Retirement Planning

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.

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. However, as the result of new proposed rules issued by the Internal Revenue Service (IRS), the requirements regarding minimum distributions are much simpler than they used to be, giving you greater flexibility in your decisions.

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.

The IRS's New Rules

The old rules governing minimum distributions from retirement plans required you to make a number of often difficult choices:

• which of several life expectancy tables to use;
• whether to employ the "fixed" or "recalculation" method for determining your life expectancy; and
• who to name as your beneficiary.

Once you made these choices, changing your mind later was not an option.

Under the new rules, beginning with required 2001 distributions, you can consult a simple chart to determine your required distributions (see below). 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 change in the rules will reduce almost every account owner's lifetime minimum distributions. This will allow 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. New Minimum Lifetime Distribution Chart

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's 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, the new rules permit you to change your beneficiary down the road. In fact, your beneficiary can even be changed after your death by the executor of your estate. The old rules required that you name a designated beneficiary by the date you are required to begin making distributions. The new rules postpone the date for determining designated beneficiaries until 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 under the old rules. For example, under the old rules, without a designated beneficiary, the heirs had to take distribution of the entire retirement plan within five years and pay income taxes on those distributions. Under the new rules, 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.

Recalculation: Forget You Ever Heard the Word

Another fateful choice that had to be made under the old rules was whether to elect the "fixed" or "recalculation" method of determining your minimum distributions. With the use of the new simplified chart, this choice no longer needs to be made.

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.

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:

• Moneychimp: www.moneychimp.com/articles/rothira/rothcalc.htm
• U.S. News Online: www.calcbuilder.com/cgi-bin/calcs/ira2.cgi/usnews

The Education IRA

Similar to the Roth IRA, the new 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 2005 with an estate of $1.9 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 $1.5 million (in 2005) 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 $1.9 million to $1.5 million, and each child's share from $475,000 to $375,000. This is an effective tax rate of 25 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 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 $1.5 million to $1.9 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 $1.5 million. The taxes he would have paid on converting his Roth IRAs would have reduced it by another $150,000, to $1,350,000. 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's 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.