Things to weigh with Simple IRA
Q. My girlfriend works for a small company that just started a Simple IRA offering a terrible selection of mutual funds. The least awful has a 3 percent front-end load and 0.73 percent expense ratio. Should she invest in this or put her money into low-fee funds in an ordinary taxable account?
A. A Simple IRA is a retirement account that can be offered by employers with 100 or fewer workers. They work sort of like 401(k)s, allowing both employer and employee to deduct contributions on their federal income tax returns.
As with 401(k)s and traditional IRAs, withdrawals are taxed as income, and there's generally a 10 percent penalty for withdrawals before the account holder is 59 1/2.
In a Simple IRA, the employer must, at a minimum, match participants' contributions up to 3 percent of the employee's annual pay. Or the employer can put in 2 percent of annual pay for all employees, even those who don't contribute themselves.
Some bosses let each employee choose a brokerage, bank or mutual fund company at which to establish an account.
Others, such as your girlfriend's, choose the provider and investment options. Fortunately, the rules allow employees to transfer money from Simple IRAs to traditional IRAs, but not until it's been in the Simple plan for two years.
Pros and cons
A transfer would solve one problem -- the long-term damage from that high 0.73 percent annual expense ratio.
But a transfer would not solve the bigger problem -- the onerous 3 percent front-end load, a sales charge that takes 3 of ever 100 she invests.
So she's losing the whole value of her employer's contribution. That's really unnecessary because there are thousands of excellent funds that charge no loads at all.
She and her co-workers could ask the boss to improve the plan, or to allow each worker to select his or her own provider. But what if the answer is no?
I'd probably stick with the Simple IRA, anyway -- assuming that, fees aside, its funds look like decent investments. Then I'd transfer to better investments after two years.
The reason? Your friend would still get a valuable income-tax deduction on her contributions, which this year can be as large as 10,000, or 12,500 for people over 50.
Other IRA options
She could instead set up a traditional IRA at any financial institution she preferred. This might provide better investment choices with lower fees, and she might be eligible for an income tax deduction on her contributions if her income is less than 50,000. But the maximum IRA contribution is just 4,000 this year, or 5,000 for people over 50.
Another option: Set up a Roth IRA on her own at any financial institution she likes. Individuals can make 4,000 or 5,000 annual contributions to Roth's if annual income is below 95,000. There is no income tax deduction on Roth contributions, but there also is no tax on principal and investment gains withdrawn later.
Finally, there is the option you mention of rejecting the Simple IRA in favor of an ordinary taxable account. This would give your girlfriend complete control, though there would be no tax deduction on contributions.
If she chooses investments that provide most of their returns through capital gains, such as mutual funds owning stocks, she might pay less tax on future withdrawals than if she took the same amount from a Simple IRA. That's because long-term capital gains in a taxable account are taxed at no more than 15 percent, while Simple IRA withdrawals are taxed as income as high as 35 percent.
This complicated decision can be made easier with some free calculators offered on the Web at www.dinkytown.net.
First look at the Mutual Fund Expense Calculator to see how fees damage returns. Then use the Taxable vs. Tax Advantaged Investments Calculator to see which option would work best given your girlfriend's age, income and investing goals.
Jeff Brown is a business columnist for The Philadelphia Inquirer. E-mail him at firstname.lastname@example.org.