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RETIREMENT

The Roth 401(k)

 

Employers can offer 401(k) plan participants the opportunity to make Roth 401(k) contributions. If you're lucky enough to work for an employer who offers this option, Roth contributions could play an important role in maximizing your retirement income.

What is a Roth 401(k)?
A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there's no up-front tax benefit, but if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan. (403(b) and 457(b) plans can also allow Roth contributions.)

Who can contribute?
Unlike Roth IRAs, where you can't contribute if you earn more than a certain dollar amount, you can make Roth contributions, regardless of your salary level, as soon as you are eligible to participate in the 401(k) plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck.

How much can I contribute?
There's an overall cap on your combined pretax and Roth 401(k) contributions. In 2011, you can contribute up to $16,500 ($22,000 if you're age 50 or older) to a 401(k) plan. You can split your contribution between Roth and pretax contributions any way you wish. For example, you can make $9,000 of Roth contributions and $7,500 of pretax 401(k) contributions. It's up to you. But keep in mind that if you also contribute to another employer's 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans--both pretax and Roth--can't exceed $16,500 in 2011 ($22,000 if you're age 50 or older). It's up to you to make sure you don't exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to an IRA?
Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $5,000 to an IRA in 2011 ($6,000 if you're age 50 or older). But, depending on your salary level, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

Are distributions really tax free?
Because your Roth 401(k) contributions are made on an after-tax basis, they're always free from federal income tax when distributed from the plan. But the investment earnings on your Roth contributions are tax free only if you meet the requirements for a "qualified distribution."

In general, a distribution from your Roth 401(k) account is qualified only if it satisfies both of the following requirements:

· It's made after the end of a five-year waiting period
· The payment is made after you turn 59½, become disabled, or die

The five-year waiting period for qualified distributions starts on January 1 of the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer's 401(k) plan in December 2009, your five-year waiting period begins January 1, 2009, and ends on December 31, 2013. If you participate in more than one Roth 401(k) plan, your five-year waiting period is generally determined separately for each employer's plan. But if you change employers and directly roll over your Roth 401(k) account from your prior employer's plan to your new employer's Roth 401(k) plan (assuming the new plan accepts rollovers), the five-year waiting period for your new plan starts instead with the year you made your first contribution to the earlier plan.

If your distribution isn't qualified (for example, if you receive a payout before the five-year waiting period has elapsed), the portion of your distribution that represents investment earnings on your Roth contributions will be taxable, and will be subject to a 10 percent early distribution penalty unless you're 59½ (55 in some cases) or another exception applies. You can generally avoid taxation by rolling all or part of your distribution over into a Roth IRA or into another employer's Roth 401(k) or 403(b) plan, if that plan accepts Roth rollovers. (State income tax treatment of Roth 401(k) contributions may differ from the federal rules.)

If you contribute to both a Roth 401(k) and a Roth IRA, a separate five-year waiting period applies to each. Your Roth IRA five-year waiting period begins with the first year that you make a regular or rollover contribution to any Roth IRA.

What about employer contributions?
Employers don't have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer's contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer's contributions, and investment earnings on those contributions, are not taxed until you receive a distribution from the plan. Your 401(k) plan may require up to 6 years of service before you fully own employer matching contributions. (Note: If your plan is a SIMPLE 401(k) plan, a safe-harbor 401(k) plan, or includes a qualified automatic contribution arrangement (QACA) your employer is required to make a contribution on your behalf, and special vesting rules apply.)

Should I make pretax or Roth 401(k) contributions?
When you make pretax 401(k) contributions, you don't pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax.

Which is the better option depends upon your personal situation. If you think you'll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you'll effectively lock in today's lower tax rates. However, if you think you'll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.

Whichever you choose--Roth or pretax--make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you reach your retirement goals that much sooner.

What happens when I terminate employment?
When you terminate employment you generally forfeit all contributions that haven't vested. "Vesting" means that you own the contributions. Your contributions, Roth and pretax, are always 100 percent vested. But your 401(k) plan may require up to 6 years of service before you fully vest in employer matching contributions (although some plans have a much faster vesting schedule).

When you terminate employment you can generally leave your money in your 401(k) plan until the plan's normal retirement age (typically age 65). However, the plan may be able to "cash you out" if your vested balance is $5,000 or less. But if your payment is more than $1,000, the plan must generally roll your funds into an IRA established on your behalf, unless you elect to receive your payment in cash. (This $1,000 limit is determined separately for your Roth 401(k) account and the rest of your funds in the 401(k) plan.)

You can also roll all or part of your Roth 401(k) dollars over to a Roth IRA, and your non-Roth dollars to a traditional IRA. You may also be able to roll your funds into another employer's plans that accepts rollovers.

What else do I need to know?

· Like pretax 401(k) contributions, your Roth 401(k) contributions and investment earnings can generally be paid from the plan only after you terminate employment, attain age 59½, become disabled, or die.
· You may be eligible to borrow up to one half of your vested 401(k) account, including your Roth contributions, (to a maximum of $50,000) if you need the money.
· You may be able to make a hardship withdrawal if you (or your spouse, dependents, or plan beneficiary) have an immediate and heavy financial need. But this should be a last resort--a 10 percent penalty may apply to the taxable amount if you’re not yet age 59½, and you may be suspended from plan participation for 6 months or more.
· Unlike Roth IRAs, you must begin taking distributions from a Roth 401(k) plan after you reach age 70½ (or in some cases, after you retire), but you can generally roll over your Roth 401(k) dollars into a Roth IRA if you don't need or want the lifetime distributions.
· Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts you contribute to the 401(k) plan.
· Your assets are generally fully protected from creditors in the event of your, or your employer’s, bankruptcy (some exceptions apply).

Employers aren't required to make Roth contributions available in their 401(k) plans. So be sure to ask your employer if they are considering adding this exciting new feature to your 401(k) plan.

Updated 12/7/2011

 

So You're Retired - Now What?

Most qualified retirement plans offer significant tax benefits - if you're willing to follow a few IRS-specified rules, that is. The federal government wants to make plans such as 401(k)s, Keoghs, SEP-IRAs and traditional IRAs available for specific needs, and has enacted laws to help eliminate potential abuses of these tax-advantaged investment alternatives.

Retirement Plans are Intended for Retirement
For one thing, the government wants to make sure that such savings (and income tax benefits) actually go towards providing retirement income. Stiff penalties for early withdrawal help encourage investors to hold off on receiving income from qualified plans until their retirement years.

Required Withdrawals
The government also wants to make sure they can someday tax these accumulated funds. If you have a 401(k), a Keogh, a SEP or a traditional IRA, you must begin taking mandatory minimum distributions from your plan by April 1st of the year following the year in which you turn 70-1/2.

Although the tax code allows you to wait until April 1 of the year following the year you turn 70-1/2, it is generally a good idea to take your first mandatory withdrawal in the same year you reach that age. If you wait, you will have to make two withdrawals in the first year, doubling the amount of taxable income you must declare and potentially increasing your marginal tax bracket.

The amount you are actually required to withdraw each year, and which will be subject to taxation, is based on tables that estimate your remaining lifetime.

Calculating Your Required Withdrawals
It's vital to maintain a disciplined process of taking minimum withdrawals from your qualified plans. That's because if you don't meet the required minimum distribution withdrawals, the IRS will impose a stiff penalty: 50% of the amount not withdrawn, plus the income taxes due. Ouch!

The good news is. the IRS has made calculating your required minimum distributions much easier. Based on your age, you simply divide your qualified plan balance as of the last day of the previous year by the factor from the IRS Pub. 590 table shown below. The resulting quotient is your annual required minimum distribution.

Planning for The "Golden Years"

There's a saying that if you have your health, you have everything. Well, that's not exactly true - without adequate resources, you could enjoy a long, healthy retirement at a far lower standard of living than you'd prefer!

When preparing for retirement, it's vital to keep in mind the importance of money to your quality of life during your "golden years." And with retirements now stretching as long as 20 to 30 years - and beyond - ensuring your retirement dollars outlive you is a paramount concern.

Failing to Plan, or Planning to Fail?
It's been said that he who fails to plan, plans to fail. And nowhere is that concept illustrated more starkly than with retirement planning. A sound financial plan can be the difference between the retirement of your dreams and the nightmare of discovering you have too little money, too late to change financial course.

A disciplined retirement preparation plan, diligently followed, will help you develop realistic objectives ... assess progress toward your goals ... and make periodic adjustments to keep you on track.

How Much Retirement Income Will YOU Need?
Government research has determined that most Americans need between 60 and 80 percent of their pre-retirement income in order to maintain their standard of living during retirement. However, many financial experts have raised this figure to between 80 and 100 percent of pre-retirement income, citing skyrocketing healthcare costs, lengthening life spans, and the ever-present threat of inflation - which can rob a retirement portfolio of purchasing power over time.

Of course, how much you will need in retirement will be a function of your goals, time horizon, and spending habits. Those who want to purchase a second home and travel frequently will obviously need more than those who prefer to stay at home in their paid-off house. Consider these factors when estimating your future retirement income needs:

Your support of children who will be self-sufficient by the time you retire

Your current work-related expenses that will be dramatically reduced in retirement, such as commuting costs, daily meal expenses, dry cleaning bills, etc.

Whether your mortgage will be paid off prior to or early in retirement

Whether you will need to continue your monthly savings amount or begin to spend that amount for necessities

Your tax bill in retirement

Sources of Retirement Income
Once you have estimated your target retirement income, you can begin evaluating your potential sources of regular income. In general, your income sources will fall into one of these three categories:

1) Government sources. The Social Security system was inaugurated during the Great Depression to augment retirees' incomes. Most experts feel that the system will remain solvent throughout much of the 21st century. Even so, a rising retirement age and cuts in benefits could reduce your monthly Social Security check. Benefits are based on the amount you earned during your working years.

2) Employer-sponsored plans. Many employers offer company-sponsored retirement plans, which generally fall into two categories. Defined benefit plans, which are normally funded by the employer and guarantee a retirement benefit based on a formula comprising number of years on the job and employment earnings. For example, a traditional pension is a defined benefit plan. Defined contribution plans, on the other hand - such as 401(k), 403(b), and 457 - rely on funding from employees, matching funds from the employer, or a combination of the two. The employee owns an account balance (subject to company rules regarding vesting) of contributions and earnings. Upon changing jobs, an employee may be able to roll over assets into the new employer's plan or into an IRA. At retirement, the employee decides how to withdraw the balance he or she has accumulated.

3) Personal savings. This is perhaps the most overlooked aspect of retirement planning. Personal savings include, but aren't limited to, balances in savings accounts, directly held assets, home equity, shares in a partnership or business, and even collectibles such as artwork and coins.

How to Get - And Stay - On Course
How can you determine whether you're on track to reach your retirement goals, and to make adjustments if necessary? We can help you develop a sound financial plan based on your specific situation, monitor it regularly to ensure you're making progress toward your objectives, and recommend occasional adjustments to help you stay on course.

Can You Afford to Retire Early?

Historically, most Americans have considered 65 to be their target retirement age. This is likely the result of past Social Security laws, which provided full benefits beginning at age 65.

However, many workers today are retiring at an increasingly earlier age. In just the last few years, for example, the average retirement age has fallen to age 63. And many younger workers are planning to retire even earlier; in fact, according to a recent study by the Employee Benefit Research Institute, more than a third of today's workers plan to retire before age 64.

What You Give Up
An early retirement often comes at a cost. Here are a few of the financial results of early retirement that you must consider carefully:

Not only are Social Security benefits reduced for early retirement, but the age at which full benefits begin is being gradually raised to 67.

Retiring early often happens right at the peak of your earning years, meaning you not only forego that income, but also the resulting saving and investing that would have taken place in these years.

The annual benefit provided by employer-sponsored defined benefit pension plans is usually based on a combination of years of service and your ending salary. Both are reduced by early retirement.

Health care costs tend to increase for retired individuals. Benefits that were once paid for by employer-sponsored coverage often become the responsibility of the retiree.

Consider Your Options Carefully
Choosing when to retire is one of the most important financial decisions you will make. Consider your options carefully. Careful planning can help ensure you a comfortable and financially independent retirement.

1. "2006 Retirement Confidence Survey," Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc.

How Living Expenses Change During Retirement

There are some upsides to being a retiree - senior discounts, lower taxes, subsidized healthcare, and regular Social Security checks among them. On the other hand, mature Americans must contend with worrisome issues such as rising costs for medical care, long-term care, prescription drugs, and even basic necessities such as food and energy.

To determine your monthly expenses during retirement, you might start by dividing costs into two categories: those you believe will change and those you believe will remain largely the same.

Costs You Believe Might Change

  • Housing expenses particularly if you plan to live in your paid-off home or plan to downsize to a smaller dwelling
  • Medical insurance which may shift from a premium for HMO coverage to a Medigap policy
  • Costs for dependents if you have children you believe will be self-sufficient by the time you retire
  • Entertainment and travel expenses for some people, these might decline precipitously; for others, they might be far higher
  • Taxes - most retirees find their combined tax burden is less than during their working years
  • Automobile-related costs - retirees generally drive less than workers who commute to their jobs every day, thus spending less on maintenance, tolls, gasoline, etc.
  • Monthly contributions toward retirement savings accounts - not only can you stop making this contribution, you might even consider spending it!

Costs You Think Will Remain the Same

  • Food
  • Clothing - unless you previously spent large amounts of money on uniforms or other job-specific wardrobe items
  • Household expenses - such as telephone, utilities, cable, etc.

Determine Your Individual Needs
Once you analyze all this information, you can determine your estimated monthly income needs as well as how large of an emergency fund to establish. This fund should be held in a liquid form such as a money market account, which provides stability for your funds as well as ready access to them.

Consider reviewing your estimated needs at least annually, because circumstances can and do change in today's fast-moving world.

Bridging the Income Gap

Social Security was never designed to be an individual's sole source of retirement income. Instead, it was meant to bridge the gap between people's income from pensions and savings and their monthly expenses.

Today, however, nearly two-thirds of all seniors rely on Social Security for at least 50% of their total monthly income. Nor are annual cost-of-living adjustments, or COLAs, keeping up with the spiraling costs of healthcare, housing, and energy in many areas across the country. Adjustments to extend the program's solvency have reduced benefits in real terms, as well as ratcheted up the age at which one can attain full benefits.

What's more, traditional company pension plans are fast going the way of the horse-and-buggy and the dodo bird. Instead, employers are moving toward "defined contribution plans" that put most of the responsibility for planning, funding, investing, and distributing plan funds squarely on the shoulders of individual employees.

Given these trends, one thing is clear: Each person must put increasingly greater emphasis on securing their own financial future in retirement. Your actions today and throughout your working career may make the difference between relying on government programs for a modest monthly income and enjoying a secure, independent "golden years."

The price of procrastination is steep and the cost of inadequate preparation too high for you to wait until later to start planning!

How Social Security Works

The Social Security program was signed into law in 1935 after the nation had endured more than a half-decade of the Great Depression. It was intended to provide a safety net of income for individuals too old or disabled to continue working.

Participation in the Social Security program is mandatory, with most wage earners contributing a percentage of their annual incomes to support the program. In return, participants, their spouses, and certain dependents are eligible for retirement, disability, and survivorship benefits.

Today, approximately 90% of people aged 65 and older receive a Social Security benefit check each month. For many, this benefit is their primary source of retirement income.

How Contributions are Made and Accounted For

Each year you work, you and your employer contribute to the Social Security program in equal amounts.

How Your Benefits Are Calculated
Your benefits are based on a calculation that includes how many years you worked and how much you earned. These figures are used to determine the number of quarterly credits you accumulated toward benefits. If you were born prior to 1938, you may collect full Social Security benefits when you turn 65, or you may collect 80% of your benefit if you retire at 62. For people born after 1938, Normal Retirement Age (NRA), or the age at which you can receive full benefits, gradually increases from age 65 to age 67. To determine your NRA, visit http://www.ssa.gov. When you die, your surviving spouse is entitled to your benefits, unless he or she would collect more based on their own earnings history.

Your Social Security account opens once you receive a Social Security card. However, it is not activated until you begin earning income. Once your earnings begin, the amount you contribute each year is recorded.

The accuracy of this record is important. You can obtain a copy of your earnings record from the Social Security Administration by filling out and mailing Form 7004. Forms are available at your local Social Security office or by calling 800-772-1213 or online at www.ssa.gov/online/ssa-7004.html. If you discover errors in your record, you can ask that it be corrected, though you must supply evidence of such errors. The Social Security Administration encourages people to check their earnings records every three years or so, because the earlier a problem is found, the easier it is to correct.

How Your Benefits Are Taxed
Once you begin receiving retirement benefits, you may have to include them as part of your taxable income reported to the IRS each year.

If your total income for the year, including half of your Social Security and your tax-exempt earnings, is greater than $32,000 ($25,000 for single taxpayers), you will owe federal income tax on a portion of your Social Security benefits. The IRS provides a worksheet to help you determine how much you must include in your taxable income each year.

Did you know that...

  • The Social Security Administration paid approximately $539 billion in benefits to nearly 49 million people in 2006
  • Social Security benefits were awarded to more than 4 million people
  • Among elderly Social Security beneficiaries, 54% of married couples and 74% of unmarried persons receive half or more of their income from Social Security.
  • Women accounted for 57% of adult Social Security beneficiaries
  • The average age of disabled-worker beneficiaries was 51
  • Disability and blindness were the reasons for paying 82% of Supplemental Security Income recipients

Updated 5/9/2011)

Saving for Retirement and a Child's Education at the Same Time

You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child's education at the same time can be a challenge. But take heart--you may be able to reach both goals if you make some smart choices now.

Know what your financial needs are
The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:

For retirement:

· How many years until you retire?
· Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what's your balance? Can you estimate what your balance will be when you retire?
· How much do you expect to receive in Social Security benefits? (You can estimate this amount by using your Personal Earnings and Benefit Statement, now mailed every year by the Social Security Administration.)
· What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
· Do you or your spouse expect to work part-time in retirement?

For college:

· How many years until your child starts college?
· Will your child attend a public or private college? What's the expected cost?
· Do you have more than one child whom you'll be saving for?
· Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
· Do you expect your child to qualify for financial aid?

Many on-line calculators are available to help you predict your retirement income needs and your child's college funding needs.

Figure out what you can afford to put aside each month
After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you'll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you've come up with a dollar amount, you'll need to decide how to divvy up your funds.

Retirement takes priority
Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you'll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there's no such thing as a retirement loan!

If possible, save for your retirement and your child's college at the same time
Ideally, you'll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child's college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you'd have $18,415 in your child's college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)

If you're unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you're pursuing both goals at the same time doesn't necessarily mean that the same investments will be appropriate. Each goal should be treated independently.

Help! I can't meet both goals
If the numbers say that you can't afford to educate your child or retire with the lifestyle you expected, you'll have to make some sacrifices. Here are some things you can do:

· Defer retirement: The longer you work, the more money you'll earn and the later you'll need to dip into your retirement savings.
· Work part-time during retirement.
· Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
· Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
· Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).
· Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
· Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don't feel guilty--a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.

Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.

Can retirement accounts be used to save for college?
Yes. Should they be? Probably not. Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child's college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you're under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you'll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)

Updated 12/7/2011  

Understanding IRAs

An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you're contributing to a 401(k) or other plan at work, you should also consider investing in an IRA.

What types of IRAs are available?
The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $5,000 in 2010 and 2011. You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional "catch-up" contributions. These folks can contribute up to $6,000 in 2010 and 2011.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that's best for you.

Learn the rules for traditional IRAs
Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status:

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent early withdrawal penalty if you're under age 59½, unless you meet one of the exceptions.

If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That's when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you're required to in any year. However, if you withdraw less, you'll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdrew.

· You have reached age 59½ by the time of the withdrawal
· The withdrawal is made because of disability
· The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit)
· The withdrawal is made by your beneficiary or estate after your death

Qualified distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.

Choose the right IRA for you
Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don't qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you're still working (and probably in a higher tax bracket than you'll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.

Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $5,000 for 2011 ($6,000 if you're age 50 or older).

Know your options for transferring your funds
You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You'll still avoid taxes and penalty as long as you complete the rollover within 60 days from the date you receive the funds.

You may also be able to convert funds from a traditional IRA to a Roth IRA. This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.

Note: The IRS has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.

Updated 12/7/2011

Roth IRAs
Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation is at least $5,000 in 2012 (and 2011), you may be able to contribute the full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status. Your allowable contribution may be less than the maximum possible, or nothing at all.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that, if you meet certain conditions, your withdrawals from a Roth IRA will be completely free from federal income tax, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement.

Updated 12/7/2011

Should I convert to a Roth IRA?

The Roth IRA offers a number of advantages over its traditional counterpart. These include:

· Tax-free distributions at retirement
· Ability to continue making contributions beyond age 70-1/2
· No required minimum distributions beginning in the year you turn 70-1/2
· Leaving assets to survivors that are free from income taxes

Details on eligibility to convert a traditional IRA to a Roth IRA.

· For years before 2010, if your filing status is married filing separately, you don't qualify unless you lived apart from your spouse for the entire year.
· For years before 2010, if your modified adjusted gross income is greater than $100,000, you can't convert a traditional IRA to a Roth IRA.
· For years before 2008, direct conversions from an employer plan to a Roth IRA were not permitted. You can do that now, but in some situations it may be preferable to roll to a traditional IRA and then convert to a Roth IRA.
· If you inherited a traditional IRA from a person other than your spouse, you can't convert it to a Roth IRA.
· You can convert a traditional IRA to a Roth IRA even if you made a rollover within the previous 12 months.
· If you're otherwise eligible, you can convert part of a traditional IRA to a Roth IRA. But you can't convert only the nontaxable part.

Assets converted to a Roth IRA must remain in the account for at least five years before any distributions are taken. Otherwise, a significant tax penalty may apply.

You'll maximize the potential for tax-free income later if you pay conversion taxes out of pocket, rather than withdrawal them from your IRA. If you can't pay conversion taxes without using part of your IRA funds, you probably shouldn't convert unless you are certain you will be in a high tax bracket during retirement.

Updated 3/24/2010

Choosing a Beneficiary for Your IRA or 401(k)

Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other assets such as life insurance. With retirement benefits, you need to know the impact of income tax and estate tax laws in order to select the right beneficiaries. Although taxes shouldn't be the sole determining factor in naming your beneficiaries, ignoring the impact of taxes could lead you to make an incorrect choice.

In addition, if you're married, beneficiary designations may affect the size of minimum required distributions to you from your IRAs and retirement plans while you're alive.

Paying income tax on most retirement distributions
Most inherited assets such as bank accounts, stocks, and real estate pass to your beneficiaries without income tax being due. However, that's not usually the case with 401(k) plans and IRAs.

Beneficiaries pay ordinary income tax on distributions from 401(k) plans and traditional IRAs. With Roth IRAs and Roth 401(k)s, however, your beneficiaries can receive the benefits free from income tax if all of the tax requirements are met. That means you need to consider the impact of income taxes when designating beneficiaries for your 401(k) and IRA assets.

For example, if one of your children inherits $100,000 cash from you and another child receives your 401(k) account worth $100,000, they aren't receiving the same amount. The reason is that all distributions from the 401(k) plan will be subject to income tax at ordinary income tax rates, while the cash isn't subject to income tax when it passes to your child upon your death.

Similarly, if one of your children inherits your taxable traditional IRA and another child receives your income-tax-free Roth IRA, the bottom line is different for each of them.

Naming or changing beneficiaries
When you open up an IRA or begin participating in a 401(k), you are given a form to complete in order to name your beneficiaries. Changes are made in the same way--you complete a new beneficiary designation form. A will or trust does not override your beneficiary designation form. However, spouses may have special rights under federal or state law.

It's a good idea to review your beneficiary designation form at least every two to three years. Also, be sure to update your form to reflect changes in financial circumstances. Beneficiary designations are important estate planning documents. Seek legal advice as needed.

Designating primary and secondary beneficiaries
When it comes to beneficiary designation forms, you want to avoid gaps. If you don't have a named beneficiary who survives you, your estate may end up as the beneficiary, which is not always the best result.

Your primary beneficiary is your first choice to receive retirement benefits. You can name more than one person or entity as your primary beneficiary. If your primary beneficiary doesn't survive you or decides to decline the benefits (the tax term for this is a disclaimer), then your secondary (or "contingent") beneficiaries receive the benefits.

Having multiple beneficiaries
You can name more than one beneficiary to share in the proceeds. You just need to specify the percentage each beneficiary will receive (the shares do not have to be equal). You should also state who will receive the proceeds should a beneficiary not survive you.

In some cases, you'll want to designate a different beneficiary for each account or have one account divided into subaccounts (with a beneficiary for each subaccount). You'd do this to allow each beneficiary to use his or her own life expectancy in calculating required distributions after your death. This, in turn, can permit greater tax deferral (delay) and flexibility for your beneficiaries in paying income tax on distributions.

Avoiding gaps or naming your estate as a beneficiary
There are two ways your retirement benefits could end up in your probate estate. Probate is the court process by which assets are transferred from someone who has died to the heirs or beneficiaries entitled to those assets.

First, you might name your estate as the beneficiary. Second, if no named beneficiary survives you, your probate estate may end up as the beneficiary by default. If your probate estate is your beneficiary, several problems can arise.

If your estate receives your retirement benefits, the opportunity to maximize tax deferral by spreading out distributions may be lost. In addition, probate can mean paying attorney's and executor's fees and delaying the distribution of benefits.

Naming your spouse as a beneficiary
When it comes to taxes, your spouse is usually the best choice for a primary beneficiary.

A spousal beneficiary has the greatest flexibility for delaying distributions that are subject to income tax. In addition to rolling over your 401(k) or IRA to his or her IRA, a surviving spouse can generally decide to treat your IRA as his or her own IRA. This can provide more tax and planning options.

If your spouse is more than 10 years younger than you, then naming your spouse can also reduce the size of any required taxable distributions to you from retirement assets while you're alive. This can allow more assets to stay in the retirement account longer and delay the payment of income tax on distributions.

Although naming a surviving spouse can produce the best income tax result, that isn't necessarily the case with death taxes. One possible downside to naming your spouse as the primary beneficiary is that it will increase the size of your spouse's estate for death tax purposes. That's because at your death, your spouse can inherit an unlimited amount of assets and defer federal death tax until both of you are deceased (note: special tax rules and requirements apply for a surviving spouse who is not a U.S. citizen). However, this may result in death tax or increased death tax when your spouse dies.

If your spouse's taxable estate for federal tax purposes at his or her death exceeds the applicable exclusion amount (formerly known as the unified credit), then federal death tax may be due at his or her death. The applicable exclusion amount is $5 million in 2011.

Naming other individuals as beneficiaries
You may have some limits on choosing beneficiaries other than your spouse. No matter where you live, federal law dictates that your surviving spouse be the primary beneficiary of your 401(k) plan benefit unless your spouse signs a timely, effective written waiver. And if you live in one of the community property states, your spouse may have rights related to your IRA regardless of whether he or she is named as the primary beneficiary.

Keep in mind that a nonspouse beneficiary cannot roll over your 401(k) or IRA to his or her own IRA. However, a nonspouse beneficiary can roll over all or part of your 401(k) benefits to an inherited IRA.

Naming a trust as a beneficiary
You must follow special tax rules when naming a trust as a beneficiary, and there may be income tax complications. Seek legal advice before designating a trust as a beneficiary.

Naming a charity as a beneficiary
In general, naming a charity as the primary beneficiary will not affect required distributions to you during your lifetime. However, after your death, having a charity named with other beneficiaries on the same asset could affect the tax-deferral possibilities of the noncharitable beneficiaries, depending on how soon after your death the charity receives its share of the benefits.

Updated 12/7/2011

 

Retirement Plans for Small Businesses

As a business owner, you should carefully consider the advantages of establishing an employer-sponsored retirement plan. Generally, you're allowed a deduction for contributions you make to an employer-sponsored retirement plan. In return, however, you're required to include certain employees in the plan, and to give a portion of the contributions you make to those participating employees. Nevertheless, a retirement plan can provide you with a tax-advantaged method to save funds for your own retirement, while providing your employees with a powerful and appreciated benefit.

Types of plans
There are several types of retirement plans to choose from, and each type of plan has advantages and disadvantages. This discussion covers the most popular plans. You should also know that the law may permit you to have more than one retirement plan, and with sophisticated planning, a combination of plans might best suit your business's needs.

Profit-sharing plans
Profit-sharing plans are among the most popular employer-sponsored retirement plans. These straightforward plans allow you, as an employer, to make a contribution that is spread among the plan participants. You are not required to make an annual contribution in any given year. However, contributions must be made on a regular basis.

With a profit-sharing plan, a separate account is established for each plan participant, and contributions are allocated to each participant based on the plan's formula (this formula can be amended from time to time). As with all retirement plans, the contributions must be prudently invested. Each participant's account must also be credited with his or her share of investment income (or loss).

For 2011, no individual is allowed to receive contributions for his or her account that exceed the lesser of 100 percent of his or her earnings for that year or $49,000. Your total deductible contributions to a profit-sharing plan may not exceed 25 percent of the total compensation of all the plan participants in that year. So, if there were four plan participants each earning $50,000, your total deductible contribution to the plan could not exceed $50,000 ($50,000 x 4 = $200,000; $200,000 x 25 percent = $50,000). (When calculating your deductible contribution, you can only count compensation up to $245,000 (in 2011) for any individual employee.)

 

401(k) plans
A type of deferred compensation plan, and now the most popular type of plan by far, the 401(k) plan allows contributions to be funded by the participants themselves, rather than by the employer. Employees elect to forgo a portion of their salary and have it put in the plan instead. These plans can be expensive to administer, but the employer's contribution cost is generally very small (employers often offer to match employee deferrals as an incentive for employees to participate). Thus, in the long run, 401(k) plans tend to be relatively inexpensive for the employer.

The requirements for 401(k) plans are complicated, and several tests must be met for the plan to remain in force. For example, the higher paid employees' deferral percentage cannot be disproportionate to the rank-and-file's percentage of compensation deferred.

However, you don't have to perform discrimination testing if you adopt a "safe harbor" 401(k) plan. With a safe harbor 401(k) plan, you generally have to either match your employees' contributions (100 percent of employee deferrals up to 3 percent of compensation, and 50 percent of deferrals between 3 and 5 percent of compensation), or make a fixed contribution of 3 percent of compensation for all eligible employees, regardless of whether they contribute to the plan. Your contributions must be fully vested. Another way to avoid discrimination testing is by adopting a SIMPLE 401(k) plan. These plans are similar to SIMPLE IRAs (see below), but can also allow loans and Roth contributions. Because they're still qualified plans (and therefore more complicated than SIMPLE IRAs), and allow less deferrals than traditional 401(k)s, SIMPLE 401(k)s haven't become a popular option.

If you don't have any employees (or your spouse is your only employee) a 401(k) plan (an "individual 401(k)" or "solo 401(k)" plan) may be especially attractive, Because you have no employees, you won't need to perform discrimination testing, and your plan will be exempt from the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). You can make a deductible profit-sharing contribution of up to 25 percent of pay (to $245,000) on your own behalf in 2011, and in addition you can make deductible pretax contributions of up to $16,500 in 2011 (plus an additional $5,500 of pre-tax catch-up contributions if you're age 50 or older). However, total annual additions to your account in 2011 can't exceed $49,000 (plus any age-50 catch-up contributions).

Note: A 401(k) plan can let employees designate all or part of their elective deferrals as Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there's no up-front tax benefit--contributions are deducted from pay and transferred to the plan after taxes are calculated. Because taxes have already been paid on these amounts, a distribution of Roth 401(k) contributions is always free from federal income tax. And all earnings on Roth 401(k) contributions are free from federal income tax if received in a "qualified distribution."

Note: 401(k) plans are generally established as part of a profit-sharing plan.

Money purchase pension plans
Money purchase pension plans are similar to profit-sharing plans, but employers are required to make an annual contribution. Participants receive their respective share according to the plan document's formula.

As with profit-sharing plans, money purchase pension plans cap individual contributions at 100 percent of earnings or $49,000 annually (in 2011), while employers are allowed to make deductible contributions up to 25 percent of the total compensation of all plan participants. (To go back to the previous example, the total deductible contribution would again be $50,000: ($50,000 x 4) x 25 percent = $50,000.)

Like profit-sharing plans, money purchase pension plans are relatively straightforward and inexpensive to maintain. However, they are less popular than profit-sharing or 401(k) plans because of the annual contribution requirement.

 

Defined benefit plans
By far the most sophisticated type of retirement plan, a defined benefit program sets out a formula that defines how much each participant will receive annually after retirement if he or she works until retirement age. This is generally stated as a percentage of pay, and can be as much as 100 percent of final average pay at retirement.

An actuary certifies how much will be required each year to fund the projected retirement payments for all employees. The employer then must make the contribution based on the actuarial determination. In 2011, the maximum annual retirement benefit an individual may receive is $195,000 or 100 percent of final average pay at retirement.

Unlike defined contribution plans, there is no limit on the contribution. The employer's total contribution is based on the projected benefits. Therefore, defined benefit plans potentially offer the largest contribution deduction and the highest retirement benefits to business owners.

 SIMPLE IRA retirement plans

Actually a sophisticated type of individual retirement account (IRA), the SIMPLE (Savings Incentive Match Plan for Employees) IRA plan allows employees to defer up to $11,500 (for 2011) of annual compensation by contributing it to an IRA. In addition, employees age 50 and over may make an extra "catch-up" contribution of $2,500 for 2011. Employers are required to match deferrals, up to 3 percent of the contributing employee's wages (or make a fixed contribution of 2 percent to the accounts of all participating employees whether or not they defer to the SIMPLE plan).

SIMPLE plans work much like 401(k) plans, but do not have all the testing requirements. So, they're cheaper to maintain. There are several drawbacks, however. First, all contributions are immediately vested, meaning any money contributed by the employer immediately belongs to the employee (employer contributions are usually "earned" over a period of years in other retirement plans). Second, the amount of contributions the highly paid employees (usually the owners) can receive is severely limited compared to other plans. Finally, the employer cannot maintain any other retirement plans. SIMPLE plans cannot be utilized by employers with more than 100 employees.

Other plans
The above sections are not exhaustive, but represent the most popular plans in use today. Recent tax law changes have given retirement plan professionals new and creative ways to write plan formulas and combine different types of plans, in order to maximize contributions and benefits for higher paid employees.

Finding a plan that's right for you
If you are considering a retirement plan for your business, ask a plan professional to help you determine what works best for you and your business needs. The rules regarding employer-sponsored retirement plans are very complex and easy to misinterpret. In addition, even after you've decided on a specific type of plan, you will often have a number of options in terms of how the plan is designed and operated. These options can have a significant and direct impact on the number of employees that have to be covered, the amount of contributions that have to be made, and the way those contributions are allocated (for example, the amount that is allocated to you, as an owner).

Updated 12/7/2011

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