In this post, I’ll answer 7 questions from the Money Girl community about a variety of investing and retirement topics to help you create more financial success. You’ll learn how to get higher investment returns, retire early, prioritize accounts, do rollovers, know when you should invest, and manage multiple retirement accounts.
Free Resource: Retirement Account Comparison Chart (PDF download) - get this handy, one-page resource to understand the different types of retirement accounts.
7 Questions & Answers About Investing
Investing Question #1: Carl says, “I recently heard about a way to retire early that doesn’t come with a retirement account penalty. Can you explain how to qualify for that?”
Answer:
If you’re a regular Money Girl reader or podcast listener, you know that I strongly recommend using retirement accounts, such as IRAs and workplace plans to save for retirement. They come with terrific tax benefits and legal protections that don’t come with regular investing accounts.
However, retirement accounts also have a major downside: you generally can’t take money out of one before age 59½ without paying a 10% penalty. The idea is that these accounts are meant to provide security in retirement and not to be tapped early or on a whim.
There are some qualified exceptions when you can take early distributions from an IRA that are penalty-free, such as paying for education, medical bills, or your first home. Roth IRAs give you the most flexibility, and I covered the rules for making withdrawals of both contributions and earnings in last week’s post and audio podcast, 4 Penalty-Free Ways to Use a Roth IRA Before Retirement.
See also: 10 IRA Facts Everyone Should Know
In addition to common exemptions, there’s an advanced and little-known rule you can use to avoid the early withdrawal penalty for any type of retirement account. It goes by a few different names that come from its numbered section of the IRS tax code:
- 72(t) distribution
- 72(t) payment plan
- Substantially equal periodic payments
- SEPP plan
The 72(t) regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) from a workplace plan, such as a 401(k) or 403(b), if you no longer work for your employer.
On the surface, this sounds like an easy way to begin tapping a retirement account any time you want. Problem is, creating a 72(t) plan comes with restrictions and some risky consequences if you don’t use it the right way.
The 72(t) regulation allows you to set up a plan to take equal monthly or annual distributions from your retirement account, such as a traditional IRA or a Roth IRA.
The amount you can withdraw using a 72(t) plan is calculated using one of 3 accounting methods approved by the IRS. I won’t bore you with the details of figuring substantially equal periodic payments, but some of the factors that go into the calculations include your account balance, age, and life expectancy.
All payments you receive from a 72(t) plan that weren’t previously taxed, such as for a traditional IRA or traditional 401(k), will be subject to income tax, just like when you take distributions from those accounts in retirement.
It’s important to understand that once you begin taking 72(t) distributions, you can’t stop taking them for a certain amount of time. Once the plan is put in place you must take the periodic payments for a minimum of 5 years or until you turn 59½, whichever is longer.
After you complete a series of 5-year distributions and reach the age of 59½, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 70½, you generally must take annual required minimum distributions, no matter if you used a 72(t) plan or not.
See also: 10 Costly Retirement Account Mistakes (Part 1)
Another issue with initiating a 72(t) payment plan is that you can’t make any new contributions to your retirement account or add any assets or rollovers while taking payments. It’s as if your accounts is frozen while a distribution plan is in place.
So, let’s get back to Carl’s question about who qualifies to use a 72(t). It’s available to anyone who owns a retirement account. But I’ll go a little deeper to explain who should use one.
Setting up an early distribution plan can be a huge benefit if you have plenty of money in your retirement account and are ready to retire before the official age of 59½. It’s a great way to start spending your retirement funds on anything you like—such as travel, medical expenses, paying down debt, or gifts to family—without having to pay expensive early withdrawal penalties.
Another situation when a 72(t) distribution makes sense is when you really need to supplement your income. Let’s say you get downsized from your job at age 50 and decide to transition into a less lucrative career or to work part-time. If you need additional income, you could set up a 72(t) plan and take substantially equal periodic payments until you reach age 59½.
But as I mentioned, hopping on the 72(t) payment train means the ride must last for 5 years or until you turn 59½, whichever is longer. So, after receiving payments for 9½ years, from age 50 to 59½, you could stop taking payments. Or you could keep the distributions coming in the same amount or even change it to any amount you like.
When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount.
When executed properly, taking 72(t) payments can be a smart way to tap your retirement funds early. However, figuring out the allowable payment schedule can be very complex—you can’t just name your own amount.
Taking too little, too much, or missing a distribution deadline can result in expensive consequences. In addition to owing income tax, messing up your 72(t) payments means that all your distributions will be subject to the 10% early withdrawal penalty—plus, interest on unpaid tax and penalties calculated from the original date you made an error. Ouch!
Therefore, always get help from a tax professional who has experience setting up a 72(t). Carl should weigh all his options carefully and never enter a 72(t) plan lightly. Ask yourself if you really need the money or have other sources to tap.
Make sure you can afford to trade your nest egg for an immediate cash flow. Taking payments now means that you drain the resources available to you later in retirement.
See also: 5 Retirement Account Options When You're Self-Employed
Investing Question #2: Sara V., a member of Laura’s Dominate Your Dollars Facebook group, says, “My work offers a 457 retirement plan, but with no matching funds, and I have a Roth IRA. Should I should save more in the 457 or use another account?”
Answer:
Thanks for your question, Sara. For those unfamiliar with a 457 plan, I’ll start with a brief introduction. A 457 plan has similarities to a 401k, but is only offered by state and local governments and certain non-profit organizations.
Just like with a 401k, you can contribute on a pre-tax basis to a traditional 457 or on an after-tax basis to a Roth 457. The annual contribution limits are the same as other workplace retirement plans: up to $18,000, or up to $24,000 if you’re over age 50, for 2017.
Any time you’re offered a retirement plan through work, that’s the first place you should invest. Reason is, it’s loaded with benefits like those high annual contribution limits. In contrast, IRAs currently only allow less than a third of a workplace plan, $5,500, or $6,500 if you’re over age 50.
Retirement plans at work may offer lower costs and funds that you wouldn’t have access to. Additionally, if your financial situation takes a turn for the worst, they generally provide more legal protections compared to an IRA.
And, as Sara brought up in her question, employers may kick in additional matching funds. These free, additional contributions to your retirement account are an amazing incentive to keep up good savings habits. But even if you’re like Sara, and don’t get a retirement match from your boss, don’t let that discourage you from participating.
Here are questions you and Sara can ask to know the best places for your retirement funds:
- Do I qualify to make Roth IRA contributions in the first place? Sara didn’t mention how much she’s earning, but you’re not eligible to contribute to a Roth IRA when your income exceeds annual income limits. These are the income thresholds by tax filing status for 2017: - Single taxpayers can’t contribute when modified adjusted gross income (MAGI) is at or above $133,000. - Married taxpayers who file a joint return can’t contribute when household MAGI is $196,000 or higher. - Married taxpayers who file separate returns can’t contribute when MAGI is $10,000 or higher.
- Does my employer offer a Roth 457 in addition to a traditional 457? If so, she could get the tax-free advantages that come with a Roth using her employer-sponsored plan. Plus, a major advantage of getting a Roth at work is that unlike a Roth IRA, there’s no income limit. So, even the highest paid worker in a company can max out a Roth workplace retirement account, such as a Roth 457, Roth 403b, or a Roth 401k.
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Do I want flexibility to tap a retirement account? If so, a Roth IRA puts up the fewest barriers and restrictions to take out money. Of course, leaving funds to grow for the long term gives you more to spend later—so that’s what I recommend doing. However, it’s always nice to have options!
See also: 401k or IRA: Which One Should You Invest in First?
Investing Question #3: Joe asks, “Can I contribute to a Roth IRA in addition to a traditional IRA?”
Answer:
You can contribute to both a traditional IRA and a Roth IRA in the same year, if you don’t exceed the total annual contribution limit. As I previously mentioned, for 2017, you can contribute a total of $5,500, or $6,500 if you’re over age 50, to one or both accounts.
For example, you could contribute $2,000 to a traditional IRA and $3,500 to a Roth IRA, or any proportion you like. But, to make contributions to a Roth IRA, you can’t exceed the annual income limits that I just covered.
If you become ineligible to contribute to a Roth IRA in the future, it’s not a problem. You can still manage your investments the same way. And if your income falls below the annual limit down the road, you can begin contributing again.
If you become ineligible to contribute to a Roth IRA in the future, it’s not a problem. You can still manage your investments the same way. And if your income falls below the annual limit down the road, you can begin contributing again.
See also: How to Make Kids Rich by Investing in an IRA
Investing Question #4: Adam asks, “Can I contribute to an IRA in addition to my retirement plan at work?”
Answer:
When you have a retirement plan at work you can also contribute to a traditional IRA, a Roth IRA, or to both. However, there’s a downside you should know about. If you earn over an annual threshold, the tax deduction for your traditional IRA may be limited.
To learn more, I’ll refer you to a recent post and podcast, Can You Contribute to a 401k and an IRA in the Same Year?
Investing Question #5: An anonymous podcast listener asks, “Can I roll over my traditional 401k from a previous employer into a Roth IRA?”
Answer:
You can only roll over workplace accounts into like accounts without triggering a tax consequence. For instance, you can roll over a traditional 401k into a traditional IRA and a Roth 401k into a Roth IRA.
Moving money from a traditional workplace account into a Roth IRA would be considered a Roth conversion. Since traditional retirement contributions are made on a pre-tax basis and Roth contributions are after-tax, doing a conversion means that you’re responsible for income tax on any amounts that weren’t previously taxed. So, I generally don’t recommend doing a Roth conversion because it can result in a huge tax liability.
I recommend that the anonymous listener roll over his or her old 401k into a traditional IRA and then start a new Roth IRA, assuming he or she qualifies based on annual income limits.
See also: What's the Difference Between a Roth 401k and a Roth IRA?
Investing Question #6: Angela G., a new Money Girl listener says, “I’m making an investment in my future by going to a really great law school to follow my dreams. But the debt is concerning me. I’m taking out $60,000 in loans for my first year and need advice about the best ways to manage it. What strategies do you recommend for saving or investing my loan money so I can maximize the little I’ll have during these three years and have a strong financial footing after graduation?”
Answer:
Angela, congratulations on getting into a great law school. While your student debt seems troubling now, work hard to limit your expenses during school and maximize your education. Statistics show that the cost of higher education pays off, allowing you to earn millions more over the life of your career.
Since you’re receiving money that you’ll probably need to spend over the next year or two, it should never be invested. That’s because investing exposes money to some amount of risk—and you can’t afford to lose a penny of your education funds. Instead, keep your student loans completely safe, but earning some interest, in a high-yield bank savings account while you’re in school.
Once you’re earning income, I recommend a multi-prong strategy of accumulating an emergency fund, investing at least 10% to 15% of your income for retirement, and paying extra on your student loans when possible.
After you graduate and get a good-paying job, that’s the time to hone in on an aggressive financial plan. Once you’re earning income, I recommend a multi-prong strategy of accumulating an emergency fund, investing at least 10% to 15% of your income for retirement, and paying extra on your student loans when possible.
See also: A Blueprint to Prioritize Your Personal Finances
Investing Question #7: Brandy says, “I’ve been a fan of your podcast for about 3 years and have used many of your tips. I’m 27 years old and make about $52,000 a year. I bank with a credit union and the CDs are only offering 2.96% APY. In podcast #489, you mentioned examples of investors earning an annual average return of 8%—where can I receive this return?”
Answer:
Thanks so much for being a long-time podcast listener, Brandy! There are hundreds of mutual funds and exchange-traded funds (ETFs) that offer returns north of 8%. But it depends on the performance period.
The Vanguard Mid-Cap Value ETF (VOE) is an example of a stock fund that’s part of my Betterment portfolio with the following stated returns:
- 1 year – 19.48%
- 3 year – 9.38%
- 5 year – 14.31%
- 10 year – 7.8%
- Since inception in 2006 – 8.88%
In the podcast you referenced, which is episode 489, I mentioned that you must choose investments based on your time horizon. For instance, if you’re 35 years old and plan to quit working and live solely on investment income when you’re 65, you have a 30-year horizon that allows you to take more risk.
But if you have money that you want to use for a down payment on a home next year, you have an extremely short horizon and should not take any risk. Put it in an extremely conservative and safe place, like a bank savings account or a short-term CD.
So, before you think about investment returns, you need to be clear about what you plan to use money for. If it’s for the long term, I recommend investing aggressively through a retirement account, such as a workplace plan or an IRA. If it’s for the short term, don’t use a retirement account because early withdrawals come with expensive taxes and penalties.
In 7 Simple Principles to Invest Money Wisely No Matter Your Age I mention that the highest returns typical come from stocks or stock funds. But those high returns have high risk because stocks are volatile and the value can change from minute to minute. In contrast, cash or cash equivalents, such as bank savings and CDs are the least risky, but give you low returns.
Over many decades stocks have performed better than other types of investments with average annual returns near 10%. So, when you have at least 5 to 10 years to go before you need to tap invested money, I recommend choosing one or more diversified stock funds, but not individual stocks which are riskier to own.
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