Beating Broke

Personal Finance from the Broke Perspective

Reverse Mortgage For Equity Recapture?

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Reverse Mortgages are a bit of a mystery to me.  Being a homeowner, I understand the concept of a mortgage.  I understand that I agree to pay a certain amount each month, based on the terms of my mortgage, to a bank in order to some day, hopefully, own my house.  I get that.  But, Reverse Mortgages are still a bit of a mystery.

The way that I understand it, it works, like it’s name implies, in the opposite way that a mortgage does.  Essentially, a bank is giving you a new mortgage on the house.  But, rather than giving you the large lump some at the beginning (although that’s an option it seems) to pay off the previous owner (like you would in a purchase), the bank gives you a set amount, based on the terms of the loan, each period and adds that amount onto the amount owed.  The loan continues that way until you decide to move out of the house, or sell it, at which point it becomes payable.

Mortgage © by 401K

In some ways, a reverse mortgage (more aptly called a Lifetime Mortgage in the U.K.) makes some sense.  We’ll all need a certain amount of income available to us when we retire.  If we’ve done it right, we should own our homes in full when we do retire.  Which means that we should have a whole bunch of equity in our homes that normally would only become available to us by selling the house, or through a home equity loan.  Obviously, if we want to continue to live in the house, selling isn’t an option.  And, if we’re looking for additional income, the lump sum payout and resulting monthly payments of a home equity loan aren’t a very good option either.

Looked at in that way, a reverse mortgage could be a viable option for many retirees.  The biggest downside to it would be that you’d basically be forced to sell the house (or your estate would be) and couldn’t then leave it to your children without also leaving them with a huge mortgage on the place.  Is that the biggest deal in the world?  I don’t happen to think so.  In many cases, your children aren’t going to be living in the same town anyways, and won’t want to move just to take up residence in your house.  So, the loss of the house as a physical residence probably won’t be a big deal.  The loss of the money that the house represents for your estate could be the bigger deal.  But, I’ve always been a fan of the thinking that it was your money you earned in the first place, why not enjoy it personally rather than leave a whole lot behind.

I’m curious though, how many of you have had any dealings with reverse mortgages?  Have they been good?  Bad? Otherwise?  What are your opinions of them?  What did I miss in my  (admittedly sloppy, but I’m only 32, so it’s not that pertinent to me) research?

What is the Roth IRA?

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Retirement.  Have you thought about that yet?  Still think you’re too young to deal with that?  Or, just assume that your company 401(k) is enough, so why even worry about anything else?  Let me introduce you to the Roth IRA.

IRA is an acronym that stands for (I)ndividual (R)etirement (A)ccount.  The Roth part is named after the Senator that sponsored the bill that created the Roth IRA.  But, what really matters is that it could be really important to your retirement fund building.  So, pay attention to the next few paragraphs.  Do it for the retired version of yourself!

Source: goodfinancialcents.com via Jeff on Pinterest

Why is the Roth IRA so important?

Unlike the other versions of the IRA (Traditional, SEP, SIMPLE, Self-Directed), the Roth gets some special treatment when taxes come into play.  Instead of being a pre-tax contribution, like a 401(k), or a tax deduction contribution, like other IRAs, the Roth is an after tax contribution.  That means that you’ll be taxed on the income before you contribute it to the Roth IRA.  That sounds terrible, doesn’t it?  It’s not.  And here’s why.  All of the gains on the account are tax free.  What that means is that, if you contribute $5,000 today, and gain $45,000 between now and retirement, you don’t pay any taxes on any of it when you start taking withdrawals.  That’s pretty significant.

If you had your money in any of the other retirement accounts, you’d be taxed on the whole $50,000 as you withdraw it.  At your then current tax rate.  While we can’t know what our current tax rate will be when we retire, we do know that one will exist.  Unless you think that your retirement tax rate will be significantly below your current tax rate, you really should consider adding a Roth IRA to your portfolio of retirement accounts.

How should I use a Roth IRA?

Why did I just say “adding a Roth IRA to your portfolio of retirement accounts”?  There’s a couple of reasons.  The biggest one, though is that the Roth has a contribution limit that is a bit low.  As of right now, that limit is $5,000 if you’re under the age of 50, and $6,000 if you’re over the age of 50.  Unless you really think you’ll be able to build a retirement nest egg that will be sufficient on $5k a year (hint: you won’t be able to), you’ll need to supplement with other retirement accounts. If you’ve got a 401(k) offered at your employer, use it.  At the least, contribute enough to get the maximum match from your company.  Once you’ve met the match, use the next $5,000 and put it into a Roth IRA.  (I’ve got mine at Sharebuilder, but just about every investment house does Roth accounts.)  Once you’ve got the full 5k in your Roth, you and your financial planner can decide what the next best idea is.  If you’re happy with your 401(k) and the investments offered in it, you can continue to contribute any further monies into the 401(k).  If you don’t like the 401(k), you might consider some other form of retirement account.  Maybe a traditional IRA.  The traditional doesn’t have the same tax benefit of the Roth.  Taxes are still taken out before you contribution, in most cases, and you get a tax deduction based on those contributions.  Any withdrawals taken after retirement are also taxed.  The contribution limit is the same, however.

How do I structure my retirement?

How your retirement portfolio and where/when of your contributions is very important.  There are tax codes to take into account, as well as changes to the way that you contribute.  Everyone’s retirement situation is very unique to them.  To really get a good handle on all of this, you really should talk to a financial planner who can get a good idea of what your unique situation is, and make suggestions based on that.  It will likely cost you a little bit up front, but the difference could be life changing when it comes time to retire.  (Check out these great tips on finding a great financial planner)

I’m writing this post as part of the Roth IRA Movement.  It’s a great movement, headed up by Jeff Rose of GoodFinancialCents.  He recently discovered that many of our youth are under-educated on what the Roth IRA is.  He’s gathered well over 100 personal finance bloggers (including Beating Broke) and we’re all posting a Roth IRA post today to try and help with educating on the Roth IRA.  You can read all about the movement as well as see a list of all the posts that are/were written as a part of it at Jeff’s Roth IRA Movement post today.  You can also see a list of the posts over at RothIRA.com.

Reader Question: IRAs, 401(k)s, and Dividends

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Reader David left a comment with the following question in it:

Every other mutual fund I have ever owned has at one time or another paid out dividend distributions.This includes funds that I have held on my own, and some that were held in Traditional and Roth IRA’S. Not so with any funds I have had in two 401k plans over the years. Going all the way back in my annual statements I cannot find a single entry for dividend distributions. Do you have any ideas why this might be so and whether or not I would be better off making contributions to an IRA that go above and beyond the company match??

There are several ways that I’ll attempt to answer this.  Keep in mind, I’m not a financial planner, or a financial adviser, so take what I say with a grain of salt.  Perhaps a few of my adviser readers will have slightly better advice, we’ll see. I think there are really two questions there though (I won’t charge you extra.), so let’s break it down a bit.

Dividend Distributions in 401(k) and IRA accounts

401K
Several things could be happening here, but here are the most likely scenarios.  Because of the difference in how a 401(k) and an IRA are handled for taxes, (401(k) is pre-payroll tax while IRA is post-payroll tax) the tax that you would normally pay on a dividend distribution is deferred in a 401(k).  What that means is that the dividend income in a 401(k) doesn’t have to be reported and is usually automatically reinvested.  Depending on the 401(k) provider, dividend income might just be being shown as a capital gain on the fund since that’s what it becomes in this tax scenario.  Another possibility (although somewhat unlikely) is that, like stocks, not all funds will pay a dividend.  The only way to figure that out is to do some research into the individual funds that you own in your 401(k) and determine if they pay a dividend or not.  I like finance.google.com for quick lookups, but the best place would be the website of the fund, or the prospectus for the fund.

Make Contributions to an IRA that go above and beyond the company match

I wanted to tackle this question separately.  First, you should, absolutely, take advantage of your company match to it’s full extent.  If your company will match x% up to y% of your income, you should contribute y% at a minimum.  It’s free money, and I guarantee you the company looks at it as a part of your compensation package.  You wouldn’t leave a paycheck un-cashed would you?  Once you’ve met that amount, several things come into play.  I think the biggest of these is your personal tax situation.  A 401(k) acts as a deferred tax account.  You don’t pay any taxes on your contributions, and then pay taxes (at your then tax rate), on the withdrawals.  With a Roth IRA, you pay taxes on the contributions, but not on the withdrawals.  Let’s say you make a lot of money now, and your tax rate is 35%.  When you retire, you’re no longer making those fat stacks of cash, and your tax rate drops to 25% or less.  You’ll now pay 10% less in taxes on those withdrawals.  Keep in mind that those withdrawals will include any capital gains that the account has accrued over your working career.  In the Roth IRA, you’ve already paid the taxes on contributions at 35%, and you don’t pay any taxes on the withdrawals.  In this scenario (10% drop in tax rate), you’ll need to have managed gains of 10% above your contributions by the time you retire to realize any significant difference.

Another thing to look at, is whether you are able to contribute to the limits.  In 2012, the 401(k) contribution limit is 17,000.  If you’re 50 or older, you can also make an additional “catch-up” contribution of $5,000, for a total of $22,000.  There’s an additional overall limit of $50,000 for employee plus employer contributions.  So, if you make the max contribution, your employer can only contribute the additional amount to $50,000.  For the IRA, the maximum annual contribution is $5,000 (or $6,000 if you’re 50 or older).  There are also some restrictions on how much of the contribution is tax deductible, and how much can be contributed based on income.

The simple suggestion here is that you should contribute to your 401(k) up to the % that the company will match to take full advantage of that added compensation.  Once you’ve hit that %, contribute to an IRA up to the full amount you’re allowed.  Once you’ve hit that contribution limit, invest any additional contributions into your 401(k).  Obviously, it takes a bit of math to figure all of that out, since you won’t likely know whether you’ve hit the max on the IRA without some pre-planning.  But, if you can manage to sock away the $5,000 (or $6,000 if you’re older than 50) into a savings, you can write one check at the beginning of the year as your current year contribution to your IRA, and then take whatever you’re comfortable with out of your paycheck for your 401(k).  Using a tax refund as a boost to the IRA contribution can be helpful (if you get a refund).

That’s a very high level overview of the IRA vs. 401(k) question though, and you really should consult your accountant or a financial adviser on the subject.  There are lots of factors that go into the the tax ramifications of both, and you really want to know as much as you can so that you can adjust your retirement planning accordingly.

I’m sure many of my personal finance friends who know more about the subject than I do will offer their wisdom in the comments, so be sure to check back and see what nuggets they have to offer. 😉

photo credit: urban_data