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The Investment FAQ (part 11 of 20)

( Part1 - Part2 - Part3 - Part4 - Part5 - Part6 - Part7 - Part8 - Part9 - Part10 - Part11 - Part12 - Part13 - Part14 - Part15 - Part16 - Part17 - Part18 - Part19 - Part20 )
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Archive-name: investment-faq/general/part11
Version: $Id: part11,v 1.61 2003/03/17 02:44:30 lott Exp lott $
Compiler: Christopher Lott

See reader questions & answers on this topic! - Help others by sharing your knowledge
The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance.  This is a plain-text
version of The Investment FAQ, part 11 of 20.  The web site
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for any inaccuracy, error or omission, regardless of cause, in The
Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.  

Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly.  Information given
here was current at the time of writing but is almost guaranteed to be
out of date by the time you read it.  Mention of a product does not
constitute an endorsement. Answers to questions sometimes rely on
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Please send comments and new submissions to the compiler.

--------------------Check for updates------------------

Subject: Retirement Plans - 401(k)

Last-Revised: 9 Dec 2001
Contributed-By: Ed Nieters (nieters at, David W.  Olson,
Rich Carreiro (rlcarr at, Chris Lott ( contact
me ), Art Kamlet (artkamlet at, Ed Suranyi, Ed Zollars (ezollar

This article describes the provisions of the US tax code for 401(k)
plans as of mid 2001, including the changes made by the Economic
Recovery and Tax Relief Reconciliation Act of 2001. 

A 401(k) plan is a retirement savings plan that is funded by employee
contributions and (often) matching contributions from the employer.  The
major attraction of these plans is that the contributions are taken from
pre-tax salary, and the funds grow tax-free until withdrawn.  Also, the
plans are (to some extent) self-directed, and they are portable; more
about both topics later.  Both for-profit and many types of tax-exempt
organizations can establish these plans for their employees. 

A 401(k) plan takes its name from the section of the Internal Revenue
Code of 1978 that created them.  To get a bit picky for a moment, a
401(k) plan is a plan qualified under Section 401(a) (or at least we
mean it to be).  Section 401(a) is the section that defines qualified
plan trusts in general, including the various rules required for
qualifications.  Section 401(k) provides for an optional "cash or
deferred" method of getting contributions from employees.  So every
401(k) plan already is a 401(a) plan.  The IRS says what can be done,
but the operation of these plans is regulated by the Pension and Welfare
Benefits Administration of the U.S.  Department of Labor. 

For example, the Widget Company's plan might permit employees to
contribute up to 7% of their gross pay to the fund, and the company then
matches the contributions at 50% (happily, they pay in cash and not in
widgets :-).  Total contribution to the Widget plan in this example
would be 10.5% of the employee's salary.  My joke about paying in cash
is important, however; some plans contribute stock instead of cash. 

There are many advantages to 401(k) plans.  First, since the employee is
allowed to contribute to his/her 401(k) with pre-tax money, it reduces
the amount of tax paid out of each pay check.  Second, all employer
contributions and any growth in the capital grow tax-free until
withdrawal.  The compounding effect of consistent periodic contributions
over the period of 20 or 30 years is quite dramatic.  Third, the
employee can decide where to direct future contributions and/or current
savings, giving much control over the investments to the employee. 
Fourth, if your company matches your contributions, it's like getting
extra money on top of your salary.  Fifth, unlike a pension, all
contributions can be moved from one company's plan to the next company's
plan, or a special IRA, should a participant change jobs.  Sixth,
because the program is a personal investment program for your
retirement, it is protected by pension (ERISA) laws, which means that
the benefits may not be used as security for loans outside the program. 
This includes the additional protection of the funds from garnishment or
attachment by creditors or assigned to anyone else, except in the case
of domestic relations court cases dealing with divorce decree or child
support orders (QDROs; i.e., qualified domestic relations orders). 
Finally, while the 401(k) is similar in nature to an IRA, an IRA won't
enjoy any matching company contributions, and personal IRA contributions
are subject to much lower limits; see the article about IRA's elsewhere
in this FAQ. 

There are, of course, a few disadvantages associated with 401(k) plans. 
First, it is difficult (or at least expensive) to access your 401(k)
savings before age 59 1/2 (but see below).  Second, 401(k) plans don't
have the luxury of being insured by the Pension Benefit Guaranty
Corporation (PBGC).  (But then again, some pensions don't enjoy this
luxury either.) Third, employer contributions are usually not vested
(i.e., do not become the property of the employee) until a number of
years have passed.  Currently, those contributions can vest all at once
after five years of employment, or can vest gradually from the third
through the seventh year of employment. 

Participants in a 401(k) plan generally have a decent number of
different investment options, nearly all cases a menu of mutual funds. 
These funds usually include a money market, bond funds of varying
maturities (short, intermediate, long term), company stock, mutual fund,
US Series EE Savings Bonds, and others.  The employee chooses how to
invest the savings and is typically allowed to change where current
savings are invested and/or where future contributions will go a
specific number of times a year.  This may be quarterly, bi-monthly, or
some similar time period.  The employee is also typically allowed to
stop contributions at any time. 

With respect to participant's choice of investments, expert (sic)
opinions from financial advisors typically say that the average 401(k)
participant is not aggressive enough with their investment options. 
Historically, stocks have outperformed all other forms of investment and
will probably continue to do so.  Since the investment period of 401(k)
savings is relatively long - 20 to 40 years - this will minimize the
daily fluctuations of the market and allow a "buy and hold" strategy to
pay off.  As you near retirement, you might want to switch your
investments to more conservative funds to preserve their value. 

Puzzling out the rules and regulations for 401(k) plans is difficult
simply because every company's plan is different.  Each plan has a
minimum and maximum contribution, and these limits are chosen in
consultation with the IRS (I'm told) such that there is no
discrimination between highly paid and less highly paid employees.  The
law requires that if low compensated employees do not contribute enough
by the end of the plan year, then the limit is changed for highly
compensated employees.  Practically, this means that the employer sets a
maximum percentage of gross salary in order to prevent highly
compensated employees from reaching the limits.  In any case, the
employer chooses how much to match, how much employees may contribute,
etc.  Of course the IRS has the final say, so there are certain
regulations that apply to all 401(k) plans.  We'll try to lay them out

Let's begin with contributions.  Employees have the option of making all
or part of their contributions from pre-tax (gross) income.  This has
the added benefit of reducing the amount of tax paid by the employee
from each check now and deferring it until the person takes the pre-tax
money out of the plan.  Both the employer contribution (if any) and any
growth of the fund compound tax-free.  These contributions must be
deposited no more than 15 business days after the end of the month in
which they were made (also see the May 1999 issue of Individual Investor
magazine for a discussion of this). 

The interesting rules govern what happens to before-tax and after-tax
contributions.  The IRS limits pre-tax deductions to a fixed dollar
figure that changes annually.  In other words, an employee in any 401(k)
plan can reduce his or her gross pay by a maximum of some fixed dollar
amount via contributions to a 401(k) plan.  An employer's plan may place
restrictions on the employees that are stricter than the IRS limit, or
are much less strict.  If the restrictions are less strict, employees
may be able to make after-tax contributions. 

After-tax contributions are a whole lot different from pre-tax
contributions.  In fact, by definition an employee cannot contribute
after-tax monies to a 401(k)! Monies in excess of the limits on 401(k)
accounts (i.e., after-tax monies) are put into a 401(a) account, which
is defined to be an employee savings plan in which the employee
contributes after-tax monies.  (This is one way for an employee to save
aggressively for retirement while still enjoying tax-free growth until
distribution time.) If an employee elects to make after-tax
contributions, the money comes out of net pay (i.e., after taxes have
been deducted).  While it doesn't help one's current tax situation,
funds that were contributed on an after-tax basis may be easier to
withdraw since they are not subject to the strict IRS rules which apply
to pre-tax contributions.  When distributions are begun (see below), the
employee pays no tax on the portion of the distribution attributed to
after-tax contributions, but does have to pay tax on any gains. 

Ok, let's talk about the IRS limits already.  First, a person's maximum
before-tax contribution (i.e., 401(k) limit) for 2001 is $10,500 (same
as 2000, but will change in 2002).  It's important to understand this
limit.  This figure indicates only the maximum amount that the employee
can contribute from his/her pre-tax earnings to all of his/her 401(k)
accounts.  It does not include any matching funds that the employer
might graciously throw in.  Further, this figure is not reduced by
monies contributed towards many other plans (e.g., an IRA).  And, if you
work for two or more employers during the year, then you have the
responsibility to make sure you contribute no more than that year's
limit between the two or more employers' 401k plans.  If the employee
"accidentally" contributes more than the pre-tax limit towards his or
her 401(k) account, the employer must move the excess, or the excess
contribution amount due to a smaller limit imposed by an imbalance of
highly compensated employees, into a 401(a) account. 

Next there are regulations for highly compensated employees.  What are
these? Well, when the 401(k) rules were being formulated, the government
was afraid that executives might make the 401(k) plan at their company
very advantageous to themselves, but without allowing the rank-and-file
employees those same benefits.  The only way to make sure that the plan
would be beneficial to ordinary employees as well as those "highly
compensated," the law-writers decided, was to make sure that the
executives had an incentive to make the plan desirable for those
ordinary employees.  What this means is that employees who are defined
as "highly compensated" within the company (as guided by the
regulations) may not be allowed to save at the maximum rates.  Starting
in 1997, the IRC defined "highly compensated" as income in excess of
$80,000; alternately, the company can make a determination that only the
top 20% of employees are considered highly compensated.  Therefore, the
implementation of the "highly compensated employee" regulations varies
with the company, and only your benefits department can tell you if you
are affected. 

Finally the last of the IRS regulations.  IRS rules won't allow
contributions on pay over a certain amount (the limit was $170,000 in
2001, and will change in 2002).  Additionally, the IRS limits the total
amount of deferred income (i.e., money put into IRAs, 401(k) plans,
401(a) plans, or pension plans) each year to the lesser of some amount
($30,000 in 1996, and subject to change of course) or 25% of your annual
compensation.  Annual compensation defined as gross compensation for the
purpose of computing the limitation.  This changes an earlier law; a
person's annual compensation for the purpose of this computation is no
longer reduced by 401(k) contributions and salaray redirected to
cafeteria benefit plans. 

The 401(k) plans are somewhat unique in allowing limited access to
savings before age 59 1/2.  One option is taking a loan from yourself!
It is legal to take a loan from your 401(k) before age 59 1/2 for
certain reasons including hardship loans, buying a house, or paying for
education.  When a loan is obtained, you must pay the loan back with
regular payments (these can be set up as payroll deductions) but you
are, in effect, paying yourself back both the principal and the
interest, not a bank.  If you take a withdrawal from your 401(k) as
money other than a loan, not only must you pay tax on any pre-tax
contributions and on the growth, you must also pay an additional 10%
penalty to the government.  There are other special conditions that
permit withdrawals at various ages without penalty; consult an expert
for more details.  However, in general it's probably not a good idea to
take a loan from your own 401(k) simply because your money is not
growing for you while it is out of your account.  Sure, you're paying
yourself some bit of interest, but you're almost certainly not paying

Participants who are vested in in 401(k) plans can begin to access their
savings without withdrawal penalties at various ages, depending on the
plan and on their own circumstances.  If the participant who separates
from service is age 55 or more during the year of separation, the
participant can draw any amount from his or her 401(k) without any
calculated minimums and without any 5-year rules.  Depending on the
plan, a participant may be able to draw funds without penalty at or
after age 59 1/2 regardless of whether he or she has separated from
service (i.e., the participant might still be working; check with the
plan administrator to be sure).  The minimum withdrawal rules for a
participant who has separated from service kick in at age 70 1/2.  Being
able to draw any amount and for any length of time without penalty
starting at age 55 (provided the person has separated from service) is
one of the least understood differences between 401ks and IRAs.  Note
that this paragraph doesn't mention "retire" because the person's status
after leaving service with the company that has the 401(k) doesn't seem
to be relevant. 

Anyone who has separated from service from a company with a 401(k), and
is entitled to withdraw funds without penalty, may take a lump sum
withdrawal of the 401(k) into a taxable account, and depending on their
age may use an income averaging method.  Currently anyone eligible may
use an averaging method which spreads the lump sum over 5 years, and if
born before 1937, may average over 10 years.  Or, if a lump sum is
chosen, it can be immediately rolled into an IRA (but they withhold tax)
-- or transferred from the 401(k) custodian to an IRA custodian, and the
account will continue to grow tax deferred. 

Note that 401(k) distributions are separate from pension funds.  Like
IRAs, participants in 401(k) plans must begin taking distributions by
age 70 1/2.  Also, the IRS imposes a minimum annual distribution on
401(k)s at age 70 1/2, just to guarantee that Uncle Sam gets his share. 
However, there's an exception to the minimum and required distribution
rules: if you continue to work at that same company and the 401(k) is
still there, you do not have to start withdrawing the 401(k). 

Since a 401(k) is a company-administered plan, and every plan is
different, changing jobs will affect your 401(k) plan significantly. 
Different companies handle this situation in different ways (of course). 
Some will allow you to keep your savings in the program until age
59 1/2.  This is the simplest idea.  Other companies will require you to
take the money out.  Things get more complicated here, but not
unmanageable.  Your new company may allow you to make a "rollover"
contribution to its 401(k) which would let you take all the 401(k)
savings from your old job and put them into your new company's plan.  If
this is not a possibility, you may roll over the funds into an IRA. 
However, as discussed above, a 401(k) plan has numerous advantages over
an IRA, so if possible, rolling 401(k) money into another 401(k), if at
all possible, is usually the best choice. 

Whatever you do regarding rollovers, BE EXTREMELY CAREFUL!! This can not
be emphasized enough.  Legislation passed in 1992 by Congress added a
twist to the rollover procedures.  It used to be that you could receive
the rollover money in the form of a check made out to you and you had a
60 days to roll this cash into a new retirement account (either 401(k)
or IRA).  Now, however, employees taking a withdrawal have the
opportunity to make a "direct rollover" of the taxable amount of a
401(k) to a new plan.  This means the check goes directly from your old
company to your new company (or new plan).  If this is done (ie.  you
never "touch" the money), no tax is withheld or owed on the direct
rollover amount. 

If the direct rollover option is not chosen, i.e., a check goes through
your grubby little hands, the withdrawal is immediately subject to a
mandatory tax withholding of 20% of the taxable portion, which the old
company is required to ship off to the IRS.  The remaining 80% must be
rolled over within 60 days to a new retirement account or else is is
subject to the 10% tax mentioned above.  The 20% mandatory withholding
is supposed to cover possible taxes on your withdrawal, and can be
recovered using a special form filed with your next tax return to the
IRS.  If you forget to file that form, however, the 20% is lost. 
Naturally, there is a catch.  The 20% withheld must also be rolled into
a new retirement account within 60 days, out of your own pocket, or it
will be considered withdrawn and subject to the 10% tax.  Check with
your benefits department if you choose to do any type of rollover of
your 401(k) funds. 

Here's an example to clarify an indirect rollover.  Let us suppose that
you have $10,000 in a 401k, and that you withdraw the money with the
intention of rolling it over - no direct transfer.  Under current law
you will receive $8,000 and the IRS will receive $2,000 against possible
taxes on your withdrawal.  To maintain tax-exempt status on the money,
$10,000 has to be put into a new retirement plan within 60 days.  The
immediate problem is that you only have $8,000 in hand, and can't get
the $2,000 until you file your taxes next year.  What you can do is:
  1. Find $2,000 from somewhere else.  Maybe sell your car. 
  2. Roll over $8,000.  The $2,000 then loses its tax status and you
     will owe income tax and the 10% tax on it. 

Caveat: If you have been in an employee contributed retirement plan
since before 1986, some of the rules may be different on those funds
invested pre-1986.  Consult your benefits department for more details,

The rules changed in mid 2001 in the following ways:
   * The 2001 contribution limit of $10,500 per year rises to $11,000 in
     2002, then $12,000 in 2003, a lucky $13,000 in 2004, $14,000 in
     2005, and finally $15,000 in 2005.  Thereafter the limit is indexed
     for inflation. 
   * Vesting periods for employer's matching contributions are shortened
     starting in 2002.  Monies will vest after 3 years of service
     (compare with 5 years now), or can be vested gradually from the
     second through the sixth year (compare with 3..7 years now). 
   * Beginning in 2002, a catch-up provision is available to employees
     who are over 50 years old.  This provision allows these employees
     to contribute extra amounts over and above the limit in effect for
     that year.  The additional contribution amount is $1,000 in 2002
     and increases by $1,000 annually until it reaches $5,000 in 2006;
     thereafter, it increases $500 annually. 
   * Participants are supposed to be able to move between plans (like
     when switching employers) more easily than now.  I believe it makes
     roll-overs from a 401 to a 403 plan possible. 
   * A new option for 401(k) participants appears in 2002.  This option
     is being called a Roth-style 401(k); it allows deductions to be
     taken after-tax in exchange for the right to withdraw (like a Roth
     IRA) both contributions and earnings without tax at some distant
     point in the future. 

Finally, here are some resources on the web that may help. 
   * The Pension and Welfare Benefits Administration of the U.S. 
     Department of Labor offers some (although not much) information.
   * A brief note from the IRS
   * Fidelity offers an introduction to 401k plans
   * 401Kafé is a community resource for 401(k) participants.

--------------------Check for updates------------------

Subject: Retirement Plans - 401(k) for Self-Employed People

Last-Revised: 23 Jan 2003
Contributed-By: Daniel Lamaute, Chris Lott ( contact me ),

This article describes the provisions of the US tax code for the 401(k)
plan for Self-Employed People, also called the Solo 401(k).  These plans
were established by the Economic Growth and Tax Relief Reconciliation
Act of 2001. 

A Solo 401(k) plan provides a great tax break to the smallest business
owners.  In addition to the possibility to shelter from taxes a large
portion of income, some Solo 401(k) plans offer a loan feature for
cash-strapped small business owners. 

Eligibility for a Solo 401(k) plan is limited to those with a small
business and no employees, or only a spouse as an employee.  This
includes independent contractors with earned income, freelancers, sole
proprietors, partnerships, Limited Liability Companies (LLC) or

The key benefits of the Solo 401K plan include:
   * High limits on contributions: The limits for elective salary
     deferrals and employer contributions enable sole proprietors in tax
     year 2003 to contribute up to the lesser of 100% of aggregate
     compensation or $40,000 ($42,000 if age 50 or older). 
   * Contributions are fully-tax deductible and are based on
     compensation or earned income. 
   * Assets can be rolled from other plans or IRAs to a Solo 401K. 
     There is no limit on roll-overs. 
   * The account holder can take a loan that is tax-free and penalty
     free from the Solo 401K, if allowed by the plan, up to the lesser
     of 50% or $50,000 of the account balance. 

The contribution limits depend on how the business is established:
   * For businesses that are not incorporated, the employer and salary
     deferral contributions are based on the net earned income. 
     Contributions are not subject to federal income tax, but remain
     subject to self-employment taxes (SECA).  The owner receives a tax
     deduction for both salary deferral and employer contributions on
     IRS Form 1040 at filing time.  The maximum contribution limit is
     calculated based on salary (max deferral of about $12,000) and
     profit sharing (to get you up to the current max contribution). 
   * For corporations, the employer contribution is based on the W-2
     income and is contributed by the business.  The maximum employer
     contribution is 25% of pay.  It is not subject to federal income
     tax or Social Security (FICA) taxes.  The salary deferral
     contributions are withheld from your pay and are excluded from
     federal income tax but are subject to FICA.  The business receives
     a tax deduction for both salary deferral and employer
     contributions.  The maximum elective salary deferral amount for
     2003 is 100% of pay up to $12,000 ($14,000 if age 50 or older). 

Fees for establishing and maintaining the Solo-401(k) type accounts vary
by plan provider and administrator.  The plan providers are mostly
mutual fund companies with loaded funds.  The plan fees are also a
function of the features of the Solo-401(k).  For example, plans fees
tend to be less expensive if they have no loan feature.  Plans that
allow assets other than mutual funds in the plan would also be more
costly to maintain.  On average, the cost to set up and maintain a
Solo-401(k) is modest for a 401(k) plan; fees on various plans range
from $35 to $1,200 per year. 

A solo 401(k) offers several key advantages when compared to Keogh plans
(see the article elsewhere in the FAQ).  The solo 401(k) allows higher
contribution limits for most individuals, allows for catch-up salary
deferral contributions (for those 50+ years), and allows loans to

Rather than raiding their 401K to finance their business - and paying a
big penalty to the IRS - small business owners can take a tax-free loan
and keep their hard earned money working for them.  This plan offers
small business owners all the benefits of a big-company 401K without the
administrative expense and complexity. 

Small business owners should ask their accountants about this plan and
how it may benefit them.  Each Solo 401K must be set up no later than
December 31 of the calendar year to be eligible for tax deductions in
that tax year. 

Please visit Daniel Lamaute's web site for more information.  There he
offers a Solo-401(k) plan with no set up fee and an administration fee
of $100 per year.  That plan includes the loan feature; plan investments
are restricted to mutual funds by Pioneer Investments.

--------------------Check for updates------------------

Subject: Retirement Plans - 403(b)

Last-Revised: 29 Jan 2003
Contributed-By: Joseph Morlan (jmorlan at

A 403(b) plan, like a 401(k) plan, is a retirement savings plan that is
funded by employee contributions and (often) matching contributions from
the employer. 

403(b) plans are not "qualified plans" under the tax code, but are
generally higher cost "Tax-Sheltered Annuity Arrangements" which can be
offered only by public school systems and other tax-exempt
organizations.  They can only invest in annuities or mutual funds.  They
are very similar to qualified plans such as 401(k) but have some
important differences, as follows. 

The rules for top-heavy plans do not apply. 

Employer contributions are exludable from income only to the extent of
employees "exclusion allowance." Exclusion allowance is the total
excludable employer contribution for any prior year minus 20% of annual
includible compensation multiplied by years of service (prorated for
part-timers).  Whew! I have no idea what this means.  In my own case
there is no extra employer contribution, but rather a salary reduction
agreement.  So the so-called employer contribution is actually my own
contribution.  At least I think it is. 

Employer contributions must also be the lesser of 25% of compensation or
$30,000 annually.  Excess contributions are are includible in gross
income only if employee's right to them is vested.  I also don't know
what this means. 

Contributions to a custodial account invested in mutual funds are
subject to a special 6% excise tax on the amount by which they exceed
the maximum amount excludable from income.  (This sounds scary as the
calculation for excludable income seems quite complex.  E.g.  I already
have another tax-deferred retirment plan which probably needs to be
calculated into the total allowed in the 403b). 

The usual 10% penalty on early withdrawal and the 15% excise tax on
excess distributions still apply as in 401(k) plans. 

As of 2002, an individual may participate in a 403(b) plan and a 457(b)
plan at the same time. 

NOTE: The above is my paraphrasing of the U.S.  Master Tax Guide for
1993.  Recent changes in the laws governing 401(k)-type arrangements
have made these available to non-profit institutions as well, and this
has made the old 403(b) plans less attractive to many.  The following
sites address the new law and compare 401(k) with 403(b) plans:
   * The following is a link to the IRS special publication on 403b

--------------------Check for updates------------------

Subject: Retirement Plans - 457(b)

Last-Revised: 29 Jan 2003
Contributed-By: Chris Lott ( contact me )

A 457(b) plan is a non-qualified, tax-deferred compensation plan offered
by many non-profit institutions to their employees.  This plan, like a
401(k) or 403(b) plan, allows you to save for retirement. 

Contributions are made from pre-tax wages, and the Internal Revenue Code
sets the maximum contribution limits.  The limit for 2003 is the lesser
of $12,000 or 100% of an employee's salary.  Catch-up provisions apply
to those 50 or older; these people can contribute an extra $2,000. 

Because contributions are made before tax, naturally this means that
taxes are due when withdrawals are made.  However, these plans do not
impose a penalty on early withdrawals. 

Funds in a 457(b) plan can be rolled into another 457(b) plan if you
change employers.  Alternately, a 457(b) account can be rolled into a
different type of retirement-savings plan such as an IRA or a 401(k). 

As of 2002, an individual may participate in a 457(b) plan and a 403(b)
plan at the same time. 

--------------------Check for updates------------------

Subject: Retirement Plans - Co-mingling funds in IRA accounts

Last-Revised: 19 Feb 1998
Contributed-By: Art Kamlet (artkamlet at, Paul Maffia (paulmaf

The term "co-mingling" refers to mixing monies that were saved under
different plans within a single IRA account.  You may co-mingle as much
as you want within your IRAs.  Although the bookkeeping is not a
problem, there are disadvantages; one example is discussed below. 
Remember that you can have as many IRA accounts as you wish, although
there are strict limits on contributions to IRA accounts; see the FAQ
article on ordinary IRA accounts for more details. 

The most common situation where co-mingling becomes an issue is if you
have what is known as a "conduit" IRA.  This happens if you change
employers, and in doing so, move monies from the old employer's 401(k)
plan into an IRA account in your name.  If the IRA is funded with only
401(k) monies, then it is called a conduit IRA.  Further, if a later
employer allows it, the entire chunk can be transferred into a new

Of course you can mix (co-mingle) the conduit monies with monies from
other IRA accounts as much as you want.  The major disadvantage of
co-mingling is that if your 401(k) monies get co-mingled with non-401(k)
monies, you can never place the original monies from the old 401(k) back
into another 401(k).  You may also want to read the article on 401(k)
plans in the FAQ. 

Hre's a summary of the issues that might motivate you to maintain
separate IRA accounts:

  1. Legitimate investment needs such as diversification. 
  2. Estate planning purposes
  3. With passage of the new tax law, to keep your Roth IRA money
     separate from regular IRA money and/or Education IRA money. 
  4. And of course to keep 401K rollover monies separate if you want to
     retain the ability to reroll as noted above. 

--------------------Check for updates------------------

Subject: Retirement Plans - Keogh

Last-Revised: 23 Apr 1998
From: A.  Nielson, Chris Lott ( contact me ), James Phillips

A Keogh plan is a tax-deferred retirement savings plan for people who
are self-employed, and is much like an IRA.  The main difference between
a Keogh and an IRA is the contribution limit.  Although exact
contribution limits depend on the type of Keogh plan (see below), in
general a self-employed individual may contribute a maximum of $30,000
to a Keogh plan each year, and deduct that amount from taxable income. 
The limits for IRAs are much less, of course. 

The following information was derived from material T.  Row Price sends
out about their small company plan.  There are three types of Keogh
plans.  All types limit the maximum contribution to $30K per year, but
additional constraints may be imposed depending on the type of plan. 

Profit Sharing Keogh
     Annual contributions are limited to 15% of compensation, but can be
     changed to as low as 0% for any year. 
Money Purchase Keogh
     Annual contributions are limited to 25% of compensation but can be
     as low as 1%, but once the contribution percentage has been set, it
     cannot be changed for the life of the plan. 
Paired Keogh
     Combines profit sharing and money purchase plans.  Annual
     contributions limited to 25% but can be as low as 3%.  The part
     contributed to the money purchase part is fixed for the life of the
     plan, but the amount contributed to the profit sharing part (still
     subject to the 15% limit) can change every year. 

Like an IRA, the Keogh offers the individual a chance for his or her
savings to grow free of taxes.  Taxes are not paid until the individual
begins withdrawing funds from the plan.  Participants in Keogh plans are
subject to the same restrictions on distribution as IRAs, namely
distributions cannot be made without a penalty before age 59 1/2, and
distributions must begin before age 70 1/2. 

Setting up a Keogh plan is significantly more involved then establishing
an IRA or SEP-IRA.  Any competent brokerage house should be able to help
you execute the proper paperwork.  In exchange for this initial hurdle,
the contribution limits are very favorable when compared to the other
plans, so self-employed individuals should consider a Keogh plan

--------------------Check for updates------------------

Subject: Retirement Plans - Roth IRA

Last-Revised: 31 Jan 2003
Contributed-By: Chris Lott ( contact me ), Paul Maffia (paulmaf at, Rich Carreiro (rlcarr at

This article describes the provisions of the US tax code for Roth IRAs
as of mid 2001, including the changes made by the Economic Recovery and
Tax Relief Reconciliation Act of 2001.  Also see the articles elsewhere
in the FAQ for information about the Traditional IRA . 

The Taxpayer Relief Act of 1997 established a new type of individual
retirement arrangement (IRA).  It is commonly known as the "Roth IRA"
because it was championed in Congress by Senator William Roth of
Delaware.  The Roth IRA has been available to investors since 2 Jan
1998; provisions were amended by the IRS Restructuring and Reform Act of
1998, signed into law by the president on 22 July 1998.  Plans were
amended again in 2001.  This article will give a broad overview of Roth
IRA rules and regulations, as well as summarize the differences between
a Roth IRA and an ordinary IRA. 

A Roth individual retirement arrangement (Roth IRA) allows tax payers,
subject to certain income limits, to save money for use in retirement
while allowing the savings to grow tax-free.  All of the tax benefits
associated with a Roth IRA happen when withdrawals are made:
withdrawals, subject to certain rules, are not taxed at all.  Stated
differently, Roth IRAs convert earnings (dividends, interest, capital
gains) into tax-free income.  There are no tax benefits associated with
contributions (no deductions on your federal tax return) because all
contributions to a Roth IRA are made with after-tax monies. 

Funds in an IRA may be invested in a broad variety of vehicles (e.g.,
stocks, bonds, etc.) but there are limitations on investments (e.g.,
options trading is restricted, and buying property for your own use is
not permitted). 

The contribution amounts are limited to $3,000 annually (as of 2003) and
may be restricted based on an individual's income and filing status.  In
2003, an individual may contribute the lesser of US$3,000 or the amount
of wage income from US sources to his or her IRA account(s).  A notable
exception was introduced in 1997, namely that married couples with only
one wage earner may each contribute the full $3,000 to their respective
IRA accounts.  These limits are quite low in comparison to arrangements
that permit employee contributions such as 401(k) plans (see the article
on 401(k) plans in this FAQ for extensive information about those

There are absolutely no limits on the number of IRA accounts that an
individual may have, but the contribution limit applies to all accounts
collectively.  In other words, an individual may have 34 ordinary IRA
accounts and 16 Roth IRA accounts, but can only contribute $3,000 total
to those accounts, divided up any way he or she pleases (perhaps $40
each, but that's a lot of little checks). 

Taxpayers are permitted to contribute monies to a Roth IRA only if their
income lies below certain thresholds.  However, participation in any
other retirement plan has no influence on whether a person may
contribute or not.  More specifically, a person's Modified Adjusted
Gross Income (MAGI) must pass an income test for contributions to the
Roth IRA to be permitted.  The 2003 income tests for individuals filing
singly, couples with filing status Married Filing Jointly (MFJ), and
couples living together with filing status Married Filing Separately
(MFS) look like this:

   * MAGI less than 95k (MFJ 150k, MFS 0k): full contribution allowed
   * MAGI in the range 95-110k (MFJ 150-160k), MFS 0-10k: partial
     contribution allowed
   * MAGI greater than 110k (MFJ 160k, MFS 10k): no contribution
     allowed.  That's right, the limits on married couples who file
separate tax returns are pretty darned low. 

A bit of trivia: the Roth contribution phaseout, like the phaseout for
the deductibility of ordinary IRA contributions, has a kink in it.  As
long as the MAGI is within the phaseout range, the allowable
contribution will not be less than $200, even though a strict
application of the phaseout formula would lead to an amount less than
$200.  So as your MAGI works its way into the phaseout, your
contribution will drop linearly from $2000 down to $200, then will stay
at $200 until you hit the end of the phaseout, where it then drops to

Annual IRA contributions can be made between January 1 of that year and
April 15 of the following year.  Because of the extra three and a half
months, if you send in a contribution to your IRA custodian between
January and April, be sure to indicate the year of the contribution so
the appropriate information gets sent to the IRS.  Remember,
contributions to a Roth IRA are never deductible from a taxpayer's
income (unlike a traditional IRA). 

The rules for penalty-free, tax-free distributions from a Roth IRA
account are fairly complex.  First, some terminology: a Roth account is
built from contributions (made annually in cash) and conversions (from a
traditinal IRA); earnings are any amounts in the account beyond what was
contributed or converted.  The rule are as follows:
   * Contributions can be withdrawn tax-free and penalty-free at any
   * There is 5-year clock 'A'.  Clock 'A' starts on the first day of
     the first tax year in which any Roth IRA is opened and funded. 
   * Earnings can be withdrawn tax-free and penalty-free after Clock 'A'
     hits 5 years and a qualifying event (such as turning 59.5,
     disability, etc.) occurs. 
   * Additional 5-year clocks 'B', 'C', etc.  start running for each
     traditional IRA that is converted to a Roth IRA.  Each clock
     applies just to that conversion. 
   * If you are under age 59.5 when a particular conversion is done, and
     you withdraw any conversion monies before the clock associated with
     that particular conversion hits 5 years, you are hit with a 10%
     penalty on the withdrawn conversion monies.  If you are over age
     59.5 when you did the conversion, no penalty no matter how soon you
     withdraw the monies from that conversion. 
   * The order of withdrawals (distributions) has been established to
     help investors.  When a withdrawal is made, it is deemed to come
     from contributions first .  After all contributions have been
     withdrawn, subsequent withdrawals are considered to come from
     conversions.  After all conversions have been withdrawn, then
     withdrawals come from earnings.  I believe the conversions are
     taken in chronological order. 
   * All Roth IRA accounts are aggregated for the purpose of applying
     the ordering rules to a withdrawal. 

A huge difference between Roth and ordinary IRA accounts involves the
rules for withdrawals past age 70 1/2.  There are no requirements that a
holder of a Roth IRA ever make withdrawals (unlike a traditional IRA for
which required minimum distribution rules apply).  This provision makes
it possible to use the Roth IRA as an estate planning tool.  You can
pass on significant sums to your heirs if you choose; the account must
be distributed if the holder dies. 

What the Roth IRA allows you to do, in essence, is lock in the tax rate
that you are currently paying.  If you think rates are going nowhere but
up, even in your retirement, the Roth IRA is a sensible choice.  But if
you think your tax rate after retirement will be less, perhaps much
less, than your current tax rate, it might be wiser to stick with a
conventional IRA.  (To be picky, you really need to think about the tax
rate when you are eligible to take tax-free, penalty-free distributions,
which is age 59 1/2.)

Should you use a Roth IRA at all? Answering this question is tricky
because it depends on your circumstances.  In general, experts agree
that if you have a 401(k) plan available to you through your employer,
you should max out that account before looking elsewhere.  Otherwise, if
you are allowed to put money in a Roth IRA at all (i.e., if your income
is below the limits), then making contributions to a Roth IRA is always
preferable over making contributions to a nondeductible IRA.  You pay
the same amount of taxes now in both cases, because neither is
deductible, but you don't pay taxes on withdrawal from the Roth (unlike
withdrawals from an ordinary IRA).  The only exception here is if you're
going to need to pull the money out before the minimum holding period of
5 years. 

Holders of ordinary IRA accounts will be permitted to convert their
accounts to Roth IRA accounts if they meet certain criteria.  First,
there is a limit on MAGI of $100K for that individual in the year of the
conversion, single or married.  Second, taxpayers whose filing status is
married filing separately may not convert their ordinary IRA accounts to
Roth accounts. 

Tax is owed on the amount transferred, less any nondeductible
contributions that were made over the years.  In more detail: the
current law allows the income (i.e., withdrawal) resulting from a
conversion in 1998 to be divided by 4 and indicated as income in equal
parts on 1998--2001 tax returns (the technical corrections bill changed
this from mandatory to optional).  Conversions made in 1999 and
subsequent years will be fully taxed in the year of the conversion. 
Deductible contributions and all earnings are taxed; non-deductible
contributions are considered return of capital and are not taxed. 

If you convert only a portion of your IRA holdings to a Roth IRA, the
IRS says that these withdrawals are considered to be taken ratably from
each ordinary IRA account.  You compute the rate by finding the ratio of
deductible to non-deductible contributions (also known as computing your
IRA basis).  This ignores growth or shrinkage of the account's value. 
For example, if you stashed $9,000 in deductible contributions and
$3,000 in non-deductible contributions for a total of $12,000 in
contributions to your ordinary IRA, your basis would be 25% of the total
contributions.  When you make a withdrawal, 25% will considered to be
from the non-deductible portion and 75% from the deductible portion (and
hence taxable).  Not certain whether the proper way to say this is that
your basis is 25% or 75%, but you get the idea. 

The technical corrections bill of 1998 added a provision that investors
could unconvert (and possibly recovert) with no penalty to cover the
case of a person who converted, but then became ineligible due to
unexpected income.  This opened a loophole: it put no limit on the
number of switches back and forth.  With the decline in the markets of
1998, many people unconverted and reconverted to establish a lower cost
basis in their Roth IRA accounts.  The IRS issued new regulations in
late October, 1998 that disallow this strategy effective 1 Nov 98, but
grandfather any reconversions that predate the new regulations.  Under
the new regulations, IRA holders are allowed just one reconversion. 

If you are eligible to convert your ordinary IRA to a Roth IRA, should
you? Again answering this question is non-trivial because each
investor's circumstances are very different.  There are some
generalizations that are fairly safe.  Young investors, who have many
years for their investments to grow, could benefit handsomely by being
able to withdraw all earnings free of tax.  Older people who don't want
to be forced to withdraw funds from their accounts at age 70 1/2 might
find the Roth IRA helpful (this is the estate planning angle).  On the
other hand, for people who have significant IRA balances, the extra
income could push them into a higher tax bracket for several years,
cause them to lose tax breaks for some itemized deductions, or increase
taxes on Social Security benefits. 

The following illustrated example may help shed light on the benefits of
a Roth IRA and help you decide whether conversion is the right choice
for you.  The numbers in this example were computed by Vanguard for
their pages (see the link below).  In many situations the differences
between the two types of accounts is quite small, which is perhaps at
odds with the hype you might have seen recently about Roth IRAs.  But
let's let the number speak for themselves. 

We're going to compare an ordinary deductible IRA with a Roth IRA.  Each
begins with $2,000, and we'll let the accounts grow for 20 years with no
further contributions.  We'll assume a constant rate of return of 8%,
compounded annually, just to keep things simple.  We'll also assume the
contribution to the ordinary IRA was deductible because otherwise the
Roth is a clear winner.  Here's the situation at the start; we assume
the 28% tax bracket so you have to start by earning 2,778 just to keep
What Ordinary IRA Roth IRA
Gross wages 2,778 2,778
Contributions 2,000 2,000
Taxable income 778 2,778
28% federal tax 218 778
What's left 560 0
So at this point, the ordinary IRA left some money in your pocket, but
the Feds and the Roth IRA took it all.  But we're not going to spend
that money, no sir, we're going to invest it at 8% too, although it's
taxed, so it's really like investing it at 72% of 8%, or about 6%. 
After 20 years we withdraw the full amount in each account.  What's the
What Ordinary IRA Roth IRA
Account balance 9,332 9,332
28% federal tax 2,613 0
What's left 6,719 9,332
Outside investment 1,716 0
Net result 8,435 9,332
So this worked out pretty well for the Roth IRA.  A key assumption was
that the use of the same tax rate at withdrawal time.  If the tax rate
had been significantly less, then the Ordinary IRA would have come out
ahead.  And of course you had the discipline to invest the money that
the ordinary IRA left in your hands instead of blowing it in Atlantic

I hope that this example illustrated how you might run the numbers for
yourself.  Before you do anything, I recommend you seriously consider
getting advice from a tax professional who can evaluate your
circumstances and make a recommendation that is most appropriate for

If you've decided to convert your ordinary IRA to a Roth IRA, here are
some tips offered by Ellen Schultz of the Wall Street Journal
(paraphrased from her article of 9 Jan 1998). 

Pay taxes out of your pocket, not out of your IRA account. 
     If you use IRA funds to pay the taxes incurred on the conversion
     (considered a withdrawal from your ordinary IRA), you've lost much
     of the potential tax savings.  Worse, those funds will be
     considered a premature distribution and you may be hit with a 10%
Consider converting only part of your IRA funds. 
     This decision is up to you.  There is no requirement to convert all
     of your accounts. 
Conversion amounts don't affect your conversion eligibility. 
     When you convert, the withdrawal amount does not count towards the
     100k limit on income. 

As a final note, you should be careful about any fees that the trustee
of your Roth IRA account might try to impose.  For comparison,
Waterhouse offers a no-fee Roth IRA. 

Just for the record, a number of changes were made in 1998 to the
original Roth provisions ("technical corrections").  One problem that
was corrected was that the original law included a tax break for
conversion Roth accounts.  Specifically, there was no penalty on early
withdrawals from conversion accounts.  This means that any money
converted (and any earnings after conversion) to a Roth from an ordinary
IRA could be withdrawn at any time without penalty, so you could roll to
a Roth IRA and use your ordinary IRA money immediately without penalty. 
The technical corrections bill corrected this by requiring that 5 years
elapse after conversion before any sums can be withdrawn.  Also, under
the wording of the original law, the minimum 5-year holding period for a
Roth conversion account was based on the date of the last deposit into
that account.  One of the consequences of the second problem was that
the IRS was insisting on keeping the conversion accounts separate from
contribution (new money) accounts so as to minimize the potential damage
(tax collection-wise) if the correction was not made (but of course it
was).  Another change lowered the already low income test for couples
filing MFS from 15k to 10k. 

The rules changed in mid 2001 in the following ways:
   * The contribution limit of $2,000 per year maximum rises to $3,000
     in 2002; reaches $4,000 in 2005, and finally hits $5,000 in 2008. 
   * Investors over 50 can contribute an extra $500 per year (in 2002)
     and eventually an extra 1,000 (in 2006) per year; this is called a
     catch-up provision. 

Here's a list of sources for additional information, including on-line
calculators that will help you decide whether you should convert an
ordinary IRA to a Roth IRA. 

   * Kaye Thomas maintains a site with an enormous wealth of information
     about the Roth IRA.
   * Brentmark Software offers a Roth IRA site that provides technical
     and planning information on Roth IRAs.
   * The Roth IRA Advisor provides guidelines for IRA owners and 401(k)
     participants to optimize the benefits of their retirement plans. 
     Written by James Lange, CPA.
   * Vanguard offers a considerable amount of information about the new
     tax laws and Roth IRA provisions, including detailed analyses of
     the two accounts, on their web site:
     Also see the Vanguard page that discusses conversions:
   * And also try the Vanguard calculator (no, they're not sponsoring me
   * An article about Roth IRAs from SenInvest:
   * A collection of links to sites with yet more information about Roth
     IRAs, with emphasis on mutual fund holders:
   * A conversion calculator from Strong Funds:

For the very last word on the rules and regulations of Roth IRA
accounts, get IRS Publication 553. 

--------------------Check for updates------------------

Subject: Retirement Plans - SEP IRA

Last-Revised: 16 Feb 2003
Contributed-By: Edward Lupin, Daniel Lamaute (

A simplified employee pension (SEP) IRA is a written plan that allows an
employer to make contributions toward his or her own (if self-employed)
or employees' retirement, without becoming involved in more complex
retirement plans (such as Keoghs).  The SEP functions essentially as a
low-cost pension plan for small businesses. 

As of this writing, employers can contribute a maximum of 25% of an
employee's eligible compensation or $40,000, whichever is less.  Be
careful not to exceed the limits; a non-deductible penalty tax of 6% of
the excess amount contributed will be incurred for each year in which an
excess contribution remains in a SEP-IRA. 

Employees are able to exclude from current income the entire SEP
contribution.  However, the money contributed to a SEP-IRA belongs to
the employee immediately and always.  If the employee leaves the
company, all retirement contributions go with the employee (this is
known as portability). 

The IRS regulations state that employers must include all eligible
employees who are at least age 21 and have been with a company for 3
years out of the immediately preceding 5 years.  However, employers have
the option to establish less-restrictive participation requirements, if

An employer is not required to make contributions in any year or to
maintain a certain level of contributions to a SEP-IRA plan.  Thus,
small employers have the flexibility to change their annual
contributions based on the performance of the business. 

For calendar year corporations with a March 15, 2003 tax filing
deadline, SEP-IRA contributions must be made by the employer by the due
date of the companys income tax return, including extensions.  The
contributions are deductible for tax year 2002 as if the contributions
had actually been contributed within tax year 2002. 

Sole proprietors have until April 15, 2003, or to their extension
deadline, to make their SEP-IRA contribution if they want a 2002 tax

The SEP-IRA enrollment process is an easy one.  Its generally a two
page application process.  The employer completes Form 5305-SEP.  The
employee completes the IRA investment application usually supplied by a
mutual fund company or some other financial institution which will hold
the funds.  Nothing has to be filed with the IRS to establish the
SEP-IRA or subsequently, unlike many other retirement plans that require
IRS annual returns. 

--------------------Check for updates------------------

Compilation Copyright (c) 2003 by Christopher Lott.

User Contributions:

Gerri Pisciotta
My employer accidentally advised the company handling the 401k investment that I had been terminated, when in fact I had not. As a result, withdrawals discontinued from my pay and I missed a couple years of contributions. Since I never withdrew from the plan, is my employer liable for making up these contributions? If I made a lump sum catchup contribution,could they do the same?
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Truly lots of awesome tips!
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