Personal Finance Q & A

Mixing those IRAs Is Asking for Audit

Question - I currently have two IRAs. One was started years ago with tax-deferred money. The other contains contributions made with after-tax money. Should these two accounts ever be combined? Or would that greatly complicate my tax situation when it came time to withdraw these funds?

- J.W., Arlington, Va.

Answer - Only mingle assets of tax-deferred and after-tax money in the same individual retirement account (IRA) if you have a deep hankering to meet an Internal Revenue Service tax auditor. "Keep the two accounts entirely separate," says Porter Pierpont Morgan, investment strategist at Liberty Financial Companies in Boston. Paper-work and tax requirements are totally different on the two IRAs.

If you mix the accounts together, you'll face complex calculations during retirement to determine what portion of each dollar you withdraw is tax free.

Even with separate accounts, retain all written records. In the tax-deferred accounts, when you cash out you will have to pay taxes on both contributions and the earnings. In the after-tax IRA, you have already paid taxes on the contributions. But you will still owe taxes on earnings.

Question - I'm employed at a nonprofit corporation that has a retirement plan of the 403(b) type. I hear that nonprofit businesses are now allowed to switch to 401(k) plans. What might be an advantage? Should I urge my employer to switch?

- W.P., San Diego

Answer - "Not necessarily," says Martha Priddy Patterson, a benefits expert at accounting/consulting firm KPMG Peat Marwick LLP in Washington. "Each company must compare the differences in the two plans on a case-by-case basis," she says. Moreover, a number of major distinctions between 403(b) plans and the 401(k) plans used by for-profit companies have been removed.

For example, companies with 403(b) plans may now allow their employees to change their benefit levels more than once a year. That has been allowed under 401(k) plans, but not under 403(b) plans. One advantage of 403(b) plans that continues into this year: They have certain "catch-up" provisions, says Patterson, that occasionally allow employees to salt away a little extra above their mandated caps on savings, such as before retirement. You can't do that under 401(k) rules.

Also, 403(b) plans may be "less limiting for higher-paid employees." she says, since they are not restricted by what fellow employees contribute. With 401(k) plans, executives face contribution caps based on how much lower-paid employees put in. One option, says Patterson, is for nonprofit companies to use both types of plans, but for different types of employees, depending on who is most benefited.

Question - I own shares of several large Fidelity funds, including Growth & Income. It's up so far this year, but not as much as the S&P 500 stock index. Would I do better by shifting money into smaller funds that don't have billions of dollars in assets?

- Y.E., Boston

Answer - That's a question on a lot of minds these days. Fidelity has gotten some bad publicity because its equity funds have generally failed to beat the market lately. This is disappointing to investors who have come to expect so much from Fidelity. But it's not surprising; few fund managers beat the indexes.

Small, young funds may have a better chance of outperforming, because they're nimble.

"A new fund run by a savvy, sharp, experienced portfolio manager in a good area is a gangbuster investment," says Jay Schabacker, editor of Mutual Fund Investing. "With new ideas ... he can invest as his heart desires."

But he notes that if a fund is small in assets and five years old or so, you might be concerned: Why hasn't the fund attracted more money?

In thinking about a switch, though, you should consider your investment aims. A growth-and-income fund can be a good core holding, because it will likely hold large, safe companies that can weather downturns better than small ones. The top smaller funds often invest with more aggressive strategies. One option for you, experts say, may be an S&P 500 index fund, as a sure way to follow the market, plus some new funds you think will be hot.

* Please send your questions on personal finance to Guy Halverson, at The Christian Science Monitor, 500 Fifth Avenue, Suite 1850, New York, NY 10110. Or send electronic mail to: halversong@csps.com.