Your Retirement Plan: How To Get Started
The number of people who are financially unprepared for retirement is staggering. One study revealed that more than half of the adults in the U.S. were planning to depend solely on Social Security for retirement income. Another study indicated that the great majority of Americans do not save nearly enough money. This Financial Guide provides you with the information you need to get started on this important task.
Table of Contents
To enjoy your retirement years, you need to begin planning early. With longer life expectancies and the growing senior population, people need to begin planning and saving for retirement in their 30s or even sooner. Adequate planning can help to ensure that you will not outlive your savings and that you will not become financially dependent on others.
It is never too late to start or to improve a retirement plan. This Financial Guide shows you the basics of retirement planning, and will enable you to get started or to revamp an existing plan. Basically, there are three steps to retirement planning:
- Estimating your retirement income
- Estimating your retirement needs
- Deciding on investments
Tip: In making estimates of future income needs and sources of income, be sure to estimate conservatively. This will ensure that you do not shortchange yourself.
Most people have three possible sources of retirement income: (1) Social Security, (2) pension payments, and (3) savings and investments. The income that will have to be provided through savings and investments (which you can plan for) can be determined only after you have estimated the income you can expect from Social Security and from any pension plans (over which you have little control).
Estimate how much you can expect in the way of Social Security retirement income. To do this, you should file a "Request for Earnings and Benefits Estimate" with the Social Security Administration. This form can be obtained from SSA by calling their toll-free number: 800-772-1213. You can also request a benefits statement online through the Social Security Administrations Web Site.
Planning Aid: You can also request a benefits statement online through the Social Security Administration's Web site.
Note: Many people are being sent estimates of their future Social Security benefits without having to make a request. You may have received such an estimate in the mail.
The amount of Social Security benefits you will receive depends on how long you worked, the age at which you begin receiving benefits, and your total earnings.
If you wait until your full retirement age (65 to 67, depending on your year of birth) to begin receiving benefits, your monthly retirement benefit will be larger than if you elect to receive benefits beginning at age 62. The full retirement age will increase gradually to age 67 by the year 2027.
Caution: Be aware that Social Security benefits may be subject to income tax. The basic rule is that if your adjusted gross income plus tax-exempt interest plus half of your Social Security benefits are more than $25,000 for an individual or more than $32,000 for a couple, then some portion of your Social Security benefit will be subject to income tax. The amount that is subject to tax increases as the level of adjusted gross income goes up.
Related Guide: Also, if you earn income while you are receiving Social Security, your benefit may be decreased. For the specific rule, see the Related Financial Guide: SOCIAL SECURITY BENEFITS: How To Get The Maximum.
Estimate how much you can expect to receive from a traditional pension plan or other retirement plan. If you are covered by a traditional pension plan and you are vested, ask your employer for a projection of what you can expect to receive if you continue working until retirement age or under other circumstances, for example, if you terminate before retirement age. You may already have received such an estimate.
If you are covered by a 401(k) plan, a profit-sharing plan, a Keogh plan, or a Simplified Employee Pension, make an estimate of the lump sum that will be available to you at retirement age. You may be able to get help with this estimate from your employer.
Tip: If you are in the military or formerly served in the military, contact the relevant branch of service to find out about retirement benefits.
Determine how much income you will need (or want) after retirement. Once you have determined this amount, you can figure out how much you will need to put away to have a big enough nest egg to fund your desired income level.
Many people don't realize that their retirement could last as long as their careers: 35 years or longer. Your nest egg may have to last much longer than you might think. Remember that the earlier you retire, the more you will have to save. If you want to retire at age 55, you'll have to save a lot more than if you retire at age 65.
A general guideline is that you will want to have at least 70% of whatever income stream you have before retirement. If you have any special needs or desires, for example, a desire to travel extensively-the percentage should be adjusted upward. The 70% figure is not a substitute for a thorough analysis of your income needs after retirement, but is only a guideline.
Here are some suggestions for estimating how much of an income stream you will want to have coming in after retirement:
Figure Your Current Annual Expenses. The first step in trying to figure out what your annual expenses will be after retirement is to figure what your expenses are now. Take a year's worth of checkbook, credit card, and savings account records, and add up what you paid for insurance, mortgage, food, household expenses, and so on.
Figure Out How Your Expenses Will Differ After Retirement. After you retire, your expenses will generally be a lot lower than they are while you are working. To help determine how much lower, here are some questions you might ask yourself:
- Will your mortgage be paid off?
- Will you still be paying for commuting expenses?
- How much will you pay for health insurance?
Tip: If you are not among the lucky few that will have post-retirement health insurance coverage from an ex-employer, you will probably pay more for health coverage after you retire and have to take out so-called "Medigap" coverage.
- Will you increase or decrease your life insurance coverage?
- How much will you pay for travel expenses? (Do you want to travel after you retire, either on vacation or to visit relatives? Will you be commuting between a winter and summer home?)
- Will you be spending more on hobbies after retirement?
- Will your children be financially independent by the time you retire or will you have to factor in some sort of support for them?
- Will your income tax bills be the same, lower, or higher?
Tip: If you are planning to retire to another state, take into account the different state taxes you will be paying.
The answers to these questions will help you determine your estimated annual expenses after retirement. Then subtract from this estimate the anticipated annual income from already-viable sources. (Do not subtract the lump-sum payments you expect to receive, for example, lump sum payments from 401(k) plans, which will be discussed later). The difference is the annual shortfall that will have to be financed by the nest egg you will need to accumulate.
How do you determine how much you need to save each year to accumulate a nest egg of that size by retirement age? You can do this by using the table below which, assumes an after-tax return of 5% per year. Just multiply the required nest egg by the Savings Multiplier for the number of years until retirement.
Example: You are 40 years old and want to retire at age 65. You determine that you need a nest egg of $350,000 to fund your annual shortfall. To find out how much you must save each year to have that $350,000 nest egg by the time you are 65, multiply $350,000 by the 25-year savings multiplier (2.1%). You will need to save $7,350 (2.1% times $350,000) a year for 25 years.
Subtract from this nest egg any lump sums that you expect to receive at retirement. To project the value at retirement of a present asset (retirement account, savings, investments, etc.); multiply the current value of this asset by the Growth Multiplier for the number of years until retirement.
Example: You already have $75,000 in a 401(k) plan. To find out what that amount will grow to in 25 years, multiply it by the growth multiplier for 25 years. This $75,000 will grow to $254,250 (339% times $75,000) by the time you retire. Subtract this $254,250 from the $350,000 needed in the previous example. This amount ($95,750) is the amount you must accumulate by age 65 to meet the income shortfall. Multiply this $95,750 by the 25-year savings multiplier (2.1%). You now know that, after taking the projected lump sum into consideration, you will still need to save $2,010.75 per year to accumulate $95,750.
|Years Until Retirement||Savings Multiplier||Growth Multiplier|
Generally, the longer you have until retirement, the more of your savings should be invested in vehicles with a potential for growth. If you are very close to or at retirement, you may wish to put the bulk of your savings into low-risk investments. However, this formula is subject to your own financial profile: your tolerance for risk, your income level, your other sources of retirement income (e.g., pension payments), and your unique needs.
Related Guide: Please see the Financial Guide: INVESTMENT BASICS: What You Should Know.
Here is a summary of the pros and cons of various retirement-savings investments and their pros and cons. Please note that each of these is discussed in more detail in related Financial Guides.
Tax-Deferred Retirement Vehicles
Each year, maximize your deposits in a 401(k) plan, an IRA, a Keogh plan, or some other form of tax-deferred savings. Because this money grows tax-deferred, returns will be greater. Further, if the amount you put in is deductible, you are reducing your income tax base.
Lowest Risk Investments
Money market funds, CDs, and Treasury bills are the most conservative investments. However, of the three, only the Treasury bills offer a rate that will keep up with inflation. For the average individual saving for retirement, it is recommended that these vehicles make up only a portion of investments.
Related Guide: Please see the Financial Guide: ASSET ALLOCATION: How To Diversify For Maximum Return.
Bonds provide a fixed rate of income for a certain period. The income from bonds is higher than income from Treasury bills.
Bonds fluctuate in value depending on interest rates, and are thus riskier than the lowest risk investments. If bonds are used as a conservative investment, it is a good idea to use those of a shorter term, to minimize the fluctuation in value that might occur.
Although common stock is riskier than any other investment yet discussed, it offers greater return potential.
Mutual funds are an excellent retirement savings vehicle. By balancing a mutual fund portfolio to minimize risk and maximize growth, a higher return can be achieved than with safer investments.
Related Guide: Please see the Financial Guide: INVESTING IN MUTUAL FUNDS: The Time-Tested Guidelines.
10 Retirement Saving Tips
Save As Much As You Can As Early As You Can.
Though it's never too late to start, the sooner you begin saving, the more time your money has to grow. Gains each year build on the prior year's -- that's the power of compounding, and the best way to accumulate wealth.
Set Realistic Goals.
Project your retirement expenses based on your needs, not rules of thumb. Be honest about how you want to live in retirement and how much it will cost. Then calculate how much you must save to supplement Social Security and other sources of retirement income.
A 401(k) Is One Of The Easiest And Best Ways To Save For Retirement.
Contributing money to a 401(k) gives you an immediate tax deduction, tax-deferred growth on your savings, and -- usually -- a matching contribution from your company.
An IRA Can Also Give Your Savings A Tax-Advantaged Boost.
Like a 401(k), IRAs offer huge tax breaks. There are two types: a traditional IRA offers tax-deferred growth, meaning you pay taxes on your investment gains only when you make withdrawals, and, if you qualify, your contributions may be deductible; a Roth IRA, by contrast, doesn't allow for deductible contributions but offers tax-free growth, meaning you owe no tax when you make withdrawals, but contributions are not deductible.
Focus On Your Asset Allocation More Than On Individual Picks.
How you divide your portfolio between stocks and bonds will have a big impact on your long-term returns.
Stocks Are Best For Long-Term Growth.
Stocks have the best chance of achieving high returns over long periods. A healthy dose will help ensure that your savings grows faster than inflation, increasing the purchasing power of your nest egg.
Don't Move Too Heavily Into Bonds, Even In Retirement.
Many retirees stash most of their portfolio in bonds for the income. Unfortunately, over 10 to 15 years, inflation easily can erode the purchasing power of bonds' interest payments.
Making Tax-Efficient Withdrawals Can Stretch The Life Of Your Nest Egg.
Once you're retired, your assets can last several more years if you draw on money from taxable accounts first and let tax-advantaged accounts compound for as long as possible.
Working Part-Time In Retirement Can Help In More Ways Than One.
Working keeps you socially engaged and reduces the amount of your nest egg you must withdraw annually once you retire.
There Are Other Creative Ways To Get More Mileage Out Of Retirement Assets.
You might consider relocating to an area with lower living expenses, or transforming the equity in your home into income by taking out a reverse mortgage.
Social Security Benefits: How To Get The Maximum Amount
Decisions about retirement, including understanding your Social Security benefits, are among the most important ones you will ever make. This Financial Guide provides information you need about Social Security benefits to help you plan for your retirement years.
When you work and pay Social Security taxes (referred to as FICA on some pay stubs), you earn Social Security credits. Most people earn a maximum of four credits per year. In 2014, you must earn $1,200 in covered earnings to get one Social Security or Medicare work credit ($4,800 to get the maximum four credits for the year). The number of credits you need to get retirement benefits depends on your date of birth. If you were born in 1929 or later, you need 40 credits (10 years of work). People born before 1929 need fewer than 40 credits (39 credits if born in 1928, 38 credits if born in 1927, etc.).
If you stop working before you have enough credits to qualify for benefits, your credits will remain on your Social Security record. If you return to work later on, you can then add credits so that you may qualify. No retirement benefits can be paid until you have the required number of credits.
If you are like most people, however, you will earn many more credits than you need to qualify for Social Security. While these extra credits do not increase your Social Security benefit, the income you earn while working will increase your benefit.
Your benefit amount is based on your earnings averaged over most of your working career. Higher lifetime earnings result in higher benefits. If you have some years of no earnings or low earnings, your benefit amount may be lower than if you had worked steadily.
Your benefit amount is also affected by your age at the time you start receiving benefits. Your benefit will be lower if you start your retirement benefits at age 62 (the earliest possible retirement age) than if you wait until a later age.
Planning Aid: Social Security will give you a personalized benefit estimate at your request. Call 800-772-1213 and ask for a Request for Earnings and Benefit Estimate Statement. Upon completion, and return of the form you will receive a statement of your complete earnings history along with estimates of your benefits for early retirement, full retirement, and delayed retirement (discussed below). You'll also receive an estimate of the disability benefits you could receive as well as the amount of benefits payable to your spouse and children due to your retirement, disability, or death. If you are age 60 or older, you can get an estimate of your retirement benefits by telephone.
You can also use the Retirement Estimator on the Social Security Administration website.
Note: Your actual benefit amount cannot be determined until you actually apply for benefits.
Social Security law provides for automatic cost-of-living increases. Once you start receiving benefits. The amount will go up automatically as the cost of living rises.
Persons in the Social Security system who retire at "full retirement age" receive the full retirement benefit. Your full retirement age depends on when you were born.
Because of longer life expectancies, the full retirement age starts at age 65 for those persons born 1937 or earlier and increases gradually until it reaches age 67 for those born 1960 or later. The chart below shows what your full retirement age will be:
Year of Birth
Full Retirement Age
|1937 or earlier||65|
|1938||65 and 2 months|
|1939||65 and 4 months|
|1940||65 and 6 months|
|1941||65 and 8 months|
|1942||65 and 10 months|
|1955||66 and 2 months|
|1956||66 and 4 months|
|1957||66 and 6 months|
|1958||66 and 8 months|
|1959||66 and 10 months|
|1960 and later||67|
You can start your Social Security benefits as early as age 62, but your benefit amount will be less than your full retirement benefit. If you take early retirement, your benefits will be reduced based on the number of months you will receive checks before you reach full retirement age. The reduction is 5/9 of one percent for every month before full retirement age. If your full retirement age is 66 (for example, one born in 1946 and retiring in 2008 at age 62), the reduction for starting your Social Security at 62 is about 27%.
Tip: According to the Social Security Administration, you collect more during the first 15 years if you start collecting at 62; beyond the 15 years, you collect more overall by waiting to full retirement age. Of course, the calculation changes where one starting to withdraw at 62 continues working, or returns to work, see below.
Tip: If you are unable to continue working because of poor health, you should consider applying for Social Security disability benefits. The amount of the disability benefit based on your average lifetime earnings and is stated on your Social Security statement. For more information on disability benefits, request a copy of the booklet Disability (Publication No. 05-10029).
If you decide to continue working full-time beyond your full retirement age, you will increase your Social Security benefit in two ways:
- You will be adding a year of earnings to your Social Security record. (As stated earlier, higher lifetime earnings results in higher benefits.)
- Your benefit will increase by a certain percentage for each additional year you work. These increases will be added in automatically from the time you reach your full retirement age until you either start taking your benefits or reach age 70. The percentage varies depending on your year of birth. The chart below shows the increase that will apply to you.
Year Of Birth
Yearly Rate of Increase
|1943 or later||8%|
Example: If you were born in 1943 or later, your benefit will increase by 8% (2/3 of one percent per month) for each year you delay signing up for Social Security beyond your full retirement age.
If you plan to start your retirement benefits at age 62, contact Social Security in advance to determine the best retirement month to claim your benefits. In some cases, your choice of a retirement month could mean additional benefits for you and your family.
Tip: It may be to your advantage to have your Social Security benefits start in January, even if you don't plan to retire until later in the year. Depending on your earnings and your benefit amount, it may be possible for you to start collecting benefits even though you continue to work. Under current rules, many people can receive the most benefits possible with an application that is effective in January.
If you plan to start collecting your Social Security when you turn 62, you should apply for benefits three months before the date you want your benefits to start. If you are not working your annual earnings fall below the earnings limits (discussed below), or
Tip: Because the rules are complicated, you should discuss your plans with a Social Security claims representative in the year before the year you plan to retire.
Many people do not realize that widows and widowers can begin receiving Social Security benefits at age 60 (or age 50 if disabled) on the deceased spouse's account. If you are receiving widows/widowers (including divorced widows/widowers) benefits, you can switch to your own retirement benefits (assuming you are eligible and your retirement rate is higher than your widow/widower's rate) as early as age 62.
In many cases, a widow or widower can begin receiving one benefit at a reduced rate and then switch to the other benefit at an unreduced rate at age 65. Since the rules vary depending on the situation, talk to a Social Security representative about the options available to you.
A Retirement Earnings Test limits the amount of Social Security benefit a person between age 62 and his or her full retirement age (see below) can receive while still working.
For those reaching full retirement age in 2014, $1 in benefits will be deducted for every $3 in earnings above an annual limit up to the month of full retirement age attainment. For 2014, that limit is $41,400. This applies for months before full retirement age. No limit applies beginning the month full retirement age is reached.
For those under full retirement age throughout 2014, $1 in benefits will be deducted for each $2 in earnings above the limit of $15,480 in 2014. These limits will increase in future years.
For those under full retirement age throughout 2013, $1 in benefits will be deducted for each $2 in earnings above the limit of $15,120 in 2013. These limits will increase in future years.
If other family members receive benefits on your Social Security record, the total family benefits will be affected by your earnings. Not only will your benefits be offset, but those payable to your family will be offset as well. If a family member works, however, the family member's earnings affect only his or her benefits.
A special rule applies to your earnings for one year, usually your first year of retirement. Under this rule, you can receive a full Social Security check for any month you are retired, regardless of your yearly earnings. Your earnings must be under a monthly limit. If you are self-employed, the services you perform in your business are taken into consideration as well.
If you earn more than the earnings limit and receive Social Security benefits, you must report this to Social Security. You do not have to fill out a report if you are full retirement age all year.
If you are receiving retirement benefits, some members of your family can also receive benefits. Those who can include:
- Your wife or husband age 62 or older;
- Your wife or husband under age 62 if she or he is taking care of your child who is under age 16 or disabled;
- Your former wife or husband age 62 or older (see below);
- Children up to age 18;
- Children age 18-19 if they are full-time students through grade 12;
- Children over age 18, if they are disabled.
The full benefit for a spouse is one-half of the retired worker's full benefit. However, if your spouse takes benefits between age 62 and their full retirement age, the amount will be permanently reduced by a percentage based on the number of months up to his or her full retirement age, unless she or he is taking care of a child who is under 16 or disabled.
If you are eligible for both your own retirement benefits and for benefits as a spouse, you will be paid your own benefit first. If your benefit as a spouse is higher than your retirement benefit, you will get a combination of benefits equaling the higher spouse benefit.
Example: Mary Ann qualifies for a retirement benefit of $250 and a wife's benefit of $400. At age 65, she will receive her own $250 retirement benefit and an additional $150 from her wife's benefit for a total of $400.
A divorced spouse can get benefits on a former husband's or wife's Social Security record if the marriage lasted at least 10 years and the divorced spouse is 62 or older and unmarried. For the divorced spouse to get benefits, the worker also must be 62 or older. If divorced for at least two years, the divorced spouse can get benefits even if the worker is not retired. This two-year waiting period is waived if the worker got benefits before the divorce. The amount of benefits a divorced spouse gets has no effect on the amount of benefits a current spouse can get.
If you have children eligible for Social Security, each child will receive up to one-half of your full benefit. However, there is a limit to the amount of money that can be paid to a family. If the total benefits due your spouse and children exceed this limit, their benefits will be reduced proportionately - but your benefit will not be affected.
You can apply for benefits by telephone or by going to any Social Security office. Depending on your circumstances, you will need some or all of these documents:
- Your Social Security number;
- Your birth certificate;
- Your W-2 forms or self-employment tax return for last year;
- Your checking or savings account information for direct deposit.
- Your military discharge papers if you had military service;
- Your spouse's birth certificate and Social Security number if he or she is applying for benefits;
- Your children's birth certificates and Social Security numbers if applying for children's benefits.
You will need to submit original documents or copies certified by the issuing office. You can mail or take them to Social Security, which will make photocopies and return your documents.
Tip: Don't delay your application because you don't have all the information. If you don't have a document you need, Social Security can help you get it.
If you disagree with a decision made on your claim, you can appeal it. The steps you can take are explained in the fact sheet, The Appeals Process (Publication No. 05-10041), which is available from Social Security. You have the right to be represented by an attorney or other qualified person of your choice. More information is in the fact sheet, Social Security and Your Right to Representation (Publication No. 05-10075), also available from Social Security.
Less than one-third of people who get Social Security pay taxes on their benefits. This provision affects only people who have substantial income in addition to their Social Security.
At the end of each year, you will receive a Social Security Benefit Statement (Form SSA-1099) in the mail showing the amount of benefits you received. You can use this statement when you are completing your income tax return to find out if any of your benefits are subject to tax.
If you get a pension from work where you paid Social Security taxes, it will not affect your Social Security benefits. However, your Social Security benefit may be lowered or offset if you get a pension from work that was not covered by Social Security (for example, the Federal civil service or some State or local government employment).
Tip: For more information, call Social Security to ask for the fact sheets, Government Pension (for government workers who may be eligible for Social Security benefits on the record of a husband or wife) (Publication No. 05-10007) and A Pension From Work Not Covered By Social Security (for government workers who also are eligible for their own Social Security benefits) (Publication No. 05-10045).
If you are a U.S. citizen, you can travel or live in most foreign countries without affecting your eligibility for Social Security benefits. Your checks can be sent there. However, there are a few countries where Social Security will not send your checks. If you work outside the United States, different rules apply in determining whether you can get your benefit checks.
Most people who are neither U. S. residents nor U.S. citizens will have up to 15 % of their benefits withheld for federal income tax.
Tip: For more information, ask Social Security for a copy of the booklet Your Social Security Checks While You Are Outside the United States (Publication No. 05-101373).
Medicare is a health insurance plan for people who are 65 or older. People who are disabled or have permanent kidney failure can get Medicare at any age. Medicare has four parts:
- Hospital insurance (Part A), which covers inpatient hospital care and certain follow-up care. You have already paid for it as part of your Social Security taxes while you were working.
- Medical insurance (Part B), which pays for physicians' services and some other services not covered by hospital insurance. Medical insurance is optional, and a premium is charged for it.
- Medicare Part C (also known as Medicare Advantage), which offers health plan options run by Medicare-approved private insurance companies and may cover Medicare prescription drug coverage (Part D).
- Medicare Part D (Medicare Prescription Drug Coverage), which helps cover the costs of prescription drugs.
Most people are already getting Social Security benefits when they turn 65 and their Medicare starts automatically.
Tip: If you are not getting Social Security, sign up for Medicare close to your 65th birthday, even if you do not plan to retire. For more information, ask Social Security for a copy of the booklet, Medicare (Publication No. 05-10043.)
Should You Count On Social Security?
In 2011, nearly 35 million retired American workers received an average of $1,181 average monthly benefit in Social Security retirement benefits. In fact, Social Security is the major source of income for most of the elderly. But by 2036, there will be almost twice as many older Americans as today -- from 41.9 million today to 78.1 million -- and only 2.1 workers for each beneficiary (currently there 2.9).
If you're worried about the state of social security, you're not alone. Nevertheless, Social Security is still an important part of your retirement planning. The best way to take control is to find out what your estimated benefits will be. You can do this by contacting the SSA through their website.
You'll receive a report showing your estimated annual benefits at age 62, at your "normal" retirement age (65 to 67, depending on your year of birth), and at age 70. These are estimates of future benefits, with an actual dollar amount at that time.
Taking Steps To Protect Yourself
There are some important steps to take when you get your report. First, check your reported earnings for each year you worked. Just like any other bureaucracy, mistakes are always a possibility.
Second, take a good look at how your benefit varies according to your retirement age. If you retire at 62, generally you will only get 80% of your benefits at normal retirement age. Conversely, you will get an extra 8% for each year you work past your normal retirement age. If you're married, your non-working spouse will get 37.5% of your benefits if you retire early and 50% at your normal retirement age.
Remember that the full retirement age is no longer necessarily 65. The full retirement age is increasing gradually to age 67 by the year 2027. Looking at your various retirement benefits, you can figure out the best time for you to start taking Social Security.
Third, decide how much you want to rely on Social Security. The younger you are, the more likely it is that your benefits will be less than projected. As a safety measure, you might assume your actual annual benefit would be 75% of current estimates. Whatever your method, plug that Social Security number into your retirement needs analysis to see how much you will have to save on your own to provide the income you want. Then make a plan to save even more than that, if you can.
One final tip:
When you deal with the Social Security Administration, do it online or in writing. If doing so is impossible, go to a Social Security office. For future reference, always take notes and get the employee's name and ID number of the person you spoke with.
You won't be penalized if you receive incorrect information from the employee and you have proof. If you are not happy with the Social Security Administration's decision about your situation, you can file a "reconsideration." You can also ask to have any deadlines waived until your problems are resolved.
Social Security was never designed to pay for a life of luxury, but even with its current fiscal woes, you can probably count on something when you retire.
Annuities: How They Work and When You Should Use Them
Annuities may help you meet some of your mid and long-range goals such as planning for your retirement and for a child's college education. This Financial Guide tells you how annuities work, discusses the various types of annuities, and helps you determine which annuity product (if any) suits your situation. It also discusses the tax aspects of annuities and explains how to shop for both an insurance company and an annuity, once you know which type you'll need.
While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as insurance against "living too long." In brief, when you buy an annuity (generally from an insurance company, that invests your funds), you in turn receive a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (keep in mind that there are many other options), you will have a guaranteed source of "income" until your death. If you "die too soon" (that is, you don't outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you "live too long" (and do outlive your life expectancy), you may get back far more than the cost of your annuity (and the resultant earnings). By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.
The earnings that occur during the term of the annuity are tax-deferred. You are not taxed on them until they are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.
Tip: Assess the costs of an annuity relative to the alternatives. Separate purchase of life insurance and tax-deferred investments may be more cost effective.
The two primary reasons to use an annuity as an investment vehicle are:
- You want to save money for a long-range goal, and/or
- You want a guaranteed stream of income for a certain period of time.
Annuities lend themselves particularly well to funding retirement and, in certain cases, education costs.
One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10% premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59½ and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers' penalties are termed "surrender charges," and they usually apply for the first seven years of the annuity contract.
These penalties lead to a de facto restriction on the use of annuities primarily as an investment. It only makes sense to put your money into an annuity if you can leave it there for at least ten years and the withdrawals are scheduled to occur after age 59½. These restrictions explain why annuities work well for either retirement needs or for cases of education funding where the depositor will be at least 59½ when withdrawals begin.
Tip: The greater the investment return, the less punishing the 10% penalty on withdrawal under age 59½ will appear. If your variable annuity investments have grown substantially, you may want to consider taking some of those profits (despite the penalty, which applies only to the taxable portion of the amount withdrawn).
Annuities can also be effective in funding education costs where the annuity is held in the child's name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax (and 10% penalty) on the earnings when the time came for withdrawals.
Caution: A major drawback is that the child is free to use the money for any purpose, not just education costs.
The available annuity products vary in terms of (1) how money is paid into the annuity contract, (2) how money is withdrawn, and (3) how the funds are invested. Here is a rundown on some of the annuity products you can buy:
- Single-Premium Annuities: You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout). The minimum investment is usually $5,000 or $10,000.
- Flexible-Premium Annuities: With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.
- Immediate Annuities: The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and is usually purchased by retirees with funds they have accumulated for retirement.
- Deferred Annuities: With a deferred annuity, payouts begin many years after the annuity contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuity, that is, as regular annuity payments over some guaranteed period. Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used to fund tax-deferred retirement plans and tax-sheltered annuities. They may be funded with a single or flexible premium.
- Fixed Annuities: With a fixed annuity contract, the insurance company puts your funds into conservative fixed income investments such as bonds. Your principal is guaranteed and the insurance company gives you an interest rate that is guaranteed for a certain minimum period-from a month to several years. This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on the length of the period during which interest is guaranteed. The fixed annuity is considered a low-risk investment vehicle. All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5% for the entirety of the contract. The fixed annuity is a good choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. Fixed annuity investors benefit if interest rates fall, but not if they rise.
- Variable Annuities: The variable annuity, which is considered to carry with it higher risks than the fixed annuity--about the same risk level as a mutual fund investment--gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.
The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.
Caution: The taxable portion of variable annuity distributions is taxable at full ordinary rates, even if they are based on stock investments. Unlike dividends from stock investments (including mutual funds), there is no capital gains relief (currently set to expire at the end of 2012).
Tip: Before buying an annuity, contribute as much as possible to other tax-deferred options such as IRA's and 401 (k) plans. The reason is that the fees for these plans is likely to be lower than those of an annuity and early-withdrawal fees on annuities tend to be steep.
Tip: IRA contributions are sometimes invested in flexible premium annuities-with IRA deduction, if otherwise available. You may prefer to use IRAs for non-annuity assets. Non-annuity assets gain the ability to grow tax-free when held in an IRA. The IRA regime adds no such benefit to annuity assets which grow tax-free in or outside IRAs.
When it's time to begin taking withdrawals from your deferred annuity, you have a number of choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible.
Caution: Once you have chosen a payment option, you cannot change your mind.
The size of your payout (settlement option) depends on:
- The size of the amount in your annuity contract
- Whether there are minimum required payments
- Your life expectancy (or other payout period)
- Whether payments continue after your death
Here are summaries of the most common forms of payout:
This type gives you a fixed monthly amount (chosen by you) that continues until your annuity is used up. The risk of using this option is that you may live longer than your money lasts. Thus, if the annuity is your only source of income, the fixed amount is not a good choice. And, if you die before your annuity is exhausted, your beneficiary gets the rest.
This option pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are seeking retirement income before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.
Lifetime or Straight Life
This type of payment continues until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not need the annuity funds to provide for the needs of a beneficiary and (2) you want to maximize your monthly income.
Life With Period Certain
This form of payment gives you payments as long as you live (as does the life annuity) but with a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period, the lower the monthly benefit.
This option pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life annuity.
Joint And Survivor
In one joint and survivor option, monthly payments are made during the annuitants' joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees (employment model), monthly payments are made to the retired employee, with the same or a lesser amount to the employee's surviving spouse or other beneficiary. The difference is that with the employment model , the spouse's (or other co-annuitant's) death before the employee won't affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants' ages, and whether the survivor's payment is to be 100% of the joint amount or some lesser percentage.
The way your payouts are taxed differs for qualified and non-qualified annuities.
A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefits (and penalties) that Congress saw fit to attach to such qualified plans.
The tax benefits are:
- Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
- The earnings on your investment are not taxed until withdrawal
If you withdraw money from a qualified plan annuity before the age of 59½, you will have to pay a 10% penalty on the amount withdrawn in addition to paying the regular income tax. There are exceptions to the 10% penalty, including an exception for taking the annuity out in a series of equal periodic payments over the rest of your life.
Once you reach age 70½, you will have to start taking withdrawals in certain minimum amounts specified by the tax law (with exceptions for Roth IRAs and for employees still working after age 70½).
A non-qualified annuity is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings; however, you pay tax on the part of the withdrawals that represent earnings on your original investment.
If you make a withdrawal before the age of 59½, you will pay the 10% penalty only on the portion of the withdrawal that represents earnings.
With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70½.
Tax on Your Beneficiaries or Heirs
If your annuity is to continue after your death, other taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your estate or those who take through the estate if you didn't designate a beneficiary).
Income tax: Annuity payments collected by your beneficiaries or heirs are subject to tax on the same principles that would apply to payments collected by you.
Exception: There's no 10% penalty on withdrawal under age 59½ regardless of the recipient's age, or your age at death.
Estate tax: The present value at your death of the remaining annuity payments is an asset of your estate, and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.
If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.
Although annuities are typically issued by insurance companies, they may also be purchased through banks, insurance agents, or stockbrokers.
There is considerable variation in the amount of fees that you will pay for a given annuity as well in the quality of the product. Thus, it is important to compare costs and quality before buying an annuity.
First, Check Out The Insurer
Before checking out the product itself, it is important to make sure that the insurance company offering it is financially sound. Because annuity investments are not federally guaranteed, the soundness of the insurance company is the only assurance you can rely on. Consult services such as A.M. Best Company, Moody's Investor Service, or Standard & Poor's Ratings to find out how the insurer is rated.
Next, Compare Contracts
The way you should go about comparing annuity contracts varies with the type of annuity.
- Immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Be sure to consider the interest rate and any penalties and charges.
- Deferred annuities: Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract. It is important to consider all three of these factors and not to be swayed by high interest rates alone.
- Variable annuities: Check out the past performance of the funds involved.
If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.
Be sure to compare the following points when considering an annuity contract:
Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is 7% for first-year withdrawals, 6% for the second year, and so on, with no charges after the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be acceptable.
Tip: Be sure the surrender charge "clock" starts running with the date your contract begins, not with each new investment.
Fees And Costs
Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might include:
- Mortality fees of 1 to 1.35% of your account (protection for the insurer in case you live a long time)
- Maintenance fees of $20 to $30 per year
- Investment advisory fees of 0.3% to 1% of the assets in the annuity's portfolios.
These provisions are not costs, but should be asked about before you invest in the contract.
Some annuity contracts offer "bail-out" provisions that allow you to cash in the annuity if interest rates fall below a stated amount without paying surrender charges.
There may also be a "persistency" bonus which rewards annuitants who keep their annuities for a certain minimum length of time.
In deciding whether to use annuities in your retirement planning (or for any other reason) and which types of annuities to use, professional guidance is advisable.
At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly, or yearly payments that represent a portion of principal plus interest and is guaranteed to last for life. The portion of the periodic payout that constitutes a return of principal is excluded from taxable income.
However, this strategy contains risks. For one thing, when you lock yourself into a lifetime of level payments, you fail to guard against inflation. Furthermore, you are gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn't go to your heirs. Finally, since the interest rate is fixed by the insurer when you buy it, you may be locking yourself into low rates.
You can hedge your bets by opting for a "period certain", or "term certain" which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options (which pay your spouse for the remainder of his or her life after you die) or a "refund" feature (in which some or all of the remaining principal is resumed to your beneficiaries).
Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of $10 at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment with a 3% maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.
Recently, a few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These "variable immediate annuities" convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.
Older seniors-75 years of age and up- may have fewer worries about inflation or liquidity. Nevertheless, they should question whether they really need such annuities at all.
If you want a comfortable retirement income, consider a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.
Retirement Plan Distributions: When To Take Them
When must you start withdrawing the funds in your retirement plans? And what happens if the funds aren't withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways the savvy taxpayer can maximize the tax shelter.
The basic rule is that you must begin withdrawing funds--and incurring taxes on these withdrawals--no later than April 1 of the year after you turn 70 ½ . This rule exists so that retirement funds will be distributed-whether or not spent-during what for most people is their retirement years.
An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire, if you are still employed when you reach the mandatory withdrawal age. The exception doesn't apply where you're a 5% or more owner of the business that provides the plan, or to withdrawals from traditional IRAs--in those-cases you are subject to the mandatory withdrawal rules.
Related Guide: Roth IRAs are another exception. For a discussion of Roth IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.
Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution--or the smaller the amount you must withdraw-the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets, and the shelter, for the next generation.
The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.
The rules are complex, but here's a general overview of the timing of retirement plan distributions which will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.
Related Guide: The tax treatment will be dictated not only by the timing of the withdrawal (i.e., when to take it) but also by the form of the withdrawal (i.e., how to take it). This Financial Guide discusses the "when." For a discussion of the "how," please see the Financial Guide: RETIREMENT PLAN DISTRIBUTIONS: HOW to Take Them.
Before You Reach Age 70 ½
Until the year you reach 70 ½, you need not take your money out of your retirement account, although your employer's plan might require you to do so. In fact, there will usually be a 10% early-withdrawal penalty if you make withdrawals from an IRA before age 59 ½. Between the ages of 59 ½ and 70 ½ you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.
Once You Reach Age 70 ½
Once you hit 70 ½, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70 ½ say April 1, 2015, if you reach 70 ½ in 2014. But waiting until April 1 means you must withdraw for two years--2014 and 2015 in 2015. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 ½.
IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.
The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy.
Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.
Example: Joe reaches age 70 ½ in October of this year. Retirement plan assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 70 is 27.4. Joe must withdraw $21,898 ($600,000/27.4) this year.
Example: Two years from now Joe is 72 and his IRA was $602,000 at the end of the preceding year (when Joe reached age 71). The IRS number for age 72 is 25.6. Joe must withdraw $23,517 two years hence.
The distribution period in the IRS table in effect assumes distribution over a period based on your life expectancy plus that of a beneficiary 10 years younger than you. (Distribution after your death is based on the actual life span or life expectancy of your actual beneficiary-see "Withdrawal after You Die" below.) Only where your designated beneficiary is a spouse more than 10 years younger than you is his or her actual life expectancy used to figure the withdrawal period during your lifetime. You may use these rules to prolong distribution for 2003 and after, even though you have been taking withdrawals over a shorter period under previous rules.
Under the current rules, the life expectancy of your designated beneficiary (if you have one) is irrelevant in figuring your withdrawal period (except for a beneficiary spouse more than 10 years younger). Thus, you can change your designated beneficiary at will, or replace one who died, without affecting your withdrawal period (except for a change to or from a spouse more than 10 years younger).
Caution: You can always take out money faster than required--and pay tax on these withdrawals. However, the tax code is strict about minimum withdrawals. If you-or your beneficiaries or heirs-fail to take out what's required, a tax penalty will take 50% of what should have been withdrawn but wasn't.
Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where your beneficiary spouse is more than 10 years younger than you). But it's still needed to prolong the distribution during your beneficiary's lifetime, should the beneficiary want that (some will want the money right away).
Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).
The rules as to how fast your beneficiaries or heirs must withdraw funds from your account-and pay the income tax-differ, depending on your beneficiary choice.
Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has options that no other beneficiary has.
Rollover. A spouse-beneficiary of your IRA can elect to treat the balance in your IRA as his or her own IRA (like a rollover). This provides the optimal extension of the withdrawal period if your spouse is younger than you, since your spouse doesn't have to start withdrawing funds until he or she turns 70 ½ . At age 70 ½ , your spouse can then use the period in the IRS table-or a longer one if he or she then has a spouse more than 10 years younger. Rollover isn't allowed if a trust is the beneficiary, even if the spouse is the trust's sole beneficiary. A similar extension is allowed for a balance you might leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse can roll over a distribution from your retirement plan to another retirement plan in which he or she participates, as well as to an IRA.
Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the deceased participant's account. There's no 10% early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59 ½ .
Tip: Leaving the money in your account makes sense if your spouse is under age 59 1/ 2 and needs the money soon after your death.
Tip: If your spouse remains a beneficiary, he or she doesn't have to start withdrawals until you would have reached age 70 ½ -after which withdrawals will be taken under the IRS table. Generally, there will not be an estate tax on retirement plan assets left to a spouse and the spouse will pay income taxes only as funds are withdrawn.
Someone Other Than Your Spouse. A child or other non-spouse beneficiary of an IRA can choose to start withdrawals by the end of the year after your death and spread distributions over his or her own life expectancy. This method extends the payout period and the tax deferral. The life expectancy for a 55-year-old, for example, is 29.6 years.
A non-spouse beneficiary of funds in a retirement plan can elect after 2006 to have the funds rolled to an IRA, and then spread withdrawals as described above.
Tip: The required payout schedules set the minimum that can be withdrawn. The beneficiary can always take out more.
If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child. On the other hand, if you create a separate share or account for each child, the child uses his or her own life expectancy.
No beneficiary. If you die before April 1 after the year you reach age 70 ½ having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed -and income taxes paid-within five to six years of your death. Heirs don't get the option of using their own life expectancy.
If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years to complete withdrawal.
Death before distributions begin. If you should die before the time (age 70 ½) required distributions are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.
Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.
The above discussion covered the general rules as to the withdrawal of retirement plan distributions both before and after you die. Now let's look at some specific tax planning techniques, particularly as regards the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts (including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your heirs.
How Your Heirs Are Taxed
The general rule is that, while there may be an estate tax bite at your death, inherited assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn't apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it's left to charity (more on giving retirement assets to charity below).
Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)
The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:
- On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
- Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
- The value of a stock bonus is taxable when received as ordinary income, less unrealized appreciation and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
- Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
- There's no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59½, but in general, if your spouse is your heir and rolls over your retirement account to his or her IRA, a withdrawal from the IRA while under age 59½ is subject to the penalty.
Some Tax Planning Opportunities
The federal estate tax isn't a major problem for most Americans. Less than 2% of those who die in any year leave an estate that's hit by estate tax. But the larger a taxpayer's retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above.
Unlike the income tax, which is collected only as amounts are distributed--and thus is deferred on annuities and the like--the estate tax is collected up front, at the owner's death, on the present value of the annuity.
One common planning technique-making lifetime gifts to reduce your taxable estate-is impractical for retirement accounts. Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But here are more practical techniques:
Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
A charitable remainder trust is a sophisticated way to benefit family, as well as charity, at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
Consider buying life insurance to pay estate tax that can't be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.
Retirement Plan Distributions: How To Take Them
If you are thinking of retiring soon, you are about to make a major financial decision: how to take distributions from your retirement plan. This Financial Guide will discuss your various options. And, since the tax treatment of these distributions will influence your decision, we will also review the tax rules.
Table of Contents
You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has limited your choices. Essentially, you can:
Before discussing the specific withdrawal options, let's consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.
Tax-free withdrawals. If you paid tax on money that went into the plan-that is, if it was made with after-tax funds-that money will come back to you tax-free. Typical examples of after-tax investments are:
Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you withdraw funds before reaching what the law considers a reasonable retirement age-age 59 ½--you usually will face a 10% penalty tax in addition to whatever tax would ordinarily apply.
As with any other tax on withdrawal, the 10% penalty doesn't apply to any part of a withdrawal that would be tax-free as a return of after-tax investment
Now let's review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.
Take Everything in a Lump Sum
You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to take everything out of a company account because you mistrust leaving funds with a former employer or to take control of investment decisions-though here a rollover (discussed later) might be preferred. Maybe you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably available.
Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans, but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the employer may have decided to preclude the lump sum form.
Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum. For most, this relief, in the form of "forward averaging," explained below, came to an end on 12/31/99-meaning that withdrawals taken after that date don't get that relief.
Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal installments over 10 years (for the relief allowed in limited cases after 1999). Forward averaging isn't allowed if any part of the account is or was rolled over to an IRA.
Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to plan participation before 1974. Capital gain may be taken instead of forward averaging and is available after 1999.
It's a "lump sum" if you take out everything left in your account in a single calendar year. If you took $50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took $250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum relief is available only once in a worker's lifetime.
The limited lump sum relief remaining is the result of a Congressional plan to phase out the relief, as it has brought down top tax rates and liberalized rollover rules.
Roll Over The Distribution
Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.
Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.
Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.
Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:
Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:
Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.
Take A Partial Withdrawal
Partial withdrawals are withdrawals that aren't rollovers, annuities or lump sums or don't qualify for lump sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you are still working as well as withdrawals at or after retirement. They may be made for investment or consumption, including education and health care. Because they are partial, the amount not withdrawn continues its tax shelter.
A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.
A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax investment bears to the total retirement account.
Do Some Combination Of The Above
Combination withdrawals are quite complex and beyond the scope of this Financial Guide.
For an overview of how states tax retirement plan withdrawals, see State Taxes On Retirement Plan Distributions.
Life Insurance Options
Here are your typical options where whole life insurance is held for you in a retirement plan:
The tax shelter ends when cash is received. Otherwise, it continues, to some degree.
Assets Withdrawn In Kind
In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment. Exceptions:
The Economics Of Retirement Annuities
Retirement annuity economics are built around the straight life annuity, where the retiree receives a certain amount for life, however long or short that might be. This amount stops at the retiree's death. The cost of such an annuity is computed, and that's the cost the employer is obligated to provide.
However, you may want, or be obliged to take, something other than a straight life annuity, such as:
These types of annuity are worth more than the straight life annuity. But the employer isn't obliged to pay for more than the cost of a straight single life annuity. So if you opt for something other than straight life, the amount you collect each period will be correspondingly reduced to the "actuarial equivalent" of straight life.
Can Creditors Reach Your Retirement Assets
Federal law generally protects your retirement assets or accounts against claims of your creditors so long as the assets remain in the retirement plan, except for unpaid federal taxes. Generally, this protection is in federal labor law (ERISA). Protection denied under labor law is provided under bankruptcy law (if the case is begun after October 16, 2005) to:
State Taxes On Retirement Plan Distributions
With 50 different state tax systems, only an overview is possible on how states tax retirement plan withdrawals. Here are the highlights:
Roth IRAs: How They Work and How To Use Them
Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices--and why YOU might want one, or more.
With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.
With a Roth IRA, there's never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.
The 2014 annual contribution limit to a Roth IRA is $5,500 (same as 2013). An additional "catch-up" contribution of $1,000 (same as 2013) is allowed for persons age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2014 from personal services and have income (modified adjusted gross income or MAGI) below $114,000 if single or $181,000 on a joint return in 2014. The $5,500 limit in 2014 phases out on incomes between $114,000 and $129,000 (single filers) and $181,000 and $191,000 (joint filers). Also, the $5,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.
You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $11,000, up to $11,000 ($5,500 each) can go into the couple's Roth IRAs. As with traditional IRAs, there's a 6% penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.
You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.
Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings as well as contributions and conversion amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:
- At least 5 years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion, since the conversion occurred and
- At least one of these additional conditions is met:
- The owner is age 59 ½.
- The owner is disabled.
- The owner has died (distribution is to estate or heir).
- Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).
Note: A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first time home buyer who is either yourself, your spouse or you or your spouse's child, grandchild, parent or other ancestor.
To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10% tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.
Exceptions. You may not have to pay the 10% additional tax in the following situations:
- You are disabled.
- You are the beneficiary of a deceased IRA owner.
- You use the distribution to pay certain qualified first-time homebuyer amounts.
- The distributions are part of a series of substantially equal payments.
- You have significant unreimbursed medical expenses.
- You are paying medical insurance premiums after losing your job.
- The distributions are not more than your qualified higher education expenses.
- The distribution is due to an IRS levy of the qualified plan.
- The distribution is a qualified reservist distribution.
Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10% tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10% early distribution tax, even if the contributions have been included as income in an earlier year.
Ordering Rules for Distributions
If you receive a distribution from your Roth IRA that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.
- Regular contributions.
- Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
- Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
- Nontaxable portion.
Disregard rollover contributions from other Roth IRAs for this purpose.
Aggregation (grouping and adding) rules.
Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.
- Add all distributions from all your Roth IRAs during the year together.
- Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
- Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution was made in 2011 and the conversion or rollover contribution was made in 2012, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2012.
Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.
Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.
Example: On October 15, 2007, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 - $20,000) in his gross income. On February 23, 2007, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2007, at age 60, Justin takes a $7,000 distribution from his Roth IRA.
- The first $4,000 of the distribution is a return of Justin's regular contribution and is not includible in his income.
- The next $3,000 of the distribution is not includible in income because it was included previously.
Distributions after Owner's Death
Qualified distributions after the owner's death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn't met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there's no penalty tax on early withdrawal. However, an owner's surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.
Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.
The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were available to taxpayers.
You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.
You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.
- Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
- Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
- Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.
- An annuity plan,
- A tax-sheltered annuity plan (section 403(b) plan),
- A deferred compensation plan of a state or local government (section 457 plan), or
- An IRA.
Note: Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.
Prior to 2008, you could only rollover (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA. A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
Any amount rolled over is subject to the same rules for converting a traditional IRA into a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.
There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there's no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.
Starting in 2010, conversion is now allowed to all taxpayers. The prior income restriction allowing conversion only for taxpayers of income (again, MAGI) of $100,000 or less in the conversion year has been terminated. All taxpayers are able to convert a regular IRA to a Roth IRA starting in 2010. The conversion is a taxable distribution, which can be taken into income in the conversion year or averaged over the next two years. The conversion will not be subject to the 10% early distribution penalty.
Since everyone recognizes that conversion is a high-risk exercise, the law and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a "re-characterization". This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.
Tip: One reason to do this would be where you find you've exceeded the $100,000 income ceiling for Roth IRA conversions.
Tip: Another reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.
Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you're taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.
Can you undo one Roth IRA conversion and then make another one-a reconversion? Yes-once, subject to these requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.
You are not required to take distributions from your Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs
Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.
Also known as the saver's credit, this credit helps low and moderate income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can't be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2014 for a married filer is below $60,000 ($59,000 in 2013). For heads-of-household MAGI is below $45,000 ($44,250 in 2013) and for others (single, married filing separately) it is below $30,000 ($29,550 in 2013). These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10-50% of each dollar placed into a qualified retirement plan up to the first $2,000. The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50% of $2,000).
Note: Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.
The following table details the percentage of Saver's credit based on Adjusted Gross Income (AGI):
2014 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $30,000
more than $45,000
more than $60,000
2013 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $29,500
more than $44,250
more than $59,000
2012 Saver's Credit
Single Filers AGI
Head of Household AGI
Joint Filers AGI
50% of contribution
20% of contribution
10% of contribution
Credit Not Available
more than $28,750
more than $43,125
more than $57,500
Note: The saver's credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until April 15 of the following year and still be considered in the current tax year.
Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund-largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.
Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.
Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.
A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases-a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there's the question whether Roth IRA benefits currently promised will survive into future decades.
Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call us if you have any questions.
The "SIMPLE" Plan: A Retirement Plan for the Really Small Business
Several different types of retirement plan - 401(k), defined benefit, and profit-sharing - can be made to suit a prosperous small business or professional practice. But if yours is a really small business such as a home-based, start-up, or sideline business, maybe you should consider adopting a SIMPLE IRA plan.
A SIMPLE IRA plan is a type of retirement plan specifically designed for small business and is an acronym for "Savings Incentive Match Plans for Employees." SIMPLE IRA plans are intended to encourage small business employers to offer retirement coverage to their employees, but work just as well for self-employed persons without employees.
SIMPLE IRA plans contemplate contributions in two steps: first by the employee out of salary, and then by the employer, as a "matching" contribution (which can be less than the employee contribution). Where SIMPLE IRA Plans are used by self-employed persons without employees - as IRS expressly allows - the self-employed person is contributing both as employee and employer, with both contributions made from self-employment earnings. (One form of SIMPLE IRA plan allows employer contributions without employee contributions. The ceiling on contributions in this case makes this SIMPLE IRA Plan option unattractive for self-employed individuals without employees.)
Note: To establish a SIMPLE IRA Plan you:
- Must have 100 or fewer employees.
- Cannot have any other retirement plans.
- Need to annually file a Form 5500.
- Employees must earn $5,000 a year.
A quick list of pros and cons:
- Plan is not subject to the discrimination rules that everyday 401(k) plans are.
- Employees are fully vested in all contributions.
- Straightforward benefit formula allows for easy administration.
- Optional participant loans and hardship withdrawals add flexibility for employees.
- No other retirement plans can be maintained.
- Withdrawal and loan flexibility adds administrative burden for the employer.
Those with relatively modest earnings will find that a SIMPLE IRA Plan lets them contribute (invest) and deduct more than other plans. With a SIMPLE IRA Plan, you can put in and deduct some or all of your self-employed business earnings. The limit on this "elective deferral" is $12,000 in 2014 (same as 2013). This limit is expected to be adjusted for inflation in future years.
If your earnings exceed that limit, you could make a modest further deductible contribution--specifically, your matching contribution as employer. Your employer contribution would be 3 percent of your self-employment earnings, up to a maximum of the elective deferral limit for the year. So employee and employer contributions for 2014 can't total more than $24,000 ($12,000 maximum employee elective deferral, plus a maximum $12,000 for the employer contribution.)
Catch up contributions. Owner-employees age 50 or over can make a further deductible "catch up" contribution as employee of $2,500 in 2014 (same as 2013).
Example: An owner-employee age 50 or over in 2014 with self-employment earnings of $40,000 could contribute and deduct $12,000 as employee plus an additional $2,500 employee catch up contribution, plus a $1,200 (3 percent of $40,000) employer match, for a total of $15,700.
Low-income owner-employees in SIMPLE IRA Plans may also be allowed a tax credit up to $2,000 in 2014 for single filers ($4,000 married filing jointly). This is known as the "Saver's Credit" and income must not be more than $60,000 for married filing jointly, $30,000 for singles, and $45,000 for heads of household.
SIMPLE IRA plans are an excellent choice for home-based businesses and ideal for full-time employees or homemakers who make a modest income from a sideline business.
If living expenses are covered by your day job (or your spouse's job), then you would be free to put all of your sideline earnings, up to the ceiling, into SIMPLE IRA plan retirement investments.
An individual 401(k) plan however, could allow you to contribute more, often much more, than SIMPLE IRA Plan. For example, if you are less than 50 years old with $50,000 of self-employment earnings in 2014, you could contribute $12,000 as employee to your SIMPLE IRA PLAN plus an additional 3 percent of $50,000 as an employer contribution, for a total of $13,500. A 401(k) plan would allow a $30,000 contribution.
With $100,000 of earnings, the total for a SIMPLE IRA Plan would be $15,000 and $42,500 for a 401(k).
There's no legal barrier to withdrawing amounts from your SIMPLE IRA Plan, whenever you please. There can be a tax cost, though: Besides regular income tax, the 10 percent penalty tax on early withdrawal (generally, withdrawal before age 59 1/2) rises to 25 percent on withdrawals in the first two years the SIMPLE IRA Plan is in existence.
A SIMPLE IRA Plan really is a "simple" plan to set up and operate than most other plans. Contributions go into an IRA that you set up. Those already familiar with IRA rules investment options, spousal rights, and creditors' rights don't have a lot new to learn.
Requirements for reporting to the IRS and other agencies are negligible, at least for you, the self-employed person. Your SIMPLE IRA Plan's trustee or custodian, typically an investment institution, has reporting duties and the process for figuring the deductible contribution is a bit simpler than with other plans.
We've seen that other plans can do better than SIMPLE IRA Plan once self-employment earnings become significant. Other not-so-good features include the following:
Because investments are through an IRA, you're not in direct control. You must work through a financial or other institution acting as trustee or custodian, and will in practice have fewer investment options than if you were your own trustee, as you could be in a Keogh. For many self employed individuals however, this won't be an issue. In this respect, a SIMPLE IRA Plan is like the SEP-IRA.
Other plans for self-employed persons allow a deduction for one year (say 2014) if the contribution is made the following year (2015) before the prior year's (2014) return is due (April 2015 or later extensions). This rule applies with SIMPLE IRA Plans, for the matching (3 percent of earnings) contribution you make as employer. But there's no IRS pronouncement on when the employee's portion of the SIMPLE IRA Plan is due where the only employee is the self-employed person. Those who want to delay contribution would argue that they have as long as it takes to compute self-employment earnings for 20143 (though not beyond the 2014 return due date, with extensions).
Tip: The sooner your money goes in the plan, the longer it's working for you tax-free. So delaying your contribution isn't the wisest financial move.
You can’t set up the SIMPLE IRA Plan after the year ends and still get a deduction for that year, as is allowed with SEPs. Generally, to make a SIMPLE IRA Plan effective for the year it must be set up by October 1 of that same year. A later date is allowed where the business is started after October 1. In this instance the SIMPLE IRA Plan must be set up as soon thereafter as administratively feasible.
Then there's this problem if the SIMPLE IRA Plan is intended for a sideline business and you're already in a 401(k) plan in another business or as an employee. In this scenario, the total amount you can put into the SIMPLE IRA Plan and the 401(k) plan combined can't be more than $17,500 in 2014 (same as 2013)--$23,000 if catch up contributions are made to the 401(k) by one age 50 or over. Here’s an example: If someone who is less than age 50 puts $8,500 in her 401(k), he or she can't put more than $9,000 in her SIMPLE IRA Plan in 2014. The same limit applies if you have a SIMPLE IRA Plan while also contributing as an employee to a "403(b) annuity" (typically for government employees and teachers in public and private schools).
You can set up a SIMPLE IRA Plan on your own by using IRS Form 5304-SIMPLE IRA PLAN or Form 5305-SIMPLE IRA PLAN, but most people turn to financial institutions. SIMPLE IRA Plans are offered by the same financial institutions that offer IRAs and 401(k) plans.
You can expect the institution to give you a plan document (approved by IRS or with approval pending) and an adoption agreement. In the adoption agreement you will choose an "effective date", which is the beginning date for payments out of salary or business earnings. Remember, that date can't be later than October 1 of the year you adopt the plan, except when a business is formed after October 1.
Another key document is the Salary Reduction Agreement, which briefly describes how money goes into your SIMPLE IRA Plan. You need such an agreement even if you pay yourself business profits rather than salary.
Printed guidance on operating the SIMPLE IRA Plan may also be provided. You will also be establishing a SIMPLE IRA Plan account for yourself as participant.
SIMPLE IRA PLAN
Plan type: Can be defined benefit or defined contribution (profit-sharing or money purchase)
Defined contribution only
Defined contribution only
Owner may have two or more plans of different types, including a SEP, currently or in the past
Owner may have SEP and Keoghs
Generally, SIMPLE IRA PLAN is the only current plan
Plan must be in existence by the end of the year for which contributions are made
Plan can be set up later--if by the due date (with extensions) of the return for the year contributions are made
Plan generally must be in existence by October 1st of the year for which contributions are made
Dollar contribution ceiling (for 2014): $52,000 for defined contribution plan; no specific ceiling for defined benefit plan
Percentage limit on contributions: 50% of earnings, for defined contribution plans (100% of earnings after contribution). Elective deferrals in 401(k) not subject to this limit. No percentage limit for defined benefit plan.
50% of earnings (100% of earnings after contribution). Elective deferrals in SEPs formed before 1997 not subject to this limit.
100% of earnings, up to $12,000 for 2014 for contributions as employee; 3% of earnings, up to $12,000 for contributions as employer
Deduction ceiling: For defined contribution, lesser of $52,000 or 20% of earnings (25% of earnings after contribution). 401(k) elective deferrals not subject to this limit. For defined benefit, net earnings.
Lesser of $52,000 or 20% of earnings (25% of earnings after contribution). Elective deferrals in SEPs formed before 1997 not subject to this limit.
Maximum contribution $12,000 (in 2014)
Catch up contribution 50 or over: Up to $5,500 in 2014 for 401(k)s
Same for SEPs formed before 1997
Half the limit for Keoghs, SEPs (up to $2,750 in 2014)
Prior years' service can count in computing contribution
Investments: Wide investment opportunities. Owner may directly control investments.
Somewhat narrower range of investments. Less direct control of investments.
Same as SEP
Withdrawals: Some limits on withdrawal before retirement age
No withdrawal limits
No withdrawal limits
Permitted withdrawals before age 59 1/2 may still face 10% penalty
Same as Keogh rule
Same as Keogh rule except penalty is 25% in SIMPLE IRA PLAN Plan's first two years
Spouse's rights: Federal law grants spouse certain rights in owner's plan
No federal spousal rights
No federal spousal rights
Rollover allowed to another plan (Keogh or corporate), SEP or IRA, but not a SIMPLE IRA PLAN.
Same as Keogh rule
Rollover after 2 years to another SIMPLE IRA PLAN and to plans allowed under Keogh rule
Some reporting duties are imposed, depending on plan type and amount of plan assets
Few reporting duties
Negligible reporting duties