Do I earn too much to have a Roth IRA? Nope.

There is an income limitation for contributing "directly" to a Roth IRA ($173,000 Modified Adjusted Gross Income for 2012 for married couples filing jointly).  However, back in 2010, the income limitation for Roth "Conversions" expired, completely.  Thus, it is not possible to earn too much to have a Roth IRA.  If you exceed the income limitations for a direct contribution to a Roth IRA, one just needs to make a non-deductible contribution to a Traditional IRA then "convert" the Traditional IRA to a Roth IRA as soon as possible.

Annual contribution limits for IRAs and Roth IRAs are $5,000 per person in 2012 and $5,500 in 2013 unless you are over 50 in which case your annual limits are $6,000 and $6,500 for 2012 and 2013, respectively.  Thus, a husband and wife can EACH put $5,000 away this year for a total amount of $10,000, or $12,000 if they are both over 50.  I recommend everyone get money into a Roth IRA every year if at all possible since earnings grow tax free and withdrawals in retirement are also tax free.

Should I invest in a Roth 401(k)? No, probably not.

Many company 401(k) plans have added a Roth 401(k) option.  I believe most people should NOT use the Roth 401(k) option.  The Roth feature seems very appealing since withdrawals from a Roth account can be made tax-free in retirement.  However, these FUTURE tax-free withdrawals come at a high up-front cost since the employee must pay more taxes right NOW.  Let me go through an example and provide an alternative strategy.

Scenario 1:

Take a married couple, 40 years old, with taxable income of $85,000.  This couple would be in the 25% Federal Income Tax bracket and the 7.75% North Carolina State Income Tax bracket.  Let's assume the couple contributes $15,000 per year to a Roth 401(k).  This means the couple is paying an extra $4,912 in income taxes than if they contributed to a traditional 401(k) plan (15,000 x 32.75%).  So, the couple is paying an extra $4,912 for the privilege of placing $15,000 into a Roth account.

Scenario 2:

My suggestion to this couple is to stop making contributions to the Roth 401(k) and instead switch back to the traditional 401(k).  By switching from the Roth 401(k) back to the traditional 401(k) this couple will have an additional $4,912 in take home pay due to the lower income taxes.  The couple should then take that $4,912 in additional take home pay and contribute that money into a Roth IRA (I suggest doing this at Vanguard and use only low-cost index funds).

'Tis the Season to Give Financial Gifts to Children

Christine Benz of Morningstar recently published an interesting article called "The Best Ways to Give a Financial Gift to Children."  The article has good information for different ways to give a financial gift, but I might not classify them as the "best" ways. The article really focuses on more sophisticated ways to give larger amounts of money without letting the child spend it - at least not right away.

The article proposes 4 ways of gifting to children:

1. Set up a UGMA/UTMA account (Uniform Gifts/Transfers to Minors Act)
2. Contribute to a 529 Plan (college savings account)
3. Fund a Roth IRA (Individual Retirement Arrangement)
4. Give a financial knowledge gift (a basic finance book)

The article explains these 4 strategies pretty well so I'll let you read it yourself.  But, I'd like to add three simpler options below:

You can have a “do-over” on that Roth Conversion

Golfers love a mulligan after a bad shot, but so do investors. You have a chance at a do-over courtesy the IRS. Here is a great article from SmartMoney magazine for those folks that converted a Traditional IRA to a Roth IRA.  With the fall in the stock market, you may be able to save some taxes by reversing that conversion if your account is smaller now than when you converted.  The process is called “recharacterization” and is explained well in the article.  The deadline for this is October 17 so you need to hurry.

Keep in mind, if you converted to Roth in 2010, the IRS gave you an option to declare the income from the conversion over two years - ½ in 2011 and ½ in 2012.  If you undo the 2010 Roth Conversion, you will lose this option.  If you later reconvert into a Roth you will not be able to spread the income over two years and will have to declare all the income in the year of conversion.

The article says you need to wait 30 days after recharacterization before you reconvert to a Roth IRA.  Keep in mind you can’t convert and reconvert in the same tax year.  Someone made a comment on the article that is incorrect about this.  Neither the article nor the comment is exactly correct. I urge you to read the IRS language for yourself on page 30 of IRS Publication 590 and consult a local tax CPA if you want to do this.