Rich in America Secrets to Creating and Preserving Wealth PHẦN 8 doc

In case of a malpractice claim, credi-tors generally can’t get to the money within a retirement plan; it’snot transferable.. Retirementplans allow you to put your money into tax-deferred

that doctors are among the most likely to overfund their retirementplans, but they’re a special case: They do it because these plans arealso asset-protection vehicles In case of a malpractice claim, credi-tors generally can’t get to the money within a retirement plan; it’snot transferable This rule does vary state by state and by the type ofretirement plan, so if you’re moving, your IRA or other plan may nolonger be protected.)

There’s another reason you should be saving for retirement,besides having money to live on later: tax advantages Retirementplans allow you to put your money into tax-deferred savings, thanks

to the many government-sanctioned vehicles for accumulating money.Not only can you defer taxes on the interest generated by a retire-ment account, but your contributions will generally be excludedfrom your taxable income, as will contributions made on your behalf

by your employer The earlier you start thinking about takingadvantage of these tax-deferred vehicles, the better off you will be infuture years

Tax Savings

The impact of tax deferral on retirement savings is impressive.The sooner you start saving, the more dramatic the results Ifyou contribute $3,000 each year to an IRA (the new maximum, as

of 2003) and it receives an 8 percent annualized return, after 20years the balance would be $148,000; after 30 years it grows to

$367,000; and after 40 years you would have saved $839,000.Although $3,000 may seem like an inconsequential amount, itdoes grow to a substantial sum if you start early and stay the course(see Figure 5.2)

Future Value of Annual $3,000 IRA Contributions at an 8% Annualized Return

F IGURE 5.2 F UTURE V ALUE OF A NNUAL IRA C ONTRIBUTIONS

Individual Retirement Accounts

The number of available individual retirement vehicles is sive, but they are also limited Tax codes specify how your moneymay or may not be taxed, how much money you can contribute toindividual retirement plans, and what portion of those contribu-tions is tax-deductible Your choices are discussed in the followingparagraphs

exten-Individual Retirement Accounts (IRAs) provide tax-deferredgrowth and, in some cases, a current income tax deduction In order

to be eligible to contribute to an IRA, you must have earned income.For tax year 2003, you could contribute up to $3,000 of your earnings.You also may contribute an additional $3,000 for a nonemployedspouse, raising your total household contribution to $6,000 For tax-payers over the age of 50, starting in 2002, you will be able to make anadditional catch-up contribution of $500 per year for tax years 2002

to 2005 and $1,000 per year for tax year 2006 (adjusted for inflationstarting in 2007)

If you qualify, you may be able to deduct all or part of your IRA contribution from your taxable income For example, you can de-duct the entire amount if neither you nor your spouse is covered by a qualified retirement plan Otherwise, as your income increases, the amount available for deduction decreases and is eventually phasedout entirely However, tax law restrictions have made it impossiblefor many individuals to fund individual retirement accounts on afully tax-deductible basis when they are considered “active partici-pants” in employer-sponsored retirement plans and have an adjustedgross income (AGI) over specified levels.

For married couples, the active participation of one spouse in anemployer-sponsored plan is enough to trigger possible limitations onIRA deductions for both spouses if AGI limits are exceeded

Nonemployed Spousal IRAs

If one spouse actively participates in an employer-sponsored plan andthe other does not, the nonparticipant spouse may make a deductibleIRA contribution of up to the maximum allowable for that year if theAGI on the joint return is $150,000 or less The deductible amount isphased out with AGI over $150,000, with full phase-out at $160,000.The current law does not index these AGI limits for inflation

Nondeductible Traditional IRAs

Individuals (and nonemployed spouses) with $3,000 of earned income

in 2003 whose AGI exceeds the aforementioned limits may choose tomake contributions to a nondeductible IRA

Nondeductible Roth IRAs

Although no tax deductions are allowed for Roth IRAs, they offer afeature that may be even more attractive than an upfront deduction

Specifically, withdrawals after age 591⁄2will be tax-free provided theRoth IRA has been in existence for more than five years Also, youare not required to take minimum distributions at age 701⁄2, as youwould with most other retirement plans As with traditional IRAs,contributions to a Roth IRA may only be made by individuals whoseearned income is at least equal to the contribution amount A RothIRA contribution may also be made on behalf of a nonworking spouse.The allowable contribution will phase out for single taxpayers whoseAGI is between $95,000 and $110,000 (or $150,000 to $160,000 forjoint filers).

Any child can contribute to a Roth IRA, assuming he or she hassome earned income and adjusted gross income of no more than

$110,000, which is probably a good assumption for most children (still,14-year-old Daniel Radcliffe earned exactly $110,000 for his starring

role in Harry Potter and the Sorceror’s Stone; however, for his next movie, Harry Potter and the Chamber of Secrets, he made $3 million) Yet, many

kids earn money from doing chores, delivering papers, or babysitting,and some manage to find summer jobs that can be fairly lucrative, on asmall scale All these can count as earned income (the money can’t bedividend income—the child must truly work for the money)

A gift also can be made in order to help someone else build up anice retirement fund For example, let’s say your college-aged daugh-ter made $10,000 this past summer during her vacation; you can giveher $3,000 to set up a Roth IRA even though she’s already spent allthe money she made The government doesn’t care how she spent themoney; it simply requires that she made enough money to establishthe contribution (this assumes that you already haven’t given her thefull $22,000 gift allowable under current rules)

Although they may not be able to make contributions to a tional IRA, individuals who continue working after age 701⁄2 maycontinue to make contributions to a Roth IRA, provided the incomelimitations are not exceeded Roth IRAs do not require minimum dis-

tradi-tributions Therefore, if you are retired and don’t need income fromyour Roth IRA, you have the option of allowing your money to con-tinue compounding tax-free This tax-free growth also may be passed

on to Roth IRA beneficiaries Unlike the original Roth IRA owner,the beneficiaries of a Roth IRA must withdraw the account’s funds overtime and according to IRS regulations

Traditional versus Roth IRA

Investors who can participate in the new Roth IRA may receivesignificantly more after-tax income during retirement from thataccount than from traditional IRAs (both deductible and non-deductible)

In general, the longer the period of investment before ment, the greater the advantage of the Roth IRA, since earningscompound tax-free over a longer period of time If the IRA assetswill not be used during the investor’s lifetime and will be passed tothe next generation, the greater the advantage of the Roth IRA,since there are no required minimum distributions to deplete theRoth IRA account during the contributor’s life

retire-Be aware that this comparison hinges upon certain variables,such as tax rates at the time of your contributions and when youretire, the length of time remaining until withdrawal, and pro-jected rates of return If you do qualify for a Roth, fund it to themaximum extent allowable

If a Roth IRA has been in existence for less than five years, drawals are presumed, for tax purposes, to come first from contribu-tions (as opposed to earnings) Since contributions are considered areturn of capital, no tax or penalty is due on contributions regardless

with-of when they are withdrawn However, earnings withdrawn before the

age of 591⁄2 from a Roth IRA in existence less than five years will besubject to both income tax and a 10 percent penalty (as always, certainexceptions may apply).

Rollover to a Roth IRA

Note that a traditional IRA may be rolled over into a Roth IRA ifyour AGI is $100,000 or less This $100,000 AGI limit applies to bothsingle and married filers Income taxes (but no penalties—unless the Roth IRA is not held for at least five years) will have to be paid on therollover, however Such rollovers may be a good idea, depending on cur-rent and future tax rates and whether you have non-IRA funds avail-able to pay the taxes due If you have low or depressed stock values,consider it a good time to convert a regular IRA into a Roth IRAbecause when you do, it becomes taxable income, but you’ll have nofuture capital gains to worry about

If the value of your traditional IRA account is not depressed, itmay not make sense to convert from a traditional IRA to a Roth IRA

As noted above, doing so will accelerate income tax with respect toyour IRA assets Therefore, the decision to convert a traditional IRAinto a Roth IRA must be carefully examined Some of the key factors

to consider in making this decision include:

• How much time you have until you begin taking the moneyout, and how long you expect to be making withdrawals afterretirement

• The total amount you might convert, since you would have topay taxes on the taxable portion of the rollover

• Your current tax bracket and projected tax bracket after ment

retire-• For those over age 701⁄2, whether you have made the properdistribution elections, and if a spousal rollover is possible

Other Retirement Plans Qualified Plans

These include pension plans, 401(k) plans, profit-sharing and savingsplans, Keoghs, employee stock ownership plans (ESOPs), qualifiedannuities, and stock bonus plans Such plans can be divided into twobroad categories: defined contribution plans and defined benefit plans.Each type of plan is distinct in its characteristics and tax rules In gen-eral, however, you need to know which of your company plans arequalified and the distribution options available for each plan, such as alump sum or annuity payment

401(k)s

As with other retirement plans, the 401(k) lets you place a portion

of your pretax salary into a retirement account Not only do yoursavings grow tax-free, but many employers will match some or all ofyour contributions At a minimum, you should make contributions

to the extent your company matches all or some of them Failing totake advantage of this option is like turning down a small bonus.The amount contributed by you and your company is not taxableuntil withdrawal Although your company’s matching contributionmay not be yours to keep if you end employment before the con-tribution vests, your prior contributions and their earnings alwaysbelong to you

Defined Benefit Plans

These plans pay a fixed monthly amount of income at retirementperiod The benefit payable to you is based on a complex formula, tak-ing into account your earnings and years of service Contributions tothese plans are almost always made entirely by the employer The mostcommon defined benefit plan is an employer pension plan

Most defined benefit plans pay out in the form of an annuity althoughsome provide for a discounted lump sum payment An annuity is astream of payments usually lasting for the life of the retiree (called by

the legal-sounding term annuitant) If you choose to take a reduced

annuity payment, a second or joint annuitant (usually a spouse) alsocan receive a payment if he or she outlives you Typical joint annuitantoptions include 100 percent joint and survivor ( J&S), in which eachperson receives the same payout, regardless of the order of death; 50 per-cent J&S, where the surviving joint annuitant receives 50 percent ofthe annuitant’s payment; and other options You also can guarantee

the number of payments (called a term certain option).

The more protection you provide for the joint annuitant (e.g., yourspouse), the smaller the payment to the annuitant (you) In the case of

a married couple, the greater the sum of assets owned by the couple,the lesser the need to protect the surviving spouse with an annuity Ifnecessary, an estate can be augmented with life insurance on the life ofthe retiree (but as we’ve discussed, life insurance can be very expensivewhen you buy it at retirement age) An annuity may be attractive if youseek a safe, secure, guaranteed stream of level payments during the life

of the surviving spouse

The risks of an annuity are twofold:

1.An annuity offers inadequate protection in an inflationaryenvironment

2.The family may suffer a financial loss if the annuitant diesearly in retirement and there is no joint annuitant, or if bothannuitant and joint annuitant die early in retirement

For more on annuities, see Chapter 6

Savings Incentive Match Plan for Employees (SIMPLE)

Companies with 100 or fewer employees (and no other plans) canestablish this inexpensive retirement plan Employees can defer up to

$7,000 of their income into these plans (the figure increases annuallyafter 2002) Employers, too, generally must make contributions onbehalf of their employees, usually 2 to 3 percent per employee Theseplans operate like a no-frills 401(k) plan

The 2001 Tax Law

The 2001 tax law has created significant changes to retirementplanning vehicles For instance, since 1981 there has been a $2,000limit on contributions to IRAs; beginning in 2002, the new lawpermits contributions of up to $3,000, and the allowable contribu-tion amount increases gradually to $5,000 by 2008 To help thosecloser to retirement, the new law contains a catch-up provision,allowing those age 50 and older to save more For instance, in 2002,they can contribute up to $3,500 to an IRA, and the catch-upprovision increases gradually to $6,000 by 2008 After 2008, theseamounts will be adjusted for inflation in increments of $500

As always, remember that there will be complex participationand coverage rules

Nonqualified Plans

Nonqualified plans are often used to supplement benefits that are wise limited by IRS rules They can be broken down into two broadcategories: the employee elective plan and the excess or supplementalbenefit plan In the employee elective plan, your company takes moneyfrom your upcoming bonus (or deducts money from each paycheck)and puts it into a retirement plan; this money is not considered incomeand will continue to grow These plans are generally available only to aselect group of employees, such as highly compensated executives orsenior management

other-The excess or supplemental benefit plan also applies to highlycompensated employees Let’s say 15 percent of your compensation up

to $200,000 is taken into account for a company’s qualified retirementplan, but you earn $350,000; a percentage of the excess ($150,000) can

be contributed to a nonqualified benefit plan

Nonqualified plans that are not available to all employees and are usually designed for senior executives or highly paid employees are(naturally) not qualified (under IRS rules) and are not eligible forfavorable tax treatment upon distribution or rollover to an IRA Ondistribution, nonqualified plan payments are subject to ordinary incometax (and in some cases Social Security taxes), but are not subject to anyminimum distribution rules or age distribution rules

A variety of nonqualified plans exist, including elective deferredcompensation plans, long-term incentive plans, benefit equalizationplans, excess (additional) pension plans, and restricted stock plans, toname a few The decision to defer within these plans or to continuedeferral upon an award maturity is usually made during employment.You must be aware of when your plan assets will be distributed andwhat investment allocation choices, if any, are available within yourplan If such plans are pegged to company stock performance and paid

in the form of shares of stock, they are subject to ordinary income taxupon distribution.

The advantages of these plans are that they are nontaxable in theyear of deferral, offer compounded tax-deferred growth, can be paidout when you’re in a lower tax bracket, and may not be subject tostate tax if you do not reside in the state at the time the funds are dis-tributed to you The disadvantage of these plans is that they gener-ally are not funded In other words, if you elect to defer a portion ofyour salary, say $1,000, and earmark it for this plan, your companywon’t pay that amount to you, but also won’t necessarily set it asidefor you, either Your employer must keep track of it as if you actuallymade a deposit, and promises to pay you that sum plus the hypo-thetical return on it But the money doesn’t physically exist in an ac-count for you

Nonqualified plan assets are also unsecured, which means they’resubject to the company’s general creditors in the event of insolvency orbankruptcy (although there are various trusts the money can go intothat can protect part of it) These plans are also subject to rescission ifmanagement decides to terminate the plan, or if there is a change incontrol and new management makes that decision

Certain irrevocable trusts (so-called rabbi trusts) can be used to

lessen the risks associated with nonqualified benefits, but completeprotection of your money from a company’s general creditors is vir-tually impossible without causing the funds to be taxable to you on acurrent basis As with regular qualified plans, the payouts from non-qualified plans are taxed as ordinary (compensation) income whenyou withdraw them; moreover, the money may be subject to the FICA(Social Security and Medicare) tax at that time That is, if you retireand take the payments over a period of time, they may be subject toFICA taxes, whereas when you were working they may well have beenover the FICA limit