Let your retirement money grow

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Retirement 101

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Ultimate Guide to Retirement

• Getting started
• 401(k)s & company plans
• Investing
• Annuities
• IRAs
• Self-employment plans
• Pensions and benefit plans
• Social Security
• Insurance
• Estate planning
• Living in retirement
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NEW YORK (Money) -- Question: I've reached the age where I've got to start taking mandatory withdrawals from my retirement accounts. I don't need the money, so I'm wondering where I can stash it to earn more gains and possibly get some tax advantages as well. Any suggestions? --Joe, Redondo Beach, Calif.

Answer: Before I get to the issue of where to invest withdrawals you don't want to spend, let me first tell you that you and others in your position are in luck this year.

Normally, anyone who is 70 1/2 or older has to make minimum annual withdrawals from tax-deferred retirement accounts like IRAs and 401(k)s based on their remaining life expectancy as laid out in IRS tables (although if you're still working you don't have to pull money out of your retirement plan with your current employer).

Fail to do so, and you'll be whacked with a penalty equal to 50% of the shortfall, or the difference between what you should have withdrawn and what you did.

But you've got a reprieve for 2009. In December, Congress passed and the president signed the Worker, Retiree, and Employer Recovery Act of 2008. Among other things, this law waives required minimum distributions (RMDs) for 2009.

Congress enacted this legislation so that retirees (as well as people who have inherited retirement accounts) won't be forced to pull money out of tax-advantaged retirement accounts at a time when balances have been ravaged by the financial crisis.

But this relief is good for only one year. Unless Congress decides to extend the waiver, you'll have to start making RMDs again for 2010 and beyond. (If you turned 70 1/2 in 2008 and elected to postpone your first RMD until April 1, 2009, you still have to make that withdrawal.)

So the upshot is that you don't have to make 2009 withdrawals from your 401(k), IRA or other retirement plan if you don't want to.

Well, let me start with what you might be tempted to do with the money but can't.

If you've taken an RMD from a former employer's 401(k), you can't just put the money back into the plan. That's a no-no. Similarly, you can't simply take the RMD from a traditional IRA and then slip it back in by making a contribution to that IRA or by opening a new traditional IRA and contributing to it. Starting in the year you turn 70 1/2, you're no longer eligible to make contributions to a traditional IRA.

You might, however, be able to plow at least some of your RMD into a Roth IRA. Unlike a traditional IRA, a Roth has no age limit for contributions. And you're not required to make withdrawals from a Roth either. This year, you can contribute up to $6,000 to a Roth if you're 50 or older. If you're married, you may also be able to invest another $6,000 in a Roth IRA for your spouse. And as long as you do it by April 15th, you can also make a contribution to a Roth IRA and have it count for the 2008 tax year (the max is the same as for this year).

In order to make a Roth contribution, however, you or your spouse must have earned income that equals or exceeds the amount you contribute. And I mean "earned" - i.e., income from work (alimony can count also). Social Security, pension payments and withdrawals from retirement accounts don't qualify.

You must also meet the income eligibility rules for Roth IRAs for the tax year the contribution applies to.

Of course, if you do this, you're not actually transferring your RMD into a Roth; you're making an annual Roth contribution from earned income. Your required distribution is still subject to income tax. But once your money is in the Roth any gains it racks up aren't taxed. And assuming you meet the withdrawal requirements, you can withdraw your contributions and earnings from the Roth tax free.

Otherwise, you're pretty much relegated to investing your required withdrawals in taxable accounts. Even so, you may at least be able to minimize the taxes you owe on investment gains by investing in tax-efficient vehicles such as index funds, tax-managed funds and ETFs.

If you're really intent on avoiding RMDs, there is another strategy you might consider: convert some of your 401(k) or IRA to a Roth IRA. Since Roth IRAs have no minimum withdrawal requirement, you can let your money sit in the Roth as long as you like.

Remember, though, you'll have to pay income tax on the amount of the conversion. That means you'll be paying tax on money in your 401(k) or IRA today instead of paying it later, as you would if you just take your RMDs each year. Or to put it another way, by converting you're avoiding the RMD, but not income taxes on the RMD.

That strategy could backfire if it you pay a higher tax rate at conversion than you would face when you eventually pull the money out of your Roth IRA. So I don't think a conversion is something anyone, especially an older person, should take lightly. At the very least, you'll want to run a few scenarios on a Roth conversion calculator or perhaps talk to an adviser before taking such a step.

That said, a conversion can have other advantages. Unlike withdrawals from 401(k)s and regular IRAs, the money you pull from a Roth doesn't count in determining whether your Social Security benefits are taxable. And if you're sure you won't need the money in your 401(k) or IRA to pay for living expenses, converting to a Roth is a way to provide an income-tax-free legacy to your heirs, if that's want you want to do.

One final note: if you do choose to reinvest your RMDs or convert funds to a Roth, make sure that the investments you choose make sense given your financial circumstances and retirement prospects.

If you're really confident you won't need this money during your lifetime, then you can at least consider putting some of it into growth-oriented investments such as stock funds.

But if you're not so sure, then you'll want to take a more conservative approach and invest, at least primarily, in more stable investments - short-term bond funds, money-market funds, CDs and the like. After all, if it turns out you do need the money, you want as much as possible of it to be there.

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