow for the consideration of a broader range of Social Security reform options including eventual reductions in benefits.

The Social Security reform measures considered here include:

A new tax earmarked for Social Security and Medicare. The tax would be imposed on all forms of income and would have a progressive tax structure.

Increase in both the minimum retirement age for Social Security benefits and the age for full benefits, by one year each phased in over a 24-year period with a one month increase in the retirement age every two years. The age at which people receive the maximum allowable Social Security benefit would remain unchanged.

Guarantee future Social Security benefits by allocating some general tax revenue towards future benefits if the Trust fund balance falls to a certain level.

Economic Notes on the Policy Package:

The combination of tax credits to stimulate private retirement savings, tax increases to fund current Social Security and Medicare benefits and long-term increases in the retirement age create a healthy macroeconomic environment and will lower household financial distress in retirement.

Short-term changes in tax revenue will be modest because losses in tax revenue from tax credits to stimulate private retirement savings are offset by increases in tax revenue from the new tax to maintain Social Security and Medicare benefits.

The phased in increases in the retirement age will not have an immediate impact on government deficits but will reduce future Debt-to-GDP ratios. Since markets are forward looking the projected lower future debt burdens will have a beneficial impact on asset prices even if near term deficits rise.

The tax base to continue funding Social Security and Medicare benefits should be relatively broad. The tax could be imposed for all households making more than $50,000. The tax would be progressive. The marginal tax rate might range from 0.5 percent to a cap of 5.0 percent. The tax would be applied to both wages and investment income.

Concluding Remarks: Unless changes are made to rules governing Social Security and Medicare there will be automatic benefit cuts once trust funds assets are partially depleted. Many Republicans favor large and abrupt changes to Social Security benefits and the retirement age. Any abrupt change in benefits would have an extremely adverse impact on household poverty and on aggregate demand.

A reduction in Social Security benefits that is not preceded by a substantial expansion in private retirement savings by the workers who are now having the most difficulty saving for retirement would lead to catastrophic financial impacts for many households. This outcome can only be avoided by coupling private pension reforms with Social Security reforms.

David Bernstein is the author of A 2024 Health Care Reform Proposal.

2024 Economic Issues: The Case for Expanding and Improving Individual Retirement Accounts (IRAs)

Workers without access to firm-sponsored 401(k) plans often do not save enough for retirement. Insufficient retirement savings caused by lack of access to 401(k) plans could be more effectively reduced by expanding and improving Individual Retirement accounts (IRAs) instead of expanding the use of 401(k) plans.

Introduction: A recent GAO study found that most retirees and workers approaching retirement have limited financial resources. Many people start their careers with substantial student debt and for a variety of reasons overspend and fail to save enough for retirement.

Part of the disparity in retirement savings stems from lack of access to firm-sponsored 401(k) plans, which allow for much greater retirement saving than IRAs. Part of the shortfall in retirement savings stems from the common practice of workers spending savings in retirement plans prior to retirement.

The most effective way to reduce disparities in retirement wealth is to expand and improve Individual Retirement Accounts. The approach outlined here differs sharply from the proposals in Secure Act 2.0, which favor expansion of 401(k) plans. The proposed improvements to IRAs include a new tax credit, a mechanism for simultaneous contributions to traditional and Roth IRA accounts, increases in the allowable annual contribution, and alterations in rules governing distributions prior to age 59 ½. Specific policy changes that should be implemented include:

A tax credit for contributions of 20 percent of contributions to an IRA.

Allow employers to make employer contributions to IRAs instead of a 401(K) plan.

A new rule allocating part of the IRA contribution to a traditional IRA and part to a Roth IRA. (Eighty percent of employee contributions would go to the Roth account. Twenty percent of employee contributions and all employer contributions would be allocated to the traditional account.)

Prohibit all disbursements from the traditional account until the account holder reaches retirement age.

Increase the allowable annual contribution to an IRA to the current contribution limit for 401(k) plans.

Allow automatic contributions to IRAs and opt-out rules like the automatic enrollment and opt-out rules currently applied to 401(k) plans.

Comments:

Comment One: The use of a tax credit instead of a tax deduction favors low-income households with lower marginal tax rates. These household often have the most difficulty saving for retirement.

Comment Two: The new IRA contribution rules allow for the benefits of both Roth and traditional accounts. The contribution to the Roth account reduces taxes in retirement. The contribution to the traditional account reduces current-year taxes. The plan described here would provide benefits comparable to benefits received from a Roth 401(k) where the employer match is allocated to a traditional 401(K) and employee contributions are allocated to the Roth component of the plan. Many firms do not offer a 401(K) plan, do not offer a Roth 401(k), or do not match employer contributions. The new rules would allow all workers to allocate funds to both traditional and Roth plans, regardless of what their firm offers.

Comment Three: Current tax law allows for unlimited disbursements from retirement accounts subject to tax and penalty. The rules governing penalty and tax on disbursements differ for traditional and Roth accounts, however, in both cases taxpayers are allowed to withdraw the entire balance of their retirement account prior to retirement. This often happens when workers leave a job and take a disbursement rather than maintain their retirement account or roll over funds into an IRA. The new rule requires the amount of the IRA contribution equal to the tax credit and the amount of the contribution received from the employer remain in a traditional account until age 59 ½. Call this the George Bailey rule after the banker in A Wonderful Life who refused to close people’s accounts during a rush on the bank.

Comment Four: Some people may be more receptive to contributing to a 401(k) plan instead of an IRA because some firms allow 401(K) owners to borrow from the plan. Loans from IRAs are not allowed. However, contributions to a Roth IRA can be withdrawn without penalty or tax at any time. The combination of a tax credit and early use of funds contributed to ithe Roth component of the new IRA should facilitate contributions by people with limited cash flow for emergencies.

Comment Five: Current IRA contribution limits are substantially lower than current 401(k) contribution limits. This proposal eliminates this disparity.

Comment Six: The IRS allows firms to automatically enroll employees into the firm-sponsored 401(k) plan and allow employees to opt out if they do not want to contribute. Vanguard has found that automatic enrollment into 401(K) plans has the potential to substantially increase 401(k) participation. Automatic enrollment into IRAs could have a similar effect, especially when combined with a new tax credit for IRA contributions and other proposed enhancements to IRAs.

Comment Seven: Congress is currently considering the Secure Act 2.0, which would expand the use of 401() plans and create an incentive for 401(k) contributions for people who are currently prioritizing student debt repayment over retirement saving. Even if the Secure Act 2.0 is enacted many small firms would still not offer a 401(k) plan, due to limited resources. For example, the Secure Act 2.0 would do little to increase retirement savings for people working at multiple part-time jobs. The tax credit for IRA contributions described here would be available for all workers. The new rules governing early distributions from IRAs would better balance the need for all workers to save for retirement while reducing debt and preparing for emergencies.

Authors Note: David Bernstein, a retired economist has written several papers advocating for innovative centrist policy solutions.

The kindle book Defying Magnets: Centrist Policies in a Polarized World has essays on policies student debt, retirement savings and health care.

The paper A 2024 Health Care Proposal provides solutions to health care problems that are not currently under consideration.

The proposals in Alternatives to the Biden Student Debt Plan are less expensive to taxpayers than the Biden student loan proposals. The reforms presented here provide better incentives and reductions for future students while the Biden debt-relief proposal offers a one-time improvement for current debtors.

Excel Hint 6: The FV function and 401(k) fees

Hint 6: The Excel FV function is used to calculate the future value of a dormant 401(k) or IRA when the only difference between the two accounts is the level of fees.

The situation: Finance tip #6 considers potential benefits realized by rolling over funds from a high-cost 401(k) to a low-cost IRA. The retirement account is not accepting new contributions. The person at age 50 will either leave $500,000 in a 401(k) or move $500,000 to a Roth for 15 years. The pre-fee annual rate of return on both the 401(k) and the IRA is 6.0 percent. The 401(k) has an annual fee of 1.3 percent. The IRA has an annual fee of 0.03 percent.

Question on use of Excel: How does one calculate the value of the retirement account after 15 years?

Analysis:

This calculation can be completed with the FV function. The FV function has arguments – Rate, Nper, Pmt, Pv, and Type.

The Rate is .047 for the 401(k) and 0.057 for the IRA.
The Nper or holding period is 15 for both accounts.
The PMT is 0 for both accounts. (The worker is no longer making contributions.)
The PV is the initial account balance, $500,000.
The type is 0 because the $500,000 exists in the account at the beginning of the period.

Results

FV(0.047,15,0,500,000,1) is $995,796.

FV(0.057,15,0,500,000,1) is $1,148,404.

Remember to go to finance tip 6 for a more complete discussion of factors impacting the choice between a high-fee 401(k) and a low-fee IRA.

Financial Tip #6: Rollover 401(k) assets to IRAs

Employees changing jobs with funds in a high-cost 401(k) need to consider rolling funds into a low-cost IRA.

Tip #6: An employee leaving a firm can substantially increase retirement wealth by moving401(k) funds to an IRA. Be careful though! Protections against creditors are stronger for 401(k) plans than for IRAs in many states.

Examples of potential gain from rolling over assets in a high-cost 401(K) to a low-cost IRA:

Example One: A worker leaving her firm at age 50 can keep $500,000 in 401(k) funds in the firm-sponsored retirement plan that charges an annual fee of 1.3% or can move the funds to a low-cost IRA that charges an annual fee of 0.3%. The return on assets prior to fees in both the 401(k) plan and the IRA is 6.0 percent per year.

What is the value of the account at age if assets remain in the high-cost 401(k) and if assets are rolled over into the low-cost IRA?

Account value of high-fee 401(k) plan is $995,796.
Account value of low-cost IRA is $1,148,404.
Gain from rollover is $152,609.

Example Two: A worker changing jobs at age 30 can keep $20,000 in the firm 401(k) or move the funds to a low-cost IRA. The annual fee for the 401(k) is 1.3 %, the annual fee for the IRA is 0.3%. The underlying returns prior to fees for both assets in the 401(k) and assets in the IRA is 8.0%.

What is the value of the account at age 60 if the person keeps assets in the high-cost 401(k) or moves funds to a low-cost IRA?

Account value of high-cost 401(k) plan is $139,947.
Account value of low-cost IRA is $185,140.
Gain from rollover is $45,194.

Note: The impact of financial fees on the future value of the account can be calculated with the FV function in Excel. The arguments of the FV function are the rate of return after fees, holding period in years, and the initial balance in the 401(k) plan.

Additional Comments:

Most roll overs from 401(k) plans to IRAs occur when a worker leaves a firm for another employer. Some firms allow for some in-service rollovers.

Some workers, in need of cash routinely, disburse funds from their 401(k) plan. The disbursement of funds from a traditional 401(k) plan prior to age 59 ½ can lead to penalties or tax. A roll over of funds from a 401(k) plan does not lead to additional tax or any financial penalties.

One motive for moving funds from a 401(k) plan to an IRA is the desire to place funds in a Roth account when a firm only offers a traditional retirement plan. The act of rolling over funds from a 401(k) to an IRA and the act of converting the new conventional IRA to a Roth IRA are separate and do not have to occur together. Conversion costs are lowest when a worker has low marginal tax rate. Several future posts will examine the costs and benefits on converting traditional retirement accounts to Roth accounts.

The federal bankruptcy code protects both 401(k) plans and IRAs. However, 401(k) plans offer stronger protection against creditors than IRAs outside of bankruptcy. Whether IRAs are protected from creditors is determined by state law. ERISA, a national law, provides protection against creditors for 401(k) plans. This difference can persuade some people to keep funds in a 401(k) plan, rather than covert funds to an IRA. Go here for a state-by-state analysis of protections against creditors for owners of IRAs.

The calculations, presented above, of greater wealth from the rollover assumes identical pre-tax returns for the high-cost 401(k) plan and the low-cost IRA. Most financial experts believe that low-cost passively managed funds tend to outperform high-cost funds. Interestingly, Warren Buffet, probably the best active investor of all times suggests passive investing in low-cost funds is generally the better approach.

Factors other than transaction costs can impact the decision to rollover 401(k) funds or stay. Some 401(k) plans allow investors to purchase an annuity at retirement. The existence of automatic enrollment from a 401(k) plan to an annuity could induce some workers to keep funds in a 401(k) rather than roll over funds into an IRA.

Financial Tip #5: Maximize the 401(k) match and then contribute to IRAs

Maximize the employer matching contribution then save additional funds in an IRA!

Tip #5: A worker at a firm with a 401(k) plan that has high fees should maximize receipt of the employer match and divert additional funds to a low-cost IRA.

Analysis:

The Situation:

Worker has access to a 401(k) plan that matches contributions equal to 5.0% of salary.
The 401(k) plan has an annual fee equal to 1.3% of assets.
Vanguard and Fidelity offer a deductible IRA with an annual fee of 0.3% of assets.

The Choice:

Choice One: Contribute 10 percent of income to a 401(K)
Choice Two: Contribute 5% percent of income to a 401(K) and 5.0% of income to an IRA.

Additional Assumptions:

The person earns $75,000 per year for 35 years.
The return on investments prior to fees is 6.0% per year.
Contributions are bi-weekly

The Outcome:

Choice One: Wealth at Retirement $998,933 all in a 401(K).
Choice Two: Wealth at Retirement $1,083,089, with both 401(K) and IRA.
Additional wealth from diverting funds to an IRA is $83,876.

Concluding Remarks: Many financial advisors ignore fees and recommend maximizing contributions to a 401(k) plan. A better solution is to maximize the employer match and divert additional savings to a low-cost IRA.

How to minimize the impact of 401(k) fees

Retirement plan fees vary substantially across firms.
Annual fees appear trivial but small differences in the annual fee have a substantial impact on retirement wealth.
A median-wage worker at a firm with a high-cost retirement plan can pay more than $100,000 in retirement plan fees over her lifetime.
Workers can reduce lifetime retirement fees by moving to a job at firm with a low-fee plan, moving retirement funds to a low-cost IRA when changing jobs, greater use of IRAs, and greater use of investments outside retirement plans.

Background on impact of high retirement plan fees: A report by the Center for American Progressrevealed that 401(k) fees are a substantial expense and drain on retirement income for many workers. On average, annual 401(k) fees are 1.0 percent of assets.

There is substantial dispersion in the annual fee percentage across firms. A 2011 survey cited in the report found the average annual 401(k) fee for firms with fewer than 100 participants was 1.32%. The report found that a well-managed retirement account could have a fee as low as 0.25%.

The report calculates lifetime 401(k) fees for workers at three different annual fee rates – 0.25%, 1.0%, and 1.3%. The scenarios assumed the worker contributes 5% of salary and receives a 5% employer match. The findings indicate that relatively small annual differences in fees as a percent of asset leads to large differences in lifetime fees paid by workers to the sponsor of their retirement plan.

Lifetime 401(k) fees for a median-wage worker starting her career are $42,000 at a 0.25% annual fee, 138,000 at a 1.0% annual fee, and $166,000 for a worker at 1.30% annual fee.

The report also contained lifetime fee calculations for a higher wage worker. Results were proportionate to income.

Higher retirement fees were associated with a higher likelihood of ending up with insufficient retirement income.

An increase in retirement plan fees from 0.5% of assets to 1.0% of assets will reduce the likelihood a worker will have sufficient retirement income from 69% to 57%.

The reported annual fee as a percent of retirement plan assets appears to be small, almost trivial. However, the fee is applied each year. The annual fee becomes large for older workers with larger amounts accumulated in the account.

High retirement fees are an especially important issue when interest rates are low. When the fee percentage is larger than the bond interest rate, the de-facto interest rate is negative. This is currently the case with a two-year Treasury rate stands at 0.16% below the level of even a low-cost retirement fund.

The Center for American Progress argues that a key solution to problems created by high retirement plan fees is better information about the fees. Workers are not explicitly billed for retirement fees. The retirement plan fee is an indirect charge deducted from investment returns. Workers would be much more cognizant of retirement fees if they were directly charged the service.

Investment managers charging high fees claim their fees are justified because their fund realizes higher returns. The finance literature indicates that passive funds with low returns tend to outperform active funds with higher fees. Moreover, Warren Buffet, arguably the best active stock picker of all time, argues sticking with the S&P 500 will lead to better returns than active management.

Workers would be better served if they were automatically placed in low-cost funds unless they opted out. The current default retirement plan is the plan chosen by the worker’s employer. However, workers at firms that choose a high-cost retirement plan with inadequate options can and should take several steps to reduce fees and work towards a secure retirement.

Mitigation of the adverse financial impact on high retirement fees:

A worker who is aware that a retirement plan at her current or prospective job imposes high fees can take several steps to reduce fees. These steps include, moving to a job with a better retirement plan, rolling over funds from the high-cost plan to a low-cost IRA when changing jobs, greater use of individual retirement accounts, and increased savings outside of retirement plans.

Moving to a firm with a better retirement plan: A person with multiple job offers should consider the quality of the retirement plan when weighing different offers. Factors determining the quality of a firm’s retirement plan include – whether the firm matches employer contributions, the level of the match, whether the firm offers a Roth 401(k) option and as shown above the level of fees.

Change jobs and rolling over retirement funds: The existence of high retirement fees should motivate a person with assets in a retirement plan to look for a new gig. Preferably the new job would have a retirement plan with a lower-cost plan; however, even if it does not the worker can take her funds out of the high-cost plan and place them in a low-cost IRA.

Consider, a 45-year-old worker with $300,000 in a retirement plan charging a 1.3 percent annual fee. The person is paying $3,900 in retirement fees in her current year. She could quit her job and move the retirement funds to a low-cost IRA with a fee at perhaps 0.5 percent. The current-year annual fee would be $1,500.

The annual leakage from high fees grows over time in tandem with the growth of assets. One of the worse mistakes a person can make preparing for retirement is to leave assets in a high-cost plan once you move to a new position or retiring.

Investment related fees at reputable firms like Vanguard, Fidelity and Schwab have fallen in recent years and with a little research you can roll funds into a low-cost IRA when you leave your current position. The impact on your retirement wealth is considerable and I see no advantages in keeping funds with a high-cost retirement funds after you move to a new position.

Use of IRAs to replace or complement firm retirement plan savings: The person who accepts a job at a firm with a high-fee retirement plan must decide whether to contribute to the retirement plan, contribute to an individual retirement plan instead of the IRA or contribute to both the firm retirement plan and an IRA.

There are some limitations with IRAs. Contribution limits are lower for IRAs than for 401(k) plans. The contribution limit for IRAs in 2020 is $6,000 for people under 50 and $7,000 for people 50 and over. The contribution limit for 401(k) plans in 2020 is $19,500 for people under 50 and $26,000 for people 50 and over.

Tax rules link eligibility for Roth IRAs to household income. Tax rules also link the tax deductibility of traditional IRAs to both household income and whether a person and/or spouse contributes to a 401(k). These rules limit but do not eliminate advantages associated with a strategy of complementing investments in a firm-sponsored retirement plan with investments in a lower-cost IRA.

A person at a firm with a high-cost retirement plan might choose to contribute to the plan if the firm matches employer contributions. The employee could take full advantage of the matching contribution and divert any additional savings to accounts outside the retirement plan. The employer match will lead to a generous return in the year the contribution is made, however, the annual fee will erode the fund over time. The use of the IRA for contributions over the match can result in increased retirement wealth if the IRA has lower fees.

The employee contributing to both the firm 401(k) plan and an IRA may have to place funds in a non-deductible IRA rather than a Roth or deductible IRA depending on her household income. This allows for deferral of tax. The worker may be able to convert the conventional IRA to a Roth IRA in a future year but this is a topic for another day.

Once the worker leaves the firm, the entire retirement fund should be rolled over to a low-cost IRA. Brokerage firms may allow you to combine funds in the two accounts.

A person with at a firm with a high-cost retirement plan that does not match employer contributions should consider and should probably choose a low-cost IRA instead of the firm’s high-cost retirement plan. This strategy limits contributions and retirement income for some workers because as noted contribution limits are substantially higher for firm-sponsored 401(k) plans than for independent IRAs. However, the difference between IRA and 401(k) contribution limits may not matter for most workers because many companies, in. a response to IRA non-discrimination rules, limit contributions to a 401(k) plan to a percent of income.

Use of Low or No-Fee Bond Purchases Directly from the U.S. Treasury: The current market environment is challenging. The valuations of popular stocks like Microsoft and Apple are at historic highs. Interest rates are low and for some maturities below the annual 401(k) fee. The actual investment return on many bonds in 401(k) accounts after accounting for the annual fees is negative.

Investors improve outcomes by purchasing I and EE Bonds directly from the Treasury. The purchases can be done inside or outside of retirement accounts.

There are several advantages associated with the greater use of I-Bonds and E-Bonds directly from the U.S. Treasury.

There are no fees on bonds purchased through Treasury Direct and no fees on the purchase of I and EE bonds as stated in these FAQs.
Tax is deferred on I and EE bonds until the instrument is sold.
The tax on matured bonds is limited to deferred interest or capital gains while all funds distributed from conventional retirement accounts are fully taxed as ordinary income.
Individual bonds can be redeemed at maturity at their par value while the value of the bond fund is determined by the prevailing interest rate.

Advantages of use of bonds as part of an overall retirement strategy and advantages associated with the purchase of bonds from Treasury Direct deserve and will get future analysis.

The point stressed here is that investments in bonds at Treasury Direct can reduce lifetime retirement fees.

Concluding Remarks: Virtually all financial planners emphasize the importance of taking full advantage of retirement plans. The advice starts as soon as a person enters the workforce even if the person has substantial student debt and a strategy of rapid repayment of student loans would substantially reduce costs, financial risk and stress for the new worker. The financial planners often don’t worry nearly enough about paying off the mortgage prior to retirement.

Financial planners often don’t mention or stress the importance of high fees, which as discussed here have a large impact on retirement wealth and the likelihood a worker will have a secure retirement.

The message presented in this post is that workers need to be aware of the retirement plan fees and the overall quality of the plan and come up with an alternative solution if the firm’s plan is inadequate.

Complicated rules for inherited retirement accounts

The 2019 Secure Act changed rules governing distributions from inherited IRAs and 401(k) plans. The new rules prevent some beneficiaries from stretching withdrawals across their lifetime. This CNBC article does a good job explaining the rules.

The new rules require many people who inherit a 401(k) plan to take disbursements within a 10-year period. However, there are some exceptions for minors and spouses.

The clock for disbursements over a 10-year period starts at 18 for minors inheriting a Roth IRA. However, prior to becoming 18 the minor must make a required minimum distribution RMD based on life expectancy. The RMD for minors should be really small because minors have a large future expected life. This rule might make sense if the IRA or 401(k) is huge but is it rational for people who inherited a small account?

The distributions from Roth accounts are tax free while the distributions from conventional accounts are taxed as ordinary income. I guess the Treasury will gain some tax revenue from accelerated Roth distributions if the funds are invested in assets with taxable interest, dividends or capital gains.

The distributions over the 10-year window can occur in any year. Since Roth accounts are not taxed it may make sense to distribute the funds in year 10. Conventional accounts are taxed; hence, taxpayers may want to spread distributions across years.

Funds not distributed by year 10 are subject to a 50% tax. Ouch!

Spouses who inherit an IRA do not have to take distributions until age 72.

The time frame for distributions for people who inherit an account through probate is 5 years not 10. Hence, it is important to name a beneficiary on your 401(k) or IRA.

Many people who inherit IRAs or 401(k) plans have modest income. This bill requires distributions even when the person might be better off saving for retirement. Many people inheriting a small IRA or 401(k) are not wealthy.

The bill was passed during the Trump Administration. Trump Administration and Republican tax policy was in general very generous to high-income people but not averse to using complicated rules to get a bit more tax from some people who may be middle income.