Where Do You Start?
Providing for a comfortable retirement requires
comprehensive planning, taking into account cash
flow, income taxes, available assets, retirement plan
distributions, and preferred lifestyle. The goal is to match
expected expenditures to projected retirement income
cash flow and provide for contingencies (such as extended
illness, rapid inflation, and investment losses).
Most individuals share similar concerns when they
consider their retirement years. These concerns include
having enough income to live comfortably, providing
security for a spouse or children, minimizing income and
transfer taxes, accounting for inflation, and outliving assets.
Take a serious look ahead to determine how much income
you will need to maintain your current lifestyle when you
retire. When you estimate how much income you will
need, take into account inflation, future tax rates, and
the investment returns on your retirement savings. Most
retirement planning advisers say that you will need 60%
to 80% of your pre-retirement income to maintain your
current standard of living
Determining Your Retirement Income Needs
By completing the Calculating future income needs
worksheet below, you can assess your financial position
in terms of future retirement income. This assessment
will help you determine a realistic investment goal.
To evaluate future income sources, start with Social
Security. The Social Security Administration website has
a retirement benefit estimator that can determine your
maximum benefit at your normal retirement age (generally
age 66–68) and your maximum benefit at age 70.
Next, consider retirement distributions you can expect from
your company’s qualified retirement plan (See Retirement
savings through an employer’s plan, below). Talk to your HR
person or plan administrator to get an estimate of future
distributions at different retirement ages.
| Year | Max Salary Employer Match | Highly Compensated Employee |
|---|
Note: If your annual income from your employer exceeds
the amounts listed in above table for years indicated,
the compensation over those amounts is not
included when your employer contributes on your behalf to
your company’s qualified retirement plan. As an example,
if your employer matches up to 3% of income, the match is
capped at 3% of the maximum compensation listed above for the years indicated.
If you are a highly compensated employee making more that the amounts listed above
for a highely compensated employee, you may be able to negotiate deferred compensation
in a nonqualified plan to increase your retirement savings
(see Nonqualified deferred compensation, below).
If you are a self-employed individual who is not a partner
in a partnership, you can set up your own
SEP, SIMPLE, or qualified retirement plan
.
Beyond these types of retirement income, you will have to
develop resources on your own through other savings and
investment strategies. Most people have to provide for at
least 40% of their retirement income from other sources.
Other retirement instruments, such as annuities, enable
tax-deferred accumulation of earnings but without the
contribution restrictions of an individual retirement account.
An annuity allows you to choose guaranteed life income
payments or payments for a predetermined period of time,
usually beginning at retirement.
A comprehensive investment program is an integral part of
retirement planning, with periodic adjustment of strategies
to fit your objectives as you progress toward retirement.Nugent & Associates can help you determine your retirement needs and
develop a feasible retirement savings plan.
Should You Have an Individual Retirement Account?
Traditional individual retirement accounts (IRAs) were
first introduced to encourage taxpayers to save for
retirement even if their employers did not offer retirement
savings plans.
Many working Americans qualify for at least a partial income
tax deduction for retirement savings. You may make a
deductible IRA contribution, provided neither you nor your spouse is an active
participant in an employer-sponsored retirement plan and
you are younger than age 70½ at the end of the year.
IRA contributions are taxable as ordinary income on
distribution. Distributions before age 59½ may be subject to
an early withdrawal penalty. At age 70½, you would have to
start receiving minimum required distributions from the IRA.
Planning Tips:
If you are at least age 70½ and have a traditional
IRA, you may be able to contribute your minimum
required distributions from the IRA to a charity (up to
$100,000) without having to pay tax on the amount
transferred to the charity.
Roth IRAs
A Roth IRA is an IRA with a special tax structure.
Contributions to a Roth IRA are not deductible, but the
eventual distributions are not included in income (and
thus earnings are distributed tax-free). In addition, a Roth
IRA is not subject to the required minimum distribution
requirements that apply to an IRA, so the amounts can be
left in the Roth IRA until needed. Special penalties apply to
distributions from a Roth IRA before the Roth IRA has been
in existence for five years and before you reach age 59½.
Married individuals and single taxpayers, regardless of the
adjusted gross income (AGI) are allowed to convert a traditional IRA into
a Roth IRA. On conversion, all taxable amounts in all of the
individual’s aggregate IRAs are used to determine the taxable
and nontaxable portions of the conversion amount.
Example A: Sarah has a nondeductible traditional IRA with
$10,000 of contributions and $2,000 of earnings (and has
no other IRAs). She converts the IRA to a Roth IRA. The
$10,000 of after-tax contributions is treated as basis and is
not taxed again on conversion, but the $2,000 of earnings
is taxable as ordinary income when it is contributed to the
Roth IRA.
Example B: Michael has two IRAs, one a non-deductible
traditional IRA with $10,000 of contributions and $2,000 of
earnings, and one an old rollover IRA with $20,000 that has
never been taxed (such as from a 401(k) rollover). Michael
wants to convert the $12,000 traditional IRA to a Roth
IRA. On conversion, he has an aggregate IRA balance of
$32,000 ($12,000 plus $20,000) and a total nondeductible
balance of $10,000.
Michael calculates the nontaxable part of the conversion
as ($10,000/$32,000) × $12,000, or $3,750. The remaining
$8,250 is taxable income on conversion.
If Michael rolls his old rollover IRA into his current
employer’s 401(k) plan, and later converts the remaining
IRA to a Roth IRA, he would include in income only the
$2,000 of earnings above the after-tax contributions
in income.
Roth(k) contributions
A section 401(k) plan can be designed to allow plan
participants to elect to defer amounts as pre-tax
contributions (normal 401(k) elective contributions)
or as post-tax Roth contributions. Post-tax Roth contributions
(sometimes called Roth(k) contributions) are treated
the same way as the pre-tax contributions (subject to
FICA on contributions and subject to the same dollar
restrictions). An employee can choose to contribute
partly pre-tax and partly through Roth(k) contributions.
Between the pre-tax contributions and the post-tax Roth(k)
contributions, the employee cannot contribute more than
$19,000 (or $25,000 if the participant is at least age 50).
Your employer can match your elective contributions,
whether they are 401(k) elective contributions or
Roth(k) contributions.
Like Roth IRA contributions, Roth(k) contributions are
taxable as made, but the accrued earnings on the
contributions are not taxable on distribution, so long as
the Roth rules are satisfied at the time of distribution.
Thus, the first Roth(k) contribution starts the 5-year Roth
holding period. The amounts in a Roth(k) account can
be rolled over to a Roth IRA if all of the requirements
are satisfied.
In-plan Roth conversions
Some plans now also allow “conversion” of pre-tax
contributions (such as 401(k) elective contributions)
into Roth accounts within the same plan. This is a fairly
new feature. On conversion, the pre-tax amounts are
not distributed to the individual and remain in the same
plan, but the amounts converted are subject to ordinary
tax in the year of the conversion. Once in the Roth
account, the earnings accrue under the Roth rules and
can eventually be rolled over to a Roth IRA if all of the
Roth rules are satisfied at the time of distribution. As with
other Roth accounts, there is a 5-year holding period on
converted amounts. There is no withholding within the plan
on these conversions, so you would have to be prepared to
pay the tax on the amount converted from other sources
of cash
Planning Tips:
-
Some individuals contribute the maximum to a
nondeductible IRA and convert the IRA to a Roth
IRA the next day. In this case, there is no income
to include (assuming the individual has no other
IRAs). This makes the conversion tax-free; all
additional interest or other earnings will fall under
the Roth IRA rules and not be subject to tax
on distribution.
-
If you have money in an IRA, are under age
59½, and need cash, consider using the
substantially- equal-payment exception. By using
this “life annuity” option, you can arrange for
equal, periodic withdrawals to be made at least
annually and avoid penalties for early withdrawal.
The withdrawal amount is based on life
expectancy and actual or projected IRA earnings.
Withdrawals will be subject to income tax but
not the 10% early withdrawal penalty. However,
the same rules do not apply to a Roth IRA.
-
If you need a short-term loan, under the rollover
rules, you may withdraw money from an IRA
temporarily and redeposit the full amount within
60 days in the same or a different IRA without
tax consequences.
-
If you are divorced and receive alimony, you can
make an IRA contribution even if all your income
is from taxable alimony
-
To maximize the accumulation of tax-deferred
income, consider making your contribution
as early as possible. You can make an IRA
contribution in the first week of the new year.
If you cannot deduct the amount, you can
leave it in as a nondeductible contribution or
you can withdraw the contribution (and the
attributable earnings) without penalty before
the due date (including extensions) of your tax
return. The income attributable to the withdrawn
contribution will be taxable income for the year in
which the contribution was made.
- Note, however, that if you contribute to an
IRA and decide after the due date (including
extensions) of your tax return that you do not
want to make a contribution, you are treated
as taking a distribution from your account on
which you will be taxed currently. If you are
younger than 59½, you most likely will incur a
nondeductible penalty tax of 10% of the taxable
amount of the distribution.
Other IRA and Roth IRA issues
Contributions to an IRA in excess of the limits are subject
to an annual 6% penalty. Also, money generally cannot be
withdrawn from an IRA without a 10% penalty tax—except
in substantially equal payments over your life expectancy
(or the joint life expectancy of you and a designated
beneficiary) or after you are at least age 59½, disabled,
or deceased.
Planning Tips:
-
Consider the gift of an IRA or a Roth IRA
contribution on behalf of a working child or
grandchild. By taking advantage of the annual
gift tax exclusion, you can make a contribution
for another person up to the lesser of his or
her earned income for the year or the IRA
limit for the year, generally $6,000. If you
contribute $6,000 a year for four years while a
child attends college (ages 18 to 22) and works
part time, that contribution will grow to around
$77,000 by the time he or she reaches age 62
(assuming 3% annual return). Those same four
$6,000 contributions beginning at age 30 would
accumulate to around $54,000 by the time the
child reached age 62.
Retirement Savings Through an Employer’s Plan
Many employers have established 401(k) plans (or 403(b)
plans for certain tax-exempt organizations—because
401(k) and 403(b) plans have similar rules, they will be
discussed together). If you are enrolled in a 401(k) or 403(b)
plan, you can reduce your salary by making pre-tax plan
contributions (which are still subject to Social Security taxes)
Some 401(k)/403(b) plans permit Roth(k) contributions as
well as pre-tax contributions. Roth(k) contributions are
includible in taxable income, but distributions are not.
Your employer may match a portion of your pre-tax or
Roth(k) contributions.
| Year | Limit | Catchup for 50yo + |
|---|
The amount you can contribute to a 401(k) or 403(b) plan
in years indicated above is limited, but may
be less depending on participation in the plan by other
employees. If you inadvertently elect to defer more than
a total of allowed in the respective year to all 401(k) and 403(b) plans in
which you participate, you must notify your employer and
have excess amounts returned to you by April 15, {}.
You will owe income tax on any excess deferrals and on
income earned on the funds. No penalty will apply to this
amount. However, if excess deferrals are not paid to you by
April 15, {}, you must include the excess deferral as
income both in the year of contribution and in the year of
distribution. Additionally, the 10% early withdrawal penalty
applies to the amount distributed from the plan.
Some plans allow additional after-tax contributions.
These funds accumulate tax-deferred, and you pay tax
only on the earnings when you receive distributions at
retirement or later.
Planning Tips:
-
Consider some Roth(k) contributions to the
401(k) plan. Roth(k) contributions are taxed
as contributed, but savings are never taxed if
they’re held in a Roth(k) for at least five years
and distributed only after age 59½.The amounts
can be rolled over from a Roth(k) into a Roth
IRA at distribution and held until needed.
As noted above, Roth IRAs do not have required
minimum distributions.
-
Make maximum contributions to your 401(k).
For contributions made with pre-tax dollars,
you save taxes now and accumulate tax-deferred
retirement savings. If the plan allows, you may
withdraw contributions to a 401(k) plan when
you terminate your employment or if you face
a financial hardship, as defined in stringent
IRS regulations. If you withdraw funds before
age 59½, you generally will be subject to a
10% penalty tax in addition to ordinary income
tax. On termination, you can direct the plan
administrator to roll over the amount to an IRA
or a new employer’s plan without paying any tax
at the time of the rollover, allowing further tax
deferral until you need to take distributions.
-
If you need a loan and have money invested in
your company 401(k) or 403(b) plan, you may
be able to borrow against your savings.
Although loan conditions vary according to plans,
the interest rates tend to be lower than for
other consumer loans, and the interest you pay
goes back into your account in the retirement
plan. In most cases, the interest you pay
is nondeductible.
Nonqualified Deferred Compensation
If you are a highly compensated employee, your employer
may provide additional retirement savings for you by
establishing a nonqualified deferred compensation plan.
Such plans have no contribution limits, and employers
generally may use their discretion as to who will
participate. Because the amounts are contributed pre-tax,
you get the immediate increase in savings as compared
to after-tax savings, because the amount you would
have paid as tax is available for savings and generates
returns throughout the saving period. As with all deferred
compensation (other than Roth IRAs and Roth 401(k)
accounts), you receive compensation (taxed at ordinary
income rates) on amounts deferred once the plan provides
for distributions. Your employer cannot deduct the
promised compensation until the year in which you include
the amount as income.
Remember, however, that you are a general creditor of the
corporation with regard to this deferred compensation;
therefore, in bankruptcy, the corporation’s secured creditors
will be paid before you. In many cases, there is nothing left
with which to pay the nonqualified deferred compensation.
Another disadvantage of a nonqualified deferred
compensation plan is that distributions will be taxed as
ordinary income
Planning Tips:
-
In negotiating a compensation package with your
employer, evaluate the risk of forfeiture and weigh
the after-tax advantages of each choice available
to you. Taking some non-taxable compensation
(such as additional pre-tax fringe benefits or
health coverage) may be worth more than taxable
compensation. Likewise, if your employer will pay
for something for you and include the payment in
your taxable compensation you have only “paid”
the tax rather than the full cost of the benefit.
As an example, if your employer agrees to pay
for life insurance premiums equal to $20,000
and includes the value of the premiums in your
income, you pay tax only on amounts equal
to your tax rate plus Medicare (and additional
Medicare if applicable).
-
Compare the overall benefit of deferred
compensation to receiving cash today. For some
companies and their executives, upfront cash
makes good business sense. Payments now
can be put into savings vehicles with lower tax
rates (such as municipal bonds). Also, if tax rates
are low, individuals generally include amounts
in income while the taxes are low rather than
deferring until the tax rates are higher. Employees
defer more when tax rates are high, assuming
that post-retirement income may be lower and
thus subject to lower tax rates.
-
Nonqualified deferred compensation plans must
comply with the rules of section 409A or the
compensation deferred will be subject to an
additional 20% tax and other penalties.
Planning for Retirement Distributions
Retirement planning involves determining future needs and
how your resources will satisfy those needs. As discussed
above, penalty taxes apply to early distributions, late
distributions, excess distributions, and distributions of less
than the required minimums. You also must consider the
effect penalties will have on undistributed retirement plan
balances that are part of your estate. To avoid incurring
these penalties you should review your retirement plans to
determine the optimum method of taking distributions.
The most advantageous way to receive retirement
distributions from an employer’s plan or an IRA depends
not only on penalty taxes and your need for income,
but also on the tax treatment of the distribution.
Minimum Annual Distributions
You generally are required to take minimum annual
distributions from most retirement plans no later than
April 1 of the year following the year in which you reach
age 70½ or once you retire, if you are not at least a 5%
owner. Distributions for subsequent years must be made
by December 31 of each year. For example, if you reach
age 70½ in {}, you must begin receiving distributions by
April 1, {}. However, delaying the required {}
distribution until {} will force you to include in your
{} taxable income required distributions for both {}
and {}.
The minimum annual distribution amounts are determined
by calculating the amount necessary to distribute the
retirement plan interest over your life, or over your life
and that of a designated beneficiary. The minimum annual
distribution rules allow you to avoid depletion of your
retirement savings through annual recalculation of your life
expectancy (and the life expectancy of your designated
beneficiary if that person is your spouse).
If minimum distributions are required, the amounts
must be taken out timely. Otherwise, you will be
subject to a penalty totaling half the amount you should
have withdrawn.
Planning Tips:
-
In negotiating a compensation package with your
employer, evaluate the risk of forfeiture and weigh
the after-tax advantages of each choice available
to you. Taking some non-taxable compensation
(such as additional pre-tax fringe benefits or
health coverage) may be worth more than taxable
compensation. Likewise, if your employer will pay
for something for you and include the payment in
your taxable compensation you have only “paid”
the tax rather than the full cost of the benefit.
As an example, if your employer agrees to pay
for life insurance premiums equal to $20,000
and includes the value of the premiums in your
income, you pay tax only on amounts equal
to your tax rate plus Medicare (and additional
Medicare if applicable).
-
Compare the overall benefit of deferred
compensation to receiving cash today. For some
companies and their executives, upfront cash
makes good business sense. Payments now
can be put into savings vehicles with lower tax
rates (such as municipal bonds). Also, if tax rates
are low, individuals generally include amounts
in income while the taxes are low rather than
deferring until the tax rates are higher. Employees
defer more when tax rates are high, assuming
that post-retirement income may be lower and
thus subject to lower tax rates.
-
Nonqualified deferred compensation plans must
comply with the rules of section 409A or the
compensation deferred will be subject to an
additional 20% tax and other penalties.
Planning Tips:
-
IRA distributions must begin by April 1 of the
year after you turn age 70½. If you keep money
in your employer’s plan (if permitted), you can
avoid minimum required distributions while you
are still working as an employee of that employer
(or as a less-than-5% owner of the company).
Roth IRAs do not have minimum required
distribution requirements.
-
For individuals other than at-least-5% owners,
so long as you are working at least part-time as
an employee, amounts held in your employer’s
401(k)/403(b) plan do not have to be distributed
as minimum required distributions starting at age
70½. Some companies allow you to roll over IRA
amounts so you can prevent minimum required
distributions until you are ready to stop working.
Consider the minimum annual distribution with a
younger beneficiary to minimize distributions and
delay them as long as possible. If the beneficiary
is your spouse, you can recalculate your and
your spouse’s life expectancies. However, this is
not a decision to be made lightly. If you elect
to recalculate life expectancy, the distribution
is treated as a single life annuity when one of
you dies. If either of you is not in good health,
recalculation may not defer distributions.
Taxation of distributions
A 10% penalty tax generally applies if you receive
tax-deferred retirement savings from your 401(k) or broader
pension plan or your IRA before you reach age 59½, die,
or become disabled. The penalty does not apply if you roll
over amounts to an IRA or another qualified plan. However,
distributions in substantially equal payments over your life
expectancy (or the joint lives of you and your beneficiary)
are also exempt from the penalty. If the payment schedule
is modified for reasons other than death or disability, the
tax will be applied retroactively if you are not age 59½ and
have not been receiving payments for at least five years.
Several techniques are available to defer or reduce tax
on distributions:
-
You can defer taxes on a lump-sum distribution and
certain partial distributions by rolling the distribution
amounts into an IRA or, when permitted, to another
qualified plan. The plan administrator can usually do a
“direct rollover” to another plan or IRA. Otherwise,
you need to move the money within 60 days
(see Withholding requirement below)
-
If you receive your distributions as payments over a life
annuity payment, you will pay tax in the year in which
you receive each payment.
Planning Tips:
-
In certain instances, you may find it advantageous
to receive a lump sum from your employer’s plan
and purchase a commercial annuity. Whether or
not this is beneficial depends on the assumptions
the plan makes in computing your lump-sum
distribution and the investment opportunities
available to you, and also on the amount of
the annuity surrender costs, commissions,
and other fees.
-
If your plan permits annuity payments,
sometimes it is more beneficial to elect a single
life annuity and use the excess amounts received
to purchase life insurance or a commercial
annuity that will pay your beneficiary at your
death. The benefits of this approach will
depend on the assumptions a plan uses to
calculate a single-life annuity that is equivalent
to a jointlife- and-last-survivor annuity and the
investment opportunities available to you,
including commercial annuities. Compare the
single-life to joint-type payments from your plan.
-
If the individual or family is covered by a
“high deductible health care” arrangement
(see IRS Publication 969 or ask your health
care provider whether your plan is a highdeductible health care plan), an individual can
contribute up to $3,500 ({}) or a family
can contribute up to $7,000 ({}) to a health
savings account (HSA), with an additional $1,000
contribution if a covered member is at least age
50. This contribution is fully deductible and the
account grows tax free. If amounts in the account
are used for approved health care expenses,
the payments from the HSA are also tax free.
The HSA is the property of the family and can
be used for qualified health care expenses, or it
can be saved to use for qualified health care
expenses, including later Medicare premiums,
in a later year. Some families choose to pay
health care expenses currently and save the HSA
for later expenses when they are covered by a
less generous plan or have higher expenses as
older individuals. HSAs often have investment
provisions allowing a portion of the account to be
invested for longer-term growth.
Withholding Requirement
If you do not elect to have your qualified plan (401(k), 403(b)
or deferred benefit plan) distribution transferred or rolled
over directly to an IRA or another qualified plan, you will
receive only 80% of your distribution. The remaining 20%
will be withheld to pay income taxes. This is the case even
if you plan to roll the funds into an IRA within 60 days of
receiving the distribution. Of course, you will not owe tax
on the amount you roll over. But if you only receive 80%
of your distribution and only roll over that 80%, you will
be taxed on the 20% withheld. Also remember that any
portion of the distribution not rolled over may be subject
to the 10% penalty on early distributions in addition to
ordinary income taxes, if you are under age 59½ and do
not meet certain other exceptions.
Planning Tips:
-
Elect a direct transfer from your plan to an IRA
or another qualified plan to avoid the withholding
rule. You can withdraw the funds from the IRA
with no withholding.
-
If you don’t do a direct rollover, contribute the
80% distribution plus out-of-pocket cash equal to
the 20% withheld within 60 days of distribution.
You will receive a refund for the withheld amount
(adjusted for your other ordinary income taxes
due, if any) after you file your income tax return
for the year. However, these funds will not be
working for you during the interim period before
you receive the refund.
-
There may be other ways to bypass the
withholding requirement, depending on whether
your employer offers these alternatives: Some
employers will let employees keep the funds in
the company plan. Also, some plans may include
an option of taking the money in substantially
equal payments made over a period of 10 years or
more or for life.
-
To determine the optimum method of taking
distributions and the timing of those distributions,
evaluate your retirement plans in conjunction with
such factors as your age, health, beneficiaries,
and cash flow requirements. Work closely with
your tax adviser to consider the complex rules
that govern distributions.
Social Security Benefits
If you are under your normal retirement age (between age
65 and age 67, depending on your birth year) and are
still employed but are taking Social Security benefits,
your Social Security benefits will be reduced if your current
earnings exceed a prescribed limit.
You should review the Social Security Administration (SSA)
report on earnings and confirm that it is a correct record of
your earnings.
To correct an error, you must notify the SSA
within three years, three months, and 15 days after you
discover the discrepancy.
You can check the Social Security website
(www.ssa.gov)
to obtain this information and
model payments at various ages.
Planning Tips:
-
If you are newly eligible for Social Security benefits
and would be subject to tax on the Social Security
payments, you may want to delay applying for those
benefits. Doing so will increase the monthly benefits
you are eligible to receive. However, you should
sign up for Medicare at your normal retirement
age, as medical insurance may cost more if you
delay application.
