Retirement Planning

As life expectancies continue to rise, most people could spend a significant portion of their lives in retirement, which means their income must last longer. Everyone should begin investing well in advance of retirement in order to have enough money in later years.

Retirement income usually comes from a combination of sources-Social Security benefits, employer-sponsored retirement programs and self-directed retirement savings plans. The rules regarding many of these plans are constantly changing. Income and contribution limitations often increase every year. So make sure you check what rules apply in each tax year in order to get the maximum advantage from these plans.

How do I calculate my Social Security benefits when doing retirement projections?

When you work, a portion of your paycheck is paid into the Social Security program. When you retire, you can apply to receive benefits.

Your Social Security benefits are determined by your work history-how much you have earned and paid into the Social Security program over your lifetime. The Social Security Administration adds up your highest 35 years of earnings, adjusts them for inflation and calculates your average monthly earnings. You then receive a percentage of that average in Social Security benefits.

The formula is weighted in favor of lower-wage workers who will probably depend more on these benefits for retirement income than higher-wage workers will. Higher-wage workers will receive more in benefits because they earned more, but lower-wage workers will have a greater percentage of their pre-retirement earnings replaced by benefits.

You can begin collecting retirement benefits at age 62. You get full retirement benefits at age 65 to age 67, depending on the year you were born. You then receive your Social Security benefits for the rest of your life.

In order to get a rough idea of how much you will get, refer to the Social Security statement that is sent out to you every year. It lists your yearly earnings and estimates retirement benefits. Consider these figures in your retirement planning projections.

What are "pension plans"?

Pension plans, also called defined benefit plans, are qualified retirement plans offered by some employers. The employer funds the plan and maintains responsibility for the underlying investments. Employer contributions are based on actuarial formulas and must meet minimum funding requirements.

Workers usually become eligible for a pension after working a certain number of years, typically 5 to 7, known as a vesting period. If you leave the job, your benefits stay in the company pension plan and can be claimed at age 65.

Upon retirement, the pension plan guarantees to pay employees a fixed amount every year for the rest of their lives. Some plans allow employees to opt for a lump sum payment instead. Whether you choose an annuity or a lump sum, the amount is based on your salary, years of service and a fixed percentage rate. The more you made and the longer you worked there the more you will receive from the pension plan in retirement.

The Pension Benefit Guaranty Corporation is a federal agency that protects most pension plans. The PBGC insures a certain monthly amount for each worker who retires at age 65.

What are "401(k) plans"?

A 401(k) plan, also called a defined contribution plan, is an employer-sponsored retirement savings program in which both the employee and the employer can contribute to the plan. The amount you receive in retirement is based on the contributions and investment returns earned on the contributions.

Employee contributions are made through automatic payroll deductions each pay period. You decide how much you would like taken out of your check, up to certain limits ($14,000 per year in 2005; $15,000in 2006). Employees over age 50 can make additional "catch-up" contributions. Employers often match employee contributions up to certain limits. In some cases, employers match with company stock instead of cash.

Sidebar: Other limits may apply to the contribution amount. For example, a highly compensated employee may be limited depending on the extent to which rank-and-file employees participate in the plan. Your employer must advise you in writing of any limits that may apply to you.

Contributions are made on a pre-tax basis, which means the money comes out of your paycheck before your income is taxed. This reduces your overall taxable income and defers tax on the contributions (and earnings) until you withdraw the money at retirement.

Employers usually give employees a limited number of investment choices in which to put their 401(k) funds. The average plan has 15 options, but they can range from 8 to 20.

Depending on your company's plan, you may be able to borrow money from your 401(k) account and make hardship withdrawals. If you leave your job, you can take your 401(k) funds with you by rolling them over into another 401(k) or an IRA.

You can begin to make withdrawals from your 401(k) account at age 59, at which time, the distributions are taxed as ordinary income.

What are "403b plans"?

A 403b plan works just like a 401(k) plan. Only employees of eligible non-profit organizations, such as schools and hospitals, can contribute to a 403b.

What tax-deferred retirement plans are available for small businesses and self-employed workers?

• SEP-IRA (Simplified Employee Pension)

A SEP-IRA is a tax-deferred retirement plan used by small businesses that do not have any other retirement plan. The employer makes contributions to the SEP-IRA for the employees. Self-employed workers can contribute to their own SEP-IRA.

An employer can contribute up to 25 percent of the employee's compensation or $42,000 in 2005, whichever is less, to each employee's account. Employers are not required to make a contribution every year and the amount they contribute can vary each year.

Contributions and earnings grow tax-deferred. Upon withdrawal, the distributions are taxed as ordinary income. If you make withdrawals before age 59, you must pay a 10 percent tax penalty.

• Simple IRA (Savings Incentive Match Plans for Employees)

A Simple IRA is also a tax-deferred retirement plan used by small businesses that do not have any other retirement plan. Simple IRAs can be established by small businesses with 100 employees or less. With this plan, contributions are made by both the employee and the employer.

Employees can contribute up to a maximum of $10,000 annually starting in 2005, and the employer matches the contribution up to 3 percent of total compensation. Employees get to decide how to invest the money, and they get to keep the accounts when they change jobs.

Contributions are made on a pre-tax basis, which reduces your taxable income, and the contributions and earnings grow tax-deferred. Upon withdrawal, the distributions are taxed as ordinary income. If you make withdrawals before age 59, you must pay a tax penalty.

• Keogh plans

Self-employed workers can establish Keogh plans as their retirement savings program. Keogh plans allow you to save more money than in a Simple IRA. In order to use a Keogh, your business must be unincorporated-that is, a sole proprietorship or partnership.

There are two different types of Keogh plans:

• Money purchase plans. You can contribute $40,000 or 25 percent of your income, whichever is less, to a money purchase plan. But you must contribute the same amount every year, regardless of how much you made.
• Profit-sharing plans. Contributions to profit sharing-plans can vary from year to year from 0 to 20 percent of your income, but no more than $40,000.

Contributions are made on a pre-tax basis, which reduces your taxable income, and the contributions and earnings grow tax-deferred. Upon withdrawal, the distributions are taxed as ordinary income. If you make withdrawals before age 59, you must pay a 10 percent tax penalty.

What are "IRAs"?

In many cases, Social Security benefits and employer-sponsored retirement programs may not provide enough income in retirement. Fortunately, there are tax-advantaged investment accounts that you can initiate, fund and manage on your own as an additional resource for retirement. The traditional and Roth IRAs are two such savings vehicles.

Funds in an IRA can be invested any way you want in any type of publicly traded security. Unlike participants in employer-sponsored plans, IRA investors have nearly unlimited choices of stocks, bonds and mutual funds.

• Traditional IRAs

Contributions to IRAs may be fully or partially deductible, depending on your income, filing status and whether you are covered by another retirement plan. In 2005, you can contribute up to $4,000 per year to your IRA accounts. If you are 50 years of age or older, you can contribute an additional "catch-up" amount of $500.

Contributions and investment earnings grow tax-deferred. You can begin withdrawing funds at age 59, at which time the distributions are taxed as ordinary income. If you withdraw funds before then, you usually must pay a 10 percent penalty, plus ordinary income taxes on the amount.

When you turn age 70, you can no longer make contributions, and you must start taking minimum distributions or face penalties.

• Roth IRAs

Contributions to Roth IRAs are not tax-deductible, but earnings are withdrawn tax-free at retirement. In many cases, this tax advantage provides an enormous savings that beats the deductions you can take with a traditional IRA, particularly if you are in a low tax bracket now but anticipate being in a high tax bracket by retirement.

Contribution limitations depend on your income and filing status. You can contribute to a Roth IRA even if you participate in an employer-sponsored plan. In 2005, you can contribute up to $4,000 per year and another $500 if you are 50 years of age or older.

You can withdraw your contributions tax-free at any time since you already paid income taxes on the money before investing it. You can begin withdrawing earnings tax-free at age 59, but you must have your Roth IRA account for at least 5 years before you can take any distributions from earnings.

Unlike a traditional IRA, you do not have to make withdrawals from a Roth IRA after age 70. You can continue to grow the earnings tax-free until your death, at which time you can pass the Roth IRA on to your heirs, who can continue to maintain the account.

Who is qualified to open a traditional IRA?

Anyone with income from a job, self-employment income or alimony may open an IRA. There is no upper income limit in order to participate in a traditional IRA.

TIP: If your income is only from investments, annuities or a pension plan, you are not qualified to open an IRA.

Sidebar: Whether you can deduct the full amount of your contribution from your federal income taxes depends on your annual gross income. For joint filers making up to $54,000, the entire amount (for each spouse) is deductible.

How much can I contribute to a traditional IRA?

Beginning in 2005, you can contribute $4,000 per year. The amount increases to $5,000 per year in 2008. If you are over 50 years of age, you may contribute an extra $500 per year. In 2006, the extra amount increases to $1,000 per year.

If you are married and your spouse is not employed, you can contribute into the IRA on behalf of your spouse. You must file your tax return jointly to take advantage of spousal contributions.

Sidebar: Do not contribute more than the annual limit to your IRA. You can be penalized with a 6 percent tax on the entire IRA every year the extra money is in the account.

Is there a minimum age for opening an IRA?

No. Any child who is receiving compensation can open an account.

Can I convert my traditional IRA to a Roth IRA?

Yes, depending on your income and filing status. You will pay taxes on the contributions and earnings in the traditional IRA in the year of the conversion, but from that point on, the earnings grow tax-free.

However, the reverse does not apply. You cannot convert funds from a Roth IRA to a traditional IRA.