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Introduction
The main goal of retirement planning is to make sure
that you have enough money when you retire to
maintain your standard of living. How much is enough
depends on when you wish to retire, what your
anticipated living expenses will be, what rate of
return you can expect on your savings, and whether
you will continue to work at all after retirement.
The anticipated date of your retirement affects two
important factors: how much time you will have to
save up for retirement and the number of years you
can expect to live after you retire. A qualified
financial advisor can help you sketch out your
retirement plans in terms of timing and lifestyle.
Once you put these down on paper, she can help you
calculate how much money you need to set aside to
meet your goals and how it should be invested.
Unfortunately, one likely answer will be that
"You’ll probably need more money than you
think." Americans are living longer than ever
before and inflation inevitably eats away at the
value of dollars saved.
Many Web sites now offer free tools and information
to assist with retirement planning, including
so-called
"retirement calculators". By providing
a few details about yourself and your finances,
these calculators can predict how much you need to
save to achieve your retirement objectives. You can
find links to a number of different calculators by
clicking on the Calculators button of the Resources
section of this site.
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Making the Most of Your
Retirement Plan
One of the most critical and frequently overlooked
issues in retirement planning comes after most
people have retired. Beginning on the April 1
occurring after you reach age 70 ½, you must
begin taking minimum distributions from your
retirement plan. How you structure these
distributions can have a profound effect on your own
retirement and even more on what you leave your
heirs.
There are some basic steps you can take to get the
most out of your retirement plan. Failing to follow
these basic strategies could wind up costing you and
your heirs many thousands of dollars in unnecessary
taxes. A
case study of how poor retirement planning can
cost one’s heirs appears at the end of this
section.
Calculating Your Minimum Distribution
Congress created the rules governing the minimum
distribution of retirement plan funds to encourage
saving for retirement and to allow retirement assets
to build up tax-free during the plan owner’s
working years. You do not pay tax on income you put
into a retirement plan when earned or on investment
income on the account itself. However, the funds you
withdraw upon retirement are treated as taxable
income in the year you take the distribution. And if
your children withdraw the funds that they inherit
from you, they will be taxed on such distributions
at their income tax rates.
Since the idea of retirement plans is to encourage
taxpayers to save for retirement, lawmakers imposed
a penalty for early withdrawal – before age 59
½ -- and a penalty for failure to withdraw
once the owner reaches retirement age -- after age
70 ½. Until recently, there was also a
penalty for excess withdrawals -- in other words,
for those who saved more than they need for
retirement -- but that penalty has been repealed.
These penalties apply to all tax-advantaged
retirement plans, including Individual Retirement
Accounts (IRAs), Keogh accounts, 401(k) plans, and
pensions.
The withdrawal penalties are in the form of excise
taxes. Early withdrawals, those taking place before
you reach age 59 ½, are subject to a 10
percent excise tax (with limited exceptions). In
other words, you pay the government 10 percent of
the amount withdrawn in addition to the taxes
that would normally be due upon withdrawal. As for
late withdrawals, you must begin taking
distributions by the April 1 occurring after you
reach age 70 ½ (known as the required
beginning date), or pay a whopping 50 percent excise
tax on the amount that should have been distributed
but was not.
Distributions
The rules regarding distributions were simplified in
2001. To determine your required distributions, you
can consult a simple chart. Unless you name a spouse
as beneficiary who is more than 10 years younger
than you, the beneficiary of your account has no
impact on your minimum distributions. This allows
you to accumulate more money in your retirement
accounts, tax-deferred. (If you name a spouse as
beneficiary who is more than 10 years younger than
you, your minimum distributions can be reduced even
further by consulting a separate joint-and-survivor
table.)
Note: Chart extends from age 101 to “115
and older,” for which the distribution
period is 1.9 years.
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New Minimum Lifetime Distribution Chart
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Age of
Account Owner
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Distribution
Period
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70
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27.4
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71
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26.5
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72
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25.6
|
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73
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24.7
|
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74
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23.8
|
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75
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22.9
|
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76
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22.0
|
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77
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21.2
|
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78
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20.3
|
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79
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19.5
|
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80
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18.7
|
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81
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17.9
|
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82
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17.1
|
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83
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16.3
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84
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15.5
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85
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14.8
|
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86
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14.1
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87
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13.4
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88
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12.7
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89
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12.0
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90
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11.4
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91
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10.8
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92
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10.2
|
|
93
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9.6
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|
94
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9.1
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|
95
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8.6
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|
96
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8.1
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|
97
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7.6
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98
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7.1
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99
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6.7
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100
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6.3
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To calculate your required minimum distribution for
a given year using the chart, find the distribution
period for your age as of December 31 of the prior
year and then divide that figure into your prior
year-end retirement account balance. So, for
example, if you had $100,000 in a retirement account
on December 31 of last year and you were 73 as of
that date, you would have to withdraw $4,049 from
the account by the end of this year ($100,000
divided by your distribution period of 24.7 years).
Retirement account owners whose spouses are more
than 10 years younger than they are should consult
the "Joint Life and Last Survivor
Expectancy" table in the Appendix of the
IRS' Publication 590. To see this
publication, go to:
http://www.irs.gov/publications/p590/ch01.html
The Designated Beneficiary
It used to be that the first rule of retirement
plans was to always designate a beneficiary. While
it is still important to designate a person or
institution to inherit your retirement accounts, the
choice of beneficiary is not nearly as critical a
decision as it once was.
First, as explained above, your choice of
beneficiary generally won’t have an impact on
your required minimum distributions. Second, you can
change your beneficiary down the road. In fact, your
beneficiary can even be changed after your death by
the executor of your estate. The date for
determining designated beneficiaries is September 30
of the year following the year of your death.
All this means that your designation of a
beneficiary (or failure to name one) will rarely
result in the kinds of tax-planning disasters that
were common before. In most cases, your heirs will
be able to take steps that will ensure deferral of
taxes on retirement accounts over their lifetimes.
But these changes also mean that it is doubly
important that your heirs consult with a qualified
elder law or tax attorney to ensure that they are
making the best decisions regarding beneficiaries
from a tax-planning standpoint.
Designating a Trust As the Plan Beneficiary
For tax planning purposes, many couples with
estates larger than $1.5 million set up "A and
B" trusts to take advantage of the unified
credit of the first spouse to pass away. (See the Estate Tax
Planning section.) Where a large portion of the
estate consists of retirement plans, it often makes
sense to have them payable to the trust rather than
to the surviving spouse. Unless the trust is
properly drafted, however, it won’t be
considered a designated beneficiary and the
surviving spouse will have to withdraw all the
retirement plan monies within five years. Making
sure the trust is carefully drafted is complicated
and requires the services of an attorney experienced
in such matters.
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The Roth and Education
IRAs
The Roth IRA
As part of the Taxpayer Relief Act of 1997
Congress created two new planning vehicles: the Roth
IRA, named after former Sen. William V. Roth
(R-Del.), and the Education IRA. The Roth IRA, in
effect, turns a traditional IRA on its head. While
traditional IRAs permit the taxpayer to shelter
pre-tax earnings but taxes them upon withdrawal, the
Roth IRA is for after-tax savings, but both the
original deposits and the earnings on them are not
taxed on withdrawal. In addition, unlike traditional
IRAs, Roth IRAs are available to taxpayers already
contributing to a plan at work and to taxpayers who
continue to work after age 70 ½. Finally,
there is no minimum distribution requirement upon
reaching that age. In other words, you don’t
have to make any withdrawals at all during
your lifetime. And any withdrawals you do make are
not taxed and are not counted as part of your gross
income, as long as the account has been in existence
for at least five years.
Eligibility for the Roth IRA is limited to taxpayers
with an adjusted gross income of under $110,000 if
single and $160,000 if married. The contribution is
limited to $2,000 a year, with smaller limits for
taxpayers with income of between $95,000 and
$110,000 if single and between $150,000 and $160,000
if married and filing a joint return. Taxpayers who
qualify may also change some or all of their old IRA
to a Roth IRA, but will have to pay taxes on the
total amount transferred.
Financial experts calculate that for many Americans,
a Roth IRA will save them more money than a
traditional IRA. This is because the future value of
the interest earned, which will never be taxed,
often far outweighs the value of deferring taxes on
the investment itself. Consult with your financial
advisor to help decide if a Roth IRA makes sense for
you.
A number of guides to Roth IRAs are available on the
Web. One of the best is from Fairmark Press, www.fairmark.com/rothira. There
are also many Web-based calculators to help you
decide whether the Roth IRA will offer an advantage
over a regular deductible IRA for your situation.
Two Roth calculators are:
The Roth 401(k)
Starting January 1, 2006, some employees will have
a new Roth savings option: the Roth 401(k).
Employers may offer the Roth 401(k) as benefit to
employees in place of or in addition to a
traditional 401(k). The Roth 401(k) differs from a
traditional 401(k) the same way a Roth IRA differs
from a traditional IRA. Contributions to a
traditional 401(k) are made pre-tax, so while it
reduces your taxable income in the year you
contribute to it, you have to pay taxes on the money
you withdraw during retirement. On the other hand,
contributions to the Roth 401(k) are made after
taxes. This means you won't have to pay any
taxes when you withdraw the money. The Roth 401(k)
has the same contribution cap as the traditional
401(k): a maximum of $15,000 a year or $20,000 a
year if you are over age 50.
The Education IRA
Similar to the Roth IRA, the education IRA permits
individuals to set aside up to $500 annually for a
child’s future education expenses, with the
earnings accumulating tax free. This may be of
special interest to parents and grandparents who can
contribute this amount annually to accounts owned by
their children and grandchildren. Although $500 a
year isn’t a lot of money given the size of
college tuition, over time it can make a difference.
It is only available to taxpayers whose adjusted
gross income is under $110,000 for single taxpayers
and $160,000 for married taxpayers filing a joint
return, with limits on contributions for taxpayers
with income between $95,000 and $110,000 and between
$150,000 and $160,000, respectively (all numbers
adjusted annually for inflation). If the
parents’ income exceeds these levels,
grandparents and others with lower taxable incomes
can contribute to the accounts. But only $500 can be
added per child per year.
Funds can only be added to the accounts while the
child is under age 18, and the funds must be
withdrawn by the time he or she reaches age 30, or
turned over into an account for another family
member. An advantage that these accounts have over
most accounts created for children is that the funds
do not have to be turned over to the child at age
18. But a word of caution: if you expect that your
child or grandchild will apply for financial
assistance for college, it may be wiser to invest
the money in your own name. The financial aid
application process for college has become
increasingly complex, but, in general, colleges
treat assets held by the family--especially a
grandparent--differently from assets held by the
student. Only a portion of family assets are
expected to be used for a specific student’s
education, while all of the child’s assets are
expected to be used before the student draws on
financial aid.
Case Study: The
Consequences of Failing to Plan
George Parrot (not his real name) died in January
2006 with an estate of $2.4 million, of which $1
million consisted of tax-deferred retirement plans.
At first blush, it would appear that Mr. Parrot did
quite well and should have left each of his four
children a substantial nest egg. But that’s
before taxes.
First, every dollar above $2 million (in 2006) is
subject to state and federal estate taxes. (This
amount will increase annually until it reaches $3.5
million for those dying in 2009, and as things stand
now the estate tax will be eliminated entirely for
those dying in 2010. However, for those dying in
2011 and thereafter, the tax-free credit amount dips
back down to $1 million. For details, see
Estate Taxation.) The tax on Mr. Parrot’s
estate will total approximately $180,000.
Second, after Mr. Parrot’s wife died, he did
not change the designated beneficiary on his
retirement plans to his children. Therefore, the
retirement plans are payable to his estate. The
children will have to withdraw the funds from the
plans within five years of his death. Upon
withdrawal, they will have to pay taxes on the
income. Assuming a 30 percent average tax rate, this
will come to approximately $200,000 in income taxes
after taking a deduction for the estate taxes paid.
The combined taxes will total approximately
$380,000, reducing the estate that will pass to Mr.
Parrot’s family from $2.4 million to
approximately $2 million, and each child’s
share from $600,000 to $500,000. This is an
effective tax rate of 15 percent.
Could this have been avoided? Yes, at least in part.
With careful planning, the effective tax rate could
have been brought down to less than 10 percent, and
possibly even lower.
Reducing Estate Taxes
The easiest way to limit estate taxes is to
reduce the size of one’s estate. This can be
done by spending money, by making gifts -- either
during life or at death -- to charity or to children
(or others). Gifts of $11,000 (in 2006) or less a
year per recipient do not need to be reported to the
IRS. If Mr. Parrot had given each of his children
$11,000 a year for the 10 years prior to his death,
he would have reduced the size of his estate by
$440,000 (not counting the earnings on his money,
which during that time would have gone to his
children instead of being added to his estate). This
would have eliminated the estate tax, saving
$180,000.
If Mr. Parrot was uncomfortable about giving his
children this money outright, he could have put the
gifts in trust for their benefit. Often, such trusts
purchase life insurance so that if the parent dies
before substantially reducing the size of his or her
estate, at least the life insurance proceeds (which
will not be subject to estate tax if held in a
properly-drafted trust) help offset the estate tax
due.
Reducing Income Taxes
There are two steps Mr. Parrot could have taken (or
his children could now take) to reduce or postpone
the taxes due on his retirement plans. First, if his
four children had been named as the designated
beneficiaries, they would not be under the five-year
rule. Instead, they could have withdrawn their
shares over their projected life expectancies. For
instance, a 30-year-old with a 45-year life
expectancy need not withdraw -- and pay taxes on --
any more than 1/45th of her share this
year, 1/44th next year, and so on. She
cannot avoid the tax forever, but the longer she can
put off withdrawing the funds, the longer the
account will grow tax free.
Unless his income was too high to qualify, Mr.
Parrot also could have converted some or all of his
retirement plans to Roth IRAs. Doing so would have
forced him to pay taxes on the converted funds at
the time, but they would have continued to grow
tax-free indefinitely. And his children would not
have to pay taxes on their withdrawal of funds from
the Roth IRAs they inherited. This approach has the
added advantage of reducing Mr. Parrot’s
estate by the amount of the income tax paid, thus
reducing the amount subject to estate taxes.
If, for purposes of example, Mr. Parrot converted
$500,000 to a Roth IRA and if he paid taxes at an
average rate of 30 percent on this amount (this
might be reduced by spreading the conversion out
over several years) he would pay $150,000 in income
taxes. By decreasing his estate by this amount, the
estate taxes would have been reduced by
approximately $60,000.
Putting It All Together
If Mr. Parrot had taken all of these steps --
gifting $440,000 over 10 years, converting $500,000
of his IRA, and designating his children as
beneficiaries on his remaining IRAs -- he would have
increased the amount passing to his children from $2
million to $2.4 million (with $500,000 still subject
to deferred taxes during his children’s
lifetimes).
The gifts to the children would have reduced Mr.
Parrot’s estate to $2 million. The taxes he
would have paid on converting his Roth IRAs would
have reduced it by another $150,000, to $1,850,000.
There would be no tax on an estate of this size.
Annuities
Annuities are very useful retirement planning tools
for some people, some of the time. They can add to
the retirement savings of younger investors who
would like to save more than is permitted in
traditional tax-deferred retirement plans, such as
IRAs and 401(k) plans. For older investors,
"immediate annuities" can be more useful,
guaranteeing an assured retirement income or, in
certain circumstances, protecting the financial
well-being of the spouse of a nursing home resident.
To determine whether an annuity makes sense in your
case, you need to understand what they are and how
they work.
Annuities are investment vehicles purchased through
insurance companies. They can come in many forms,
but, in general, they fall into two categories:
deferred annuities and immediate annuities.
Deferred Annuities
Deferred annuities are similar to IRAs in that they
permit you to invest for retirement and delay
payment of taxes on your investment earnings until
you begin withdrawing funds. These annuities charge
penalties for early withdrawal, typically for any
withdrawal within seven years of investing funds.
The annuity funds can be invested as the owner (or
"annuitant") directs during the
accumulation phase from a variety of options offered
by the insurance company. These can include mutual
funds and other investment vehicles.
While deferred annuities share with IRAs and other
retirement plans the benefits of compound returns on
deferred taxes, they do not enjoy all of the tax
benefits of such plans. Only after-tax funds may be
invested in annuities and the earnings on such
investments are taxed when they are withdrawn. The
benefit of deferred annuities comes when they are
held for many years.
Due to the early-withdrawal penalties, it is
important to invest in deferred annuities only if
you have enough outside funds for a
"rainy" day--a period of unemployment, a
house repair, a disability, or other unexpected
occurrence. Otherwise, you may find yourself drawing
on the deferred annuity and paying both taxes and
penalties at a time when you can least afford to do
so.
Financial planners typically recommend deferred
annuities for younger clients who have saved as much
money as they can in their IRA, 401(k) or other
retirement plans and still want to put more aside
for retirement. They make less sense for older
clients, who are less likely to get much benefit
from the deferred taxation and are more likely to
face an illness that may require use of the annuity
funds at a time when a penalty would have to be
paid.
Immediate Annuities
Immediate annuities are, in effect, private
pensions. The annuitant pays money to an insurance
company, which agrees to pay a fixed amount back to
the annuitant for a period of time. Typically, the
insurer agrees to make monthly payments for the
duration of the annuitant’s life with a
guaranteed number of years of payment, known as a
"term certain." For instance, an annuity
for life with a 10-year term certain would pay out
every month as long as the annuitant lives. If the
annuitant dies within the guarantee period, it would
pay out for the duration of the 10 years to whomever
the annuitant names as beneficiary.
The amount of each payment is based on the
annuitant’s actuarial life expectancy and the
length of any term certain. An 80-year-old will
receive larger monthly payments than a 60-year-old
because the insurance company probably won’t
pay out for nearly so long. An annuity for
‘life only’ without a term certain would
also pay out more each month, but if the annuitant
dies early, it results in a windfall to the
insurance company since the insurer would not have
to pay anything to the annuitant’s heirs. The
annuitant may also purchase an annuity for a
‘term only’ that does not base payments
on the annuitant’s life expectancy at all.
Again, this arrangement will provide for higher
monthly payments, but the payments will end at the
end of the specified term.
Immediate annuities provide a guaranteed stream of
income that is not affected by the vagaries of the
market. It saves the annuitant from worrying about
how to invest his or her savings and whether or not
the nest egg will last a lifetime. Annuities of this
sort should only be purchased from the most
financially sound insurance companies so that
there’s as little risk as possible that the
payments won’t be made. The biggest problem
with relying on immediate annuities as a principal
source of retirement income is that they typically
are not adjusted for inflation. What may be an
adequate monthly income stream today may not be in
10 or 20 years.
Annuities in Medicaid Planning
In recent years, immediate annuities have become
important tools in ensuring the financial health of
spouses of nursing home residents. The use of these
annuities in this way is described in the
Medicaid Planning section.
Charitable Gift Annuities
A charitable gift annuity (CGA) allows you to make a
gift to a charity and receive not only a sizeable
tax deduction but also fixed annual payments, a
portion of which will be tax free as well.
A CGA enables you to transfer cash or marketable
securities to a charitable organization or
foundation in exchange for an income tax deduction
and the organization' promise to make fixed
annual payments to you (and to a second beneficiary,
if you choose) for life.
A variety of resources—cash, stocks, or
bonds—can be used to establish a CGA. The
donor of a CGA receives an income tax deduction in
the year of the gift equal to the difference between
the amount paid to the charity and the value of the
annuity reserved to the donor (see link to
calculator below). A fixed portion of each annuity
payment is tax free, calculated based on the age of
the annuitant. When appreciated property is given,
the donor pays capital gains tax on only part of the
appreciation. If the donor is also the annuitant,
the capital gains tax is spread out over many years.
Annuity payments can begin immediately or can be
deferred to some future date, allowing donors to
enjoy the charitable income deduction immediately
and receive a guaranteed income later--for example
when they retire and are in a lower tax bracket. By
contrast, a child who is providing financial support
for a parent may want to establish an immediate CGA
for the parent. The child would receive an
income-tax deduction and the parent would receive
income for life.
The older the annuitants are at the time of the
gift, the greater the fixed income the charitable
organization will pay. The Committee on Charitable
Gift Annuities sets annuity rates for all charities
to follow. Although it is not mandatory that the
rates be used, most charities that offer gift
annuities voluntarily adhere to the rates.
Example: Mrs. Generous, age 82, gives $10,000
to Favorite Charity in return for a single life
annuity. She will receive an annual annuity payment
of $940 (figured at 9.4 percent per year). Her
charitable income tax deduction will be $4,692.29
the year the gift is given, or spread over five
years following. Of the $940 received each year,
Mrs. Donor can exclude $639.48 as tax- exempt income
for 10 years. The gift is excludable from estate
taxes. (Calculation is for illustration purposes
only; for your actual benefits, consult your
attorney or financial advisor.)
While the regulation of charitable gift annuities
varies from state to state, almost all states that
regulate charitable gift annuities require the
maintenance of financial reserves, annual filings
with the attorney general of the state, and
compliance with other regulatory requirements.
If you want to know what your tax deduction and
annual income from a CGA might be, a company called
PhilanthroTec offers a free Web-based gift
calculator that runs the numbers. Go to:
http://pcalc.ptec.com/hosts/989357365/CGA/simple.html.
Bear in mind that calculations vary depending on the
assumptions used, the timing of the gift, and the
donor’s unique financial situation. For your
actual benefits, consult your attorney or financial
advisor.
Be sure to seek the advice of an elder law attorney
or financial advisor before purchasing annuity
products.
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