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Cunningham, Malone, & Morton

The Tax Professionals

Improving Your Retirement

In this section we've amassed a selection of financial guides designed to help you make the most of your retirement experience. Read at your leisure!

Table of Contents

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 And what happens if the funds aren't withdrawn before you die?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.

Withdrawal While You're Alive

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.

Withdrawal after You Die

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.

Tax Planning

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.

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:

  1. Take everything in a lump sum.
  2. Take some kind of annuity.
  3. Roll over the distribution.
  4. Take a partial withdrawal.
  5. Do some combination of the above.
Note: As you will see, the rules on retirement plan distributions are quite complex. They are offered here only for your general understanding. Professional guidance is advised before taking retirement distributions or other major withdrawals from your retirement plan.

Before discussing the specific withdrawal options, let's consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.

Related Guide Related Guide: The tax treatment will be dictated not only by the form of the withdrawal (i.e., how to take it) but also by the timing of the withdrawal (i.e., when to take it). This Financial Guide discusses the "how." For a discussion of the "when," please see the Financial Guide RETIREMENT PLAN DISTRIBUTIONS: WHEN to Take Them.

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:

  • Your non-deductible IRA contributions.
  • Your after-tax contributions to company or Keogh plans (usually, thrift, savings or other profit-sharing plans, but sometimes pension plans).
  • Your after-tax contributions to 401(k)s (in excess of the pre-tax deferral limit).

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.

Example Example: At age 47, you withdraw $10,000 from your retirement account (and do not roll over the funds). That $10,000 is ordinary income on which you'll owe regular tax at your applicable rate plus a 10% penalty tax ($1,000).

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

Tip Tip: There are several ways to avoid this penalty tax. The most common are:
  • You're age 59 ½ or older.
  • You're retired and are age 55 or older (however, this does not apply to IRAs).
  • You're withdrawing in roughly equal installments over your life expectancy or your joint-and-survivor life expectancy (discussed later).
  • You're disabled.
  • The withdrawal is required by a divorce or separation settlement (here, too, this does not apply to IRAs).
  • The withdrawal is for certain medical expenses.
  • The withdrawal is for health insurance while unemployed (also available to self-employed).
  • For IRAs only: The withdrawal is for certain higher education expenses and for first-time home purchases (up to $10,000).

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

The Basics

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.

Tip Tip: While your funds remain in the plan, earnings on the investment assets grow tax-free. The tax shelter ends once the funds are withdrawn. Preserving this tax shelter is one reason to decide not to withdraw the funds at all or to decide against withdrawing everything in a lump sum. The tax shelter continues, in one form or another, for funds withdrawn as annuities and for funds left in the plan when there's a partial withdrawal of funds. And the shelter continues on rollovers.

Tax Planning

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.

Tip Tip: Because lump sum withdrawal ends the tax shelter, it's rarely the road to maximizing wealth. Retirees will usually do better with arrangements that preserve the shelter, through rollovers, annuities or partial withdrawals.

Roll Over The Distribution

The Basics

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.

Tip Tip: A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employer's plan. Rollovers can be of the entire retirement account or only part of the account.

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:

Caution Caution: Federal law grants a person no rights in his or her spouse's IRA. Thus, a plan participant's rollover will strip the participant's spouse of rights the spouse had under the plan from which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)

Caution Caution: A rollover will eliminate the chance of lump sum tax relief, unless the IRA was just a conduit for the movement of funds between retirement plans.

Tip Tip: In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 70 ½, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.

Tip Tip: A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.

Tax Planning

Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:

  • After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
  • You can't roll over amounts you're required to withdraw after reaching age 70 ½ or amounts you're due to receive under a fixed annuity.
Caution Caution: If you do the rollover yourself-personally withdrawing funds from one plan and moving them to another-the plan you're withdrawing from must withhold tax at a 20% rate on the withdrawal. To avoid tax on the 20% withheld, you'll have to come up with that amount from elsewhere and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year's tax liability.) On the other hand, a direct rollover (having the funds transferred directly from the transferring plan to the receiving plan) avoids withholding.

Caution Caution: If you do the rollover yourself, the withdrawn funds are taxable if they don't reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to roll over funds is a direct rollover.

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.

Caution Caution: The rollover is not tax-free if cash is withdrawn, used to buy investment assets, and the new assets are then transferred to the new plan.

Take A Partial Withdrawal

The Basics

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.

Note: Before retirement, partial withdrawals are fairly common with profit-sharing plans, 401(k)s, and stock bonus plans. After retirement, they are fairly common in all types of plans (though least common with defined-benefit pension plans)

Tax Planning

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.

Example Example: Your retirement account totals $100,000, which includes an after-tax investment of $10,000. You withdraw $5,000. The withdrawal is tax-free to the extent of $500 ($10,000/$100,000x$5,000).

Note: The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.

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.

Related Guide Related Guide: For a discussion of Roth IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.

Life Insurance Options

Here are your typical options where whole life insurance is held for you in a retirement plan:

  • Your employer surrenders the policy to the insurance company for its cash surrender value, which it pays over to you.
  • Your employer trades in the policy for an annuity on your life.
  • Your employer distributes the policy to you.
  • Some mix of the above, such as getting some cash proceeds and an annuity.

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:

  • Stock distributed by a stock bonus plan. Your after-tax investment in the stock comes back tax-free and you pay no tax on the stock's appreciation in value until you sell it. But you have the option to pay tax on the value when received.

  • Annuity contract. These aren't taxed when distributed. You're taxed under the annuity rules above on annuity payments as received.

  • Insurance policy. If you convert the policy to an annuity contract within 60 days, the distribution is tax-free. However, you're taxed under the annuity rules as payments are received. If you keep the policy, you're taxed on the policy's cash value (less your after-tax investment).

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:

  • A fixed-term annuity, whereby the annuity will continue for a fixed term (say, ten years) even though you die before the end of this term. (This additional benefit is called a "refund feature.")
  • A joint and survivor annuity, where the annuity is payable over two lives instead of one.

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:

  • Keogh plans where the Keogh owner (or owner and spouse) are the only ones in the plan and
  • IRA plans, up to the amount rolled over from retirement plans, plus up to $1 million (which the bankruptcy court may increase where appropriate).

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:

  • A state cannot tax a retirement plan distribution if it imposes no income tax on individuals (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
  • A state from which a pension is paid, by an employer or former employer in the state, can't tax the pension recipient in another state. In other cases, states generally follow the basic federal approach of taxing retirement distributions as ordinary income (and treating return of after-tax investment as tax-free). But some states don't follow the federal rules for Keogh or IRA investment. Hence, withdrawals from such plans can get state tax relief not allowed under federal law.
  • Some states grant tax relief for a certain dollar amount of retirement income, relief that extends to retirement plan withdrawals. In some states the relief may look something like the federal credit for the elderly.
  • Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals after age 70 ½.

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.

Eligibility for Retirement Benefits

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.

Amount of Your Retirement Benefits

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.

Full Retirement

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 earlier65
193865 and 2 months
193965 and 4 months
194065 and 6 months
194165 and 8 months
194265 and 10 months
195566 and 2 months
195666 and 4 months
195766 and 6 months
195866 and 8 months
195966 and 10 months
1960 and later67

Early Retirement

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).

Delayed Retirement

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 later8%

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.

Choosing Your Retirement Date

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.

Benefits for Widows/Widowers

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.

How Work Affects Your Benefits

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.

Your Family's Benefits

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.

How to Apply

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.

Your Right to Appeal

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.

Taxability of Benefits

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.

Pensions from Work Not Covered by Social Security

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).

Leaving the United States

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 Insurance

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.)

Survivors Benefits: A Guide To This Often overlooked Insurance Add-On

Many people think that Social Security only provides retirement checks, but that's just part of what the Social Security Administration (SSA) does. In the event of your death, your survivors may also be entitled to Social Security benefits, an important consideration when figuring out how much life insurance you'll need to provide for your family when you die.

Part of the Social Security tax you pay goes toward survivors benefits. When someone who has worked and paid into Social Security dies, these survivors benefits can be paid to certain family members, including widows, widowers (and divorced widows and widowers), children, and dependent parents. It's a benefit that shouldn't be overlooked when figuring out your life insurance needs.

Related Guide: Please see the Financial Guide: LIFE INSURANCE: How Much And What Kind To Buy.

You, along with millions of other people, earn survivors benefits by working and paying Social Security taxes and roughly 98% of the children in this country are eligible for benefits if a working parent should die. In fact, Social Security pays more benefits to children than any other federal program.

Eligibility for Survivors Benefits

When you die, certain members of your family may be eligible for survivors benefits if you paid Social Security taxes and earned enough "credits". Most people earn a maximum of four credits per year. In 2013 for example, you receive one credit for each $1,160 of earnings ($4,640 to get the maximum of four credits). 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.). The younger you are, the fewer credits are needed to be eligible for survivors benefits, but nobody needs more than 40 credits (10 years of work).

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.

Under a special rule, benefits can be paid to your children, as well as your spouse who is caring for the children even if you don't have the number of credits needed. Benefits can be paid as long as you have credit for one-and-one-half years of work in the three years just before your death.

Who Can Get the Benefits?

When you die, your widow or widower may be able to receive full benefits at full retirement age. Full retirement age is age 66 for people born in 1945-1956 and gradually increases to age 67 for people born in 1962 or later. Reduced widow or widower benefits can be received as early as age 60. If your surviving spouse is disabled, benefits can begin as early as age 50.

In addition, a widow or widower can be paid benefits at any age if she or he takes care of your child who is under 16 or disabled and who gets benefits.

Dependent parents, age 62 or older (for parents to qualify as dependents, you would have had to provide at least one-half of their support) and unmarried children under age 18 (up to age 19 if they are attending elementary or secondary school full time) are also eligible for survivors benefits. Your children can get benefits at any age if they were disabled before age 22 and remain disabled, and under certain circumstances, benefits can also be paid to your stepchildren or grandchildren.

There is a special one-time payment of $255 that can be made when you die if you have accumulated enough work credits. This payment can be made only to your spouse or minor children if they meet certain requirements.

If you have been divorced, your former wife or husband who is age 60 or older (50-59 if disabled) can get benefits if your marriage lasted at least 10 years. Your former spouse, however, does not have to meet the age or length-of-marriage rule if he or she is caring for his/her child who is younger than age 16 or who is disabled and also entitled based on your work. The child must be your former spouse's natural or legally adopted child.

Benefits paid to you as a surviving divorced spouse who meets the age or disability requirement as a widow or widower won't affect the benefit rates for other survivors getting benefits on the worker's record. However, if you are the surviving divorced mother or father who has the worker's child under age 16 or disabled in your care, your benefit will affect the amount of the benefits of others on the worker's record.

Benefits paid to a surviving divorced spouse who is 60 or older will not affect the benefit rates for other survivors getting benefits.

How Much Are the Benefits?

The amount of money your family receives from Social Security depends on your average lifetime earnings. The higher your earnings, the higher their benefits will be. There is a limit to the benefits that can be paid to you and other family members each month. The limit varies, but is generally between 150 and 180 percent of the deceased's benefit amount.


Tip: To get an estimate of the Social Security survivors benefits that could be paid to your family, call Social Security at 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. 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. There is no charge for this service.

How to Apply for Benefits

When you apply for benefits, you will need to furnish certain information including proof of death—either from a funeral home or death certificate, your Social Security number as well as the deceased worker's, your birth and marriage certificates (if applicable), dependent children's Social Security numbers, if available, and birth certificates.

How you sign up for survivors benefits depends on whether or not you are getting other Social Security benefits, but in general, survivors receive:

  • A widow or widower, at full retirement age or older, generally receives 100 percent of the worker's basic benefit amount;
  • A widow or widower, age 60 or older, but under full retirement age, receives about 71-99 percent of the worker's basic benefit amount; or
  • A widow or widower, any age, with a child younger than age 16, receives 75 percent of the worker's benefit amount.
  • Children receive 75 percent of the worker's benefit amount.

No Other Social Security Benefits

You should apply for survivors benefits promptly because, in some cases, benefits may not be retroactive. The rules are complicated and vary depending on your situation, so you should talk to a Social Security representative about the options available to you.

Getting Other Social Security Benefits

If you are getting benefits as a wife or husband based on your spouse's work, when you report the death to SSA, your payments will change to survivors benefits.

If you are getting benefits based on your own work, you may be able to get more money as a widow or widower. If so, you will receive a combination of benefits that equals the higher amount. You will need to complete an application to switch to survivors benefits, and SSA will need to see your spouse's death certificate. In addition, if you get Social Security survivors benefits, the amount of your benefits may be reduced if your earnings exceed certain limits. There are no limits once you reach 70.

Pensions from work not covered by Social Security

If you get a pension from work where you paid Social Security taxes, that pension will not affect your Social Security benefits. However, if you get a pension from work that was not covered by Social Security— for example, the federal civil service, some state or local government employment or work in a foreign country—your Social Security benefit may be reduced.

If You Still Work

If you work while getting Social Security survivors benefits and are younger than full retirement age, your benefits may be reduced if your earnings exceed certain limits. The full retirement age was 65 for people born before 1938 but will gradually increase to 67 for people born in 1960 or later. There is no earnings limit beginning with the month you reach full retirement age. Also, your earnings will reduce only your benefits, not the benefits of other family members.


Tip: To find out what the limits are this year and how earnings above those limits reduce your Social Security benefits, contact Social Security to request the leaflet How Work Affects Your Social Security Benefits (Publication No. 05-10069).

If You Remarry

In general, you cannot get survivors benefits if you remarry. But remarriage after 60 (50 if disabled) will not prevent benefit payments on your former spouse's record. And, at 62 or older, you may get benefits on the record of your new spouse if they are higher.


Medicare is a health insurance plan for people who are 65 or older. People who are disabled or have kidney failure also can get Medicare. Like Social Security, Medicare is financed by a portion of the payroll taxes paid by workers and their employers.

Note: If you live in Puerto Rico you will not receive Medicare Medical Insurance (Medicare Part B) automatically. You will need to sign up for it during your initial enrollment period or you will pay a penalty. To sign up, call the Social Security Administration at 1-800-772-1213 or contact your local Social Security office.

Medicare has four parts:

  • Hospital Insurance - helps pay for inpatient care in a hospital or skilled nursing facility (following a hospital stay), some home health care and hospice care.

  • Medical Insurance - helps pay for doctors' services and many other medical services and supplies that are not covered by hospital insurance.

  • Medicare Advantage - plans are available in many areas. People with Medicare Parts A and B can choose to receive all of their health care services through one of these provider organizations under Part C.

  • Prescription Drug Coverage - helps pay for medications doctors prescribe for treatment.

Confidentiality of Your Personal Information

Social Security keeps personal information on millions of people. That information, such as your Social Security number, earnings record, age, and address, is kept confidential. Generally, SSA will discuss this information only with you and needs your permission if you want someone else to help with your Social Security business.

If you send a friend or family member to an SSA office to conduct your Social Security business, send your written consent with them. Only with your written permission can SSA discuss your personal information with them and provide the answers to your questions.

In the case of a minor child, the natural parent or legal guardian can act on the child's behalf in taking care of the child's Social Security business.

The privacy of your records is guaranteed. There are times when the law requires Social Security to give information to other government agencies to conduct other government health or welfare programs-such as Aid to Families with Dependent Children, Medicaid, and SNAP, the Supplemental Nutrition Assistance Program (formerly known as food stamps). Programs receiving information from Social Security are prohibited from sharing that information.

Your Pension: What You're Entitled To

What happens to your pension if your employer goes out of business? How careful does a plan administrator have to be in managing retirement plan assets? What rights does your spouse have in your retirement plan benefits? This Financial Guide answers these and other major questions that you may have.

Federal law, mainly the Employee Retirement Income Security Act (ERISA), provides you with certain safeguards and guarantees as to the money you have in a plan maintained by an employer. This Financial Guide provides the answers to the major questions you may have about your pension plan.

What Does ERISA Do For You?

ERISA sets minimum standards that pension plans in private industry must meet. Thus, if your employer maintains a pension plan, ERISA dictates, for example, the latest date by which you can become a participant and how long you may be required to work before you obtain a vested (non-forfeitable) interest in your pension.

If not for ERISA (or some other federal or state law), plans would, for example, be able to require that employees work ten years before becoming vested in a pension plan or to require them to work five years before having to put in any money for them.

ERISA does not force an employer to establish a pension plan. It merely requires that if the employer establishes a plan, the plan must meet ERISA's standards. The law also does not specify how much money a participant must be paid as a benefit.

What Standards Does ERISA Set?

ERISA does the following (these will be examined in more detail later on in the guide):

  • Requires plans to provide participants with information about the plan. Participants are employees who have worked a certain length of time and are therefore eligible to participate in the plan.

  • Sets minimum standards for participation, vesting, benefit accrual and funding. The law defines how long a person may be required to work before becoming eligible to participate in a plan, to accumulate benefits, and to have a vested right to those benefits. The law also has detailed funding rules that require employer plan sponsors to provide adequate funding for your plan.

  • Requires accountability of plan fiduciaries. ERISA says a fiduciary is anyone who exercises discretionary authority or control over a plan's management or assets, including anyone who provides investment advice to the plan. Fiduciaries who do not follow the ERISA principles of conduct may be liable for restoring losses to the plan.

  • Gives participants the right to sue for benefits and breaches of fiduciary duty.

  • Guarantees payment of certain benefits if a defined benefit plan is terminated.

Before we discuss what ERISA guarantees, it is important to distinguish among the different types of employee retirement plans, since the rights guaranteed with pension plans vary according to the type of plan. Generally speaking, there are two types of pension plans: (1) defined benefit plans and (2) defined contribution plans.

What is a Defined Benefit Plan?

A defined benefit plan, usually a traditional pension plan, promises you a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service-for example, one percent of your average salary for the last five years of employment for every year of service with your employer. The amount of your benefit depends on what is promised, not on the performance of the investments.

The general rules of ERISA apply to defined benefit plans, and some specialized rules also apply.

What is a Defined Contribution Plan?

A defined contribution plan, on the other hand, does not promise you a specific amount of benefits at retirement. In these plans, you or your employer (or both) contribute to your individual account under the plan, sometimes at a set rate, such as five percent of your earnings annually.

The contributions are invested on your behalf. When you retire, quit, or otherwise separate from service, you will receive the balance in your account, which is based on contributions plus or minus investment gains or losses. The value of your account will fluctuate due to changes in the value of your investments.

Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans. The general rules of ERISA apply to each of these types of plans.

Tip: To determine what type of plan your employer provides, check with your plan administrator or read your summary plan description.

There are a number of variations on the defined contribution plan. These include (1) the Money Purchase Plan, (2) the Simplified Employee Pension Plan (SEP), (3) the Profit Sharing Plan and Stock Bonus Plan, (4) the 401 (k) Plan, (5) the "Simple" Plan, and (6) the Employee Stock Ownership Plan (ESOP). They are discussed below:

Money Purchase Plan. A money purchase pension plan requires fixed annual contributions from your employer to your individual account. This is a type of defined contribution plan. Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.

Simplified Employee Pension Plan (SEP). Your employer may sponsor a Simplified Employee Pension plan (SEP). SEPs are relatively simple retirement savings vehicles which allow employers to make contributions on a tax-favored basis to individual retirement accounts (IRAs) owned by the employees. SEPs are subject to fewer reporting and disclosure requirements than other retirement plans. Under a SEP, you as the employee generally set up an IRA to accept your employer's contributions. (Sometimes the employer does this.) Your employer can contribute a percentage of your pay into a SEP each year.

Related Guide: For tax rules and contribution limits on pension and other employee retirement plans, see the Financial Guide: EMPLOYEE BENEFITS: How To Handle Them.

Profit Sharing Plan and Stock Bonus Plan. A profit sharing or stock bonus plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise). The plan contains a formula for allocating to each participant a portion of each annual contribution. A profit sharing plan or stock bonus plan may include a 401(k) plan.

401(k) Plan. Your employer may establish a defined contribution plan that is a cash or deferred arrangement, usually called a 401(k) plan. You can elect to defer receiving a portion of your salary, which is instead contributed on your behalf, before taxes, to the 401(k) plan. Sometimes the employer matches your contributions. There are special rules governing the operation of a 401 (k) plan.

Tip: Your employer must advise you of any limits that may apply to you.

"Simple" Plan. Recent legislation allows self-employed persons and employers with 100 or fewer employees to establish "SIMPLE" retirement plans. The SIMPLE combines the features of an IRA and a 401(k).

Employee Stock Ownership Plan (ESOP). Employee stock ownership plans (ESOPs) are a form of defined contribution plan in which the investments are primarily in employer stock. Congress authorized the creation of ESOPs as one method of encouraging employee participation in corporate ownership.

What Information Does the Plan Have to Provide You With?

ERISA requires plan administrators, the people who run plans, to give you in writing the most important facts you need to know about your pension plan. Some of these facts must be provided to you regularly and automatically by the plan administrator. Others are available upon request, free-of-charge or for copying fees.

Tip: Your request for plan information should be made in writing.

The two most important documents you are entitled to are (1) the summary plan description and (2) the summary annual report. The summary annual report is a summary of the annual financial report that most pension plans must file with the Department of Labor. It is available to you at no cost.

Tip: To learn more about your plan's assets, ask the plan administrator for a copy of the annual report in its entirety.

What is the Summary Plan Description?

One of the most important documents you are entitled to receive automatically, when you become a participant of an ERISA covered pension plan or a beneficiary receiving benefits under such a plan, is a summary of the plan, called the summary plan description (SPD). Your plan administrator is legally obligated to provide the SPD to you free of charge.

The SPD tells you what the plan provides and how it operates. It tells you when you begin to participate in the plan, how your service and benefits are calculated, when your benefit becomes vested, when you will receive payment and in what form, and how to file a claim for benefits.

Tip: Read your SPD to learn about the particular provisions that apply to you. If a plan is changed you must be informed, either through a revised summary plan description, or in a separate document, called a summary of material modifications, which also must be given to you free of charge.

What if You Can't Obtain these Documents?

If you are unable to get the summary plan description, the summary annual report, or the annual report from the plan administrator, you may be able to obtain a copy by writing to the Department of Labor, PWBA, Public Disclosure Room, Room N-5638, 200 Constitution Avenue, N.W., Washington, D.C. 20210, for a nominal copying charge. If possible, provide the name of the plan, employer identification number (a 9-digit number assigned by the IRS) and the plan number (a 3-digit number, such as 002). If you do not have this information, give the name of the plan and the city and state.

Where Else Can I Get Plan Documents?

Documents for some plans are available for public inspection at the IRS. These documents include the applications filed by pension plans to determine if they meet federal tax qualification requirements, applications filed by certain organizations to determine if they qualify as tax-exempt, and the IRS responses to these applications. For information on available documents, contact the IRS Freedom of Information Electronic Reading Room via their website: IRS Freedom of Information Electronic Reading Room

Tip: If you terminate employment and you have a vested pension benefit (see below for an explanation of vested benefits) that you are not eligible to receive until later, that information will be reported by your plan to the IRS, which, in turn, will inform the Social Security Administration. This information must also be provided to you by the plan.

Tip: Keep the plan administrator informed about any change of address or name change after you leave employment to assure that you will receive the pension benefit due you.

What Age and Length of Service Requirements May Your Plan Impose?

Generally speaking, you must be permitted to become a participant if you have reached age 21 and have completed one year of service. Even if you work part-time or seasonally, you cannot be excluded from the plan on grounds of age or service if you meet this service standard. You must be permitted to begin to participate in the plan no later than the start of the next plan year or six months after meeting the requirements of membership, whichever is earlier.

ERISA imposes certain other participation rules. They depend on the type of employer for whom you work, the type of plan your employer provides, and your age. For example:

  • If you were an older worker when you were hired, you cannot be excluded from participating in the plan on grounds of age just because you are close to retirement age.
  • If, upon your entry into the plan, your benefit will be immediately fully "vested," or non-forfeitable (see below), the plan can require that you complete two years of service before you become eligible to participate in the plan. 401 (k) plans, however, cannot require you to complete more than one year of service before you become eligible to participate.
  • If you work for a tax-exempt educational institution and your plan benefit becomes vested after you earn one year of service, the plan can require that you be at least age 26 (instead of age 21 ) before you can participate in the plan.
  • If your employer maintains a SEP, you must be permitted to participate if you have performed services for the employer in three of the immediately preceding five years.

How is "Service" Measured?

ERISA has rules for how employers must measure employees' employment to determine how the eligibility, benefit accrual, and vesting rules apply. ERISA generally defines a year of service as 1,000 hours of service during a 12-month period. Different rules apply to counting service for purposes of eligibility, benefit accrual, and vesting.

Tip: A plan basically has a choice among three methods for determining whether you must be credited with a year of service for participation, vesting, and, in some circumstances, benefit accrual: the general method of counting service, a simplified equivalency method, or the elapsed time method. Refer to your summary plan description to see which method is used by your plan.

What is Benefit Accrual and how does it Work?

When you participate in a pension plan, you accrue (earn) pension benefits. Your accrued benefit is the amount of benefit that has accumulated or been allocated in your name under the plan as of a particular point in time. ERISA generally does not set benefit levels or specify precisely how benefits are to accumulate.

Plans may use any definition of service for purposes of benefit accrual as long as the definition is applied on a reasonable and consistent basis. Service for benefit accrual generally takes into account only the years of service you earn after you become a plan participant, not all service you have performed since you were hired by your employer. Employees who work less than full time, but at least 1,000 hours per year, must be credited with a pro rata portion of the benefit that they would accrue if they were employed full-time.

To illustrate: If a plan requires 2,000 hours of service for full benefit accrual, then a participant who works 1,000 hours must be credited with at least 50 percent of the full benefit accrual .

A special rule applies to SEPs: all participants who earn a certain minimum amount in compensation from their employers are entitled to receive a contribution.

Tip: Since ERISA generally does not regulate the amount of your benefit, you can estimate how much pension you are building up only by examining the summary plan description or the plan document. These documents should explain how you earn service credit for full benefit accrual each plan year.

Are Plan Features Other Than Accrued Benefits Protected?

Your accrued benefit includes more than just the amount of benefit you have accumulated. Your plan provides you with various rights and options, some of which are protected rights attached to your benefit amount. As a general rule, protected rights cannot be reduced or eliminated, nor can they be granted or denied at your employer's discretion. If a plan feature you care about has been eliminated, this section is designed to help you determine whether it was a protected right.

The rights that are protected include (1) optional forms of benefit payments, (2) early retirement benefits, and (3) retirement-type subsidies.

  • Optional forms of benefit payment. An example of an optional form of benefit that your plan may provide is the right to receive payment of your benefits in a lump sum payment rather than as an annuity.

  • Early retirement benefit. ERISA does not require a pension plan to provide participants with the option to retire earlier than at the plan's normal retirement age, but if such an option is offered, a plan generally may not be changed to eliminate the right to take such an early retirement as to benefits accrued before the change.

  • Retirement-type subsidy. Retirement-type subsidies are also a protected part of your benefit and cannot be eliminated retroactively.

Certain important plan features are not protected, such as a Social Security supplement, the right to direct investments, the right to a particular form of investment, the right to take a loan from a plan, or the right to make employee contributions at a particular rate on either a before or after tax basis.

Can Your Plan Reduce Future Benefits?

ERISA does not prohibit your employer from amending the plan to reduce the rate at which benefits accrue in the future. For example, a plan that pays $5 in monthly benefits at age 55 for years of service through 2001, may be amended to provide that years of service beginning in 2002 will be credited at the rate of $4 per month.

If you are a participant in a defined benefit plan or a money purchase plan, you must receive written notice of a significant reduction the rate of future benefit accruals after the plan amendment is adopted and at least 15 days before the effective date of the plan amendment. The written notice must describe the plan amendment and its effective date.

The 2001 Tax Relief Act put teeth in this rule by imposing a penalty excise for a plan's failure to provide notice to participants (or QDRO recipients) of plan amendments making significant reduction in the rate of future benefit accrual. The penalty generally is imposed on the employer, and applies after June 6, 2001. "Egregious" (for example, intentional) failure to give notice can in effect void the amendment. The toughened provision was prompted by widespread conversions of regular defined benefit pension plans to cash balance plans.

What if You Leave Your Job and Return Later?

A break in service can have serious consequences for your pension if it extends for a long enough time and your pension benefit is not yet fully vested. However, ERISA does not permit your accrued benefit to be forfeited if you have a short break in service. ERISA in general guarantees that your service credit cannot be forfeited for absences shorter than five consecutive years.

Tip: If you need to take a leave of absence, you should carefully examine your plan's rules so that you do not lose pension benefits you have accrued.

If you continue to work past normal retirement age without retiring, you continue to accrue benefits, regardless of age. However, a plan can limit the total number of years of service that will be taken into account for benefit accrual for anyone under the plan. If you retire and later go back to work with your employer, you must be allowed to continue to accrue additional benefits, subject to any such limit on total years of service credited under the plan.

Plans that provide for the payment of early retirement benefits may suspend payment of those benefits if you are re-employed before reaching normal retirement age. However, if the plan suspends payment of benefits before normal retirement age, under circumstances that would not have permitted a suspension after normal retirement age and the plan pays an actuarially reduced early retirement benefit, the plan must actuarially recalculate your monthly payment when you later begin to again receive payments.

Under certain circumstances (described below), your pension payments after you reach normal retirement age may be suspended if you return to work. For example, ERISA permits a multi-employer plan to suspend the payment of normal retirement benefits if you return to work in the same industry, the same trade, and the same geographical area covered by the plan as when benefits commenced.

Before suspending benefit payments, the plan must notify you of the suspension during the first calendar month in which the plan withholds payments. The notification must give you the information on why benefit payments are suspended, a general summary and a copy of the plan's suspension of benefit provisions, a statement regarding the Department of Labor regulations, and information on how you can request a review of the decision to suspend benefit payments. If most of this information is contained in the plan's summary plan description, the notification may simply refer to the appropriate pages of the summary plan description.

A plan that suspends benefit payments must tell you how you can request an advance determination of whether a particular type of reemployment would result in a suspension.

Tip: If you are a retiree and are considering taking a job, write to the administrator of your plan to ask if your pension benefits will be suspended.

What is Vesting and How does it Work?

Vesting refers to the amount of time you must work before earning a non-forfeitable right to your accrued benefit. When you are fully vested, your accrued benefit is yours, even if you leave the company before reaching retirement age.

Generally, if you are employed when you reach your plan's normal retirement age (usually 65), you will be fully vested. You also must be permitted to earn a vested right to your accrued benefit through service as described below.

You are always entitled to 100% vesting in your own contributions and salary reduction contributions and their investment earnings. However, if your employer contributes to your accrued benefit (as most do) you may be required to complete a certain number of years of service with the employer before the employer portion of your accrued benefit becomes vested. Thus, if you terminate employment before working for a long enough period with your employer, you may forfeit all or part of the accrued benefit provided by your employer.

You must be permitted to earn vesting credit according to a vesting schedule that is at least as generous as prescribed in ERISA schedules. Plans may provide a different standard, as long it is more generous than these minimums.

Tip: Check your summary plan description for a description of your employer's vesting schedule.

With some exceptions, once you begin participating in a pension plan, all of your years of service with the employer after you reached age 18 must be taken into account to determine whether and to what extent your accrued benefits are vested. This includes service you earned before you began to participate in the plan and service you earned before the effective date of ERISA.

However, ERISA does allow plans to disregard certain periods for purposes of determining an employee's vesting service.

Tip: For further details on what periods of service may be disregarded, see your summary plan description or the plan document to find out what periods are counted in your plan.

Tip: When you receive a benefit statement, compare the amount of your accrued benefit with the amount or percentage of your vested benefit to determine its accuracy. If these items are not clear from your benefit statement, ask your plan administrator.

The plan administrator may send you a benefit statement each year. If not, you may request a copy.

Tip: In order to keep track of your vesting service, you may want to keep records of your hire date, the date you began participating in the plan, and the dates of any leaves of absence that could affect your total service.

If the plan's vesting schedule is changed after you have completed at least three years of service, you have the right to select the vesting schedule that existed prior to the change for the entire length of your service, rather than the new schedule.

Plans are considered top-heavy if they are tax qualified and more than 60 percent of the benefits accrue to certain owners and officers, otherwise known as key employees. This could, for example, occur in small companies that have frequent turnover of rank-and-file workers. In years in which a plan is top-heavy, you have the right to both faster vesting and minimum benefits, if you are not a key employee. The 2001 Tax Relief Act eased the top-heavy rules for 2002 and after. This could have the effect of increasing key employees' shares in the plan, and reducing others' shares.

When Will Your Benefits Be Paid?

ERISA provides specific rules governing when you may or must begin receiving your pension benefits. First, ERISA sets the latest date by which the plan must permit you to begin receiving your benefit. Under this rule, payment must begin by the 60th day after the end of the plan year in which the latest of the following events occur:

  1. Your reaching of age 65 or, if earlier, the normal retirement age specified by your plan
  2. The end of 10th year after you began participation in the plan
  3. Your termination of service

Example: Your plan must provide-at a minimum-that you will be entitled to begin to receive your benefit 60 days after the end of the plan year in which you reach age 65, if you began participation in the plan at least 10 years before that year.

Your plan may allow you to receive payment of your benefit earlier than required by the above rule (and many plans do, subject to rules described below). However, as long as the present value of your vested accrued benefit is greater than $5,000, the plan cannot force you to begin receiving your benefit before you reach the age that is generally considered normal retirement age (or age 62 if later) .

If the present value of your vested accrued benefit under the plan is $5,000 or less, the plan may require you to receive your benefit when it first becomes distributable, such as when you terminate. Under the 2001 Tax Relief Act, such amounts, if more than $1,000, are automatically rolled over to an IRA for your benefit, unless you decide otherwise. This rule becomes effective after implementing regulations are issued.

How Early May Your Plan Allow You to Take Payments?

ERISA provides rules governing the times at which a pension plan may permit you to receive benefits. As these limitations on "distribution events" for payment vary, depending on the type of pension plan, you should consult your summary plan description for the specific conditions under which you will be entitled to receive your benefits. After the event occurs that permits payment of your benefit, your plan may require some reasonable period of time during which to calculate your benefit and determine your payment schedule, or to value your account balance and to liquidate any investments in which your account is invested.

The following are a few general rules about possible distribution events for which your plan may provide.

  • If your plan is a defined benefit plan or a money purchase plan, it will set a normal retirement age, which is generally the time at which you will be eligible to begin receiving your vested accrued benefit. These types of plans may permit earlier payments, however, either by providing for early retirement benefits, for which the plan may set additional eligibility requirements, or by permitting benefits to be paid when you terminate employment, suffer a disability, or die.

  • If your plan is a 401(k) plan, it may permit you to take some or all of your vested accrued benefit when you terminate employment, retire, die, become disabled, reach age 59-1/2, or if you suffer a hardship.

  • If your plan is a profit-sharing plan or a stock bonus plan, your plan may permit you to receive your vested accrued benefit after you terminate employment, become disabled, die, reach a specific age, or after a specific number of years have elapsed.

Your plan's summary plan description should describe all of the rules applicable to any of the events that permit distributions.

When Must You Take Payment?

ERISA also sets a date by which you must begin to receive your benefits, regardless of your wishes or the plan's rules, if your plan is tax-qualified. This mandatory beginning date is generally April 1 of the calendar year following the calendar year in which you reach age 70-1/2. ERISA provides rules for determining how much of your accrued benefit you must then receive each year.

Note: Unless you own more than 5% of the business, the plan can allow you to postpone taking money out of your retirement plan beyond age 70-1/2 if you're still employed.

In What Form Will Your Benefits Be Paid?

With some very important limits, your plan can dictate the forms in which you may receive your accrued benefit. The protections that ERISA provides about form of benefit payments vary again depending on whether you have a defined benefit plan, money purchase plan, or other kind of defined contribution plan.

If you are covered under a defined benefit plan or a money purchase plan, your benefit must be available in the form of a life annuity, which means you will receive equal periodic payments (e.g., monthly, quarterly, etc.) for the rest of your life. If you are married, your benefit must be available in the form of a qualified joint and survivor annuity. (That form of benefit payment is described in the next section on spousal rights to benefit payments.) It is also free to offer benefits in a lump sum, as an alternative, subject to the participant's or spouse's right to insist on an annuity.

Caution: Be careful about choosing a lump sum payout instead of an annuity under a defined benefit plan. The lump sum can be calculated-legally-in an amount which is less than what pension advisers consider the present value of the annuity. Consult a professional before deciding.

If you are covered under a defined contribution plan that is not a money purchase plan, the plan may choose to pay your benefits in a single lump sum payment, or in any other form it chooses. If it offers a life annuity option, however, and you choose that option, you and your spouse (if any) will be protected by being offered a life annuity or a joint and survivor annuity that satisfies the requirements of ERISA.

What Will Your Surviving Spouse Get When You Die?

ERISA provides some guarantees for surviving spouses of deceased participants who had earned a vested pension benefit before death. The nature of the guaranteed interest depends on the type of plan and whether the participant dies before or after the annuity starting date-i.e., before or after payment of the pension benefit is scheduled to begin.

Tip: The rules we discuss apply to participants who completed an hour of service (or paid leave) on or after August 23, 1984. ERISA's survivor annuity rules are different if you are the surviving spouse of a participant who left employment before that date.

In the case of a defined benefit plan (traditional pension plan) or a money purchase plan, the plan must provide for a qualified joint and survivor annuity. In the case of a defined contribution plan (a 401(k) plan or profit-sharing plan), the protections are somewhat different. Let's take a look at each of these.

Tip: The summary plan description will tell you the type of plan involved and whether survivor annuities or other death benefits are provided under the plan.

What is a Qualified Joint and Survivor Annuity (QJSA)?

The QJSA requirement applies to defined benefit plans and money purchase plans. ERISA says the retirement benefit payment must be paid in a series of equal, periodic payments over your lifetime, with a payment continuing to your spouse for life if you die first-unless you and your spouse have chosen otherwise. The periodic payment to your surviving spouse must be at least 50% and not more than 100% of the periodic payment received during your joint lives.

If the plan provides other forms of benefit payment, and you and your spouse want to waive your rights to receive the QJSA and select one of the other payment forms, you can do so as long as:

  • You and your spouse receive a timely explanation of the QJSA,
  • Your waiver is made in writing within certain time limits, and
  • Your spouse consents to the waiver in writing, as witnessed by a notary or plan representative.

What is a Qualified Pre-Retirement Survivor Annuity (QPSA)?

A survivor annuity must also be offered by a defined benefit or money purchase plan if a married participant with a vested benefit dies before he or she begins receiving benefits. This survivor annuity is called a qualified pre-retirement survivor annuity (QPSA), and ERISA specifies how the QPSA is calculated. You and your spouse must be given a timely explanation of the QPSA. You may only waive the right to a QPSA in writing, and your spouse must consent to the waiver of the QPSA in writing, witnessed by a notary or plan representative.

What Survivor Benefit Rules Apply to Defined Contribution Plans (such as 401(k) Plans)?

Most profit sharing and stock bonus plans, e.g., 401(k) plans, generally need not offer a survivor annuity. However, there are different rules for such plans that protect the spouse as beneficiary.

Before you begin to receive your benefits under such a plan your spouse is automatically presumed to be your beneficiary. Thus, if you die before you receive your benefits, all of your benefits will automatically go to your surviving spouse. If you wish to select a beneficiary other than your spouse, your spouse must consent in writing, witnessed by a notary or plan representative. This protects your spouse in the event of your death before any payout has been made.

However, when it is time for you to take payouts from the plan (e.g., you terminate employment or reach retirement,) you may choose-without your spouse's consent-among any optional forms of payment offered by the plan, including a life annuity. If you choose a life annuity, however, your spouse is then protected by QJSA rules, and the benefit will be paid as a QJSA unless you and your spouse consent to a different form, as outlined above.

Tip: For more in-depth information on the rules governing QJSA and QPSA rights, IRS publications are available.

How Do You Make a Claim for Benefits?

Under ERISA you have a right to make a claim for benefits due under a plan. ERISA requires all plans to have a reasonable written procedure for processing your claims for benefits and for appealing if your claim is denied. The summary plan description should contain a description of your plan's procedures.

Tip: If you believe you are entitled to a benefit from a pension plan, but your plan fails to set up a claims procedure, present the claim to the plan administrator.

If you make a claim for benefits that is denied, the plan must notify you in writing, generally within 90 days after receipt of the claim, of the reasons for the denial and the specific plan provisions on which the denial is based. If the plan denies your claim because the administrator needs more information to make a decision, the administrator must tell you what information is needed. Any notice of denial must also tell you how to file an appeal.

If special circumstances require your plan to take more time to examine your request, it must tell you within the 90 days that additional time is needed, why it is needed, and the date by which the plan expects to make a final decision. If you receive no answer at all in 90 days, this is treated the same as a denial, and you can appeal.

You must be allowed at least 60 days to appeal any denial. After receiving your appeal, the plan generally must issue a ruling within 60 days, unless the plan provides for a special hearing. If the plan notifies you that it must hold a hearing, or that it has other special circumstances, it may have an additional 60 days.

The plan must furnish you with a final decision on your appeal and the reasons for the decision with references to the relevant plan documents. If you disagree with the final decision, you may then file a lawsuit seeking your benefit under ERISA, as explained below. But courts generally require that you complete all the steps available to you under the claims procedure in a timely manner before you seek relief through a lawsuit. This is called "exhausting your administrative remedies."

Can You Choose Your Own Investments?

In certain defined contribution plans, instead of one group or individual making all the investment decisions for the plan's assets, plan officials provide a number of investment options, and ask you to decide how to invest your account balance by choosing among those options.

The Department of Labor has rules about plans that permit you to direct your own investments. Under these rules, only if you truly exercise independent control in making your investment choices will plan officials be excused from fiduciary responsibility for your investment decisions.

A plan in which you actually exercise independent control over the investment of your individual account is called a 404(c) plan (after section 404(c) of ERISA). If you are a participant in a 404(c) plan, you are responsible for the consequences of your investment decision, and you cannot sue the plan officials for investment losses that result from your decision.

You are entitled to receive a broad range of information about the investment choices available under a 404(c) plan.

Tip: A plan that intends to relieve plan officials of fiduciary duties over investments must inform you of that fact.

A 404(c) plan must give you sufficient information about investment options for you to be able to make informed decisions. The information you are entitled to receive without asking includes the following:

  • Notice that the plan officials may be relieved of liability of losses.
  • A description of each investment option, including the investment goals, risk and return characteristics.
  • Information about designated investment managers.
  • An explanation of when and how to make investment instructions and any restrictions on when you can change investments.
  • A statement of the fees that may be charged to your account when you change investment options or buy and sell investments.
  • Information about your shareholder voting rights and the manner in which confidentiality will be provided on how you vote your shares of stock.
  • The name, address, and phone number of the plan fiduciary or other person designated to provide certain additional information on request.
  • For security investors, a copy of the most recent prospectus for the security.

Effective starting in 2007, a plan may arrange to provide individual investment advice, without liability for plan officials, subject to strict conditions.

How Must Your Plan Be Funded?

ERISA sets minimum funding rules to make sure sufficient money is available to pay promised pension benefits to you when you retire. Funding rules establish the minimum amounts that employers must contribute to plans to ensure that plans have enough money to pay benefits when due. The minimum funding rules apply to defined benefit plans and money purchase plans.

Defined benefit plans generally fund future benefits over time. The plans consider probable investment gains and losses and make assumptions about factors such as future interest rates and potential workforce changes. ERISA provides detailed funding rules to protect you from financing methods that could prove inadequate to pay the promised benefits when they are due.

ERISA provides severe sanctions against an employer who fails to meet the funding obligations. Any employer who fails to comply with the minimum funding requirements is charged an excise tax on the amount of the accumulated funding deficiency, unless the employer receives a waiver of the minimum funding requirements. This tax is imposed whether the under-funding was accidental or intentional.

Certain actions can also be taken by the Department of Labor and the Pension Benefit Guaranty Corporation to enforce the minimum funding standards.

Tip: A plan that intends to relieve plan officials of fiduciary duties over investments must inform you of that fact.

Tip: If a defined benefit plan is less than 90% funded, you must be notified each year about the plan's funding status and PBGC's guarantees. This rule is effective for plan years beginning after December 8, 1994.

Can Your Plan Be Terminated?

Although pension plans must be established with the intention of being continued indefinitely, employers are allowed to terminate plans.

If your plan terminates or becomes insolvent, ERISA provides you some protection. In a tax-qualified plan, your accrued benefit must become 100% vested as soon as the plan terminates, to the extent then funded.

If a partial termination occurs, for example, if your employer closes a particular plant or division that results in the layoff of a substantial portion of plan participants, immediate 100% vesting, to the extent funded, also is required for affected employees.

What If Your Plan Terminates Without Enough Money to Pay the Benefits?

If your terminated plan is a defined benefit plan insured by the Pension Benefit Guaranty Corporation, PBGC will guarantee the payment of your vested pension benefits up to the limits set by law. Benefits that are not guaranteed or that exceed PBGC's limits may be paid, depending on the plan's funding and on whether PBGC is able to recover additional amounts from the employer.

Tip: If a plan terminates, and the plan purchases annuity contracts from an insurance company to pay pension benefits in the future, plan fiduciaries must take certain steps to select the safest available annuity. Thus, in accordance with Department of Labor guidance, the plan must conduct a thorough search with respect to the financial soundness of insurance companies that provide annuities, to better assure the future payment of benefits to participants and beneficiaries.

Is Your Accrued Benefit Protected if Your Plan Merges?

Your employer may choose to merge your plan with another plan. If your plan is terminated as a result of the merger, the benefit you would be entitled to receive after the merger must be at least equal to the benefit you were entitled to receive before the merger.

Special rules apply to mergers of multi-employer plans, which are generally under the jurisdiction of the PBGC.

Suing Under ERISA

As a plan participant or beneficiary, you may bring a civil action in court to do any of these things:

  • Recover benefits due you and enforce your rights under the plan.
  • Get access to plan documents you requested in writing.

Tip: If your plan administrator does not supply the plan documents within 30 days of your written request, a court could find the plan administrator personally liable for up to $100 per day (unless the failure results from circumstances reasonably beyond his or her control).

  • Clarify your right to future benefits.
  • Get appropriate relief from a breach of fiduciary duty.
  • Enjoin any act or practice that violates the terms of the plan or any provision of Title I of ERISA, such as the reporting and disclosure, participation, vesting or funding, and fiduciary provisions, or to obtain other relief.
  • Enforce the right to receive a statement of vested benefits on termination of employment.
  • Obtain review of a final action of the Secretary of Labor; restrain the Secretary from taking action contrary to ERISA; or compel the Secretary to take action.
  • Obtain review of any action of the PBGC or its agents that adversely affects you.

A lawsuit under ERISA is filed in a federal district court. If you seek benefits or clarification of your right to future benefits, you can choose to file in a state court.

Tip: The court has the discretion to order either party in the suit (you or the plan, fiduciaries, or sponsor) to pay reasonable attorney fees and costs in a suit under ERISA.

Does the Government Ever Sue Employers or Sponsors?

The Secretary of Labor may directly bring a civil action under ERISA to enforce the fiduciary duty provisions of ERISA (explained later). The Labor Secretary also has limited authority to bring a civil action to enforce ERISA's participation, vesting, and funding standards with respect to a tax-qualified plan. In addition, the Secretary has discretion to intervene in lawsuits filed in federal court to enforce rights under ERISA.

If you sue in federal court claiming a breach of fiduciary duty, you must provide a copy of the complaint to the Secretary of Labor and the Secretary of the Treasury by certified mail.

Tip: It is not necessary to provide such notice to any government agency if you bring a lawsuit solely to recover benefits under the plan.

Can You Be Fired for Suing for Making a Claim Under ERISA?

ERISA prohibits employers from promising pensions and then firing or disciplining workers to avoid paying a pension. To that end, ERISA says it is unlawful for an employer to discharge, fine, suspend, expel, discipline, or discriminate against you or any beneficiary for the purpose of interfering with the attainment of any right to which you may become entitled under the plan or the law.

Also, employers cannot take any of these steps against you for exercising your rights under a plan or under ERISA, or for giving information or testimony in any inquiry or proceeding relating to ERISA. Further, the use of force or violence to restrain, coerce, or intimidate you for the purpose of interfering with your rights or prospective rights is punishable by a fine of up to $10,000 and/or up to one year in prison.

Can Your Creditors Get to Your Pension if You Get into Financial Trouble?

In general, your pension benefits cannot be taken away from you by people to whom you owe money. However, the IRS can attach such benefits for tax claims. And the law makes a limited further exception when family support is at stake. Thus, a state court can transfer some of your pension benefit by issuing a qualified domestic relations order (QDRO), and the plan must honor the order.

What Is a QDRO?

Before a plan honors a domestic relations order awarding part or all of your pension benefit to your spouse, former spouse, child or other dependent, the plan must determine whether the order is a qualified domestic relations order (QDRO.) The order must meet these requirements:

  • It must relate to child support, alimony, or marital property rights
  • It must be made under state domestic relations law.
  • It should clearly specify your name and last known mailing address and the name and last known address of each alternate payee. (The alternate payee is the spouse, ex-spouse, or dependent to whom the benefits are awarded.)
  • It must state the name of your plan; the amount or percentage--or the method of determining the amount or percentage--of the benefit to be paid to the alternate payee; and the number of payments or time period to which the order applies.

It cannot provide a type or form of benefit that is not provided under the plan, and it cannot require the plan to provide an actuarially increased benefit.

If an earlier QDRO applies to your benefit, the earlier QDRO takes precedence over a later one.

In certain situations, a QDRO may provide that payment is to be made to an alternate payee before you are entitled to receive your benefit. For example, if you are still employed, a QDRO could require payment to an alternate payee to begin on or after your "earliest retirement age," whether or not the plan would allow you to receive benefits at that time.

Tip: If you are in the process of a divorce, and a QDRO is being prepared for your family, be sure that the QDRO addresses (1) whether a benefit is payable to an alternate payee on your death and (2) the consequences of the death of the alternate payee.

The court's order can be in the form of a state court judgment, decree or order, or court approval of a property settlement agreement.

Who Enforces ERISA?

The Department of Labor enforces Title I of ERISA, which, in part, establishes participants' rights and fiduciaries' duties. However, certain plans are not covered by the protections of Title I. They are:

  • Federal, state, or local government plans, including plans of certain international organizations
  • Certain church or church association plans
  • Plans maintained solely to comply with state workers' compensation, unemployment compensation or disability insurance laws
  • Plans maintained outside the United States primarily for non-resident aliens
  • Unfunded excess benefit plans-plans maintained solely to provide benefits or contributions in excess of those allowed for tax-qualified plans

The Labor Department's Pension and Welfare Benefits Administration is the agency charged with enforcing the rules governing the conduct of plan managers, investment of plan assets, reporting and disclosure of plan information, enforcement of the fiduciary provisions of the law, and workers' benefit rights.

Other federal agencies that regulate plans include:

  • The Internal Revenue Service is responsible for ensuring compliance with the Internal Revenue Code, which establishes the rules for operating a tax-qualified pension plan, including pension plan funding and vesting requirements. A pension plan that is tax-qualified can offer special tax benefits both to the employer sponsoring the plan and to the participants who receive pension benefits.

  • The Pension Benefit Guaranty Corporation, PBGC, a non-profit, federally-created corporation, guarantees payment of certain pension benefits under defined benefit plans (traditional pension plans) that are terminated with insufficient money to pay benefits.

Summary of Information you're entitled to:

Following is a list and description of the documents that must be made available to you. If a plan administrator refuses to comply with your request for documents, and the reasons for the delay are within his or her control, a court may impose a penalty of up to $100 per day. You will have to sue to enforce your rights, since the Department of Labor does not have the authority to impose this penalty.

Type of DocumentWhom You Can Get It FromWhen You Can Get ItYour Cost
Summary Plan Description: This summary of your pension plan tells you what the plan provides and how it operates.
Plan AdministratorWithin 30 days of your requestReasonable charge
Dept. of LaborAutomatically within 90 days of your becoming covered under the plan.Free
Automatically every 5 years if your plan is amendedFree
Automatically every 10 years if your plan has not been amendedFree
Summary of Material Modifications: This summarizes any changes to your plan
Plan AdministratorAutomatically within 210 days after the end of the plan year for which the plan has been amendedFree
Dept. of LaborUpon RequestCopying Charge
Summary Annual Reports: This summarizes the annual financial reports that most pension plans file with the Dept. of Labor
Plan AdministratorAutomatically within 9 months after the end of the plan year, or 2 months after the filing of the annual report.Free
Dept. of LaborUpon requestCopying Charge
Latest Annual Report (Form 5500 Series): Annual financial reports that most pension plans file with the Dept. of Labor.
Plan AdministratorWithin 30 days of written requestReasonable Charge
Dept. of LaborUpon RequestCopying Charge
Annual Financial Report: This is the last financial report filed by a plan that has been terminated
Plan AdministratorWithin 30 days of written requestReasonable charge
Individual Benefit Statement: Describes your total accrued and vested benefits
Plan AdministratorOnce every 12 monthsFree
Plan Document (or any other documents under which the plan is established or operated):
Plan AdministratorWithin 30 days of written requestReasonable Charge
Available for Inspection at Plan's OfficeUpon RequestFree
Notice to Participants on Plan Funding and PBGC Guarantees (when a Plan is Less than 90% funded.)
Plan AdministratorAnnuallyFree

Reverse Mortgages: How They Can Enhance Your Retirement

If you're 62 or older and looking for money to finance a home improvement, pay off your current mortgage, supplement your retirement income, or pay for healthcare expenses – you may be considering a reverse mortgage. It's a product that allows you to convert part of the equity in your home into cash without having to sell your home or pay additional monthly bills. This Financial Guide explains how reverse mortgages work.

Three types of reverse mortgage plans are available:

  • Single-purpose reverse mortgages, offered by some state and local government agencies and nonprofit organizations
  • Federally-insured reverse mortgages, known as Home Equity Conversion Mortgages (HECMs) and backed by the U. S. Department of Housing and Urban Development (HUD)
  • Proprietary reverse mortgages, private loans that are backed by the companies that develop them

This guide describes the similarities and differences among them and discusses the benefits and drawbacks of each. Since each plan differs slightly, it is important to choose the one that best meets your financial needs.

The reverse mortgage is not without risk however, and knowing the pros and cons will help you acquire the best possible deal should you decide to go with a reverse mortgage. Staying informed of your rights and responsibilities as a borrower may help to minimize your financial risks and avoid the threat of losing your home.

How Does A Reverse Mortgage Work?

A reverse mortgage is a type of home equity loan that allows you to convert some of the equity in your home into cash while you continue to own the home. Reverse mortgages operate like traditional mortgages, only in reverse. Rather than paying your lender each month, the lender pays you.

Reverse mortgages differ from home equity loans in that most reverse mortgages do not require any repayment of principal, interest, or servicing fees as long as you live in the home. The loan is repaid when you die, sell your home, or when your home is no longer your primary residence. The proceeds of a reverse mortgage generally are tax-free, and many reverse mortgages have no income restrictions. When the homeowner dies or moves out, the loan is paid off by a sale of the property. Any leftover equity belongs to the homeowner or the heirs.

In other words, the primary benefit of a reverse mortgage is that it allows homeowners who are age 62 and over to keep living in their homes and to use their equity for whatever purpose they choose. A reverse mortgage might be used to cover the cost of home health care, to pay off an existing mortgage to stop a foreclosure, or to support children or grandchildren.

Who Qualifies for a Reverse Mortgage?

  • Applicants must be 62 years of age.
  • Potential borrowers must either completely own their home or only have a couple of mortgage payments remaining.
  • Reverse mortgage borrowers must live in the home being used as collateral.
  • Borrowers must have an excellent credit history in order to qualify for reverse mortgage loans.
  • All homeowners are required to sign the paperwork in order to secure the reverse mortgage.
  • Primarily, single family one-unit dwellings are required to qualify for a reverse mortgage.
  • During the reverse mortgage process, the homeowners are responsible for property taxes and repairs to the property as they still own their home.

How Payments Are Received

Depending on the lender, borrowers can choose to receive monthly payments, a lump sum, a line of credit, or some combination.

Tip: The line of credit offers the most flexibility by allowing homeowners to write checks on their equity when needed up to the limit of the loan

Tax Rules

The reverse mortgage payments you receive are nontaxable. Further, if you receive Social Security Supplemental Security Income, reverse mortgage payments do not affect your benefits, as long as you spend them within the month you receive them. This rule is also true for Medicaid benefits in most states.

Tip: To find out the exact impact of reverse mortgage payments on benefits you are receiving, check with a benefits specialist at your local area agency on aging or legal services office.

Interest on reverse mortgages is not deductible until you pay off your reverse mortgage debt.

Maximum Loan Amounts

Maximum loan amount limits are based on the value of the home, the borrower's age and life expectancy, the loan's interest rate, and whatever the lender's policies are. Maximum loan amounts range (depending on the lender) from 50% to 75% of the home's fair market value. The general rule is: The older the homeowner and the more valuable the home, the more money will be available.

Example: A 65-year-old homeowner with a home worth $150,000 would be able to get a $30,000 lump sum or credit line. A 90-year-old homeowner with the same home could be eligible for as much as $94,000.

All reverse mortgages have non-recourse clauses, meaning the debt cannot be more than the home's value. Thus, the lender seeks repayment from heirs, family members, or the borrower's income or other assets.

Negative Aspects

Here are some of the downside aspects of reverse mortgages.

You Incur a Large Amount of Interest Debt

Reverse mortgages are rising-debt loans: The interest is added to the loan balance each month, since it is not paid currently, and the total interest you owe increases greatly over time as the interest compounds.

Note: Some plans provide for fixed rate interest. Others have adjustable rates that change based on market conditions.

Fewer Assets for Heirs

Reverse mortgages use up the equity in your home, leaving fewer assets for your heirs.

High Costs

The high up-front costs of reverse mortgage may make them less attractive to some people. All three types of plans charge origination fee, interest rate, closing costs, and servicing fees. Insured plans also charge insurance premiums.

Tip: If you are forced to move soon after taking the reverse mortgage (e.g., because of illness), you will almost certainly end up with a great deal less equity to live on than if you had simply sold the house. This is particularly true in the case of loans terminated in five years or less.

Tip: Your lender may permit you to finance these costs, so that you won't have to pay them up front. But they will be added to your loan amount. Because of the high up-front costs on all reverse mortgages, effective interest rates for short-term loans are out of this world.

Adjustable Interest Rates

With many reverse mortgage plans, interest rates are adjustable annually or monthly and tied to a financial index, in some cases with limits on how far the rate can go up or down. Reverse mortgages with interest rates that adjust monthly have no limit. Bear in mind that the higher the rate, the faster your equity is used up.

In order to give a fixed rate, one lender requires appreciation sharing, with which it gets a part of any increase in the home's value over and above the debt. Another lender offers percent of value pricing, collecting a fixed percentage of the home's value when the loan comes due. The latter option can be very expensive if the loan must be paid off after only a few years.

Is A Reverse Mortgage For You?

Although a reverse mortgage may be the answer for house-rich and cash-poor retirees, they are not for everyone. For instance, if you plan to move a few years down the road or there is a possibility you will have to move due to illness or any other unforeseen event, then a reverse mortgage makes no sense. They make the most sense for those who plan to stay in their homes permanently. Also, if you already have a substantial mortgage on your home, the reverse mortgage is probably not for you, since you will have to pay it off before you can become eligible.

If you want to pass your home to your children or heirs, the reverse mortgage is also not a good choice since the lender will get most of the equity when the home is sold.

Other Alternatives

Besides the reverse mortgage, here are some alternatives to consider.

  • Programs that help with real estate taxes, repairs. Many state and local governments have programs that provide special purpose loans to seniors for (1) the deferral of property taxes and (2) making home repairs or improvements. These loans can often prevent retirees' having to sell their homes. To find out whether your state has a special-purpose loan program for property taxes and/or for home repairs and improvements, contact your state agency on aging.

  • The Qualified Personal Residence Trust (QPRT). If you want to pass your home to your children or other heirs, this option should be considered, especially if your home is worth a great deal and you want to remove it from your estate for estate tax purposes. The QPRT trust allows you to keep the home for a certain amount of time with ownership eventually passing to your heirs.

  • The sale-leaseback. You sell your home to your kids, and continue to live in it, paying them a fair market rent.

Note: Do not arrange a sale-leaseback without professional guidance.

Getting a Good Deal

Reverse mortgages are complex financial transactions. How do you know you are getting the best deal? Fortunately there are laws in place (such as the Federal Truth in Lending Act) to make sure you understand the terms and costs involved before you sign. The Federal Truth in Lending Act requires lenders to disclose such things as the Annual Percentage Rate (APR) and payment terms. On plans with adjustable rates, lenders must provide specific information about the variable rate feature. On plans with credit lines, lenders also must inform you of any charges to open and use the account, such as an appraisal, a credit report, or attorney's fees.

If you're considering a reverse mortgage, shop around. Compare your options and the terms various lenders offer. Learn as much as you can about reverse mortgages before you talk to a counselor or lender. That can help inform the questions you ask that could lead to a better deal.

If you want to make a home repair or improvement or you need help paying your property taxes, then you should find out if you qualify for any low-cost single-purpose loans in your area. Area Agencies on Aging (AAAs) generally know about these programs. To find the nearest agency, visit or call 1-800-677-1116. Ask about "loan or grant programs for home repairs or improvements," or "property tax deferral" or "property tax postponement" programs, and how to apply.

All HECM lenders must follow HUD rules. And while the mortgage insurance premium is the same from lender to lender, most loan costs, including the origination fee, interest rate, closing costs, and servicing fees vary among lenders.

If you live in a higher-valued home, you may be able to borrow more with a proprietary reverse mortgage, but the more you borrow, the higher your costs are. The best way to see key differences between a HECM and a proprietary loan is to do a side-by-side comparison of costs and benefits. Many HECM counselors and lenders can give you this important information.

No matter what type of reverse mortgage you're considering, understand all the conditions that could make the loan due and payable. Ask a counselor or lender to explain the Total Annual Loan Cost (TALC) rates: they show the projected annual average cost of a reverse mortgage, including all the itemized costs.

A Summary of Available Plans

This section describes the three types of reverse mortgages available. Although the FHA and lender-insured plans appear similar, important differences exist. This section also discusses advantages and drawbacks of each loan type.

FHA-Insured Home Equity Conversion Mortgages (HECMs)

Backed by the U. S. Department of Housing and Urban Development (HUD), over 90 percent of all reverse mortgages are HECMs. These mortgages offer several payment options:

  • Monthly loan advances for a fixed term, or for as long as you live in the home
  • A line of credit
  • Monthly loan advances plus a line of credit

This type of reverse mortgage is not due as long as you live in your home. With the line of credit option, you may draw amounts as you need them over time. Closing costs, a mortgage insurance premium, and, sometimes, a monthly servicing fee are required. Interest is at an adjustable rate on your loan balance. Interest rate changes do not affect the monthly payment, but rather how quickly your loan balance grows.

The FHA-insured reverse mortgage allows you to change the way you are paid at little cost. This plan also protects you by guaranteeing that loan advances will continue to be made to you if a lender defaults. However, the downside of FHA-insured reverse mortgages is that they may provide smaller loan advances than lender-insured plans. Also, loan costs may be greater than with uninsured plans.

The most widely available plan is the Federal Housing Administration's Government-insured Home Equity Conversion Mortgage (HECM) program. To qualify for an HECM loan, homeowners must be at least 62 and live in a single-family home or condominium that is their principal residence. Under this program, the amount of equity homeowners may borrow against depends on where they live, as well as on prevailing interest rates.

For people who have more expensive homes or who need to borrow more, there are alternatives. A program from the Federal National Mortgage Association grants larger reverse mortgages on home equity.

Counseling is required before homeowners can apply for an HECM loan. This counseling allows homeowners to discover whether a reverse mortgage is really the best answer to their cash-flow problems.

Tip: For an approved counselor, contact any HECM lender.

Single-purpose reverse mortgages

Offered by some state and local government agencies and nonprofit organizations, these reverse mortgages are the least expensive option. They are not available everywhere and can be used for only one purpose, which is specified by the government or nonprofit lender. For example, the lender might say the loan may be used only to pay for home repairs, improvements, or property taxes. Most homeowners with low or moderate income can qualify for these loans.

Proprietary reverse mortgages

This type of reverse mortgage is a private loan that is backed by the company that develops it. Like HECM loans, they may be more expensive than traditional home loans and upfront costs can be high. There are no income requirements and can be used for any purpose.

Tip: Most private reverse mortgages are not insured. Only the strength of the lender backs whatever promises it may make as to payments and other terms. So if you are looking to a reverse mortgage for future income, rather than a lump sum up front, you are better off in a federally insured program.

Government and Non-Profit Agencies

To obtain a current list of lenders participating in the FHA-insured program, sponsored by the Department of Housing and Urban Development (HUD), or additional information on reverse mortgages and other home equity conversion plans, contact:

Reverse Mortgage Education Project
American Association of Retired Persons
601 E St., NW
Washington, DC 20049
National Reverse Mortgage Lenders Association
1400 16th St., NW
Suite 420
Washington, DC 20036

If you have a question or complaint concerning reverse mortgages, call:

Federal Trade Commission
Tel. 1-877-382-4357

Note: Although the FTC generally does not intervene in individual disputes, the information you provide may indicate a pattern or practice that requires action by the Commission.

Tap Your Retirement Money Early and Minimize Penalties

The purpose of retirement plans such as the 401(k) and Individual Retirement Account (IRA) is to save money for your retirement years. As such, the IRS imposes a penalty of 10% for early withdrawals taken from qualified retirement plans before age 59½. Qualified retirement plans include section 401(k) plans, 401(k) plan, tax-sheltered annuity plans under section 403(b) for employees of public schools or tax-exempt organizations, and individual retirement accounts.

While you should always think carefully about taking money out of your retirement plan before you've reached retirement age, there may be times when you need access to those funds, whether it's buying a new house or pay for out of pocket medical expenses. Fortunately, IRS provisions allow a number of exceptions that may be used to avoid the tax penalty.

  1. If you are the beneficiary of a deceased IRA owner, you do not have to pay the 10% penalty on distributions taken before age 59½ unless you inherit a traditional IRA from your deceased spouse and elect to treat it as your own. In this case, any distribution you later receive before you reach age 59½ may be subject to the 10% additional tax.

  2. Distributions made because you are totally and permanently disabled are exempt from the early withdrawal penalty. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

  3. Distributions for qualified higher educational expenses are also exempt, provided they are not paid through tax-free distributions from a Coverdell education savings account, scholarships and fellowships, Pell grants, employer-provided educational assistance, and Veterans' educational assistance. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution, as well as expenses incurred by special needs students in connection with their enrollment or attendance. If the individual is at least a half-time student, room and board are qualified higher education expenses. This exception applies to expenses incurred by you, your spouse, children and grandchildren.

  4. Distributions due to an IRS levy of the qualified plan.

  5. Distributions that are not more than the cost of your medical insurance. Even if you are under age 59½, you may not have to pay the 10% additional tax on distributions during the year that are not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply: you lost your job, you received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job, you receive the distributions during either the year you received the unemployment compensation or the following year, you receive the distributions no later than 60 days after you have been reemployed.

  6. Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty after September 11, 2001 and on or after December 31, 2007.

  7. Distributions in the form of an annuity. You can take the money as part of a series of substantially equal periodic payments over your estimated lifespan or the joint lives of you and your designated beneficiary. These payments must be made at least annually and payments are based on IRS life expectancy tables. If payments are from a qualified employee plan, they must begin after you have left the job. The payments must be made at least once each year until age 59 1/2, or for five years, whichever period is longer.

  8. If you have out-of-pocket medical expenses that exceed 7.5% (10% in 2013) of your adjusted gross income, you can withdraw funds from a retirement account to pay those expenses without paying a penalty. For example, if you had an adjusted gross income of $100,000 for tax year 2012 and medical expenses of $12,500, you could withdraw as much as $5,000 ($2,500 in 2013) from your pension or IRA without incurring the 10% penalty tax. You do not have to itemize your deductions to take advantage of this exception.

  9. An IRA distribution used to buy, build, or rebuild a first home also escapes the penalty; however, you need to understand the government's definition of a "first time" home buyer. In this case, it's defined as someone who hasn't owned a home for the last two years prior to the date of the new acquisition. You could have owned five prior houses, but if you haven't owned one in at least two years, you qualify.

    The first time homeowner can be yourself, your spouse, your or your spouse's child or grandchild, parent or other ancestor. The "date of acquisition" is the day you sign the contract for purchase of an existing house or the day construction of your new principal residence begins. The amount withdrawn for the purchase of a home must be used within 120 days of withdrawal and the maximum lifetime withdrawal exemption is $10,000. If both you and your spouse are first-time home buyers, each of you can receive distributions up to $10,000 for a first home without having to pay the 10% penalty.

Remember that although using the above techniques will help you avoid the 10% penalty tax, you are still liable for any regular income tax that's owed on the funds that you've withdrawn. Distributions rolled over into another qualified retirement plan or distributions from a Roth IRA however, escape both the regular income tax and the 10% penalty tax. Rollovers should be made directly between your brokers, to avoid paying the 20% withholding required on distributions that you touch.

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.

How Annuities Work

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.

How Annuities Best Serve Investors

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:

  1. You want to save money for a long-range goal, and/or
  2. 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.

Types Of Annuities

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: Variable annuities have higher costs than similar investments that are not issued by an insurance company.

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.

Choosing A Payout Option

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:

  1. The size of the amount in your annuity contract
  2. Whether there are minimum required payments
  3. Your life expectancy (or other payout period)
  4. Whether payments continue after your death

Here are summaries of the most common forms of payout:

Fixed Amount

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.

Fixed Period

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.

How Payouts Are Taxed

The way your payouts are taxed differs for qualified and non-qualified annuities.

Qualified Annuity

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:

  1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
  2. 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).

Non-Qualified Annuity

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.

How To Shop For An Annuity

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.

Costs, Penalties, And Extras

Be sure to compare the following points when considering an annuity contract:

Surrender Penalties

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.

Risk To Retirees of Using An Immediate Annuity

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.

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.

How Contributions Are Treated

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.

How Withdrawals Are Treated

You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.

Qualified Distributions

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:

  1. 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
  2. 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.

Non-Qualified Distributions

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.

  1. Regular contributions.
  2. 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.
  3. Earnings on contributions.

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.

Converting From a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA

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.

Conversion Methods

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.
  • 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),

    • 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.

    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.

    Undoing a Conversion to a Roth IRA

    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: 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.

    Withdrawal Requirements

    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.

    Retirement Savings Contributions Credit

    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.

    Use in Estate Planning

    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.

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