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WOMEN & RETIREMENT PLANNING
Understanding Retirement Plans, Investment Choices, and Retirement Plan Distributions
By Donald S. Gudhus, Carol J. Ventura
iUniverse LLCCopyright © 2013 Donald S. Gudhus, MBA, and Carol J. Ventura, MBA, CFP
All rights reserved.
RETIREMENT PLANS THAT YOU MAY HAVE
Like most of us, you're probably planning to provide for at least a portion of your retirement income from investments you've made to an IRA, from a company-sponsored retirement plan, or both. Many kinds of plans exist, all designed to help you save for retirement.
In this chapter, we present an overview of common retirement plans. Essentially, this chapter establishes a baseline of information from which you may identify the types of plans in which you currently participate or that you might want to consider for future participation. So sit back and enjoy the read. It should be very educational.
Retirement plans can be Individual Retirement Arrangements (IRAs), defined contribution plans, or defined benefit plans.
There are many types of IRAs; some you can establish for yourself, while others must be set up by your employer. With an IRA, the amount available at retirement depends on both the level of funding and the performance of the invested funds.
Defined contribution plans are employer-sponsored retirement plans that do not promise a specific amount of benefit at retirement. Instead, employees or their employer contribute to employees' accounts under the plan, sometimes at a set rate (such as 5 percent of compensation annually). These accounts can either be trustee directed, meaning the employer or its representative chooses the investment allocations, or individually directed by the employee. The plan can also be pooled, meaning that all plan money is combined and managed together, or segregated, where the individual employee accounts are established and directed by each employee. At retirement, an employee receives the accumulated contributions, plus earnings or minus losses, on the invested amounts.
Below are types of employer-sponsored defined contribution retirement plans:
money purchase pension plans
target benefit plans
thrift savings plans
employer stock ownership plans (ESOPs)
Defined benefit plans, unlike defined contribution plans, promise a specified benefit at retirement based on salary earned throughout years of employment and number of years of service. Employer contributions must be sufficient to fund promised benefits. Unlike the defined contribution plans, where earnings and losses affect the benefits payable to the individual, the defined benefit plan guarantees an annual benefit to the retired employee. The benefits are calculated by an actuary and formalized in the plan document. The plan allows employees to earn benefits as soon as they become participants; however, the right to secure a minimum benefit is usually based on the number of years worked.
Defined benefit plans are always pooled accounts, although each individual gets a report at the end of the year specifying his or her anticipated benefits.
Types of defined benefit plans include:
cash balance; and
fully funded and insured 412(i) and 412(e).
The next sections explore three categories of plans: IRAs, employer-funded plans, and employee-funded plans.
An IRA may be a traditional IRA or a Roth IRA. This section defines each type and explains the differences.
A traditional IRA is an account set up with a financial institution such as a bank, brokerage firm, insurance company, or mutual fund company. The sole purpose of the account is to store funds that are intended to be used during the account owner's retirement. A traditional IRA is used to hold investments as well as any capital gains, dividends, and interest that such investments may generate, on a tax-deferred basis. Tax-deferred means you don't pay the taxes at the time you make the investment or earn the dividends; taxes are paid upon a future event, such as when money is taken from the account.
Many types of investments may be used to fund an IRA: stocks, bonds, mutual funds, annuities, certificates of deposit, etc. At the same time, there are specific investments that cannot be used to fund an IRA: life insurance and collectibles are two examples.
In order to establish and make current-year contributions to a traditional IRA, you must meet two criteria: (1) the account owner must have earned income; and (2) the account owner must be younger than age 70 ½ during the year of contribution. Earned income is reported on a W-2 from an employer; it can also be income from self-employment. Individuals under the age of eighteen can establish a traditional IRA account as long as they have earned income; however, the financial institution where the traditional IRA has been set up may require a legal guardian to transact business on behalf of the minor because contract law prohibits a minor from entering into a binding legal contract.
Money can also be moved into an IRA by an individual who does not have current income. For example, after separation from employment, you might move money accumulated in an employer retirement plan to an IRA; this is referred to as a rollover IRA. Contributions to a rollover IRA can be made at any time and do not require earned income, since the contributions were made out of income earned in previous years. Another way money is placed into a traditional IRA is through a process called recharacterization. A recharacterization occurs when money originally contributed to a Roth IRA needs to be removed because of earned-income limitations. A recharacterization can also reverse a taxable conversion, changing the account back to a traditional IRA from a Roth IRA.
Traditional IRA contributions are made using after-tax dollars, and therefore may be partially or fully tax deductible for federal income tax purposes. But beware; if you withdraw money from an IRA before you reach age 59 ½, you will pay an early withdrawal penalty of 10 percent. Most IRA distributions are taxed as ordinary income, the exception being the portion representing any nondeductible contributions. Nondeductible contributions occur when either by account-owner choice or IRS limitation, an income tax deduction is not taken during the year of the contribution. And you must begin to take traditional IRA distributions by age 70 ½, or you may be penalized 50 percent on any required amount not withdrawn.
Like the traditional IRA, the Roth IRA is an account that is used to house funds that are intended to be used during the account owner's retirement. Investments, capital gains, dividends, and interest in a Roth IRA are not subject to tax while they remain in the account. More importantly, unlike the traditional IRA, where distributions are subject to federal and possibly state income tax, distributions from a Roth IRA are tax-free! Yes, tax-free—as long as certain criteria are met prior to distribution. (These requirements will be discussed in chapter 7.)
As with the traditional IRA, the Roth account must be established through and held by a third-party custodian. Similarly, in order to establish and contribute to a Roth IRA account, the account owner must have earnings from an employer or self-employment. However, there are income limitations that cannot be exceeded in order to make a Roth IRA contribution. Unlike the traditional IRA, the account owner can contribute to a Roth IRA after reaching age 70 ½, as long as he or she has earnings from employment. Like the traditional IRA, individuals under the age of eighteen can contribute to a Roth IRA, as long as they have earnings from employment. Again, like the traditional IRA, there may be requirements for a legal guardian or court-appointed individual to transact business on behalf of a minor.
Investments are made with after-tax dollars but are not federally tax deductible, which allows withdrawals to be tax-free. And as important, and unlike with traditional IRAs, account owners are not required to take distributions by age 70 ½—or ever. But withdrawals of earnings prior to age 59 ½ may be subject to a 10 percent early withdrawal penalty unless certain criteria are met.
Five differences between the traditional IRA and the Roth IRA are:
1. Tax deductibility of contributions:
The traditional IRA contribution may be deductible for tax purposes.
The Roth IRA contribution is not tax deductible.
2. Age limitation:
To make a traditional IRA contribution, you cannot be age 70 ½ or older in the year of the contribution.
The Roth IRA allows anyone with earnings to make a contribution, regardless of age.
In a traditional IRA, distributions must begin by age 70 ½.
There is no requirement to take distributions from a Roth IRA starting at age 70 ½.
4. Taxability of distributions:
Distributions from a traditional IRA are subject to federal and state income tax.
Distributions from a Roth IRA are tax-free if certain criteria are met.
5. Contribution income limitations:
There are no income limits restricting the amount of contribution to a traditional IRA.
Income limits restrict contributions to Roth IRAs.
The following types of IRAs are variations of the traditional IRA and Roth IRA; the underlying account is either a traditional IRA or a Roth IRA. Let's take a closer look at these account titles:
payroll deducted IRA
A Roth conversion is a type of Roth IRA account that was previously a traditional IRA or an employer retirement plan. The money in the account was taxed and redesignated a Roth IRA, so future distributions would be tax-free. Roth conversion accounts do not need to be kept separate from contributory Roth IRA accounts. If you have separate Roth IRA accounts and conversion accounts, you might consider consolidating the accounts if you are being charged annual trustee fees for both accounts.
A beneficiary IRA is sometimes known as an Inherited IRA, a Stretch IRA, or a Beneficiary Designated Account (BDA). The beneficiary IRA is a retirement account that is inherited from another individual. The beneficiary IRA can be either a traditional IRA or a Roth IRA. The beneficiary IRA allows the account to continue to grow tax-deferred.
Since this is a traditional or Roth IRA, the beneficiary IRA is an account used to hold investments, plus any capital gains, dividends, and interest that such investments may generate, on a tax-deferred basis. This means that all investments, gains, dividends, and interest are not subject to tax while they remain in the beneficiary IRA. These investments can be varied and can include stocks, bonds, mutual funds, certificates of deposit, etc.
This type of account is opened when an account owner passes away and leaves a retirement account to a designated beneficiary. If the beneficiary is someone other than the surviving spouse, assets cannot be transferred to an existing or new IRA owned by the beneficiary; they must be transferred to an account that includes the original owner's name and "for the benefit of" the named beneficiary. A common registration would read: "Natalie Smith beneficiary of John Smith IRA" or "John Smith IRA fbo (for benefit of) Natalie Smith."
Again, since this is a traditional or Roth IRA, the beneficiary IRA account must be established through and held by a third-party custodian. But unlike the traditional and Roth IRA, contributions generally cannot be made to the beneficiary IRA. Only a surviving spouse has the ability to make contributions to a beneficiary IRA account.
Another way for a beneficiary IRA to receive money is from an employer-sponsored retirement plan: 401(k), profit sharing, defined benefit, etc. The employer's plan must contain language allowing for a beneficiary to move money directly to a beneficiary IRA or convert directly from the employer's retirement plan to a beneficiary Roth IRA. Funds converted directly from the employer's retirement plan to a beneficiary Roth IRA are taxable to the beneficiary.
Money cannot be held in a beneficiary IRA indefinitely. Distributions must begin to the beneficiary within a specified time frame, depending on the age of the account owner and the type of account owned at the time of his or her passing. The distribution rules are complex, and a financial advisor or tax professional should be consulted. The beneficiary may be able to take distributions from the account over his or her single life expectancy or take distributions so that the entire balance is withdrawn within five years. These rules are referred to as Required Minimum Distributions or Minimum Required Distributions, which direct the beneficiary to start taking distributions to avoid a 50 percent penalty for not taking the distributions timely. The IRS requires a minimum distribution, but the account holder can take more than the required minimum. An entire chapter, chapter 7, is devoted to retirement plan distributions.
The spousal IRA is either a traditional IRA or a Roth IRA. The spousal IRA is a term used to describe the situation that occurs when a spouse does not have earnings; the non–wage-earning spouse can make contributions based on his or her spouse's earnings. For example: Jane earned $62,000; however, her husband's business, a sole proprietorship, generated a loss. Jane's husband can still make an IRA contribution based on Jane's earnings. Another situation when a spousal IRA might be used is when the wage-earner is over age 70 ½ and no longer allowed to make a traditional IRA contribution. A younger spouse (under 70 ½) who doesn't have earnings can still contribute to an IRA, since he or she still qualifies for a traditional IRA contribution.
Payroll Deducted IRA
A payroll deducted IRA is either a traditional or Roth IRA, but the contributions are made by an employer. The employer makes payments to the IRA instead of paying the employee that amount in salary or wages. The payments to the IRA are treated as if they were part of the employee's pay—that is, payroll taxes are withheld on the amount. If the contribution is made to a traditional IRA, the employee may be able to deduct the contribution on his or her federal income tax return. If the contribution is made to a Roth IRA, the contribution is not deductible on a federal income tax return.
"Rollover" is not a type of IRA; it is a title used to distinguish traditional IRAs that originate from an employer retirement plan. In the past, money from these plans was kept separate from other contributory IRAs so that they could be rolled into another employer's retirement plan in order to receive special tax treatment when the account owner retires and withdraws funds from the retirement plan. The rules have changed, though, and these rollover amounts no longer need to be segregated from contributory or other pre-tax contributions; the rollover amounts can be rolled to other IRAs or to other qualified plans. The special tax savings, for the most part, have been phased out.
Employer-Funded Retirement Plans
As a way to encourage people to save for retirement, employers are offered tax incentives for making contributions on behalf of their employees or establishing plans where employees can save for their own retirement.
Employer-funded retirement plans are plans where your employer makes plan contributions for you, the employee. These plans do not allow employees to make contributions from salary deferrals. These plans can receive rollover money from IRAs as well as from other employer-sponsored retirement plans, such as SEP IRAs, 401(k)s, etc.—as long as the plan document has this provision.
Simplified Employee Pension or SEP IRA
A SEP IRA is an IRA where the employer must contribute a uniform percentage of pay for each eligible employee. The employer is not required to make contributions every year, though. In a year where a contribution is made for one employee, all eligible employees must receive a contribution. Since these accounts are IRA accounts, each individual has his or her own account: the individual employee controls the investment direction and distributions.
Excerpted from WOMEN & RETIREMENT PLANNING by Donald S. Gudhus, Carol J. Ventura. Copyright © 2013 Donald S. Gudhus, MBA, and Carol J. Ventura, MBA, CFP. Excerpted by permission of iUniverse LLC.
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