Roth IRAs are tax-favored financial vehicles that enable investors to save money for retirement. They differ from traditional IRAs in that taxpayers cannot deduct contributions made to a Roth. However, qualified Roth IRA distributions in retirement are free of federal income tax and aren’t included in a taxpayer’s gross income. That can be advantageous, especially if the account owner is in a higher tax bracket in retirement or taxes are higher in the future.
A Roth IRA is subject to the same contribution limits as a traditional IRA ($5,500 in 2016, unchanged from 2015). (The maximum combined annual contribution an individual can make to traditional and Roth IRAs is $5,500 in 2016, unchanged from 2015.) Special “catch-up” contributions enable those nearing retirement (age 50 and older) to save at an accelerated rate by contributing $1,000 more than the regular annual limits.
Another way in which Roth IRAs can be advantageous is that investors can contribute to a Roth after age 70½ as long as they have earned income, and they don’t have to begin taking mandatory distributions due to age, as they do with traditional IRAs; however, beneficiaries of Roth IRAs must take mandatory distributions.
Roth IRA withdrawals of contributions (not earnings) can be made at any time and for any reason; they are tax-free and not subject to the 10% federal income tax penalty for early withdrawals. In order to make a qualified tax-free and penalty-free distribution of earnings, the account must meet the five-year holding requirement and you must be age 59½ or older. Otherwise, these withdrawals are subject to the 10% federal income tax penalty (with certain exceptions including death, disability, unreimbursed medical expenses in excess of 10% of adjusted gross income, higher-education expenses, and for the purchase of a first home ($10,000 lifetime cap).* However, these withdrawals would be subject to ordinary income tax.
Keep in mind that even though qualified Roth IRA distributions are free of federal income tax, they may be subject to state and/or local income taxes. Eligibility to contribute to a Roth IRA phases out for taxpayers with higher incomes.
If you’re looking for a retirement savings vehicle with some distinct tax advantages, the Roth IRA could be appropriate for you.
* Individuals age 65 and older can continue to claim qualified medical expenses that surpass 7.5% of AGI through 2016.
Most people have good intentions about saving for retirement. But few know when they should start and how much they should save.
Sometimes it might seem that the expenses of today make it too difficult to start saving for tomorrow. It’s easy to think that you will begin to save for retirement when you reach a more comfortable income level, but the longer you put it off, the harder it will be to accumulate the amount you need.
The rewards of starting to save early for retirement far outweigh the cost of waiting. By contributing even small amounts each month, you may be able to amass a great deal over the long term. One helpful method is to allocate a specific dollar amount or percentage of your salary every month and to pay yourself as though saving for retirement were a required expense.
Here’s a hypothetical example of the cost of waiting. Two friends, Chris and Leslie, want to start saving for retirement. Chris starts saving $275 a month right away and continues to do so for 10 years, after which he stops but lets his funds continue to accumulate. Leslie waits 10 years before starting to save, then starts saving the same amount on a monthly basis. Both their accounts earn a consistent 8% rate of return. After 20 years, each would have contributed a total of $33,000 for retirement. However, Leslie, the procrastinator, would have accumulated a total of $50,646, less than half of what Chris, the early starter, would have accumulated ($112,415).*
This example makes a strong case for an early start so that you can take advantage of the power of compounding. Your contributions have the potential to earn interest, and so does your reinvested interest. This is a good example of letting your money work for you.
If you have trouble saving money on a regular basis, you might try savings strategies that take money directly from your paycheck on a pre-tax or after-tax basis, such as employer-sponsored retirement plans and other direct-payroll deductions.
Regardless of the method you choose, it’s extremely important to start saving now, rather than later. Even small amounts can help you greatly in the future. You could also try to increase your contribution level by 1% or more each year as your salary grows.
Distributions from tax-deferred retirement plans, such as 401(k) plans and traditional IRAs, are taxed as ordinary income and may be subject to an additional 10% federal income tax penalty if withdrawn prior to age 59½.
*This hypothetical example of mathematical compounding is used for illustrative purposes only and does not represent the performance of any specific investment. Rates of return will vary over time, particularly for long-term investments. Investments offering the potential for higher rates of return involve a higher degree of investment risk. Taxes, inflation, and fees were not considered. Actual results will vary.
Employer-sponsored retirement plans are more valuable than ever. The money in them accumulates tax deferred until it is withdrawn, typically in retirement. Distributions from a tax-deferred retirement plan such as a 401(k) are taxed as ordinary income and may be subject to a 10% federal income tax penalty if withdrawn prior to age 59½. And contributions to a 401(k) plan actually reduce your taxable income.
But figuring out how to manage the assets in your retirement plan can be confusing, particularly in times of financial uncertainty.
Conventional wisdom says if you have several years until retirement, you should put the majority of your holdings in stocks. Stocks have historically outperformed other investments over the long term. That has made stocks attractive for staying ahead of inflation. Of course, past performance does not guarantee future results.
The stock market has the potential to be extremely volatile. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Is it a safe place for your retirement money? Or should you shift more into a money market fund offering a stable but lower return?
And will the instability in the markets affect the investments that the sponsoring insurance company uses to fund its guaranteed interest contract?
If you’re participating in an employer-sponsored retirement plan, you probably have the option of shifting the money in your plan from one fund to another. You can reallocate your retirement savings to reflect the changes you see in the marketplace. Here are a few guidelines to help you make this important decision.
Consider Keeping a Portion in Stocks
In spite of its volatility, the stock market may still be an appropriate place for your investment dollars — particularly over the long term. And retirement planning is a long-term proposition.
Since most retirement plans are funded by automatic payroll deductions, they achieve a concept known as dollar-cost averaging. Dollar-cost averaging can take some of the sting out of a descending market.
Dollar-cost averaging does not ensure a profit or prevent a loss. Such plans involve continuous investments in securities regardless of the fluctuating prices of such securities. You should consider your financial ability to continue making purchases through periods of low price levels. Dollar cost averaging can be an effective way for investors to accumulate shares to help meet long-term goals.
Diversify
Diversification is a basic principle of investing. Spreading your holdings among several different investments (stocks, bonds, etc.) may lessen your potential loss in any one investment.
Do the same for the assets in your retirement plan.
Keep in mind, however, that diversification does not guarantee a profit or protect against investment loss; it is a method used to help manage investment risk.
Find Out About the Guaranteed Interest Contract
A guaranteed interest contract offers a set rate of return for a specific period of time, and it is typically backed by an insurance company. Generally, these contracts are very safe, but they still depend on the security of the company that issues them.
If you’re worried, take a look at the company’s rating. The four main insurance company rating agencies are A.M. Best, Moody’s, Standard & Poor’s, and Fitch Ratings. A.M. Best ratings are based on financial conditions and operating performance; Fitch Ratings, Moody’s, and Standard & Poor’s ratings are based on claims-paying ability. You should be able to find copies of these guides at your local library.
Periodically Review Your Plan’s Performance
You are likely to have the chance to shift assets from one fund to another. Use these opportunities to review your plan’s performance. The markets change. You may want to adjust your investments based on your particular situation.
A 401(k) plan is a self-directed, qualified retirement plan established by an employer to provide future retirement benefits for employees. Employee contributions are made on a pre-tax basis, and employer contributions are often tax deductible.
If you have a Roth 401(k) option, contributions are made with after-tax dollars, but qualified distributions after age 59½ are free of federal income tax. To qualify for a tax-free distribution, the distribution must also satisfy the five-year holding rule.
Many employers are now enrolling new hires automatically in 401(k) plans, allowing them to opt out later if they choose not to participate. This is done in the hope that more employees will participate and start saving for retirement at an earlier age.
If you elect to participate in a 401(k) plan, you can allocate a percentage of your salary to your plan every paycheck. The maximum annual contribution is $18,000 in 2016 (unchanged from 2015). If you will be 50 or older before the end of the tax year, you can contribute an additional $6,000. Contribution limits are indexed annually for inflation. The funds in your account will accumulate tax deferred until withdrawn, when they are taxed as ordinary income.
Employer contributions are often subject to vesting requirements. Employers can determine their own vesting schedules, making employees partially vested over time and fully vested after a specific number of years. When an employee is fully vested, he or she is entitled to all the contributions made by the employer when separating from service.
In plans that offer loans, you may also be allowed to borrow money from your account (up to 50% of the vested account value or $50,000, whichever is less) with a five-year repayment period. Of course, if you leave your job, the loan may have to be repaid immediately.
The assets in a 401(k) plan are portable. When you leave your job or retire, you can move your assets or take a taxable distribution. However, if you leave a company before you are fully vested, you will be allowed to take only the funds that you contributed yourself plus any vested funds, as well as any earnings that have accumulated on those contributions.
Within certain limits, the funds in your 401(k) plan can be rolled over directly to your new employer’s retirement plan without penalty. Alternatively, you can roll your funds directly to an individual retirement account (IRA).
Generally, you must begin taking required minimum distributions from 401(k) plans no later than April 1 of the year after you reach age 70½. Distributions from regular 401(k) plans are taxed as ordinary income and may be subject to a 10% federal income tax penalty if withdrawn before age 59½, except in special circumstances such as disability or death.
A 401(k) plan can be a great way to save for retirement, especially if your employer offers matching contributions. If you are eligible to participate in a 401(k) plan, you should take advantage of the opportunity, even if you have to start by contributing a small percentage of your salary. This type of plan can form the basis for a sound retirement funding strategy.
Traditional individual retirement accounts (IRAs) can be a good way to save for retirement. If you do not participate in an employer-sponsored retirement plan or would like to supplement that plan, a traditional IRA could work for you.
A traditional IRA is simply a tax-deferred savings account that has several investing options and is set up through an investment institution. For instance, an IRA can include stocks, bonds, mutual funds, cash equivalents, real estate, and other investment vehicles.
One of the benefits of a traditional IRA is the potential for tax-deductible contributions. You may be eligible to make a tax-deductible contribution of up to $5,500 ($6,500 if you are 50 or older) in 2016 (unchanged from 2015). Contribution limits are indexed annually for inflation.
You can contribute directly to a traditional IRA or you can transfer assets directly from another type of qualified plan, such as a SEP or a SIMPLE IRA. Rollovers may also be made from a qualified employer-sponsored plan, such as a 401(k) or 403(b), after you change jobs or retire.
Not everyone contributing to a traditional IRA is eligible for a tax deduction. If you are an active participant in a qualified workplace retirement plan — such as a 401(k) or a simplified employee pension plan — your IRA deduction may be reduced or eliminated, based on your income.
In 2016 (as in 2015), for example, if your modified adjusted gross income (AGI) is $61,000 or less as a single filer ($98,000 or less for married couples filing jointly), you can receive the full tax deduction. On the other hand, if your AGI is more than $71,000 as a single filer ($118,000 for married couples filing jointly), you are not eligible for a tax deduction. Partial deductions are allowed for single filers whose incomes are between $61,000 and $71,000 (or between $98,000 and $118,000 for married couples filing jointly). If you are not an active participant in an employer-sponsored retirement plan, you are eligible for a full tax deduction.
Nondeductible contributions may necessitate some very complicated paperwork when you begin withdrawals from your account. If your contributions are not tax deductible, you may be better served by another retirement plan, such as a Roth IRA. (The maximum combined annual contribution an individual can make to traditional and Roth IRAs is $5,500 in 2016 (unchanged from 2015).)
The funds in a traditional IRA accumulate tax deferred, which means you do not have to pay taxes until you start receiving distributions in retirement, a time when you might be in a lower tax bracket. Withdrawals are taxed as ordinary income. Withdrawals taken prior to age 59½ may also be subject to a 10% federal income tax penalty. Exceptions to this early-withdrawal penalty include distributions resulting from disability, unemployment, and qualified first home expenses ($10,000 lifetime limit), as well as distributions used to pay higher-education expenses.
You must begin taking annual required minimum distributions (RMDs) from a traditional IRA after you turn 70½ (starting no later than April 1 of the year after the year you reach 70½), or you will be subject to a 50% income tax penalty on the amount that should have been withdrawn. Of course, you can always withdraw more than the required minimum amount or even withdraw the entire balance as a lump sum.
An IRA can be a valuable addition to your retirement and tax management efforts. By working with a financial advisor, you can determine whether a traditional IRA would be appropriate for you.
When it comes to receiving the fruits of your labor — the money accumulated in your employer-sponsored retirement plan — you are faced with a few broad options. Should you take the payout as systematic payments, a lifetime annuity, or a lump sum?
Systematic Withdrawals
Some retirement plans may allow you to take systematic withdrawals: either a fixed dollar amount on a regular schedule, a specific percentage of the account value on a regular schedule, or the total value of the account in equal distributions over a specified period of time.
The Lifetime Annuity Option
Your retirement plan may allow you to take payouts as a lifetime annuity, which converts your account balance into guaranteed monthly payments based on your life expectancy. If you live longer than expected, the payments continue anyway.
There are several advantages associated with this payout method. It helps you avoid the temptation to spend a significant amount of your assets at one time and the pressure to invest a large sum of money that might not last for the rest of your life. Also, there is no large initial tax bill on your entire nest egg; each monthly payment is taxed incrementally as ordinary income.
If you are married, you may have the option to elect a joint and survivor annuity. This would result in a lower monthly retirement payment than the single annuity option, but your spouse would continue to receive a portion of your retirement income after your death. If you do not elect an annuity with a survivor option, your monthly payments end with your death.
The main disadvantage of the annuity option lies in the potential reduction of spending power over time. Annuity payments are not indexed for inflation. If we experienced a 4% annual inflation rate, the purchasing power of the fixed monthly payment would be halved in 18 years.
Lump-Sum Distribution
If you elect to take the money from your employer-sponsored retirement plan as a single lump sum, you would receive the entire vested account balance in one payment, which you can invest and use as you see fit. You would retain control of the principal and could use it whenever and however you wish.
Of course, if you choose a lump sum, you will have to pay ordinary income taxes on the total amount of the distribution in one year. A large distribution could easily move you into a higher tax bracket. Another consideration is the 20% withholding rule: Employers issuing a check for a lump-sum distribution are required to withhold 20% toward federal income taxes. Thus, you would receive only 80% of your account balance, not 100%. Distributions taken prior to age 59½ are also subject to a 10% federal income tax penalty.
To avoid some of these problems, you might choose to take a partial lump-sum distribution and roll the balance of the funds directly to an IRA or other qualified retirement plan in order to maintain the tax-deferred status of the funds. An IRA rollover might provide you with more options, not only in how you choose to invest the funds but also in how you access the funds over time.
After you reach age 70½, you generally must begin taking required minimum distributions from traditional IRAs and most employer-sponsored retirement plans. These distributions are taxed as ordinary income.
Before you take any action on retirement plan distributions, it would be prudent to consult with a tax professional regarding your particular situation. Choose carefully, because your decision and the consequences will remain with you for life.
If you want to participate in the potentially attractive returns of a market-driven investment but would also like a guaranteed return, an indexed annuity might be worth checking out.
The performance of indexed annuities, also referred to as equity-indexed or fixed-indexed annuities, are tied to an index (for example, the Standard & Poor’s 500*). They provide investors with an opportunity to earn interest based on the performance of the index. If the index rises during a specified period in the accumulation phase, the investor participates in the gain. In the event that the market falls and the index posts a loss, the contract value is not affected. The annuity also has a guaranteed minimum rate of return, which is contingent on holding the indexed annuity until the end of the term.
This guaranteed minimum return comes at a price. The percentage of an index’s gain that investors receive is called the participation rate. The participation rate of an indexed annuity can be anywhere from 50% to 90% or more. A participation rate of 80%, for example, and a 10% gain by the index would result in an 8% gain by the investor.
Some indexed annuities have a cap rate, the maximum rate of interest the annuity will earn, which could potentially lower an investor’s gain.
Indexing Formula
Several formulas are used to calculate the earnings generated by an indexed annuity. These indexing methods can also have an effect on the final return of the annuity. On preset dates, the annuity holder is credited with a percentage of the performance of the index based on one of these formulas.
Annual Reset (or Ratchet): Based on any increase in index value from the beginning to the end of the year.
Point-to-Point: Based on any increase in index value from the beginning to the end of the contract term.
High-Water Mark: Based on any increase in index value from the index level at the beginning of the contract term to the highest index value at various points during the contract term (often anniversaries of the purchase date).
Indexed annuities are not appropriate for every investor. Participation rates are set and limited by the insurance company. Like most annuity contracts, indexed annuities have certain rules, restrictions, and expenses. Some insurance companies reserve the right to change participation rates, cap rates, and other fees either annually or at the start of each contract term. These types of changes could affect the investment return. Because it is possible to lose money in this type of investment, it would be prudent to review how the contract handles these issues before deciding whether to invest.
Most annuities have surrender charges that are assessed during the early years of the contract if the contract owner surrenders the annuity. In addition, withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty. Any guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company.
If you want to limit potential losses but still tap into the potential benefits of equity investing, you might consider an indexed annuity.
* The S&P 500 Index is an unmanaged group of securities that is widely reconized as representative of the U.S. stock market in general. You cannot invest directly in any index. You do not actually own any shares of an index. Past performance is no guarantee of future results.
A self-employed retirement plan is a tax-deferred retirement savings program for self-employed individuals. In the past, the term “Keogh plan” or “H.R. 10 plan” was used to distinguish a retirement plan established by a self-employed individual from a plan established by a corporation or other entity. However, self-employed retirement plans are now generally referred to by the name that is used for the particular type of plan, such as SEP IRA, SIMPLE 401(k), or self-employed 401(k).
Self-employed plans can be established by any individual who is self-employed on a part-time or full-time basis, as well as by sole proprietorships and partnerships (who are considered “employees” for the purpose of participating in these plans).
Unlike IRAs, which limit tax-deductible contributions to $5,500 per year (in 2016, the same as in 2015), self-employed plans allow you to save as much as $53,000 of your net self-employment income in 2016 (unchanged from 2015), depending on the type of self-employed plan you adopt.
Contributions to a self-employed plan may be tax deductible up to certain limits. These contributions, along with any gains made on the plan investments, will accumulate tax deferred until you withdraw them.
Withdrawal rules mirror those of other qualified retirement plans. Distributions are taxed as ordinary income and may be subject to an additional 10% federal income tax penalty if taken prior to age 59½. Self-employed plans can typically be rolled over to another qualified retirement plan or to an IRA. Annual minimum distributions are required after the age of 70½. Unlike the case with other qualified retirement plans, hardship distributions are not permitted with a self-employed plan.
You can open a self-employed plan account through banks, brokerage houses, insurance companies, mutual fund companies, and credit unions. Although the federal government sets no minimum opening balance, most institutions set their own, usually between $250 and $1,000.
The deadline for setting up a self-employed plan is earlier than it is for an IRA. You must open a self-employed plan by December 31 of the year for which you wish to claim a deduction. However, you don’t have to come up with your entire contribution by then. As with an IRA, you have until the day you file your tax return to make your contribution. That gives most taxpayers until April 18 in 2016 (unless you are resident of Massachusetts and Maine in which case you have until April 19 due to Patriots’ Day) to deposit their annual retirement savings into a self-employed plan account.
Each tax year, plan holders are required to fill out Form 5500, for which they may need the assistance of an accountant or tax advisor, incurring extra costs.
If you earn self-employment income, a self-employed plan could be a valuable addition to your retirement strategy. And the potential payoff — a comfortable retirement — may far outweigh any extra costs or paperwork.
Estimating your future Social Security benefits used to be a difficult task, but not any longer. For an estimate of your projected benefits, go to www.ssa.gov/estimator. The retirement estimator gives estimates based on your actual Social Security earnings record.
The website form will ask you for a number of facts, including your name, Social Security number, date and place of birth, your mother’s maiden name, additional information you provide about future earnings, and the age at which you expect to stop working.
Based on this information and your actual earnings history as maintained by the Social Security Administration, the Retirement Estimator generates an estimate of the amount you would receive if you were to retire at age 62 (the earliest date you can receive benefits), the amount if you waited until full retirement age (which currently ranges from 65 to 67, based on year of birth), and the larger benefit you would receive if you continued working until age 70 before claiming retirement benefits.
It’s interesting to note that the 2015 Social Security Trustees Report includes a warning about the serious problems facing Social Security in the future. The trustees indicated that program costs (benefits paid) have been more than non-interest income (Social Security payroll taxes) since 2010, and they expect this situation to continue. Without changes, the Social Security Trust Fund will be exhausted by 2034 and there will be enough money to pay only about 79 cents for each dollar of scheduled benefits at that time, declining to 73 cents by 2089 (based on the current formula).1 This is a reminder that taxpayers are ultimately responsible for funding their own retirements and that their future Social Security benefits may be lower than indicated by the Retirement Estimator.
People have traditionally seen Social Security benefits as the foundation of their retirement planning programs. The Social Security contributions deducted from workers’ paychecks have, in effect, served as a government-enforced retirement savings plan.
However, the Social Security system is under increasing strain. Better health care and longer life spans have resulted in an increasing number of people drawing Social Security benefits. As the baby boom generation (those born between 1946 and 1964) has begun to retire, even greater demands are being placed on the system.
In 1950, there were 16.5 active workers to support each person receiving Social Security benefits. In 2015, there were only 2.8 workers supporting each Social Security pensioner. And it is projected that there will be only 2.1 active workers to support each Social Security beneficiary by 2035.1
Although Social Security payments are typically adjusted for inflation, your own income and expenses may rise at a faster pace. And you might have to wait longer than you anticipated to qualify for full benefits.
It used to be that full benefits were available after you reached age 65. But since 2003, the age to qualify for full benefits has been increasing on a graduated scale based on year of birth. By 2027, the age to qualify for full Social Security benefits will have increased to age 67, where it is currently scheduled to remain.
That means you may have to wait longer to qualify for full Social Security benefits to start replacing a smaller percentage of your pre-retirement income.
When calculating the income you will have in retirement, you might recognize that Social Security benefits may play a more limited role. Some financial professionals suggest ignoring Social Security altogether when developing a retirement income plan.
Source: 1) Social Security Administration, 2015
Note: The Social Security Administration no longer mails an annual estimated benefit statement to all taxpayers. You can view your statement online by visiting www.ssa.gov/myaccount and creating your own personal Social Security account on the Social Security website.
