The Retirement Corporation of America

Reviewing The Retirement Tax Rules

ONE BIG ALLY you always have on your side in saving for retirement is Uncle Sam because there are now so many ways of building a retirement nest egg that is sheltered from taxes.

Before you finally quit working and retire, it's likely that your retirement savings accounts will rank as the biggest tax shelter you have. Here are some of those retirement savings rules—presented again, but with the emphasis all on the tax side:

The 401(k) Plan

It's a 401(k) plan because that's the section of the tax law Congress passed in 1978 that made it possible. The following are the basic 401(k) rules:

•  You contribute a percentage of your salary to your employer's 401(k) plan each year, up to an allowable maximum ($11,000 in 2002, but increasing to $12,000 in 2003 and eventually to $15,000 in 2006).

•  Your contribution is deducted from your paycheck before it is taxed, so you cut taxable income.

•  You decide how your 401(k) is invested. The typical plan offers several stock funds, a bond fund, a money market fund, a guaranteed investment contract (or GIC), which pays a fixed rate of interest and perhaps stock in your company.

•  Your employer may match your contribution with contributions of its own—usually in company stock equal to 50 cents or more for each $1 you contributed.

•  All the money in your 401(k) keeps compounding tax-free over the years. You owe taxes when you finally withdraw money but you can stall that to age 70 1/2.

•  Your 401(k) is portable. Change jobs and your 401(k) goes with you. Also when you retire, you can roll your 401(k) into an IRA and continue the tax-sheltered compounding.

The Do-it-Yourself Retirement Plans

If there's no 401(k) plan at work, do it yourself. The do-it-yourself universe consists of:

•  Individual Retirement Accounts (IRAs)—both regular and Roth.

•  Keogh plans for the self-employed.

•  Annuities—sold mostly by life insurance companies.

All these plans let your retirement funds compound and stay sheltered from taxes. Your contributions to IRAs and Keogh plans are tax-deductible, while the money spent to buy an annuity or contributed to a Roth IRA are not. But all allow tax-sheltered compounding.

All About Individual Retirement Accounts

There used to be one IRA. Since 1998, there have been two:

•  The regular IRA with contributions tax-deductible, but withdrawals taxable.

•  The Roth IRA with contributions not deductible, but withdrawals tax-free. You can open a Roth IRA even if you have a regular IRA. You can convert a regular IRA into a Roth IRA, but you'll owe taxes. Just keep this rule in mind:
You can't contribute more than $3,000 per year to all IRAs combined.

Regular IRA

•  Contributions of up to $3,000 a year in 2002 through 2004, climbing to $5,000 in 2008, are deductible from your income tax. You can continue contributing until you turn 70 1/2.

•  Once your money is in the plan, it compounds tax-free until you begin withdrawing it. You must start withdrawing money at age 70 1/2.

•  All withdrawals are taxed as ordinary income (not capital gains).

•  You can invest your IRA as you wish—in stocks and/or bonds and/or mutual funds.

•  If you participate in a company retirement plan (or in your own plan if you're self-employed), you lose the deduction on your IRA contribution if your income goes above a certain level.

•  Even if your contributions are no longer deductible, you still can contribute and enjoy tax-free compounding whatever your income level.

Roth IRA

•  You can contribute up to $3,000 a year in 2002 through 2004, climbing to $5,000 in 2008. Unlike regular IRAs, contributions to a Roth IRA are NOT tax-deductible.

•  You can contribute at any age. In a regular IRA, contributions cease at 70 1/2.

•  You can contribute the full $3,000 a year to a Roth IRA, even if you are in a company retirement plan or if you're self-employed—in your own plan.

•  Once your money is in the plan, it compounds tax-free until you begin withdrawing it. You can keep the money in a Roth IRA as long as you want, unlike a regular IRA where you must start withdrawing at age 70 1/2.

•  Once the Roth IRA is five years old, all withdrawals after age 59 1/2 are tax-free, unlike a regular IRA where withdrawals are taxed as income.

•  You can invest your Roth IRA as you wish—in stocks, bonds, mutual funds, etc.

•  There is an income phaseout on a Roth IRA as with a regular IRA but the phaseout on a Roth IRA is higher: between $95,000 and $110,000 of adjusted gross income (AGI) if single, between $150,000 and $160,000 if married, filing jointly.
Whether you choose a regular or Roth IRA depends on when the tax deduction is most useful to you:

•  Short-term: that $3,000-a-year, upfront deduction with a regular IRA is a great feature. It will take a lot of years of tax-free compounding before the back-end tax break from the Roth IRA makes sense. You can't tap your Roth IRA in the first five years anyway. If you're likely to need your IRA money within 10 years, favor the regular IRA.

•  Long-term: not owing taxes on the accumulated buildup with a Roth IRA is also a great feature. All withdrawals from tax-sheltered retirement plans are taxed at ordinary income tax rates, not capital gains rates. If you won't need your IRA money for at least 10 years, favor the Roth IRA.

If your adjusted gross income is $100,000 or less, you can convert a regular IRA into a Roth IRA. You'll owe taxes at your ordinary tax rate on whatever part of your regular IRA wasn't taxed before. The longer period of time until you need the money, the more the conversion makes sense.

All About a Keogh Plan

If you're self-employed without a company pension plan or 401(k) to rely on, you can create your own plan. You actually have two choices:

•  Keogh plans.

•  Simplified Employee Pension (SEP).

The difference between the two mostly has to do with the paperwork. Paperwork for a Keogh isn't very demanding, while paperwork for an SEP is easier still. All contributions to a Keogh or SEP are fully tax-deductible. You can work at one job with a pension and run a sideline business with its own Keogh plan. There aren't any income phaseouts on a Keogh or SEP. No matter how much you earn, you can contribute to a Keogh or SEP. Here's how much income you can contribute:

•  Profit-sharing Keogh plan. Up to 25% of self-employment earnings each year, to a maximum of $40,000.

•  Money-purchase Keogh plan. Up to 100% of self-employment earnings each year, to a maximum of $40,000. But only contributions up to 25% of compensation are deductible—making that the effective ceiling.

•  SEP. Up to 15% of self-employment earnings each year, to a maximum of $40,000.

So, what's the difference between a profit-sharing Keogh plan and a money-purchase Keogh plan?

Profit-sharing lets you contribute a different amount each year based on income. If you have a bad year, you contribute less. In a really bad year, you may contribute nothing. If you have a good year, you contribute more.

Money-purchase requires you to declare the percentage of net earnings you will contribute when you establish the plan and then you have to contribute the same percentage each year. Even if your business didn't make any money, you still have to contribute the same percentage each year.

Before Congress passed the 2001 law, people opted for money-purchase plans because they could contribute more. Since the ceiling in both plans is now $40,000, you're better off with the flexibility of the profit-sharing plan. SEP plans may be simpler to create, but that contribution limit of 15% of compensation makes them less attractive than Keogh plans.

The best bet is to talk to an attorney, CPA, financial planner or investment advisor before creating a self-employed retirement plan. Most will be created through a brokerage house or mutual fund—which also should have experts in the subject. You want to make sure you are sheltering the maximum amount of self-employment income you are allowed to and that you can afford.

All About Annuities

The ultimate in do-it-yourself retirement plans is an annuity—usually bought from a life insurance company. But unlike life insurance which pays when you die, the annuity makes regular payments as long as you (and/or your beneficiary) are alive.

There's no upfront tax break with an annuity as from a 401(k) plan, regular IRA, or Keogh. And withdrawals aren't sheltered from taxes as they are in a Roth IRA. But while your money is in an annuity, you do get tax-free compounding. That's no small advantage. If you have contributed all you can to an IRA or a 401(k) plan and you still have spare cash, consider buying an annuity. Here's how to think about annuities:

You get several options in selecting an annuity. You could purchase a:

•  Fixed annuity. Your premiums earn a fixed rate of return which the company can change at fixed intervals (usually once a year).

•  Variable annuity. Your premiums are invested in mutual fundlike investments of your choosing and earn a return that varies according to the performance of those funds. (Insurance companies and mutual fund companies sell variable annuities.)

You get several options on taking money out of the annuity. You could purchase an:

•  Immediate annuity. You pay a single premium and begin getting back periodic payments of your money almost at once.

•  Deferred annuity. You pay a single premium or a series of payments and you start getting repaid at some point in the future.

Consider an annuity when you have:

•  Contributed all you can to all your tax-sheltered retirement plans and still have money you'd like to put aside for retirement.

•  Come into a large sum of money which you'd like to put aside for retirement. It could be a pension payment from your employer or the proceeds from the sale of your home. Wherever the money came from, an annuity is a place to put it.