Friends who are 70 1/2 are receiving their minimum distribution and investing each year in a Roth IRA even though they don't have any earned income. Can I do this?
-- Patricia Kunkel, Cleveland
You need earned income to contribute to a Roth individual retirement account, but your friends may be doing something a little different, said Julie Schatz, a financial planner with Investor's Capital Management Inc. in Menlo Park, Calif.
They may be withdrawing funds from a 401(k) or traditional IRA to satisfy their required minimum distributions and paying the tax on that money, then withdrawing even more from their accounts, paying the owed income tax and converting that additional money to a Roth account, which is legal, she said.
If they are putting their required minimum distributions directly into a Roth, that is against the rules, Schatz said. They could be subject to a 6 percent penalty for making excess contributions for every year the problem goes uncorrected, in addition to having to pull out those contributions and their earnings, Schatz said.
Few, if any, investment professionals seem to offer any risk/benefit advice on tax-free bonds. Being risk averse, I have no stocks but am heavily invested in Maryland AAA bonds. So far, I sleep very well during ups and downs in the markets, and since I only sell at time of maturity, I collect interest and my principal. I have also purchased non-AMT bonds. Will the interest on these bonds be taxed? What increased risks would be applicable to Maryland tax-free bondholders during a recession or depression?
-- Donald Doll, Sykesville, Md. You're right, stocks and mutual funds, even bond funds, receive a lot more attention than direct investments in bonds held to maturity.
As to your specific issues about your portfolio and risk tolerance in an economic downturn, there is a risk in having so much of your nest egg riding on one state's debt.
That is the concern expressed by Josh Gonze, an associate portfolio manager with Thornburg Investment Management Inc. in Santa Fe, Calif. Gonze's firm specializes in issues surrounding the alternative minimum tax, and he has written several journal articles about the topic, including one dealing with municipal bonds for the Journal of Financial Planning at www.fpanet. org/journal/BetweenTheIssues/Contributions/111501.cfm.
Although the earnings on tax-free bonds must be reported, it is not included in taxable income, Gonze said. And because you did not seek out mortgage-related bonds specifically, your overall risk in generalized bond categories shouldn't be a problem, he said.
As for your alternative-minimum-tax-exempt bonds, those are taxable only if you already fall into the AMT without that income, Gonze said.
But Gonze said other bond investors should check their AMT exposure within their tax-exempt bond holdings because the alternative tax system does loom large for high-bracket bondholders. Money market funds in particular often have a large portion of investments that are snagged under the AMT, he said.
"He has a great deal of exposure to the Maryland economy, perhaps because he is attempting to avoid taxes on other states' bonds," Gonze said.
But remember to look at the total picture: Comparatively, Maryland can be an expensive place to buy bonds because of their relatively low yields. It may work out better to buy another state's bonds for higher yield and pay the tax, he said.
A note on retirement calculators:
A recent column that dealt with the issue of life-expectancy calculations in portfolio planning drew several questions about why $500,000 might not last 20 years at a spending rate of $25,000 annually.
One reader, for example, asked why it wouldn't last a lifetime if the investor put all the money in an insured certificate of deposit that earned at least 5 percent, or $25,000, every year.
In our example, we used a T. Rowe Price calculator (www3. troweprice.com/ric/RIC) on a portfolio that was invested 60 percent in stocks and 40 percent in bonds and cash. The calculator then runs the portfolio through many potential market scenarios, known as a Monte Carlo simulation, arriving at a confidence level for not exhausting the funds.
The trade-off between investing in a CD and the stocks/bonds portfolio is that over 20 years the guaranteed withdrawal of $25,000 will be worth less and less because of inflation. In the simulations with the stock/bond portfolio, the calculator assumes a 3 percent annual inflation figure, showing investors the likelihood they can withdraw enough money to maintain the buying power of $25,000 today.