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July 1, 2003

Straightening Out Your Personal Finances

Many of us purchase and accumulate things over the years, without taking time to clean them out periodically. That applies to our finances as well as to our possessions. How many credit cards do you carry? How many stocks and bonds, brokerage accounts, and Individual Retirement Accounts (IRAs) do you own? It's not just a matter of finding time to keep track of all these different financial assets. Often, these assets are acquired without a clear-cut strategy, so you may own assets with similar investment objectives or that are not compatible with your financial goals. If you sense it's time to straighten out your finances, follow these steps:
  1. Make a list of all your assets and debts. List each one individually, so you have a sense of how many different accounts you're dealing with.

  2. Go through each one of your investments. Make sure you understand why you own each one. Are you really adding diversification to your portfolio or do you have overlapping investments? Assess the prospects of each investment and decide whether you should continue to own it. Don't avoid selling just because of a loss. You may be better off selling that investment at a loss and reinvesting in one with better prospects.

  3. Look for ways to consolidate accounts. Try to get down to one bank account, one brokerage account, and one IRA. This can significantly reduce the time needed to review and reconcile accounts.

  4. Assess your outstanding debts. Do you really need all those credit cards? Consider keeping only one or two cards, so it'll be easier to monitor balances. Look for ways to reduce the cost of your borrowing. Is it time to take another look at refinancing your mortgage?

Teaching Money Basics

Even though it seems like money and financial topics are discussed everywhere, these are not concepts your children will learn automatically. Teaching your children basic money concepts, including the value of saving and investing, can benefit them for a lifetime. Some strategies to help teach these concepts include:
  • Impart money concepts along with the children's allowance. You must decide whether to tie your children's allowance to the performance of chores. Some people feel that doing so instills the concept of working for pay, while others feel chores should be performed without pay as part of a child's family responsibilities. When setting the allowance, make sure the child understands what expenses must be paid with it. The allowance should increase as your children grow older and should be large enough that the children have money left over to make their own purchasing decisions.

  • Provide opportunities to earn extra money. Offer to pay your children for additional chores around the house, so they learn the connection between effort and pay. Once your children start working at a paying job, go over their pay stubs with them, making sure they understand what taxes are deducted for and how much of their pay it represents. Start teaching your children ways to reduce their taxes, such as funding an Individual Retirement Account (IRA) when they become eligible.

  • Allow your child to make financial decisions. You may not agree with the choices your children make, but they should learn from their mistakes. That doesn't mean you can't discuss options with them, but the final decision should be theirs.

  • Encourage your child to save money. Saving for tomorrow rather than spending today is a difficult concept for adults as well as children. Thus, you may need to offer incentives to encourage saving. You may require a certain percentage of your child's allowance be set aside for long-term goals. Or you can match your child's savings, perhaps contributing 50ยข or a dollar for every dollar your child saves.

  • Explain the basics of investing. At an early age, open a bank account for your child, explaining concepts like saving and compound interest. Around age eight or so, explain how businesses operate and how investors buy and sell stocks. As their interest grows, help them purchase stocks with some of their savings. Since minors cannot own stocks, you will need to purchase the stock as custodian for your children. Teach your children how to research a stock, follow its price, review its annual report, and decide when to sell.

  • Encourage your children to take finance courses. Many high schools and colleges offer courses that teach stock basics and personal finance. Encourage your children to take at least one of these courses.

  • Be conscious of the money messages you send to your children. Your children watch your actions closely, so how you treat money will be a significant influence on their views. If you make large purchases only after careful research and price comparisons, your children will learn to be careful before making a purchase. If you use your credit card cautiously and explain how to select a card, what items to charge, and how to pay off the balance every month, your children will learn not to abuse credit cards.

Recharacterizing Your Roth Conversion

The steep market declines of the past three years have made converting from a traditional Individual Retirement Account (IRA) to a Roth IRA more attractive. When you convert, transferred amounts must be included in income if taxable when withdrawn (e.g., contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10% federal income tax penalty. Once the IRA is converted to a Roth IRA, qualified distributions may be taken on a tax-free basis. Thus, converting while values are low allows you to pay a lower tax bill and then withdraw the funds tax free in the future, hopefully after the values have recovered.

To convert, your adjusted gross income (AGI) cannot exceed $100,000 in the conversion year, excluding any conversion amounts. There are many factors to consider before converting, but the ability to pay the tax bill with funds outside the IRA is a major advantage.

To use this strategy effectively, you need to decide when to convert. Taxes are paid based on your investments' values on the conversion date. If those values decline after you convert, you end up paying taxes on more than the current market value.

If you're in that situation, consider recharacterizing your conversion. For conversions made in 2002, you can recharacterize until October 15, 2003, meaning you can convert back to your original traditional IRA. Just make sure not to take possession of the funds. The transfer from the Roth IRA to the traditional IRA should be a trustee-to-trustee transfer. After the recharacterization, it is as if you did not convert, so you owe no taxes.

If you already filed your 2002 tax return and paid the taxes, you may file an amended return to get a refund. You can then reconvert your traditional IRA at a later date, provided your AGI does not exceed $100,000 in the conversion year. The reconversion can be completed at the later of 30 days after the recharacterization or the beginning of the tax year following the first conversion.

You may recharacterize just a portion of the conversion. However, if you have several investments in the IRA, you can't simply choose the ones with the biggest losses for recharacterization. In that situation, a pro-rata portion of all the gains and losses in the account will be considered in the recharacterization.

You can bypass this rule by setting up separate Roth IRAs for each investment. Then, if one declines substantially, you may recharacterize that one Roth IRA account, leaving the other accounts intact.

There are other situations where you might want to recharacterize. You might have converted to a Roth IRA, thinking your income for the year would be less than $100,000. If you later find out your income is over that threshold, you may recharacterize the conversion. Otherwise, in addition to the income taxes due, you would also have to pay a 10% federal income tax penalty and a 6% excise tax.

You may also recharacterize annual IRA contributions. Perhaps you contributed to a traditional IRA, but found out your income is too high. You could then recharacterize to a Roth IRA contribution. Or you may have contributed to a Roth IRA, only to find your income is too high for a Roth contribution. You may recharacterize the contribution as a traditional nondeductible IRA contribution.

Keep Contributing to a Roth IRA

Even if you're retired, consider contributing to a Roth Individual Retirement Account (IRA), provided you have some earned income. Single taxpayers with adjusted gross income (AGI) less than $95,000 and married taxpayers filing jointly with AGI less than $150,000 are eligible to make a nondeductible contribution to a Roth IRA. Contributions are phased out for married taxpayers filing jointly with AGI between $150,000 and $160,000 and for single taxpayers with AGI between $95,000 and $110,000. In 2003, the maximum annual contribution is the lesser of $3,000 ($6,000 for married couples) or earned income. Individuals age 50 and older can make an additional $500 catch-up contribution in 2003. Pension, investment, and rental income are not considered earned income.

Roth IRAs are a flexible way to save for retirement. Contributions can be withdrawn at any time with no tax consequences. Earnings and capital gains may be withdrawn on a tax-free basis if a qualified distribution is made:

  • at least five years after your first contribution, and;

  • after you have attained age 59 1/2, due to death or disability, or to pay up to $10,000 of first-time home buyer expenses.

Other characteristics of a Roth IRA may make it an attractive investment for retirees:

  • You may make contributions as long as you have earned income, no matter what your age. With traditional deductible IRAs, you must stop making contributions when you reach age 70 1/2.

  • Mandatory withdrawals after age 70 1/2 are not required. You can take out as much or as little as you want, whenever you want, after age 59 1/2, as long as the account has been open for five tax years. If you don't need the money, the balance can continue to grow on a potentially tax-free basis.

  • Qualified distributions from Roth IRAs are not included in AGI. Thus, these distributions will not affect income taxation of your Social Security benefits.

  • Roth IRAs can provide a tax-advantaged way to accumulate assets for heirs. Both traditional and Roth IRAs are subject to estate taxes. However, the beneficiaries of a traditional IRA must also pay income taxes on the proceeds, while beneficiaries of a Roth IRA receive qualified amounts income-tax free.

With all the advantages, retirees with earned income should definitely take a look at Roth IRAs.

Another Look at IRA Accounts

You have three choices for Individual Retirement Accounts (IRAs), each with different eligibility requirements and tax laws. In addition, the maximum annual contribution is changing. All this complexity makes it difficult to decide which IRA to select. To help you with that decision, first review the rules for each.
  1. Traditional deductible IRAs. Every year, the lesser of the maximum IRA contribution limit or your earned income can be contributed. Contributions are deductible on your current-year tax return and all earnings are tax deferred until withdrawn. At withdrawal, deductible contributions and earnings are taxed at ordinary income tax rates. Contributions can only be made until the year you reach age 70 1/2, when you must start taking minimum required distributions.

    If you and your spouse aren't participants in a company-sponsored pension plan, you can make deductible contributions regardless of the amount of your adjusted gross income (AGI). A spouse who isn't an active participant can make a contribution even if his/her spouse is a participant, as long as the couple's AGI does not exceed $150,000 to $160,000. Active participants can make deductible contributions as long as their AGI in 2003 is less than $40,000 for single taxpayers and less than $60,000 for married couples filing jointly. Contributions are phased out for married taxpayers filing jointly with AGI between $60,000 and $70,000 (scheduled to gradually increase to $80,000 to $100,000 by 2007) and for single taxpayers with AGI between $40,000 and $50,000 (scheduled to increase to $50,000 to $60,000 by 2005).

  2. Roth IRAs. Contributions are not deductible on your current-year tax return, so contributions are made from after-tax dollars. However, as long as the distribution is qualified, all earnings are withdrawn federal income tax free. Again, the lesser of the maximum contribution limit or your earned income can be contributed every year. Contributions can be made at any age, even past age 70 1/2, and no mandatory withdrawals are required.

    Contributions can be made by single taxpayers with AGI less than $95,000 and married taxpayers filing jointly with AGI less than $150,000. It doesn't matter whether you are a participant in a company-sponsored pension plan. Contributions are phased out for married taxpayers filing jointly with AGI between $150,000 and $160,000 and for single taxpayers with AGI between $95,000 and $110,000.

  3. Traditional nondeductible IRAs. Contributions are not deductible on your current-year tax return, but earnings are tax deferred until withdrawn. At withdrawal, earnings, but not contributions, are taxed at ordinary income tax rates. Contributions must stop at the year you reach age 70 1/2, when you must start taking minimum required distributions. All taxpayers, regardless of income or pension plan participation, can make contributions.


The maximum annual contribution will increase from $3,000 in 2003 to $4,000 in 2005 to $5,000 in 2008, with adjustments for inflation after that. Individuals age 50 and over can make additional catch-up contributions of $500 in 2003 to 2005 and $1,000 starting in 2006. Based on current tax law, however, those limits will go back to $2,000 in 2011 unless further legislation is passed.


With all three types of IRAs, you may make withdrawals without penalty starting at age 59 1/2 (with a Roth IRA, the distribution must also be made at least five tax years after your first contribution to also not be subject to income tax). Withdrawals before age 59 1/2 are assessed a 10% federal income tax penalty in addition to any income taxes, unless the distribution is made:
  1. due to death
  2. due to disability
  3. in annual withdrawals in substantially equal amounts over your life expectancy or the life expectancy of you and your beneficiary
  4. for deductible medical expenses in excess of 7.5% of AGI
  5. to pay medical insurance when a person has received unemployment compensation provided certain conditions are met
  6. to pay up to $10,000 of qualified first-time home buyer expenses
  7. to pay for qualified higher education expenses

In addition, for Roth IRAs, income taxes will be assessed on earnings if withdrawals are made for items 3, 4, 5, or 6. You may withdraw Roth IRA contributions at any time with no penalties or income taxes assessed.

Which IRA should you choose?

With so many different rules, it can be difficult to decide which alternative to select. Consider these points:
  • A Roth IRA is always a better alternative than a traditional nondeductible IRA. While both have nondeductible contributions, qualified distributions from a Roth IRA are federal income tax free, while taxes must be paid on the earnings in a nondeductible IRA.

  • When deciding between a traditional deductible IRA and a Roth IRA, consider your current marginal income tax bracket and your expected bracket at withdrawal. If your marginal tax bracket will be the same at both times, either IRA will produce a similar result. Declining marginal tax rates may make a deductible IRA a better alternative, while increasing marginal tax rates may make the Roth IRA a better alternative.

  • If you can make the maximum IRA contribution to a Roth IRA, this will result in a larger after-tax balance than making maximum contributions to a deductible IRA. This result occurs because you are essentially funding the tax bill with funds outside the Roth IRA. With the traditional deductible IRA, income taxes are assessed on the IRA assets. To offset the Roth IRA's advantage, you would also have to invest the tax savings from your traditional IRA contribution.

  • Some of the Roth IRA's features may make it a good option for you. If you don't think you'll need to make withdrawals after age 70 1/2, the Roth IRA can continue to grow on a tax-free basis. Or, if you may need your contributions before age 59 1/2, you may withdraw Roth IRA contributions at any time with no tax consequences.


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