Even if Americans never get the option of investing some of their Social Security tax money, the idea has certainly stirred up some heated debate on the issue of retirement investing. Specifically, where should retirement investment savings belong?!
The accepted wisdom is that retirement investing should be in the stock market, because that's where you can expect to earn the highest returns in the long term. But some financial experts say that's a dangerous assumption rooted in investors' recent historical experience — an experience that may tell us nothing about the future, they say.
President Bush, who is championing the idea of diverting a share of Social Security payroll taxes into private accounts, said at a forum on the subject that Americans should be able to harness "the power of the capital markets" to boost their retirement income. That certainly sounded like an endorsement of the stock market's long-term promise.
Personal retirement financial planning and retirement investing advice is not hard to come by. However, personal retirement investing advice that works for you and that you can understand IS hard to come by. Retirement calculators are good forecasting tools available when it comes to planning for retirement – however they are extremely limited in their scope.
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Few retirement investors really understand the plans available, despite the critical function they fulfill in our lives. To help increase that understanding, here is an overview of those retirement plans that are most common. It also provides a few definitions along the way, too, to help clarify some of the terminology used in discussing these plans.
Qualified Retirement Plan.
A qualified retirement plan is one that meets the numerous requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). Plans meeting these requirements qualify for four important tax benefits.
First, employers may deduct allowable contributions in the year they were made on behalf of plan participants. Second, plan participants may exclude contributions and all earnings thereon from their taxable income until the year they are withdrawn. Third, earnings on the funds held by the plan's trust are not taxed to that trust. And fourth, many times participants and/or beneficiaries may further delay taxation on a plan's benefits by transferring those amounts into another tax-deferred vehicle such as an Individual Retirement Arrangement (IRA).
A qualified retirement plan falls into one of three general categories: A defined benefit plan, a defined contribution plan, or a hybrid plan. A hybrid plan is one that combines various attributes of the first two categories, which are discussed below.
Nonqualified Retirement Plan. A nonqualified retirement plan is one that does not meet the requirements of the IRC or ERISA. These plans may be discriminatory in their application and are typically used to provide deferred compensation to key personnel. Because these plans allow a broader flexibility to the employer, they do not receive the same favorable tax treatment as that permitted qualified plans. Employers receive no tax deduction until the employee receives proceeds from the plan. Except for a governmental 457 plan as discussed later, on receipt, the proceeds of a nonqualified plan are taxed to the employees and are ineligible for transfer to an IRA. In some situations the employee may face immediate taxation on the benefit even when the funds will not be received until much later in the future.
Defined Benefit Plan. A defined benefit plan is the traditional company pension plan. It is so called because the ultimate retirement benefit is definite and determinable as a dollar amount or as a percentage of wages. To determine these amounts, defined benefit plans usually base the benefit calculation on a combination of years of employment, wages, and/or age. These plans are funded entirely by the employer, and the responsibility for the payment of the benefit and all risk on monies invested to fund that benefit rests with the employer.
Benefits typically are not payable until normal retirement age and usually are paid in the form of a lifetime annuity. Nevertheless, a large minority of plans permits lump sum payments at retirement. Monies received as a lifetime annuity will be taxed at ordinary income tax rates and are ineligible for rollover to an IRA. Lump sum payments may be transferred to an IRA to defer immediate taxation. On transfer to an IRA, the proceeds are subject to IRA rules and regulations.
Five-year forward income averaging for lump sum payments was eliminated as of January 1, 2000. However, persons born December 31, 1936 or earlier retain the option to use 10-year forward averaging based on 1986 tax rates and to use the 20% long-term capital gains rate on benefits attributable to service prior to 1974.
Under normal circumstances you may not take money from a retirement plan free of an early withdrawal penalty unless you are age 59 1/2. But that's not always true. If you leave your job in the year you reach age 55, you may take your qualified retirement plan benefits from that job free of any early withdrawal penalty. You must, though, pay ordinary income taxes on any money not transferred to a traditional IRA.
People younger than 55 who receive qualified retirement plan benefits as income in a form other than a lifetime annuity are subject to an excise tax based on a premature distribution from that plan. The excise tax will continue until the retiree reaches age 59 1/2. If you're in this unfortunate camp, you'll be taxed on that benefit at ordinary rates and will be assessed an additional 10% of that sum as an early distribution penalty as well. Care to rethink that plan about retiring at age 50?
Defined Contribution Plan. A defined contribution plan is a qualified retirement plan in which the contribution is defined, but the ultimate benefit to be paid is not. In such plans, each participant has an individual account. The benefit at retirement depends on the amounts contributed and on the investment performance of that account through the years. In such plans, the investment risk may rest solely with the employee because of the opportunity to choose from a number of investment options. These plans take many forms and are known by various names such as money purchase, profit sharing, 401(k), or 403(b) plans.
At retirement, defined contribution plan benefits are typically paid in installments or as a lump sum; however, they may also be paid as an annuity. Income tax ramifications and rollover options are the same as those described above for defined benefit plans. Installment payments for a period of less than 10 years are eligible for transfer to an IRA, while those lasting for a period of 10 years or more are not.
Individual Retirement Arrangement (IRA). An Individual Retirement Arrangement (IRA), commonly called an Individual Retirement Account, is a personal retirement savings plan available to anyone, regardless of age, who receives taxable compensation during the year. For IRA contribution purposes, compensation includes wages, salaries, fees, tips, bonuses, commissions, taxable alimony, and separate maintenance payments.
Husbands and wives may each have an IRA, even if one person in that marriage is not working. A person's annual contribution, whether made to just one or to multiple IRAs, is limited to the lesser of total taxable compensation or to the normal yearly amount shown in the following table. Persons age 50 or older may make an additional catch-up contribution in the amount indicated for the year concerned.
There is no minimum or required IRA contribution, and all earnings on the amounts in an IRA are untaxed until withdrawn. In the case of the Roth IRA, withdrawals may even be tax-free provided certain minimum rules discussed later are met.
Contributions to a Roth IRA are never tax-deductible. Contributions to a traditional IRA may or may not be deductible in the tax year made, depending on the owner's income tax filing status, Adjusted Gross Income (AGI), and eligibility to participate in a tax-qualified retirement plan through employment. If the traditional IRA owner participates in an employer's qualified retirement plan on any day in the tax year, the deductibility of contributions declines to zero between certain AGI ranges as shown in the following
A working spouse not covered by a retirement plan through employment may make a tax-deductible contribution to an IRA despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150,000, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160,000.
Money may be withdrawn from an IRA at any time, but on withdrawal it may be taxed and/or penalized. Withdrawals from a traditional IRA will always be taxed, either in whole or in part, at ordinary income tax rates. Except as noted below, withdrawals from a traditional IRA prior to age 59 1/2 will result in a 10% excise tax as well as an ordinary income tax. The potential income taxes and early withdrawal penalties on Roth and Education IRAs (now known as Coverdell Education Savings Accounts) are discussed below.
If nondeductible contributions were made to a traditional IRA, part of any withdrawal from that IRA will not be taxed. The calculations for deriving the taxable and nontaxable part of the withdrawal are too complicated to cover here. For those who may face this problem, the IRS has a handy-dandy way to make that calculation. It's called Form 8606, a tax document that must be completed and filed with your income tax return to report both nondeductible traditional IRA contributions and withdrawals whenever they occur.
Mandatory distributions for traditional IRAs must begin no later than April 1 of the year following the year the IRA owner reaches age 70 1/2. Failure to take required minimum distributions at that age results in a 50% excise tax on the amounts not distributed. Roth IRAs have no mandatory distribution requirement, but Education IRAs do as discussed below.
There are eight exceptions to the 10% penalty for IRA withdrawals prior to age 59 1/2. The early withdrawal penalty does not apply to distributions that:
1. Occur because of the IRA owner's disability.
2. Occur because of the IRA owner's death.
3. Are a series of "substantially equal periodic
payments" made over the life expectancy of the
IRA owner.
4. Are used to pay for unreimbursed medical
expenses that exceed 7 1/2% of adjusted gross
income (AGI).
5. Are used to pay medical insurance premiums
after the IRA owner has received unemployment
compensation for more than 12 weeks.
6. Are used to pay the costs of a first-time
home purchase (subject to a lifetime limit of
$10,000).
7. Are used to pay for the qualified expenses of
higher education for the IRA owner and/or
eligible family members.
8. Are used to pay back taxes because of an
Internal Revenue Service levy placed against the
IRA. |
Except as noted in the later discussions on Roth and Education IRA (Coverdell) distributions, ordinary income taxes are still due and payable on IRA withdrawals taken under any of the above exceptions.
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There are 11 types of IRAs:
1. An Individual Retirement Account Account is either a traditional or Roth IRA set up with a financial institution like a bank, broker, or mutual fund in which contributions may be invested in many types of securities such as stocks, bonds, money markets, CDs, etc.
2. An Individual Retirement Annuity is either a traditional or Roth IRA set up with a life insurance company through the purchase of a special annuity contract.
3. An Employer and Employee Association Trust Account, or Group IRA, is a traditional IRA set up by employers, unions, and other employee associations for employees or members.
4. A Simplified Employee Pension (SEP-IRA) is a traditional IRA set up by an employer for a firm's employees. An employer may contribute up to $30,000 or 15% of an employee's compensation annually to each employee's IRA. (See SEP)
5. A Savings Incentive Match Plan for Employees IRA (SIMPLE-IRA) ) is a traditional IRA set up by a small employer for a firm's employees. The employer sponsoring the SIMPLE will make a matching contribution based on a percentage of the employee's pay. (See SIMPLE)
6. A Spousal IRA is either a traditional or Roth IRA funded by a married taxpayer in the name of his or her spouse who has less than the maximum allowable annual contribution limit in annual compensation. The couple must file a joint tax return for the year of contribution. The working spouse may contribute up to the maximum allowable annual contribution limit per year to both the Spousal IRA and to his or her own IRA as well.
7. A Rollover (Conduit) IRA is a traditional IRA set up by an individual to receive a distribution from a qualified retirement plan. Distributions transferred to a rollover IRA are not subject to any contribution limits. Additionally, the distribution may be eligible for subsequent transfer into a qualified retirement plan available through a new employer.
8. An Inherited IRA IRA is either a traditional or a Roth IRA acquired by a beneficiary who is not the spouse of a deceased IRA owner. Special rules apply to an inherited IRA. A tax deduction is not allowed for contributions to this IRA, a rollover to or from another IRA owned by the heir is not permitted, and the proceeds must be distributed and taxed within a specific period as established by the Internal Revenue Code. When the owner dies, the beneficiary must receive distribution of the inherited IRA by December 31 of the fifth year following the owner's death. Alternatively, the IRA may be paid as an annuity or in installments payable over a period not extending beyond the beneficiary's life expectancy. If the owner dies without naming an IRA beneficiary but before taking minimum required distributions (MRD) at age 70 1/2, then the IRA would have to be paid out to the deceased's estate by December 31 of the fifth year following the year of death. If the owner dies without naming a beneficiary but after MRDs have begun, then the account may be paid to the estate over time, based on the deceased's life expectancy as calculated in the year of death. That life expectancy would be reduced by one in each subsequent year to calculate that year's payout.
9. An Education IRA (EIRA), now called the Coverdell Education Savings Account (ESA), is an account established to provide funds that will allow a beneficiary to attend a program of higher education. There is no tax deduction allowed for the contribution, but all deposits and earnings may be withdrawn free of tax and penalties if used to pay for the costs of higher education. Beginning in 2002, Coverdell ESA proceeds may also be used free of tax and penalty to pay for the qualified expenses for kindergarten through 12th grade education in public, private, and/or religious schools. Contributions may be made regardless of the beneficiary's income, but cannot be made on or after the beneficiary's age 18. If distributions exceed the education expenses, the earnings must be included ratably in gross income and are subject to the 10% excise tax to the extent of the excess. Contributions begin to phase out at $150K for joint filers and $95K for single filers. The EIRA, if unused on or before age 30, may be transferred to another qualifying family member as the new beneficiary for educational use. Such transfers must occur before the beneficiary reaches age 30.
10. A Traditional IRA is the term for a regular IRA available to those under age 70 1/2 who have earned income (i.e., job compensation). Earnings within the traditional IRA grow tax-deferred until withdrawal. Withdrawals must begin, and will be taxed, when the owner reaches age 70 1/2. If required distributions are not taken at that age, a 50% penalty will be assessed on the amount not taken. When made, contributions may or may not be tax deductible. If a traditional IRA owner participates in an employer's qualified retirement plan on any day in the tax year, the deductibility of contributions declines to zero between certain AGI ranges as outlined in the deductibility table shown above. A working spouse not covered by a retirement plan through employment may make a tax-deductible contribution to a traditional IRA of up to the applicable annual limit shown in the above table despite the other spouse's coverage under an employer-provided retirement plan. When the couple's AGI reaches $150,000, deductibility for such contributions begins to decline, and it reaches zero at a joint AGI of $160,000.
11. A Roth IRA is one in which:
1. Contributions to the account are not deductible.
2. "Qualified" distributions (i.e., withdrawals) from the account are not taxable; and
3. Earnings on the account are taxable and subject to an early withdrawal penalty only when a withdrawal is not a "qualified" distribution. |
A "qualified" distribution from a Roth IRA is a withdrawal that meets one or more of the following:
4. Made after the taxpayer attains age 59 1/2.
5. Made to a beneficiary after the taxpayer's death.
6. Made because the taxpayer is disabled.
7. Made by a first-time homebuyer to acquire a principal residence. |
No withdrawal except those attributable to previously taxed contributions will be a qualified distribution unless it is made after the five-taxable-year period beginning with the tax year in which the taxpayer first contributed to a Roth IRA.
Annual contributions to a Roth IRA are subject to the contribution limits as shown in the above table, as reduced by any contribution made to a traditional IRA. Contributions to a Roth IRA may be made even after the owner reaches age 70 1/2. The annual contribution limit is phased out as AGI increases from $150,000 to $160,000 (married filing jointly) or $95,000 to $110,000 (single filer).
Amounts in traditional IRAs may be transferred to Roth IRAs provided the taxpayer's AGI (married or single) for the transfer year is $100,000 or less. Transferred amounts must be included in that year's income, but the money transferred will be exempt from the 10% excise tax for a withdrawal prior to age 59 1/2. No withdrawal allocable to earnings on the transferred amounts is considered to be a qualified distribution unless it is made more than five tax years after the transfer. |
Further details on IRA
provisions may be found in IRS Publication
590, Individual Retirement Arrangements.
This publication may be obtained at no
cost by calling 1-800-TAX-FORM.
Profit-Sharing
Plan. Originally designed to encourage
productivity and to reward employees
with part of a firm's annual profits,
today employers may make contributions
even when the business earns no profits
in the year; however, no contribution
by the employer is required during a
profitable year. These plans are often
coupled with a 401(k) arrangement to
allow voluntary pre-tax contributions
by employees from their wages. Contributions
and earnings accumulate tax free until
withdrawn by the participant.
Money Purchase Plan. Also a qualified
defined contribution plan, a money purchase
plan is one in which the employer is
required to make an annual contribution
to each employee's account regardless
of the firm's profitability for the year.
Contributions are usually specified as
a percentage of annual compensation.
Contributions and earnings accumulate
tax-free until withdrawn by the participant.
Cash Balance Plan. While technically
a defined benefit plan, a cash balance
plan is actually a hybrid plan. In such
plans, the employer credits the participant's
account with a "pay credit" (such as 5% of compensation from his or her employer) and an "interest credit" (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
When a participant becomes entitled to
receive benefits under a cash balance
plan, the benefits that are received
are defined in terms of an account balance.
For example, assume that a participant
has an account balance of $100,000 when
he or she reaches age 65. If the participant
decides to retire at that time, he or
she would have the right to an annuity.
Such an annuity might be approximately
$10,000 per year for life. In many cash
balance plans, however, the participant
could instead choose (with consent from
his or her spouse) to take a lump sum
benefit equal to the $100,000 account
balance.
In addition to generally permitting participants
to take their benefits as lump sum benefits
at retirement, cash balance plans often
permit vested participants to choose
(with consent from their spouses) to
receive their accrued benefits in lump
sums if they terminate employment prior
to retirement age.
Target Benefit Plan. While technically
a defined contribution plan, a target
benefit plan is actually a hybrid plan.
In such plans, the employer sets a target
benefit for employees. Each year contributions
are made to the employee's account based
on actuarial assumptions that project
the annual funding needed to reach that
benefit. In that sense, the target benefit
plan mimics a defined benefit plan. However,
the actual earnings on the individual
accounts may differ from the estimated
earnings used in the assumptions. Thus,
because the benefit actually received
cannot be determined in advance, the
target benefit plan is like a defined
contribution plan. Regardless, contributions
and earnings accumulate tax free until
withdrawn by the participant.
Employee Stock Ownership Plan (ESOP).
An ESOP is a qualified defined contribution
plan in which the assets are invested
mostly in qualifying employer stock.
Usually, purchases of this stock are
funded by employer contributions made
to the plan based on total employee compensation.
The plan may permit purchase of stock
by employees as a plan option. When combined
with a 401(k) plan, an ESOP is sometimes
called a KSOP. On leaving the firm through
separation or retirement, the participant
will receive all vested interests in
the form of the actual shares in the
account. Alternatively, he or she may
demand a cash distribution in lieu of
the shares.
401(k) Plan. Also known as a cash or
deferred arrangement (CODA) plan, a 401(k)
is a qualified defined contribution plan
that takes its name from the section
of the Internal Revenue Code that prescribes
the rules under which it operates. It
is a retirement plan in which an employer
permits an employee to defer receipt
of part of his or her compensation by
contributing that part to his or her
account in the 401(k) plan. Deferred
contributions are made on a pre-tax basis,
and those contributions and all earnings
remain untaxed until withdrawn from the
plan. The 401(k) may permit voluntary,
after-tax contributions by employees.
Earnings on after-tax contributions accumulate
tax free until withdrawn.
Many 401(k) plans include a matching
contribution from the employer according
to a set formula (e.g., 50% of the employee's
contribution up to a maximum of 6% of
compensation). Employers may also make
contributions to an employee's account
independent of the employee's contribution,
and these contributions may be tied to
a firm's profits as part of a profit
sharing plan
A 401(k) plan generally offers participants
an opportunity to direct their account
contributions to a broad range of investment
options from conservative risk to aggressive
risk. These options may include institutional
or mutual funds investing in the money
market, bond market, or stock market;
annuities; guaranteed investment contracts
(GICs); company stock; and self-directed
brokerage accounts. A typical plan will
offer a selection of a money market fund,
a bond fund, and a stock fund.
In general, a 401(k) plan limits withdrawals
of assets to five occasions: Termination
from employment, disability, reaching
the age of 59 1/2, retirement, and death.
Additionally, the plan may optionally
include provisions for loans and/or hardship
withdrawals.
State and local governments are prohibited
from offering 401(k) plans to their employees.
This was once true of private, tax-exempt
employers as well; however, as of January
1, 1997, the latter may now establish
a 401(k) plan for their qualified employees.
403(b) Plan. A 403(b) plan is a defined
contribution plan that takes its name
from the section of the Internal Revenue
Code that establishes the rules under
which it operates. It is also known as
and sometimes called a tax-sheltered
or a tax-deferred annuity program. This
plan is for educational, religious, and
charitable (i.e. 501(c)(3)) organization
employees. It operates under similar
maximum contribution rules and withdrawal
privileges as a 401(k) plan. Like the
401(k), pre-tax contributions and all
earnings remain tax free until withdrawn.
Keogh (HR-10) Plan.A Keogh plan is a
qualified retirement plan established
by the Self Employed Individuals Tax
Retirement Act of 1962, otherwise known
as the Keogh Act, or HR-10. Keogh plans
may be set up by self-employed persons,
partnerships, and owners of unincorporated
businesses - as a defined benefit, or
defined contribution plan. As defined
contribution plans, they may be structured
as a profit sharing, a money purchase,
or a combined profit sharing/money purchase
plan.
Keogh plans may not authorize loans.
Contributions and all earnings accumulate
free of tax until withdrawn, generally
at retirement. In general, withdrawals
prior to age 59 1/2 are subject to a
10% premature distribution penalty in
addition to ordinary income tax; however,
distributions are eligible for transfer
to an IRA.
Simplified Employee Pension (SEP). A
SEP is a retirement plan designed for
self-employed persons, partnerships,
sole proprietors, independent contractors,
and owner-employees of an unincorporated
trade or business; however, it may be
set up by any type of business. A SEP
is an easy method for a small employer
to establish a retirement plan for employees
without the complex administration and
expense found in qualified retirement
plans. In fact, an employer may establish
a SEP only if that employer has no qualified
retirement plan in effect.
Under a SEP, the employer may make a
contribution of up to the lesser of 15%
or $30,000 of compensation to IRAs established
in each employee's name. Hence, such
an arrangement is known as a SEP-IRA.
When made, these contributions are owned
in their entirety by the employee, and
they may be withdrawn and/or transferred
by the employee at any time. Contributions
to a SEP by the employer are discretionary,
but must be deposited into each eligible
employee's IRA when made. Because these
accounts are IRAs, the amounts therein
are subject to all IRA rules regarding
transfer, withdrawal and taxation.
Savings Incentive Match Plan for Employees
(SIMPLE). Established by the Small Business
Protection Act of 1996, a SIMPLE may
be set up by employers who have no other
retirement plan and who have 100 or fewer
employees with at least $5,000 in compensation
for the previous year. SIMPLE plans are
the replacement for the SARSEP plans
discussed above. They may be structured
as an IRA or as a 401(k) plan. In 2001,
employees may defer any percentage of
compensation up to $6,500 per year to
the SIMPLE, and the employer is required
to make a matching contribution of up
to 3% of the employee's pay based on
that election. The employer may reduce
the maximum matching percentage in any
two years out of five. Alternatively,
the employer may establish a uniform
2% of salary contribution per year for
all eligible employees regardless of
whether they contribute to the SIMPLE
or not.
Contributions are immediately vested
with the employee, and deposits and earnings
in the account will accumulate tax free
until withdrawn. In general, distributions
from a SIMPLE are taxed like those from
an IRA. Withdrawals prior to age 59 1/2
are subject to the 10% early withdrawal
excise tax in addition to ordinary income
tax. Unlike an IRA or SEP, however, employees
who withdraw money from a SIMPLE IRA
within two years of their first participation
in the plan will be assessed a 25% penalty
tax on such withdrawals instead of 10%.
This extra penalty does not apply to
early withdrawals from a SIMPLE 401(k).
Distributions from both types of SIMPLE
may be transferred to another SIMPLE
or to an IRA, but they are ineligible
for transfer to a qualified retirement
plan.
To learn more about retirement investment
options, visit: http://www.aarp.com/money.
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