Tax-Smart Retirement Savings Choices
Financial experts are pretty much in agreement: save for retirement sooner rather than later. It’s never too early to begin saving for retirement. If you don’t already have one, consider establishing a tax-favored retirement savings account. Note that these plans, overviewed below, may be complex. You may want to consult with a financial advisor or tax professional to determine which plans are best for you.
401(k) Plans (named after a section of the federal tax code) is an employer-established plan similar to an Individual Retirement Arrangement (IRA). If your employer has a 401(k), it may be one of the best retirement savings vehicles available to you, particularly if your employer matches all or a portion of your contribution to the plan. With a 401(k) plan, you may contribute up to a certain percentage of your gross income (i.e., total income before taxes). The amount you contribute will be tax deductible for the year in which you make the contribution.
Typically, 401(k) plans offer many investment choices, including a variety of mutual funds (e.g., stocks, bonds, or money market). Some plans may allow investments in company stock and U.S. Series EE Savings Bonds, as well. You choose how to invest your savings, and you will have the option to change investments at specified times (e.g., quarterly). Usually, you may stop contributions at any time.
Earnings in a 401(k) grow tax-deferred until the money is withdrawn — usually after retirement. If you withdraw money before you turn 59 1⁄2, however, you may be subject to a 10 percent IRS penalty. While early withdrawals are generally not permitted without penalty, some 401(k) plans permit withdrawals for "hardship" reasons, such as medical emergencies or college tuition. You do pay income tax on the amount withdrawn, and a 20 percent mandatory withholding generally is required from the distribution. Some 401(k) plans may also permit loans against your savings.
403(b) Plans are also known as Tax Sheltered Annuities, or TSAs. They are retirement plans for non-profit organizations that are similar to 401(k) plans. Investment options in 403(b) plans include annuities and mutual funds.
Individual Retirement Arrangements (IRAs) are sometimes called "traditional IRAs." They were established by Congress to encourage people to save for retirement by providing tax advantages. If you are qualified to participate in an IRA, you may select from a wide variety of investment options and contribute up to $5,000 annually. You are permitted to make catch-up contributions to your IRA if you are age 50 or over. You may contribute an extra $1,000 per year in 2008 and $2,000 per year in 2009. Your money must be designated as an IRA, in an approved account.
Tax benefits vary depending on your income and whether you contribute to other tax-advantaged savings plans (e.g., a 401(k) plan). Earnings in an IRA grow tax deferred until withdrawals begin. Funds in an IRA are considered long-term savings and, as with 401(k) plans, you may be subject to a 10 percent IRS penalty as well as to tax liability for premature withdrawals — generally before the age of 59 1⁄2.
Roth IRAs have the same basic structure and restrictions as a traditional IRA. Roth IRAs have income limits and they’re not available for single filers with incomes over $114,000 or joint filers with incomes over $166,000. As with traditional IRAs, investments grow tax-free. But, unlike traditional IRAs, Roth IRA contributions are made with after-tax dollars. Withdrawals made after age 59 1⁄2 are tax-free, which can be a big advantage. Other withdrawals may be taxed or may incur tax penalties.
Keogh Plans are retirement plans for self-employed people. Rules covering contributions to Keoghs are more complex than those of IRAs. The amount you may contribute on a tax-deferred basis will depend on your net earnings from your business. Contributions and all earnings accumulate free of tax until withdrawn, usually at retirement. In general, withdrawals prior to age 59 1⁄2 are subject to a 10 percent premature distribution penalty, in addition to ordinary income tax. Keogh plans may not authorize loans. Keoghs may be more complicated than IRAs, 401(k)s or 403(b)s, so consult a tax professional before setting up a plan.
Annuities: A Steady Stream of Retirement Income
Contributions to annuities are made on an after tax-basis (assuming the annuity is not part of a qualified retirement plan), so they will not reduce your current taxable income. Annuity earnings, however, are tax-deferred for individuals.
Annuities are financial contracts you make with an insurance company. An annuity may be deferred or immediate. With a Deferred Annuity, you put money in and over time it accrues income and earnings; the payout occurs at some later date, when you may receive a steady stream of payments to supplement your income. Because insurance companies generally administer annuities, they can be set up to include life insurance benefits, such as a death benefit to a surviving spouse.
When you near retirement, you may elect to purchase an Immediate Annuity (sometimes known as an Income Annuity). Purchasers make one lump sum payment — often with savings accumulated in a tax-smart retirement plan such as an IRA or 401(k) — and then begin getting income within a short period, typically less than 13 months. You can receive payments from an Immediate Annuity on a regular basis (e.g., monthly), giving you needed income. Also, you could choose from a number of other payment options including having the payouts guaranteed by the issuer for as long as you live. Immediate income annuities may help to maximize your income in retirement.
It is important to understand the features and benefits of annuities, including their surrender charges and terms for keeping them in force. Discuss them with a qualified financial advisor to make sure you understand all the options and that you make the smartest decisions for your financial needs.
