Planning For Retirement

Retirement is another important life event that requires proper planning to make it a pleasant life experience. Here you will find invaluable information to help you make the most out of your retirement, no matter how far off it might be.

Financial Guides

The number of people who are financially unprepared for retirement is staggering. One study revealed that more than half of the adults in the U.S. were planning to depend solely on Social Security for retirement income. Another study indicated that the great majority of Americans do not save nearly enough money. This Financial Guide provides you with the information you need to get started on this important task.

To enjoy your retirement years, you need to begin planning early. With longer life expectancies and the growing senior population, people need to begin planning and saving for retirement in their 30s or even sooner. Adequate planning can help to ensure that you will not outlive your savings and that you will not become financially dependent on others.

It is never too late to start or to improve a retirement plan. This Financial Guide shows you the basics of retirement planning, and will enable you to get started or to revamp an existing plan. Basically, there are three steps to retirement planning:

  1. Estimating your retirement income
  2. Estimating your retirement needs
  3. Deciding on investments

Tip: In making estimates of future income needs and sources of income, be sure to estimate conservatively. This will ensure that you do not shortchange yourself.

Estimating Your Retirement Income

Most people have three possible sources of retirement income: (1) Social Security, (2) pension payments, and (3) savings and investments. The income that will have to be provided through savings and investments (which you can plan for) can be determined only after you have estimated the income you can expect from Social Security and from any pension plans (over which you have little control).

Social Security

Estimate how much you can expect in the way of Social Security retirement income. To do this, you should file a “Request for Earnings and Benefits Estimate” with the Social Security Administration. This form can be obtained from SSA by calling their toll-free number: 800-772-1213. You can also request a benefits statement online through the Social Security Administrations Web Site.

Planning Aid: You can also request a benefits statement online through the Social Security Administration’s Web site.

Note: Many people are being sent estimates of their future Social Security benefits without having to make a request. You may have received such an estimate in the mail.

The amount of Social Security benefits you will receive depends on how long you worked, the age at which you begin receiving benefits, and your total earnings.

If you wait until your full retirement age (65 to 67, depending on your year of birth) to begin receiving benefits, your monthly retirement benefit will be larger than if you elect to receive benefits beginning at age 62. The full retirement age will increase gradually to age 67 by the year 2027.

Caution: Be aware that Social Security benefits may be subject to income tax. The basic rule is that if your adjusted gross income plus tax-exempt interest plus half of your Social Security benefits are more than $25,000 for an individual or more than $32,000 for a couple, then some portion of your Social Security benefit will be subject to income tax. The amount that is subject to tax increases as the level of adjusted gross income goes up.

Pension Plans

Estimate how much you can expect to receive from a traditional pension plan or other retirement plan. If you are covered by a traditional pension plan and you are vested, ask your employer for a projection of what you can expect to receive if you continue working until retirement age or under other circumstances, for example, if you terminate before retirement age. You may already have received such an estimate.

If you are covered by a 401(k) plan, a profit-sharing plan, a Keogh plan, or a Simplified Employee Pension, make an estimate of the lump sum that will be available to you at retirement age. You may be able to get help with this estimate from your employer.

Tip: If you are in the military or formerly served in the military, contact the relevant branch of service to find out about retirement benefits.

Establishing Goals For Retirement

Determine how much income you will need (or want) after retirement. Once you have determined this amount, you can figure out how much you will need to put away to have a big enough nest egg to fund your desired income level.

Many people don’t realize that their retirement could last as long as their careers: 35 years or longer. Your nest egg may have to last much longer than you might think. Remember that the earlier you retire, the more you will have to save. If you want to retire at age 55, you’ll have to save a lot more than if you retire at age 65.

A general guideline is that you will want to have at least 70 percent of whatever income stream you have before retirement. If you have any special needs or desires, for example, a desire to travel extensively-the percentage should be adjusted upward. The 70 percent figure is not a substitute for a thorough analysis of your income needs after retirement, but is only a guideline.

Here are some suggestions for estimating how much of an income stream you will want to have coming in after retirement:

Figure Your Current Annual Expenses. The first step in trying to figure out what your annual expenses will be after retirement is to figure what your expenses are now. Take a year’s worth of checkbook, credit card, and savings account records, and add up what you paid for insurance, mortgage, food, household expenses, and so on.

Figure Out How Your Expenses Will Differ After Retirement. After you retire, your expenses will generally be a lot lower than they are while you are working. To help determine how much lower, here are some questions you might ask yourself:

  • Will your mortgage be paid off?
  • Will you still be paying for commuting expenses?
  • How much will you pay for health insurance?

Tip: If you are not among the lucky few that will have post-retirement health insurance coverage from an ex-employer, you will probably pay more for health coverage after you retire and have to take out so-called “Medigap” coverage.

  • Will you increase or decrease your life insurance coverage?
  • How much will you pay for travel expenses? (Do you want to travel after you retire, either on vacation or to visit relatives? Will you be commuting between a winter and summer home?)
  • Will you be spending more on hobbies after retirement?
  • Will your children be financially independent by the time you retire or will you have to factor in some sort of support for them?
  • Will your income tax bills be the same, lower, or higher?

Tip: If you are planning to retire to another state, take into account the different state taxes you will be paying.

The answers to these questions will help you determine your estimated annual expenses after retirement. Then subtract from this estimate the anticipated annual income from already-viable sources. (Do not subtract the lump-sum payments you expect to receive, for example, lump sum payments from 401(k) plans, which will be discussed later). The difference is the annual shortfall that will have to be financed by the nest egg you will need to accumulate.

How do you determine how much you need to save each year to accumulate a nest egg of that size by retirement age? You can do this by using the table below which, assumes an after-tax return of 5 percent per year. Just multiply the required nest egg by the Savings Multiplier for the number of years until retirement.

Example: You are 40 years old and want to retire at age 65. You determine that you need a nest egg of $350,000 to fund your annual shortfall. To find out how much you must save each year to have that $350,000 nest egg by the time you are 65, multiply $350,000 by the 25-year savings multiplier (2.1 percent). You will need to save $7,350 (2.1 percent times $350,000) a year for 25 years.

Subtract from this nest egg any lump sums that you expect to receive at retirement. To project the value at retirement of a present asset (retirement account, savings, investments, etc.); multiply the current value of this asset by the Growth Multiplier for the number of years until retirement.

Example: You already have $75,000 in a 401(k) plan. To find out what that amount will grow to in 25 years, multiply it by the growth multiplier for 25 years. This $75,000 will grow to $254,250 (339 percent times $75,000) by the time you retire. Subtract this $254,250 from the $350,000 needed in the previous example. This amount ($95,750) is the amount you must accumulate by age 65 to meet the income shortfall. Multiply this $95,750 by the 25-year savings multiplier (2.1 percent). You now know that, after taking the projected lump sum into consideration, you will still need to save $2,010.75 per year to accumulate $95,750.

Years Until Retirement      Savings Multiplier      Growth Multiplier     
5 18.1% 128%
10 8.0% 163%
15 4.6% 208%
20 3.0% 265%
25 2.1% 339%
30 1.5% 432%

Deciding on Investments

Generally, the longer you have until retirement, the more of your savings should be invested in vehicles with a potential for growth. If you are very close to or at retirement, you may wish to put the bulk of your savings into low-risk investments. However, this formula is subject to your own financial profile: your tolerance for risk, your income level, your other sources of retirement income (e.g., pension payments), and your unique needs.

Related Guide: Please see the Financial Guide: INVESTMENT BASICS: What You Should Know.

Here is a summary of the pros and cons of various retirement-savings investments and their pros and cons. Please note that each of these is discussed in more detail in related Financial Guides.

Tax-Deferred Retirement Vehicles

Each year, maximize your deposits in a 401(k) plan, an IRA, a Keogh plan, or some other form of tax-deferred savings. Because this money grows tax-deferred, returns will be greater. Further, if the amount you put in is deductible, you are reducing your income tax base.

Lowest Risk Investments

Money market funds, CDs, and Treasury bills are the most conservative investments. However, of the three, only the Treasury bills offer a rate that will keep up with inflation. For the average individual saving for retirement, it is recommended that these vehicles make up only a portion of investments.

Bonds

Bonds provide a fixed rate of income for a certain period. The income from bonds is higher than income from Treasury bills.

Bonds fluctuate in value depending on interest rates, and are thus riskier than the lowest risk investments. If bonds are used as a conservative investment, it is a good idea to use those of a shorter term, to minimize the fluctuation in value that might occur.

Stocks

Although common stock is riskier than any other investment yet discussed, it offers greater return potential.

Mutual Funds

Mutual funds are an excellent retirement savings vehicle. By balancing a mutual fund portfolio to minimize risk and maximize growth, a higher return can be achieved than with safer investments.

  1. Save As Much As You Can As Early As You Can.
    Though it’s never too late to start, the sooner you begin saving, the more time your money has to grow. Gains each year build on the prior year’s — that’s the power of compounding, and the best way to accumulate wealth.

  2. Set Realistic Goals.
    Project your retirement expenses based on your needs, not rules of thumb. Be honest about how you want to live in retirement and how much it will cost. Then calculate how much you must save to supplement Social Security and other sources of retirement income.
  3. A 401(k) Is One Of The Easiest And Best Ways To Save For Retirement.
    Contributing money to a 401(k) gives you an immediate tax deduction, tax-deferred growth on your savings, and — usually — a matching contribution from your company.
  4. An IRA Can Also Give Your Savings A Tax-Advantaged Boost.
    Like a 401(k), IRAs offer huge tax breaks. There are two types: a traditional IRA offers tax-deferred growth, meaning you pay taxes on your investment gains only when you make withdrawals, and, if you qualify, your contributions may be deductible; a Roth IRA, by contrast, doesn’t allow for deductible contributions but offers tax-free growth, meaning you owe no tax when you make withdrawals, but contributions are not deductible.
  5. Focus On Your Asset Allocation More Than On Individual Picks.
    How you divide your portfolio between stocks and bonds will have a big impact on your long-term returns.
  6. Stocks Are Best For Long-Term Growth.
    Stocks have the best chance of achieving high returns over long periods. A healthy dose will help ensure that your savings grows faster than inflation, increasing the purchasing power of your nest egg.
  7. Don’t Move Too Heavily Into Bonds, Even In Retirement.
    Many retirees stash most of their portfolio in bonds for the income. Unfortunately, over 10 to 15 years, inflation easily can erode the purchasing power of bonds’ interest payments.
  8. Making Tax-Efficient Withdrawals Can Stretch The Life Of Your Nest Egg.
    Once you’re retired, your assets can last several more years if you draw on money from taxable accounts first and let tax-advantaged accounts compound for as long as possible.
  9. Working Part-Time In Retirement Can Help In More Ways Than One.
    Working keeps you socially engaged and reduces the amount of your nest egg you must withdraw annually once you retire.
  10. There Are Other Creative Ways To Get More Mileage Out Of Retirement Assets.
    You might consider relocating to an area with lower living expenses, or transforming the equity in your home into income by taking out a reverse mortgage.

Decisions about retirement, including understanding your Social Security benefits, are among the most important ones you will ever make. This Financial Guide provides information you need about Social Security benefits to help you plan for your retirement years.

Eligibility for Retirement Benefits

When you work and pay Social Security taxes (referred to as FICA on some pay stubs), you earn Social Security credits. Most people earn a maximum of four credits per year. In 2016, you must earn $1,260 in covered earnings to get one Social Security or Medicare work credit ($5,040 to get the maximum four credits for the year). The number of credits you need to get retirement benefits depends on your date of birth. If you were born in 1929 or later, you need 40 credits (10 years of work). People born before 1929 need fewer than 40 credits (39 credits if born in 1928, 38 credits if born in 1927, etc.).

If you stop working before you have enough credits to qualify for benefits, your credits will remain on your Social Security record. If you return to work, later on, you can then add credits so that you may qualify. No retirement benefits can be paid until you have the required number of credits.

If you are like most people, however, you will earn many more credits than you need to qualify for Social Security. While these extra credits do not increase your Social Security benefit, the income you earn while working will increase your benefit.

Amount of Your Retirement Benefits

Your benefit amount is based on your earnings averaged over most of your working career. Higher lifetime earnings result in higher benefits. If you have some years of no earnings or low earnings, your benefit amount may be lower than if you had worked steadily.

Your benefit amount is also affected by your age at the time you start receiving benefits. Your benefit will be lower if you start your retirement benefits at age 62 (the earliest possible retirement age) than if you wait until a later age.

Planning Aid: Social Security will give you a personalized benefit estimate at your request. Call 800-772-1213 and ask for a Request for Earnings and Benefit Estimate Statement. Upon completion and return of the form, you will receive a statement of your complete earnings history along with estimates of your benefits for early retirement, full retirement, and delayed retirement (discussed below). You’ll also receive an estimate of the disability benefits you could receive as well as the amount of benefits payable to your spouse and children due to your retirement, disability, or death. If you are age 60 or older, you can get an estimate of your retirement benefits by telephone.

You can also use the Retirement Estimator on the Social Security Administration website.

Note: Your actual benefit amount cannot be determined until you actually apply for benefits.

Social Security law provides for automatic cost-of-living increases. Once you start receiving benefits. The amount will go up automatically as the cost of living rises.

Full Retirement

Persons in the Social Security system who retire at “full retirement age” receive the full retirement benefit. Your full retirement age depends on when you were born.

Because of longer life expectancies, the full retirement age starts at age 65 for those persons born 1937 or earlier and increases gradually until it reaches age 67 for those born 1960 or later. The chart below shows what your full retirement age will be:

Year of Birth

Full Retirement Age

1937 or earlier 65
1938 65 and 2 months
1939 65 and 4 months
1940 65 and 6 months
1941 65 and 8 months
1942 65 and 10 months
1943-1954 66
1955 66 and 2 months
1956 66 and 4 months
1957 66 and 6 months
1958 66 and 8 months
1959 66 and 10 months
1960 and later 67

Early Retirement

You can start your Social Security benefits as early as age 62, but your benefit amount will be less than your full retirement benefit. If you take early retirement, your benefits will be reduced based on the number of months you will receive checks before you reach full retirement age. The reduction is 5/9 of one percent for every month before full retirement age. If your full retirement age is 66 (for example, one born in 1946 and retiring in 2008 at age 62), the reduction for starting your Social Security at 62 is about 27 percent.

Tip: According to the Social Security Administration, you collect more during the first 15 years if you start collecting at 62; beyond the 15 years, you collect more overall by waiting to full retirement age. Of course, the calculation changes where one starting to withdraw at 62 continues working, or returns to work, see below.

Tip: If you are unable to continue working because of poor health, you should consider applying for Social Security disability benefits. The amount of the disability benefit is based on your average lifetime earnings and is stated on your Social Security statement. For more information on disability benefits, request a copy of the booklet Disability Benefits (Publication No. 05-10029).

Delayed Retirement

If you decide to continue working full-time beyond your full retirement age, you will increase your Social Security benefit in two ways:

  • You will be adding a year of earnings to your Social Security record. As stated earlier, higher lifetime earnings result in higher benefits.
  • Your benefit will increase by a certain percentage for each additional year you work. These increases will be added in automatically from the time you reach your full retirement age until you either start taking your benefits or reach age 70. The percentage varies depending on your year of birth. The chart below shows the increase that will apply to you.

 

Year Of Birth

Yearly Rate of Increase

1917-1924 3%
1925-1926 3.5%
1927-1928 4%
1929-1930 4.5%
1931-1932 5%
1933-1934 5.5%
1935-1936 6%
1937-1938 6.5%
1939-1940 7%
1941-1942 7.5%
1943 or later 8%

 

Example: If you were born in 1943 or later, your benefit will increase by 8 percent (2/3 of one percent per month) for each year you delay signing up for Social Security beyond your full retirement age.

Tip: If you decide to delay your retirement, be sure to sign up for Medicare at age 65. In some circumstances, medical insurance costs more if you delay applying for it.

Choosing Your Retirement Date

If you plan to start your retirement benefits at age 62, contact Social Security in advance to determine the best retirement month to claim your benefits. In some cases, your choice of a retirement month could mean additional benefits for you and your family.

Tip: It may be to your advantage to have your Social Security benefits start in January, even if you don’t plan to retire until later in the year. Depending on your earnings and your benefit amount, it may be possible for you to start collecting benefits even though you continue to work. Under current rules, many people can receive the most benefits possible with an application that is effective in January.

If you plan to start collecting your Social Security when you turn 62, you should apply for benefits three months before the date you want your benefits to start. If you are not working your annual earnings fall below the earnings limits (discussed below), or

Tip: Because the rules are complicated, you should discuss your plans with a Social Security claims representative in the year before the year you plan to retire.

Benefits for Widows/Widowers

Many people do not realize that widows and widowers can begin receiving Social Security benefits at age 60 (or age 50 if disabled) on the deceased spouse’s account. If you are receiving widows/widowers (including divorced widows/widowers) benefits, you can switch to your own retirement benefits (assuming you are eligible and your retirement rate is higher than your widow/widower’s rate) as early as age 62.

In many cases, a widow or widower can begin receiving one benefit at a reduced rate and then switch to the other benefit at an unreduced rate at age 65. Since the rules vary depending on the situation, talk to a Social Security representative about the options available to you.

How Work Affects Your Benefits

A Retirement Earnings Test limits the amount of Social Security benefit a person between age 62 and his or her full retirement age (see below) can receive while still working.

For those reaching full retirement age in 2016, $1 in benefits will be deducted for every $3 in earnings above an annual limit up to the month of full retirement age attainment. For 2016, that limit is $41,880. This applies for months before full retirement age. No limit applies beginning the month full retirement age is reached.

For those under full retirement age throughout 2016, $1 in benefits will be deducted for each $2 in earnings above the limit of $15,720 in 2016. These limits generally increase in future years.

If other family members receive benefits on your Social Security record, the total family benefits will be affected by your earnings. Not only will your benefits be offset, but those payable to your family will be offset as well. If a family member works, however, the family member’s earnings affect only his or her benefits.

A special rule applies to your earnings for one year, usually your first year of retirement. Under this rule, you can receive a full Social Security check for any month you are retired, regardless of your yearly earnings. Your earnings must be under a monthly limit. If you are self-employed, the services you perform in your business are taken into consideration as well.

If you earn more than the earnings limit and receive Social Security benefits, you must report this to Social Security. You do not have to fill out a report if you are full retirement age all year.

Your Family’s Benefits

If you are receiving retirement benefits, some members of your family can also receive benefits. Those who can include:

  • Your wife or husband age 62 or older;
  • Your wife or husband under age 62 if she or he is taking care of your child who is under age 16 or disabled;
  • Your former wife or husband age 62 or older (see below);
  • Children up to age 18;
  • Children age 18-19 if they are full-time students through grade 12;
  • Children over age 18, if they are disabled.

The full benefit for a spouse is one-half of the retired worker’s full benefit. However, if your spouse takes benefits between age 62 and their full retirement age, the amount will be permanently reduced by a percentage based on the number of months up to his or her full retirement age, unless she or he is taking care of a child who is under 16 or disabled.

If you are eligible for both your own retirement benefits and for benefits as a spouse, you will be paid your own benefit first. If your benefit as a spouse is higher than your retirement benefit, you will get a combination of benefits equaling the higher spouse benefit.

Example: Mary Ann qualifies for a retirement benefit of $250 and a wife’s benefit of $400. At age 65, she will receive her own $250 retirement benefit and an additional $150 from her wife’s benefit for a total of $400.

A divorced spouse can get benefits on a former husband’s or wife’s Social Security record if the marriage lasted at least 10 years and the divorced spouse is 62 or older and unmarried. For the divorced spouse to get benefits, the worker also must be 62 or older. If divorced for at least two years, the divorced spouse can get benefits even if the worker is not retired. This two-year waiting period is waived if the worker got benefits before the divorce. The amount of benefits a divorced spouse gets has no effect on the amount of benefits a current spouse can get.

If you have children eligible for Social Security, each child will receive up to one-half of your full benefit. However, there is a limit to the amount of money that can be paid to a family. If the total benefits due your spouse and children exceed this limit, their benefits will be reduced proportionately – but your benefit will not be affected.

How to Apply

You can apply for benefits by telephone or by going to any Social Security office. Depending on your circumstances, you will need some or all of these documents:

  • Your Social Security number;
  • Your birth certificate;
  • Your W-2 forms or self-employment tax return for last year;
  • Your checking or savings account information for direct deposit.
  • Your military discharge papers if you had military service;
  • Your spouse’s birth certificate and Social Security number if he or she is applying for benefits;
  • Your children’s birth certificates and Social Security numbers if applying for children’s benefits.

You will need to submit original documents or copies certified by the issuing office. You can mail or take them to Social Security, which will make photocopies and return your documents.

Tip: Don’t delay your application because you don’t have all the information. If you don’t have a document you need, Social Security can help you get it.

Your Right to Appeal

If you disagree with a decision made on your claim, you can appeal it. The steps you can take are explained in the fact sheet, The Appeals Process (Publication No. 05-10141), which is available from Social Security. You have the right to be represented by an attorney or another qualified person of your choice. More information is in the fact sheet, Social Security and Your Right to Representation (Publication No. 05-10075), also available from Social Security.

Taxability of Benefits

Less than one-third of people who get Social Security pay taxes on their benefits. This provision affects only people who have substantial income in addition to their Social Security.

At the end of each year, you will receive a Social Security Benefit Statement (Form SSA-1099) in the mail showing the amount of benefits you received. You can use this statement when you are completing your income tax return to find out if any of your benefits are subject to tax.

Pensions from Work Not Covered by Social Security

If you get a pension from work where you paid Social Security taxes, it will not affect your Social Security benefits. However, your Social Security benefit may be lowered or offset if you get a pension from work that was not covered by Social Security (for example, the Federal civil service or some State or local government employment).

Tip: For more information, call Social Security to ask for the fact sheets, Government Pension (for government workers who may be eligible for Social Security benefits on the record of a husband or wife) (Publication No. 05-10007) and A Pension From Work Not Covered By Social Security (for government workers who also are eligible for their own Social Security benefits) (Publication No. 05-10045).

Leaving the United States

If you are a U.S. citizen, you can travel or live in most foreign countries without affecting your eligibility for Social Security benefits. Your checks can be sent there. However, there are a few countries where Social Security will not send your checks. If you work outside the United States, different rules apply in determining whether you can get your benefit checks.

Most people who are neither U. S. residents nor U.S. citizens will have up to 15 percent of their benefits withheld for federal income tax.

Tip: For more information, ask Social Security for a copy of the booklet Your Payments While You Are Outside the United States (Publication No. 05-10137).

Medicare Insurance

Medicare is a health insurance plan for people who are 65 or older. People who are disabled or have permanent kidney failure can get Medicare at any age. Medicare has four parts:

  • Hospital insurance (Part A), which covers inpatient hospital care and certain follow-up care. You have already paid for it as part of your Social Security taxes while you were working.
  • Medical insurance (Part B), which pays for physicians’ services and some other services not covered by hospital insurance. Medical insurance is optional, and a premium is charged for it.
  • Medicare Part C (also known as Medicare Advantage), which offers health plan options run by Medicare-approved private insurance companies and may cover Medicare prescription drug coverage (Part D).
  • Medicare Part D (Medicare Prescription Drug Coverage), which helps cover the costs of prescription drugs.

Most people are already getting Social Security benefits when they turn 65 and their Medicare starts automatically.

Tip: If you are not getting Social Security, sign up for Medicare close to your 65th birthday, even if you do not plan to retire. For more information, ask Social Security for a copy of the booklet, Medicare (Publication No. 05-10043.)

In June 2015, 39.5 million retired American workers received an average of $1,335 average monthly benefit in Social Security retirement benefits. In fact, Social Security is the major source of income for most of the elderly. But by 2036, there will be almost twice as many older Americans as today and only 2.1 workers for each beneficiary (currently there 2.9).

If you’re worried about the state of social security, you’re not alone. Nevertheless, Social Security is still an important part of your retirement planning. The best way to take control is to find out what your estimated benefits will be. You can do this by contacting the SSA through their website.

You’ll receive a report showing your estimated annual benefits at age 62, at your “normal” retirement age (65 to 67, depending on your year of birth), and at age 70. These are estimates of future benefits, with an actual dollar amount at that time.

Taking Steps To Protect Yourself
There are some important steps to take when you get your report. First, check your reported earnings for each year you worked. Just like any other bureaucracy, mistakes are always a possibility.

Second, take a good look at how your benefit varies according to your retirement age. If you retire at 62, generally you will only get 80 percent of your benefits at normal retirement age. Conversely, you will get an extra 8 percent for each year you work past your normal retirement age. If you’re married, your non-working spouse will get 37.5 percent of your benefits if you retire early and 50 percent at your normal retirement age.

Remember that the full retirement age is no longer necessarily 65. The full retirement age is increasing gradually to age 67 by the year 2027. Looking at your various retirement benefits, you can figure out the best time for you to start taking Social Security.

Third, decide how much you want to rely on Social Security. The younger you are, the more likely it is that your benefits will be less than projected. As a safety measure, you might assume your actual annual benefit would be 75 percent of current estimates. Whatever your method, plug that Social Security number into your retirement needs analysis to see how much you will have to save on your own to provide the income you want. Then make a plan to save even more than that, if you can.

One final tip:
When you deal with the Social Security Administration, do it online or in writing. If doing so is impossible, go to a Social Security office. For future reference, always take notes and get the employee’s name and ID number of the person you spoke with.

You won’t be penalized if you receive incorrect information from the employee and you have proof. If you are not happy with the Social Security Administration’s decision about your situation, you can file a “reconsideration.” You can also ask to have any deadlines waived until your problems are resolved.

Social Security was never designed to pay for a life of luxury, but even with its current fiscal woes, you can probably count on something when you retire.

Annuities may help you meet some of your mid and long-range goals such as planning for your retirement and for a child’s college education. This Financial Guide tells you how annuities work, discusses the various types of annuities, and helps you determine which annuity product (if any) suits your situation. It also discusses the tax aspects of annuities and explains how to shop for both an insurance company and an annuity, once you know which type you’ll need.

How Annuities Work

While traditional life insurance guards against “dying too soon,” an annuity, in essence, can be used as insurance against “living too long.” In brief, when you buy an annuity (generally from an insurance company, that invests your funds), you in turn receive a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (keep in mind that there are many other options), you will have a guaranteed source of “income” until your death. If you “die too soon” (that is, you don’t outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you “live too long” (and do outlive your life expectancy), you may get back far more than the cost of your annuity (and the resultant earnings). By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.

The earnings that occur during the term of the annuity are tax-deferred. You are not taxed on them until they are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.

How Annuities Best Serve Investors

Tip: Assess the costs of an annuity relative to the alternatives. Separate purchase of life insurance and tax-deferred investments may be more cost effective.

The two primary reasons to use an annuity as an investment vehicle are:

  1. You want to save money for a long-range goal, and/or
  2. You want a guaranteed stream of income for a certain period of time.

Annuities lend themselves particularly well to funding retirement and, in certain cases, education costs.

One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10 percent premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59½, and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed “surrender charges,” and they usually apply for the first seven years of the annuity contract.

These penalties lead to a de facto restriction on the use of annuities primarily as an investment. It only makes sense to put your money into an annuity if you can leave it there for at least ten years and the withdrawals are scheduled to occur after age 59½. These restrictions explain why annuities work well for either retirement needs or for cases of education funding where the depositor will be at least 59½ when withdrawals begin.

Tip: The greater the investment return, the less punishing the 10 percent penalty on withdrawal under age 59½ will appear. If your variable annuity investments have grown substantially, you may want to consider taking some of those profits (despite the penalty, which applies only to the taxable portion of the amount withdrawn).

Annuities can also be effective in funding education costs where the annuity is held in the child’s name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax (and 10 percent penalty) on the earnings when the time came for withdrawals.

Caution: A major drawback is that the child is free to use the money for any purpose, not just education costs.

Types Of Annuities

The available annuity products vary in terms of (1) how money is paid into the annuity contract, (2) how money is withdrawn, and (3) how the funds are invested. Here is a rundown on some of the annuity products you can buy:

  • Single-Premium Annuities: You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout). The minimum investment is usually $5,000 or $10,000.
  • Flexible-Premium Annuities: With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.
  • Immediate Annuities: The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium and is usually purchased by retirees with funds they have accumulated for retirement.
  • Deferred Annuities: With a deferred annuity, payouts begin many years after the annuity contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuity, that is, as regular annuity payments over some guaranteed period. Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used to fund tax-deferred retirement plans and tax-sheltered annuities. They may be funded with a single or flexible premium.
  • Fixed Annuities: With a fixed annuity contract, the insurance company puts your funds into conservative fixed income investments such as bonds. Your principal is guaranteed and the insurance company gives you an interest rate that is guaranteed for a certain minimum period from a month to several years. This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on the length of the period during which interest is guaranteed. The fixed annuity is considered a low-risk investment vehicle. All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the entirety of the contract. The fixed annuity is a good choice for investors with a low-risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. Fixed annuity investors benefit if interest rates fall, but not if they rise.
  • Variable Annuities: The variable annuity, which is considered to carry with it higher risks than the fixed annuity–about the same risk level as a mutual fund investment–gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.

Tip: You can switch your allocations from time to time for a small fee or sometimes for free.

The variable annuity is a good annuity choice for investors with a moderate to high-risk tolerance and a long-term investing time horizon.

Caution: Variable annuities have higher costs than similar investments that are not issued by an insurance company.

Caution: The taxable portion of variable annuity distributions is taxable at full ordinary rates, even if they are based on stock investments. Unlike dividends from stock investments (including mutual funds), there is no capital gains relief.

Tip: Annuities are available that combine both fixed and variable features.

Tip: Before buying an annuity, contribute as much as possible to other tax-deferred options such as IRA’s and 401 (k) plans. The reason is that the fees for these plans are likely to be lower than those of an annuity and early-withdrawal fees on annuities tend to be steep.

Tip: IRA contributions are sometimes invested in flexible premium annuities with IRA deduction, if otherwise available. You may prefer to use IRAs for non-annuity assets. Non-annuity assets gain the ability to grow tax-free when held in an IRA. The IRA regime adds no such benefit to annuity assets which grow tax-free in or outside IRAs.

Choosing A Payout Option

When it’s time to begin taking withdrawals from your deferred annuity, you have a number of choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible.

Caution: Once you have chosen a payment option, you cannot change your mind.

The size of your payout (settlement option) depends on:

  1. The size of the amount in your annuity contract
  2. Whether there are minimum required payments
  3. Your life expectancy (or other payout period)
  4. Whether payments continue after your death

Here are summaries of the most common forms of payout:

Fixed Amount

This type gives you a fixed monthly amount (chosen by you) that continues until your annuity is used up. The risk of using this option is that you may live longer than your money lasts. Thus, if the annuity is your only source of income, the fixed amount is not a good choice. And, if you die before your annuity is exhausted, your beneficiary gets the rest.

Fixed Period

This option pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are seeking retirement income before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.

Lifetime or Straight Life

This type of payment continues until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not need the annuity funds to provide for the needs of a beneficiary and (2) you want to maximize your monthly income.

Life With Period Certain

This form of payment gives you payments as long as you live (as does the life annuity) but with a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period, the lower the monthly benefit.

Installment-Refund

This option pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life annuity.

Joint And Survivor

In one joint and survivor option, monthly payments are made during the annuitants’ joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees (employment model), monthly payments are made to the retired employee, with the same or a lesser amount to the employee’s surviving spouse or another beneficiary. The difference is that with the employment model, the spouse’s (or other co annuitant’s) death before the employee won’t affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants’ ages, and whether the survivor’s payment is to be 100 percent of the joint amount or some lesser percentage.

How Payouts Are Taxed

The way your payouts are taxed differs for qualified and non-qualified annuities.

Qualified Annuity

A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefits (and penalties) that Congress saw fit to attach to such qualified plans.

The tax benefits are:

  1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
  2. The earnings on your investment are not taxed until withdrawal

If you withdraw money from a qualified plan annuity before the age of 59½, you will have to pay a 10 percent penalty on the amount withdrawn in addition to paying the regular income tax. There are exceptions to the 10 percent penalty, including an exception for taking the annuity out in a series of equal periodic payments over the rest of your life.

Once you reach age 70½, you will have to start taking withdrawals in certain minimum amounts specified by the tax law (with exceptions for Roth IRAs and for employees still working after age 70½).

Non-Qualified Annuity

A non-qualified annuity is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings; however, you pay tax on the part of the withdrawals that represent earnings on your original investment.

If you make a withdrawal before the age of 59½, you will pay the 10 percent penalty only on the portion of the withdrawal that represents earnings.

With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70½.

Tax on Your Beneficiaries or Heirs

If your annuity is to continue after your death, other taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your estate or those who take through the estate if you didn’t designate a beneficiary).

Income tax: Annuity payments collected by your beneficiaries or heirs are subject to tax on the same principles that would apply to payments collected by you.

Exception: There’s no 10 percent penalty on withdrawal under age 59½ regardless of the recipient’s age, or your age at death.

Estate tax: The present value at your death of the remaining annuity payments is an asset of your estate, and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.

If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.

How To Shop For An Annuity

Although annuities are typically issued by insurance companies, they may also be purchased through banks, insurance agents, or stockbrokers.

There is considerable variation in the amount of fees that you will pay for a given annuity as well in the quality of the product. Thus, it is important to compare costs and quality before buying an annuity.

First, Check Out The Insurer

Before checking out the product itself, it is important to make sure that the insurance company offering it is financially sound. Because annuity investments are not federally guaranteed, the soundness of the insurance company is the only assurance you can rely on. Consult services such as A.M. Best Company, Moody’s Investor Service, or Standard & Poor’s Ratings to find out how the insurer is rated.

Next, Compare Contracts

The way you should go about comparing annuity contracts varies with the type of annuity.

  • Immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Be sure to consider the interest rate and any penalties and charges.
  • Deferred annuities: Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract. It is important to consider all three of these factors and not to be swayed by high interest rates alone.
  • Variable annuities: Check out the past performance of the funds involved.

If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.

Costs, Penalties, And Extras

Be sure to compare the following points when considering an annuity contract:

Surrender Penalties

Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is seven percent for first-year withdrawals, six percent for the second year, and so on, with no charges after the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be acceptable.

Tip: Be sure the surrender charge “clock” starts running with the date your contract begins, not with each new investment.

Fees And Costs

Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might include:

  • Mortality fees of 1 to 1.35 percent of your account (protection for the insurer in case you live a long time)
  • Maintenance fees of $20 to $30 per year
  • Investment advisory fees of 0.3 percent to 1 percent of the assets in the annuity’s portfolios.

Extras

These provisions are not costs per se, but should be asked about before you invest in the contract.

Some annuity contracts offer “bail-out” provisions that allow you to cash in the annuity if interest rates fall below a stated amount without paying surrender charges.

There may also be a “persistency” bonus which rewards annuitants who keep their annuities for a certain minimum length of time.

In deciding whether to use annuities in your retirement planning (or for any other reason) and which types of annuities to use, professional guidance is advisable.

Risk To Retirees of Using An Immediate Annuity

At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly, or yearly payments that represent a portion of principal plus interest and is guaranteed to last for life. The portion of the periodic payout that constitutes a return of principal is excluded from taxable income.

However, this strategy contains risks. For one thing, when you lock yourself into a lifetime of level payments, you fail to guard against inflation. Furthermore, you are gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn’t go to your heirs. Finally, since the interest rate is fixed by the insurer when you buy it, you may be locking yourself into low rates.

You can hedge your bets by opting for a “period certain,” or “term certain” which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also “joint-and-survivor” options (which pay your spouse for the remainder of his or her life after you die) or a “refund” feature (in which some or all of the remaining principal is resumed to your beneficiaries).

Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of $10 at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment with a three percent maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.

Recently, a few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These “variable immediate annuities” convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.

Older seniors–75 years of age and up–may have fewer worries about inflation or liquidity. Nevertheless, they should question whether they really need such annuities at all.

If you want a comfortable retirement income, consider a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.

When must you start withdrawing the funds in your retirement plans? And what happens if the funds aren’t withdrawn before you die? To what extent will your heirs be taxed? The rules are complex but there are ways the savvy taxpayer can maximize the tax shelter.

The basic rule is that you must begin withdrawing funds–and incurring taxes on these withdrawals–no later than April 1 of the year after you turn 70 ½. This rule exists so that retirement funds will be distributed-whether or not spent-during what for most people is their retirement years.

An exception to this general rule is that, where your retirement plan permits, you do not need to begin these mandatory withdrawals until you retire, if you are still employed when you reach the mandatory withdrawal age. The exception doesn’t apply where you’re a 5 percent or more owner of the business that provides the plan, or to withdrawals from traditional IRAs–in those-cases you are subject to the mandatory withdrawal rules.

Preserving the tax shelter. Your funds grow sheltered from tax while they are in the retirement plan. So the longer your financial situation lets you prolong the distribution–or the smaller the amount you must withdraw-the more your assets grow. Some taxpayers choose to defer withdrawals for as long as the law allows, to maximize assets and the shelter, for the next generation.

The law has specific rules about how fast the money must be taken out of the plan after your death. These rules curtail the ability to prolong a tax shelter that started out to aid your retirement.

The rules are complex, but here’s a general overview of the timing of retirement plan distributions which will help avoid unnecessary tax headaches for you and your heirs. Because of the complexity of the rules, professional guidance in this area is strongly suggested.

Withdrawal While You’re Alive

Before You Reach Age 70 ½

Until the year you reach 70 ½, you need not take your money out of your retirement account, although your employer’s plan might require you to do so. In fact, there will usually be a 10 percent early-withdrawal penalty if you make withdrawals from an IRA before age 59 ½. Between the ages of 59 ½ and 70 ½ you pay only the income tax on any amounts you decide to withdraw, with no tax on the return of after-tax contributions you made.

Once You Reach Age 70 ½

Once you hit 70 ½, withdrawals must begin. Technically they can be postponed until April 1 of the year following the year you reach 70 ½ say April 1, 2016, if you reach 70 ½ in 2016. But waiting until April 1 means you must withdraw for two years–2016 and 2017 in 2017. To avoid this income bunching and a possible higher marginal tax rate, tax advisers generally suggest withdrawing in the year you reach 70 ½.

IRS has greatly simplified and relaxed the withdrawal rules over the years to increase the retirement plan tax shelter, by lengthening, in most cases, the period over which plan withdrawals may be stretched.

The rules allow you, automatically, to spread your withdrawals over a period substantially longer than your life expectancy.

Under these rules the taxpayer (say, an IRA owner) first determines his or her retirement plan asset values as of the end of the preceding year. Then the owner takes the number for his or her age from an IRS table (the table is unisex). The number corresponds to the period over which the withdrawals may be spread. The owner divides that number into the retirement asset total. The result is the amount to be withdrawn for the year.

Example: Joe reaches age 70 ½ in October of this year. Retirement plan assets in his IRA totaled $600,000 at the end of last year. The IRS number for age 70 is 27.4. Joe must withdraw $21,898 ($600,000/27.4) this year.

Example: Two years from now Joe is 72 and his IRA was $602,000 at the end of the preceding year (when Joe reached age 71). The IRS number for age 72 is 25.6. Joe must withdraw $23,517 two years hence.

The distribution period in the IRS table in effect assumes distribution over a period based on your life expectancy plus that of a beneficiary 10 years younger than you. (Distribution after your death is based on the actual life span or life expectancy of your actual beneficiary-see “Withdrawal after You Die” below.) Only where your designated beneficiary is a spouse more than 10 years younger than you is his or her actual life expectancy used to figure the withdrawal period during your lifetime. You may use these rules to prolong distribution for 2003 and after, even though you have been taking withdrawals over a shorter period under previous rules.

Under the current rules, the life expectancy of your designated beneficiary (if you have one) is irrelevant in figuring your withdrawal period (except for a beneficiary spouse more than 10 years younger). Thus, you can change your designated beneficiary at will, or replace one who died, without affecting your withdrawal period (except for a change to or from a spouse more than 10 years younger).

Caution: You can always take out money faster than required–and pay tax on these withdrawals. However, the tax code is strict about minimum withdrawals. If you or your beneficiaries or heirs fail to take out what’s required, a tax penalty will take 50 percent of what should have been withdrawn but wasn’t.

Withdrawal after You Die

Designating a beneficiary is no longer needed to prolong distributions during your lifetime (except where your beneficiary spouse is more than 10 years younger than you). But it’s still needed to prolong the distribution during your beneficiary’s lifetime, should the beneficiary want that (some will want the money right away).

Of course, designating a beneficiary is wise as a matter of planning for the disposition of your assets. You may change the beneficiary later without affecting the amount you withdraw (except for a change to or from a spouse more than 10 years younger).

The rules as to how fast your beneficiaries or heirs must withdraw funds from your account-and pay the income tax-differ, depending on your beneficiary choice.

Your Spouse. Naming your spouse as beneficiary carries the most flexibility. A surviving spouse has options that no other beneficiary has.

  • Rollover. A spouse beneficiary of your IRA can elect to treat the balance in your IRA as his or her own IRA (like a rollover). This provides the optimal extension of the withdrawal period if your spouse is younger than you since your spouse doesn’t have to start withdrawing funds until he or she turns 70 1/2. At age 70 1/2, your spouse can then use the period in the IRS table or a longer one if he or she then has a spouse more than 10 years younger. A rollover isn’t allowed if a trust is the beneficiary, even if the spouse is the trust’s sole beneficiary. A similar extension is allowed for a balance you might leave in a qualified retirement plan: your spouse can roll it over into his or her IRA. And your spouse can roll over a distribution from your retirement plan to another retirement plan in which he or she participates, as well as to an IRA.
  • Remaining a beneficiary. Instead of a rollover, a surviving spouse can simply leave the money in the deceased participant’s account. There’s no 10 percent early-withdrawal penalty if the spouse takes funds out of your account, but that penalty would apply if the spouse rolled over the money into his or her own IRA and tapped it before reaching 59 1/2.

Tip: Leaving the money in your account makes sense if your spouse is under age 59 1/ 2 and needs the money soon after your death.

Tip: If your spouse remains a beneficiary, he or she doesn’t have to start withdrawals until you would have reached age 70 ½ after which withdrawals will be taken under the IRS table. Generally, there will not be an estate tax on retirement plan assets left to a spouse and the spouse will pay income taxes only as funds are withdrawn.

Someone Other Than Your Spouse. A child or other non-spouse beneficiary of an IRA can choose to start withdrawals by the end of the year after your death and spread distributions over his or her own life expectancy. This method extends the payout period and the tax deferral. The life expectancy for a 55-year-old, for example, is 29.6 years.

A non-spouse beneficiary of funds in a retirement plan can elect after 2006 to have the funds rolled to an IRA, and then spread withdrawals as described above.

Tip: The required payout schedules set the minimum that can be withdrawn. The beneficiary can always take out more.

If you name your children as a group as beneficiaries, minimum payouts are based on the life expectancy of the eldest child. On the other hand, if you create a separate share or account for each child, the child uses his or her own life expectancy.

No beneficiary. If you die before April 1 after the year you reach age 70 ½ having named no beneficiary or, in most cases, where your beneficiary is not a human being (such as an estate or a charity), all funds must be distributed -and income taxes paid within five to six years of your death. Heirs don’t get the option of using their own life expectancy.

If you die on or after that April 1 date without having named a beneficiary or having named your estate as the beneficiary, the money must come out by the end of the period remaining under the IRS table. For example, at age 80 the table period is 18.7. On a death at age 80, the estate or heirs would have 18.7 years to complete withdrawal.

Death before distributions begin.  If you should die before the time (age 70 ½) required distributions are to begin, minimum distributions to your beneficiary can be spread over his or her life expectancy.

Estate tax. There may be an estate tax on retirement funds left to someone other than your spouse, who will also owe an income tax as funds are withdrawn. Where an estate tax is imposed, the taxpayer who received the retirement funds is entitled to a partial income tax deduction for the estate tax paid.

Tax Planning

The above discussion covered the general rules as to the withdrawal of retirement plan distributions both before and after you die. Now let’s look at some specific tax planning techniques, particularly as regards the estate tax, for minimizing the tax bite when the funds accumulated in your retirement accounts (including pension and profit-sharing plans, 401(k) plans, IRAs and rollover IRAs) are passed on to your heirs.

How Your Heirs Are Taxed

The general rule is that, while there may be an estate tax bite at your death, inherited assets are received income-tax-free by your heirs. Unfortunately, this general rule doesn’t apply to money in a retirement plan. Whoever gets the money will incur income tax on it, unless it’s left to charity (more on giving retirement assets to charity below).

Example: If you gave your wife a $500,000 stock-and-bond portfolio, she will not pay income tax on receipt of the portfolio. Or if you leave your son a $150,000 vacation home, he will not pay income tax when he receives it. But if you leave your daughter the $150,000 in your IRA, she will be subject to income tax on it, more or less as you would be if you had received the distributions yourself. (Moreover, there may be a further estate tax as well.)

The basic income tax rule is that retirement plan distributions to heirs are taxable at ordinary rates, except for after-tax investments, which come out tax-free. There are, however, the following key exceptions or qualifications:

  • On a lump sum distribution, heirs of persons born before 1936 can sometimes claim tax relief.
  • Life insurance proceeds paid in a lump sum are tax-exempt. However, if they are paid in installments, the interest element is taxable.
  • The value of a stock bonus is taxable when received as ordinary income, less unrealized appreciation, and after-tax investment. Any appreciation is taxable as capital gain when the stock is sold.
  • Your spouse can roll over from your retirement account (IRA or other) to his or her IRA. No other heir can roll over from your account.
  • There’s no early withdrawal penalty on what your heir withdraws after your death, even if the heir is under age 59½, but in general, if your spouse is your heir and rolls over your retirement account to his or her IRA, a withdrawal from the IRA while under age 59½ is subject to the penalty.

Some Tax Planning Opportunities

The federal estate tax isn’t a major problem for most Americans. Less than two percent of those who die in any year leave an estate that’s hit by the estate tax; but the larger a taxpayer’s retirement account, the more likely it will be cut down by the federal estate tax on top of the federal income tax described above.

Unlike the income tax, which is collected only as amounts are distributed–and thus is deferred on annuities and the like–the estate tax is collected up front, at the owner’s death, on the present value of the annuity.

One common planning technique-making lifetime gifts to reduce your taxable estate is impractical for retirement accounts. Even where you might be able to give part of your retirement account away (as with an IRA, for example), your gift is a taxable distribution to you and no IRA tax shelter survives for your donee. But here are more practical techniques:

  • Make your spouse the beneficiary of your retirement plan assets and leave non-retirement plan assets to non-spouse beneficiaries. This reduces estate taxes and permits deferral of income taxes for the longest period possible.
  • If you plan on leaving assets to charity, use retirement plan assets. You can eliminate estate and income taxes on this amount while achieving charitable goals.
  • A charitable remainder trust is a sophisticated way to benefit family, as well as charity at a reduced tax cost. Typically, your children or other non-spouse beneficiaries will draw the income from the retirement assets for a period, after which the remainder goes to charity. An estate tax deduction is allowed for the present value of what will go to the charity.
  • Consider buying life insurance to pay estate tax that can’t be avoided (perhaps because you want a large retirement account to go to someone other than a spouse or charity). The insurance proceeds will be exempt from income tax (while funds withdrawn from the account to pay estate tax will be subject to income tax). With proper planning, the withdrawn funds can escape estate tax as well.

If you are thinking of retiring soon, you are about to make a major financial decision: how to take distributions from your retirement plan. This Financial Guide will discuss your various options. And, since the tax treatment of these distributions will influence your decision, we will also review the tax rules.

You may have a number of options as to HOW you can take retirement plan distributions, i.e., your share of company or Keogh pension or profit-sharing plans (including thrift and savings plans), 401(k)s, IRAs, and stock bonus plans. Your options depend (1) on what type of plan you are in and (2) whether your employer has limited your choices. Essentially, you can:

  1. Take everything in a lump sum.
  2. Take some kind of annuity.
  3. Roll over the distribution.
  4. Take a partial withdrawal.
  5. Do some combination of the above.
Note: As you will see, the rules on retirement plan distributions are quite complex. They are offered here only for your general understanding. Professional guidance is advised before taking retirement distributions or other major withdrawals from your retirement plan.

Before discussing the specific withdrawal options, let’s consider the general tax rules affecting (1) tax-free withdrawals and (2) early withdrawals.

Related Guide: The tax treatment will be dictated not only by the form of the withdrawal (i.e., how to take it) but also by the timing of the withdrawal (i.e., when to take it). This Financial Guide discusses the “how.” For a discussion of the “when,” please see the Financial Guide RETIREMENT PLAN DISTRIBUTIONS: WHEN to Take Them.

Tax-free withdrawals. If you paid tax on money that went into the plan, that is if it was made with after-tax funds that money will come back to you tax-free. Typical examples of after-tax investments are:

  • Your non-deductible IRA contributions.
  • Your after-tax contributions to company or Keogh plans (usually, thrift, savings or other profit-sharing plans, but sometimes pension plans).
  • Your after-tax contributions to 401(k)s (in excess of the pre-tax deferral limit).

Early Withdrawals. Tax-favored retirement plans are meant primarily for retirement. If you withdraw funds before reaching what the law considers a reasonable retirement age-age 59 ½–you usually will face a 10 percent penalty tax in addition to whatever tax would ordinarily apply.

Example: At age 47, you withdraw $10,000 from your retirement account (and do not roll over the funds). That $10,000 is ordinary income on which you’ll owe regular tax at your applicable rate plus a 10 percent penalty tax ($1,000).

As with any other tax on withdrawal, the 10 percent penalty doesn’t apply to any part of a withdrawal that would be tax-free as a return of after-tax investment

Tip: There are several ways to avoid this penalty tax. The most common are:
  • You’re age 59 ½ or older.
  • You’re retired and are age 55 or older (however, this does not apply to IRAs).
  • You’re withdrawing in roughly equal installments over your life expectancy or your joint-and-survivor life expectancy (discussed later).
  • You’re disabled.
  • The withdrawal is required by a divorce or separation settlement (here, too, this does not apply to IRAs).
  • The withdrawal is for certain medical expenses.
  • The withdrawal is for health insurance while unemployed (also available to self-employed).
  • For IRAs only: The withdrawal is for certain higher education expenses and for first-time home purchases (up to $10,000).

Now let’s review the basics for each of the options for taking retirement plan distributions and then discuss the tax planning for each option.

Take Everything in a Lump Sum

The Basics

You might want to withdraw all retirement funds in a lump sum, perhaps to spend them on a retirement home or assisted living arrangement, on a second home, or to buy or invest in a business. Or you might want to take everything out of a company account because you mistrust leaving funds with a former employer or to take control of investment decisions, although here a rollover (discussed later) might be preferred. Maybe you have to take a lump sum, as some employers will require, though here, too, a rollover option is probably available.

Lump sum is the standard form of retirement distribution for profit-sharing, 401(k) and stock bonus plans, but may also happen in other plans. Put another way, while plans generally allow lump sum distribution, the employer may have decided to preclude the lump sum form.

Tip: While your funds remain in the plan, earnings on the investment assets grow tax-free. The tax shelter ends once the funds are withdrawn. Preserving this tax shelter is one reason to decide not to withdraw the funds at all or to decide against withdrawing everything in a lump sum. The tax shelter continues, in one form or another, for funds withdrawn as annuities and for funds left in the plan when there’s a partial withdrawal of funds. And the shelter continues on rollovers.

Tax Planning

Special tax relief applies, in certain cases, for those who withdraw their pension assets in a lump sum. For most, this relief, in the form of “forward averaging,” explained below, came to an end on 12/31/99-meaning that withdrawals taken after that date don’t get that relief.

Forward averaging reduces your tax below what it would be if figured at regular progressive rates. You will pay tax in one year (for the year you receive it) as if the lump sum amount was received in equal installments over 10 years (for the relief allowed in limited cases after 1999). Forward averaging isn’t allowed if any part of the account is or was rolled over to an IRA.

Capital gain treatment for lump sums is available only for those born before 1936 and only with respect to plan participation before 1974. Capital gain may be taken instead of forward averaging and is available after 1999.

It’s a “lump sum” if you take out everything left in your account in a single calendar year. If you took $50,000 last year and $250,000 this year, and nothing is left, $250,000 is the lump sum. If you took $250,000 last year and $50,000 this year and nothing is left, $50,000 is the lump sum. In general, lump sum relief is available only once in a worker’s lifetime.

The limited lump sum relief remaining is the result of a Congressional plan to phase out the relief, as it has brought down top tax rates and liberalized rollover rules.

Tip: Because lump sum withdrawal ends the tax shelter, it’s rarely the road to maximizing wealth. Retirees will usually do better with arrangements that preserve the shelter, through rollovers, annuities or partial withdrawals.

Roll Over The Distribution

The Basics

Rollovers are transfers of funds from one plan to another (from one company or Keogh plan to another, from a company or Keogh to an IRA, or from one IRA to another, or from an IRA to a company or Keogh plan.

Rollovers are usually distributions from a company or Keogh plan that are put into an IRA. You might do this (1) to transfer control of the funds from your employer to yourself or (2) because your employer forces the distribution when you leave so as to close its books on your plan participation. In your own Keogh plan, you might make the rollover as part of a decision to terminate your plan or your business.

Tip: A rollover to your own IRA can give you flexibility in dealing with the funds (for example, so you can invest in options or create a separate IRA for each beneficiary) that would not be available for funds left in your employer’s plan. Rollovers can be of the entire retirement account or only part of the account.

Rollovers can be made from one IRA to another. Apart from Roth IRA situations, these are usually done to expand investment options or to create several IRA accounts. Rollovers also can be made from one pension, profit-sharing or 401(k) plan to another or between types of plan. This might happen if you change jobs or set up a new Keogh plan because of starting a new business after you retire.

Rollovers from company or Keogh plans preserve the retirement plan tax shelter while postponing retirement distributions, thereby often prolonging the tax-free buildup of retirement funds. They have other consequences, some undesirable:

Caution: Federal law grants a person no rights in his or her spouse’s IRA. Thus, a plan participant’s rollover will strip the participant’s spouse of rights the spouse had under the plan from which the assets are being removed. In the case of a pension plan, the spouse has a measure of protection because the spouse must approve the transfer that will forfeit his or her rights. However, no such approval is required in the case of 401(k)s or profit-sharing plans. Thus, a rollover from such plans can eliminate spousal rights. (Employers sometimes provide spousal rights that federal law does not require.)
Caution: A rollover will eliminate the chance of lump sum tax relief, unless the IRA was just a conduit for the movement of funds between retirement plans.
Tip: In some cases, a rollover from an IRA to a retirement plan can extend the tax shelter period. IRA distributions must begin at age 70 ½, but distributions from a retirement plan can be postponed beyond that until the participant retires, unless he or she is an owner of the business.
Tip: A rollover from an IRA to a retirement plan could also get greater creditor protection than if left in an IRA.

Tax Planning

Rollovers are tax-free when properly handled, but consider these qualifications and exceptions:

  • After-tax investments can be rolled over from a company or Keogh plan to an IRA and, in some cases, to defined contribution plans, but not to defined benefit plans.
  • You can’t roll over amounts you’re required to withdraw after reaching age 70 ½ or amounts you’re due to receive under a fixed annuity.
Caution: If you do the rollover yourself-personally withdrawing funds from one plan and moving them to another-the plan you’re withdrawing from must withhold tax at a 20 percent rate on the withdrawal. To avoid tax on the 20 percent withheld, you’ll have to come up with that amount from elsewhere and add it to the rollover IRA. (The tax withheld can be taken as a credit against the year’s tax liability.) On the other hand, a direct rollover (having the funds transferred directly from the transferring plan to the receiving plan) avoids withholding.
Caution: If you do the rollover yourself, the withdrawn funds are taxable if they don’t reach the rollover destination within the deadline (generally, 60 days). Therefore, the least risky way to roll over funds is a direct rollover.

Where the plan holds specific assets for your account, a rollover may (1) transfer the specific asset or (2) sell it and transfer the cash.

Caution: The rollover is not tax-free if cash is withdrawn, used to buy investment assets, and the new assets are then transferred to the new plan.

Take A Partial Withdrawal

The Basics

Partial withdrawals are withdrawals that aren’t rollovers, annuities or lump sums or don’t qualify for lump sum forward averaging or capital gain relief. They include certain withdrawals that you can make while you are still working as well as withdrawals at or after retirement. They may be made for investment or consumption, including education and health care. Because they are partial, the amount not withdrawn continues its tax shelter.

A partial withdrawal will usually leave open the option for other types of withdrawal (annuity, lump sum, rollover) of the balance left in the plan.

Note: Before retirement, partial withdrawals are fairly common with profit-sharing plans, 401(k)s, and stock bonus plans. After retirement, they are fairly common in all types of plans (though least common with defined-benefit pension plans)

Tax Planning

A partial withdrawal is taxable (and can be subject to the penalty tax on early withdrawal) except to the extent it consists of after-tax funds. The withdrawal is generally tax-free in the proportion the after-tax investment bears to the total retirement account.

Example: Your retirement account totals $100,000, which includes an after-tax investment of $10,000. You withdraw $5,000. The withdrawal is tax-free to the extent of $500 ($10,000/$100,000x$5,000).
Note: The tax-free portion is computed differently for plan participants who were in the plan on 5/5/86.

Do Some Combination Of The Above

Combination withdrawals are quite complex and beyond the scope of this Financial Guide.

Life Insurance Options

Here are your typical options where whole life insurance is held for you in a retirement plan:

  • Your employer surrenders the policy to the insurance company for its cash surrender value, which it pays over to you.
  • Your employer trades in the policy for an annuity on your life.
  • Your employer distributes the policy to you.
  • Some mix of the above, such as getting some cash proceeds and an annuity.

The tax shelter ends when cash is received. Otherwise, it continues, to some degree.

Assets Withdrawn In Kind

In general, assets withdrawn in kind (i.e., withdrawn in the form held by the retirement plan, rather than withdrawn in cash) are taxed at their fair market value when received, reduced by after-tax investment. Exceptions:

  • Stock distributed by a stock bonus plan. Your after-tax investment in the stock comes back tax-free and you pay no tax on the stock’s appreciation in value until you sell it. But you have the option to pay tax on the value when received.
  • Annuity contract. These aren’t taxed when distributed. You’re taxed under the annuity rules above on annuity payments as received.
  • Insurance policy. If you convert the policy to an annuity contract within 60 days, the distribution is tax-free. However, you’re taxed under the annuity rules as payments are received. If you keep the policy, you’re taxed on the policy’s cash value (less your after-tax investment).

The Economics Of Retirement Annuities

Retirement annuity economics are built around the straight life annuity, where the retiree receives a certain amount for life, however, long or short that might be. This amount stops at the retiree’s death. The cost of such an annuity is computed, and that’s the cost the employer is obligated to provide.

However, you may want, or be obliged to take, something other than a straight life annuity, such as:

  • A fixed-term annuity, whereby the annuity will continue for a fixed term (say, ten years) even though you die before the end of this term. (This additional benefit is called a “refund feature.”)
  • A joint and survivor annuity, where the annuity is payable over two lives instead of one.

These types of annuity are worth more than the straight life annuity. But the employer isn’t obliged to pay for more than the cost of a straight single life annuity. So if you opt for something other than straight life, the amount you collect each period will be correspondingly reduced to the “actuarial equivalent” of straight life.

Can Creditors Reach Your Retirement Assets

Federal law generally protects your retirement assets or accounts against claims of your creditors so long as the assets remain in the retirement plan, except for unpaid federal taxes. Generally, this protection is in federal labor law (ERISA). Protection denied under labor law is provided under bankruptcy law (if the case is begun after October 16, 2005) to:

  • Keogh plans where the Keogh owner (or owner and spouse) are the only ones in the plan and
  • IRA plans, up to the amount rolled over from retirement plans, plus up to $1 million (which the bankruptcy court may increase where appropriate).

State Taxes On Retirement Plan Distributions

With 50 different state tax systems, only an overview is possible on how states tax retirement plan withdrawals. Here are the highlights:

  • A state cannot tax a retirement plan distribution if it imposes no income tax on individuals (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
  • A state from which a pension is paid, by an employer or former employer in the state, can’t tax the pension recipient in another state. In other cases, states generally follow the basic federal approach of taxing retirement distributions as ordinary income (and treating return of after-tax investment as tax-free). But some states don’t follow the federal rules for Keogh or IRA investment. Hence, withdrawals from such plans can get state tax relief not allowed under federal law.
  • Some states grant tax relief for a certain dollar amount of retirement income, relief that extends to retirement plan withdrawals. In some states the relief may look something like the federal credit for the elderly.
  • Rarely if ever, would a state impose a penalty tax on early withdrawal or on inadequate withdrawals after age 70 ½.

Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called “traditional IRAs”), in that they promise complete tax exemption on distribution. There are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices–and why YOU might want one, or more.

With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments where invested capital is tax-free when distributed.

With a Roth IRA, there’s never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans) and distributions are completely exempt from income tax.

How Contributions Are Treated

The 2016 annual contribution limit to a Roth IRA is $5,500 (same as 2015). An additional “catch-up” contribution of $1,000 (same as 2015) is allowed for people age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2016 from personal services and have income (modified adjusted gross income or MAGI) below $117,000 if single or $184,000 on a joint return in 2016. The $5,500 limit in 2016 phases out on incomes between $117,000 and $132,000 (single filers) and $184,000 and $194,000 (joint filers). Also, the $5,500 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.

You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings (your own or combined with your spouse) of at least $11,000, up to $11,000 ($5,500 each) can go into the couple’s Roth IRAs. As with traditional IRAs, there’s a 6 percent penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.

How Withdrawals Are Treated

You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.

Qualified Distributions

Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings as well as contributions and conversion amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting the following conditions:

  1. At least, five years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion since the conversion occurred and
  2. At least one of these additional conditions is met:
  • The owner is age 59 1/2.
  • The owner is disabled.
  • The owner has died (distribution is to estate or heir).
  • Withdrawal is for a first-time home that you build, rebuild, or buy (lifetime limit up to $10,000).

Note: A distribution used to buy, build or rebuild a first home must be used to pay qualified costs for the main home of a first-time home buyer who is either yourself, your spouse or you or your spouse’s child, grandchild, parent or another ancestor.

Non-Qualified Distributions

To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10 percent tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.

Exceptions. You may not have to pay the 10 percent additional tax in the following situations:

  • You are disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You use the distribution to pay certain qualified first-time homebuyer amounts.
  • The distributions are part of a series of substantially equal payments.
  • You have significant unreimbursed medical expenses.
  • You are paying medical insurance premiums after losing your job.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10 percent tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10 percent early distribution tax, even if the contributions have been included as income in an earlier year.

Ordering Rules for Distributions

If you receive a distribution from your Roth IRA, that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.

  1. Regular contributions.
  2. Conversion contributions, on a first-in-first-out basis (generally, total conversions from the earliest year first). See Aggregation (grouping and adding) rules, later. Take these conversion contributions into account as follows:
    • Taxable portion (the amount required to be included in gross income because of conversion) first, and then the
    • Nontaxable portion.
  3. Earnings on contributions.

Disregard rollover contributions from other Roth IRAs for this purpose.

Aggregation (grouping and adding) rules.

Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.

  • Add all distributions from all your Roth IRAs during the year together.
  • Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
  • Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, in the case of any conversion or rollover in which the conversion or rollover distribution was made in 2011 and the conversion or rollover contribution was made in 2012, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2012.

Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.

Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also, disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.

Example: On October 15, 2007, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis. Justin included $60,000 ($80,000 – $20,000) in his gross income. On February 23, 2007, Justin makes a regular contribution of $4,000 to a Roth IRA. On November 7, 2007, at age 60, Justin takes a $7,000 distribution from his Roth IRA.

  • The first $4,000 of the distribution is a return of Justin’s regular contribution and is not includible in his income.
  • The next $3,000 of the distribution is not includible in income because it was included previously.

Distributions after Owner’s Death

Qualified distributions after the owner’s death are tax-free to heirs. Nonqualified distributions after death, which are distributions where the 5-year holding period wasn’t met, are taxable income to heirs as they would be to the owner (the earnings are taxed), except there’s no penalty tax on early withdrawal. However, an owner’s surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.

Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.

Converting from a Traditional IRA or Other Eligible Retirement Plan to a Roth IRA

The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were made available to taxpayers.

Conversion Methods

You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.

You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.

    • Rollover. You can receive a distribution from a traditional IRA and roll it over (contribute it) to a Roth IRA within 60 days after the distribution.
    • Trustee-to-trustee transfer. You can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of the Roth IRA.
    • Same trustee transfer. If the trustee of the traditional IRA also maintains the Roth IRA, you can direct the trustee to transfer an amount from the traditional IRA to the Roth IRA.

Note: Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, rather than opening a new account or issuing a new contract.

Prior to 2008, you could only roll over (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA.

      • A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
      • An annuity plan,
      • A tax-sheltered annuity plan (section 403(b) plan),
      • A deferred compensation plan of a state or local government (section 457 plan), or
      • An IRA.

Any amount rolled over is subject to the same rules for converting a traditional IRA to a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.

There is a cost to the rollover. The amount converted is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA. So you must pay tax now (though there’s no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs.

Starting in 2010, conversion is now allowed to all taxpayers. The prior income restriction allowing conversion only for taxpayers of income (again, MAGI) of $100,000 or less in the conversion year has been terminated. All taxpayers are able to convert a regular IRA to a Roth IRA starting in 2010. The conversion is a taxable distribution, which can be included as income during the conversion year or averaged over the next two years. The conversion is not subject to the 10 percent early distribution penalty.

Undoing a Conversion to a Roth IRA

Since everyone recognizes that conversion is a high-risk exercise, the law, and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a “re-characterization.” This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs. Re-characterization can be done any time until the due date for the return for the year of conversion.

Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you’re taxed on up to $180,000, which is $40,000 more than you now have. Undoing-re-characterization-avoids the tax, and gets you out of the Roth IRA.

Tip: One reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.

Can you undo one Roth IRA conversion and then make another one a reconversion? Yes, but only one time and subject to the following requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.

Withdrawal Requirements

You are not required to take distributions from your Roth IRA once you reach a particular age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs

Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.

Retirement Savings Contributions Credit

Also known as the saver’s credit, this credit helps low and moderate-income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can’t be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2016 for a married filer is below $61,500 ($61,000 in 2015). For heads-of-household MAGI is below $45,750 ($46,125 in 2015) and for others (single, married filing separately) it is below $37,750 ($30,500 in 2015). These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10 to 50 percent of each dollar placed into a qualified retirement plan up to the first $2,000 ($4,000 married filing jointly). The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50 percent of $2,000).

Note: Both you and your spouse may be eligible to receive this credit if you both contributed to a qualified retirement plan and meet the adjusted gross income limits.

The following table details the percentage of Saver’s credit based on Adjusted Gross Income (AGI):

 

2016 Saver’s Credit Single Filers AGI Head of Household AGI Joint Filers AGI
50% of contribution $0-$18,500 $0-$27,750 $0-$37,000
20% of contribution $18,501-$20,000 $27,751-$30,000 $37,001-$40,000
10% of contribution $20,001-$30,750 $30,001-$46,125 $40,000-$61,500
Credit Not Available more than $30,750 more than $46,125 more than $61,500

 

 

2015 Saver’s Credit Single Filers AGI Head of Household AGI Joint Filers AGI
50% of contribution $0-$18,250 $0-$27,375 $0-$36,500
20% of contribution $18,251-$19,750 $27,376-$29,625 $36,501-$39,500
10% of contribution $19,751-$30,500 $29,626-$45,750 $39,501-$61,000
Credit Not Available more than $30,500 more than $45,750 more than $61,000

 

 

2014 Saver’s Credit Single Filers AGI Head of Household AGI Joint Filers AGI
50% of contribution $0-$18,000 $0-$27,000 $0-$36,000
20% of contribution $18,001-$19,500 $27,001-$29,250 $36,001-$39,000
10% of contribution $19,501-$30,000 $29,251-$45,000 $39,001-$60,000
Credit Not Available more than $30,000 more than $45,000 more than $60,000

 

Note: The saver’s credit is available in addition to any other tax savings that apply. Further, IRA contributions can be made until April 15 of the following year and still be considered in the current tax year.

Use in Estate Planning

Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund largely through conversion of traditional IRAs-to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.

Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.

Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.

A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there’s the question whether Roth IRA benefits currently promised will survive into future decades.

Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call if you have any questions.

Several different types of retirement plan – 401(k), defined benefit, and profit-sharing – can be made to suit a prosperous small business or professional practice. But if yours is a really small business such as a home-based, start-up, or sideline business, maybe you should consider adopting a SIMPLE IRA plan.

A SIMPLE IRA plan is a type of retirement plan specifically designed for small business and is an acronym for “Savings Incentive Match Plans for Employees.” SIMPLE IRA plans are intended to encourage small business employers to offer retirement coverage to their employees but work just as well for self-employed persons without employees.

SIMPLE IRA plans contemplate contributions in two steps: first by the employee out of salary, and then by the employer, as a “matching” contribution (which can be less than the employee contribution). Where SIMPLE IRA Plans are used by self-employed persons without employees – as IRS expressly allows – the self-employed person is contributing both as employee and employer, with both contributions made from self-employment earnings.

Note: One form of SIMPLE IRA plan allows employer contributions without employee contributions. The ceiling on contributions, in this case, makes this SIMPLE IRA Plan option unattractive for self-employed individuals without employees.

Note: To establish a SIMPLE IRA Plan you:

  • Must have 100 or fewer employees.
  • Cannot have any other retirement plans.
  • Need to annually file a Form 5500.
  • Employees must earn $5,000 a year.

A quick list of pros and cons:

  • Plan is not subject to the discrimination rules that everyday 401(k) plans are.
  • Employees are fully vested in all contributions.
  • Straightforward benefit formula allows for easy administration.
  • Optional participant loans and hardship withdrawals add flexibility for employees.
  • No other retirement plans can be maintained.
  • Withdrawal and loan flexibility adds administrative burden for the employer.

How Much You Can Put in and Deduct

Those with relatively modest earnings will find that a SIMPLE IRA Plan lets them contribute (invest) and deduct more than other plans. With a SIMPLE IRA Plan, you can put in and deduct some or all of your self-employed business earnings. The limit on this “elective deferral” is $12,500 in 2016 (same as 2015).

If your earnings exceed that limit, you could make a modest further deductible contribution–specifically, your matching contribution as an employer. Your employer contribution would be 3 percent of your self-employment earnings, up to a maximum of the elective deferral limit for the year. So employee and employer contributions for 2016 can’t total more than $25,000 ($12,500 maximum employee elective deferral, plus a maximum $12,500 for the employer contribution.)

Catch up contributions. Owner-employees age 50 or over can make a further deductible “catch up” contribution as employee of $3,000 in 2016 (same as 2015).

Example: An owner-employee age 50 or over in 2016 with self-employment earnings of $40,000 could contribute and deduct $12,500 as employee plus an additional $3,000 employee catch up contribution, plus a $1,200 (3 percent of $40,000) employer match, for a total of $16,700.

Low-income owner-employees in SIMPLE IRA Plans may also be allowed a tax credit up to $2,000 in 2016 for single filers ($4,000 married filing jointly). This is known as the “Saver’s Credit” and income must not be more than $61,500 for married filing jointly, $30,750 for singles and $46,125 for heads of household.

SIMPLE IRA plans are an excellent choice for home-based businesses and ideal for full-time employees or homemakers who make a modest income from a sideline business.

If living expenses are covered by your day job (or your spouse’s job), then you would be free to put all of your sideline earnings, up to the ceiling, into SIMPLE IRA plan retirement investments.

An individual 401(k) plan, however, could allow you to contribute more, often much more, than SIMPLE IRA Plan. For example, if you are less than 50 years old with $50,000 of self-employment earnings in 2016, you could contribute $12,500 to your SIMPLE IRA PLAN plus an additional 3 percent of $50,000 as an employer contribution, for a total of $14,000. A 401(k) plan would allow a $31,000 contribution.

With $100,000 of earnings, the total for a SIMPLE IRA Plan would be $15,500 and $43,500 for a 401(k).

Withdrawal: Easy, but Taxable

There’s no legal barrier to withdrawing amounts from your SIMPLE IRA Plan, whenever you please. There can be a tax cost, though: Besides regular income tax, the 10 percent penalty tax on early withdrawal (generally, withdrawal before age 59 1/2) rises to 25 percent on withdrawals in the first two years the SIMPLE IRA Plan is in existence.

A SIMPLE IRA Plan

A SIMPLE IRA Plan really is a “simple” plan to set up and operate than most other plans. Contributions go into an IRA that you set up. Those already familiar with IRA rules investment options, spousal rights, and creditors’ rights don’t have a lot new to learn.

Requirements for reporting to the IRS and other agencies are negligible, at least for you, the self-employed person. Your SIMPLE IRA Plan’s trustee or custodian, typically an investment institution, has reporting duties and the process for figuring the deductible contribution is a bit simpler than with other plans.

What’s Not So Good about SIMPLE IRA Plans

We’ve seen that other plans can do better than SIMPLE IRA Plan once self-employment earnings become significant. Other not-so-good features include the following:

Because investments are through an IRA, you’re not in direct control. You must work through a financial or other institution acting as trustee or custodian, and will in practice have fewer investment options than if you were your own trustee, as you could be in a Keogh. For many self-employed individuals, however, this won’t be an issue. In this respect, a SIMPLE IRA Plan is like the SEP-IRA.

Other plans for self-employed persons allow a deduction for one year (say 2016) if the contribution is made the following year (2017) before the prior year’s (2016) return is due (April 2017 or later extensions). This rule applies to SIMPLE IRA Plans, for the matching (3 percent of earnings) contribution you make as an employer. But there’s no IRS pronouncement on when the employee’s portion of the SIMPLE IRA Plan is due where the only employee is the self-employed person. Those who want to delay contribution would argue that they have as long as it takes to compute self-employment earnings for 2016 (though not beyond the 2016 return due date, with extensions).

Tip: The sooner your money goes in the plan, the longer it’s working for you tax-free. So delaying your contribution isn’t the wisest financial move.

You can’t set up the SIMPLE IRA Plan after the year ends and still get a deduction for that year, as is allowed with SEPs. Generally, to make a SIMPLE IRA Plan effective for the year it must be set up by October 1 of that same year. A later date is allowed where the business is started after October 1. In this instance, the SIMPLE IRA Plan must be set up as soon thereafter as administratively feasible.

Then there’s this problem if the SIMPLE IRA Plan is intended for a sideline business and you’re already in a 401(k) plan in another business or as an employee. In this scenario, the total amount you can put into the SIMPLE IRA Plan and the 401(k) plan combined can’t be more than $18,000 in 2016 (same as 2015)–$23,500 if catch-up contributions are made to the 401(k) by one age 50 or over.

Here’s an example: If someone who is less than age 50 puts $9,000 in her 401(k), he or she can’t put more than $9,000 in her SIMPLE IRA Plan in 2016. The same limit applies if you have a SIMPLE IRA Plan while also contributing as an employee to a “403(b) annuity” (typically for government employees and teachers in public and private schools).

How to Get Started in a SIMPLE IRA Plan

You can set up a SIMPLE IRA Plan on your own by using IRS Form 5304-SIMPLE IRA PLAN or Form 5305-SIMPLE IRA PLAN, but most people turn to financial institutions. SIMPLE IRA Plans are offered by the same financial institutions that offer IRAs and 401(k) plans.

You can expect the institution to give you a plan document (approved by IRS or with approval pending) and an adoption agreement. In the adoption agreement, you will choose an “effective date,” which is the beginning date for payments out of salary or business earnings. Remember, that date can’t be later than October 1 of the year you adopt the plan, except when a business is formed after October 1.

Another key document is the Salary Reduction Agreement, which briefly describes how money goes into your SIMPLE IRA Plan. You need such an agreement even if you pay yourself business profits rather than salary.

Printed guidance on operating the SIMPLE IRA Plan may also be provided. You will also be establishing a SIMPLE IRA Plan account for yourself as a participant.

Keoghs, SEPs and SIMPLE IRA Plans Compared For 2016

 

Keogh SEP SIMPLE IRA PLAN
Plan type: Can be defined benefit or defined contribution (profit-sharing or money purchase) Defined contribution only Defined contribution only
Owner may have two or more plans of different types, including a SEP, currently or in the past Owner may have SEP and Keoghs Generally, SIMPLE IRA PLAN is the only current plan
Plan must be in existence by the end of the year for which contributions are made Plan can be set up later–if by the due date (with extensions) of the return for the year contributions are made Plan generally must be in existence by October 1st of the year for which contributions are made
Dollar contribution ceiling (for 2016): $53,000 for defined contribution plan; no specific ceiling for defined benefit plan $53,000 $25,000
Percentage limit on contributions: 50% of earnings, for defined contribution plans (100% of earnings after contribution). Elective deferrals in 401(k) not subject to this limit. No percentage limit for defined benefit plan. 50% of earnings (100% of earnings after contribution). Elective deferrals in SEPs formed before 1997 not subject to this limit. 100% of earnings, up to $12,500 for 2016 for contributions as employee; 3% of earnings, up to $12,500 for contributions as employer
Deduction ceiling: For defined contribution, lesser of $53,000 or 20% of earnings (25% of earnings after contribution). 401(k) elective deferrals not subject to this limit. For defined benefit, net earnings. Lesser of $53,000 or 20% of earnings (25% of earnings after contribution). Elective deferrals in SEPs formed before 1997 not subject to this limit. Maximum contribution $12,500 (in 2016)
Catch up contribution 50 or over: Up to $6,000 in 2016 for 401(k)s Same for SEPs formed before 1997 Half the limit for Keoghs, SEPs (up to $3,000 in 2016)
Prior years’ service can count in computing contribution No No
Investments: Wide investment opportunities. Owner may directly control investments. Somewhat narrower range of investments. Less direct control of investments. Same as SEP
Withdrawals: Some limits on withdrawal before retirement age No withdrawal limits No withdrawal limits
Permitted withdrawals before age 59 1/2 may still face 10% penalty Same as Keogh rule Same as Keogh rule except penalty is 25% in SIMPLE IRA PLAN Plan’s first two years
Spouse’s rights: Federal law grants spouse certain rights in owner’s plan No federal spousal rights No federal spousal rights
Rollover allowed to another plan (Keogh or corporate), SEP or IRA, but not a SIMPLE IRA PLAN. Same as Keogh rule Rollover after 2 years to another SIMPLE IRA PLAN and to plans allowed under Keogh rule
Some reporting duties are imposed, depending on plan type and amount of plan assets Few reporting duties Negligible reporting duties

 

Frequently Asked Questions

How do I determine my long-term financial goals?

The first step is to decide what you realistically want to achieve financially. Financial goals might include early retirement, travel, a vacation home, securing your family’s financial comfort on the death of a bread-winner, planning for the care of elderly relatives or building a family business.

Is there any validity to financial planning “rules of thumb” such as “saving 10 percent of your gross income?”

The following rules of thumb may work for some people, but they do not make financial sense for everyone. What is more important is to be able to know whether a particular rule of thumb suits your situation. Here are six of the more common rules along with some considerations that should not be overlooked.

1. Life insurance should equal five times your yearly salary
This rule of thumb has been used to answer the question: How much life insurance should I have? The ideal amount of life insurance is the amount that will, when invested, generate enough income to allow your survivors to maintain the level of income they are used to. “Five times your salary” will accomplish this objective in some cases, but there is no substitute for making the calculations necessary to find out how much life insurance you need to buy for your particular situation. The amount of life insurance you need depends on how many people there are in your family, whether there are other sources of income besides your salary, how old your children are, and a few other factors.

2. Save 10 percent of your salary per year
You may need to save much more than ten percent of your gross income to have a comfortable retirement. The amount you need to save for retirement depends on how large your existing nest egg is and how old you are. Those who started saving late in life, for instance in their 40s, need to save at least 15 or 20 percent per year.

3. Contribute as much as you can to retirement plans
This makes sense for most people, but if you’ve accumulated a large amount of money in a retirement plan, say close to a million dollars, you may reach the point where the negatives of contributing to your retirement plan savings outweigh the positives.

4. You need 80 percent of your pre-retirement income to retire comfortably
Although people may need 80 percent of their salaries during the first few years of retirement, later on, they are often able to live comfortably on less. The amount of income you need depends on whether you have paid off your mortgage, whether you will have other sources of retirement income, and other factors.

5. Subtract your age from 100 and invest that percentage in stocks
This is one of those “cookie cutter” rules that only pans out for certain investors. For others, it results in a portfolio that is much too conservative. The best method of allocating percentages among various types of investments depends on your investment goals and needs and your willingness to risk your capital. In this case, rules of thumb do not serve the investor very well at all.

6. Maintain an emergency fund of six months’ worth of expenses
Depending on your family’s situation, three months’ worth of expenses might be enough. On the other hand, for some families, even six months’ worth might be totally inadequate. The amount you should keep on hand depends on how easy it would be for you to take out a short term loan and how much money you have in savings and investments among other things.

Tip: Do not rely on any rule of thumb to make financial decisions. Instead consider carefully what your needs and goals are, and then calculate what you’ll need to do to fulfill them.

What do women in particular need to keep in mind with regard to financial planning?

With more women remaining single, nearly half of all marriages ending in divorce, and the odds of becoming a widow by the age of 55 hovering around 75 percent, nearly 9 out of 10 women will be solely responsible for their financial well-being at some point in their lives. But many are ill-prepared to do so.

Here are several areas where women fall behind when it comes to planning for their financial future:

  • Women save considerably less for retirement, on average 60 percent less than men according to a 2010 study conducted by LIMRA of close to 2,500 employees. This is significant because women typically live longer than their male counterparts and need more retirement savings.
  • In that same LIMRA study, 29 percent of men and only 14 percent of women consider themselves knowledgeable about financial services and products. Fifty-four percent of women felt at least somewhat knowledgeable about financial products and services, but nearly three-quarters of men felt the same way.
  • And, in 2011 a Harris Interactive survey commissioned by RocketLawyer.com found that of the more than 1,000 people surveyed, 5 percent of the women do not have a will, 26 percent of them citing cost as the primary reason they don’t have one.

What special problems do unmarried couples have to be concerned with in financial and estate planning?

In 2010, there were 7.5 million unmarried couples living together in the US, according to the US Census Bureau. This represents an increase of 13 percent over the previous year. And because unmarried couples don’t enjoy the same legal rights and protection as married couples do, financial planning considerations for issues such as retirement planning, estate planning, and taxes can be quite different. For example:

  • Unmarried partners do not automatically inherit each other’s property. When an unmarried partner dies intestate (without a will) the estate is divided according to laws of the state, with property and assets typically going to parents or siblings and rarely or never to the beloved partner. In other words, married couples who do not have a will have state intestacy laws to back them up, but unmarried couples need to have a will in place in order to make sure that their wishes are met.
  • Couples who aren’t married also do not have the right to speak for each other in the event of a medical crisis. If your life partner loses consciousness or becomes incapacitated, someone has to make a decision whether to go ahead with a medical procedure. That person should be you, but unless you have a health care directive such as a living will in place, you have no legal right to make decisions for your partner.
  • Tax and estate issues are also more complicated. In most cases it makes more sense not to own property such as a car or electronics equipment together or to have a joint loan. Whereas marital assets can be divided equally by a judge, there is no legal recourse for unmarried couples in the event of a breakup. Another example is home ownership. If one partner is listed as the sole owner of a home that the couple lives in together and he or she dies, the surviving partner might be left homeless. This can be resolved by properly titling assets, in this case making sure the home is in joint tenancy with rights of survivorship.

Who is entitled to Social Security disability benefits?

An individual who is determined by the Social Security Administration to be “disabled” receives an Award Letter, which is a notice of decision that explains how much the disability benefit will be and when payments start. It also tells you when you can expect your condition to be reviewed to see if there has been any improvement.

If family members are eligible, they will receive a separate notice and a booklet about things they need to know.

Under the Social Security disability insurance program (title II of the Act), there are three basic categories of individuals who can qualify for benefits on the basis of disability:

  • A disabled insured worker under full retirement age.
  • An individual disabled since childhood (before age 22) who is a dependent of a parent entitled to title II disability or retirement benefits or was a dependent of a deceased insured parent.
  • Disabled widow or widower, age 50-60 if the deceased spouse was insured under Social Security.
  • Been disabled or expected to be disabled for at least 12 months
  • Has filed an application for benefits, and
  • Completed a five month waiting period; however, the 5-month waiting period does not apply to individuals filing as children of workers. Under SSI, disability payments may begin as early as the first full month after the individual applied or became eligible for SSI. In addition, if you become disabled a second time within five years after your previous disability benefits stopped, there is no waiting period before benefits start.

Under title XVI, or SSI, there are two basic categories under which a financially needy person can get payments based on disability:

  • An adult age 18 or over who is disabled.
  • Child (under age 18) who is disabled.

For all individuals applying for disability benefits under title II, and for adults applying under title XVI, the definition of disability is the same. The law defines disability as the inability to engage in any substantial gainful activity (SGA) by reason of any medically determinable physical or mental impairment(s) which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.

Meeting this definition under Social Security is difficult. Insured means that you have accumulated sufficient credits in the Social Security system. Visit the Social Security Administration’s Website to apply for an estimate.

When do Social Security disability benefits begin?

If you are getting disability benefits on your own work record, or if you are a widow or widower getting benefits on a spouse’s record, there is a five month waiting period and your payments will not begin until the sixth full month of disability. The 5-month waiting period does not apply to individuals filing as children of workers. Under SSI, disability payments may begin as early as the first full month after the individual applied or became eligible for SSI.

If the sixth month has passed, your first payment may include some back benefits. Your check should arrive on the third day of every month. If the third falls on a Saturday, Sunday, or legal holiday, then you will receive your check on the last banking day before that day. The check you receive is the benefit for the previous month.

Example: The check you receive dated July 3 is for June. Your benefit can either be mailed to you or be deposited directly into your bank account.

Are Social Security disability benefits taxable?

Some people who get Social Security have to pay taxes on their benefits. The rules are the same regardless as to whether Social Security benefits are received due to retirement or disability. If you file a federal tax return as an “individual” and your combined income is more than $25,000, you have to pay taxes. Combined income is defined as your adjusted gross income + Nontaxable interest + ½ of your Social Security benefits. If you file a joint return, you may have to pay taxes if you and your spouse have a combined income that is more than $32,000. If you are married and file a separate return, you will probably pay taxes on your benefits. Social Security has no authority to withhold state or local taxes from your benefit. Many states and local authorities do not tax Social Security benefits. However, you should contact your state or local taxing authority for more information.

How long do Social Security disability payments continue?

Your disability benefits generally continue for as long as your impairment has not medically improved and you cannot work. They will not necessarily continue indefinitely, however.

Because of advances in medical science and rehabilitation techniques, an increasing number of people with disabilities recover from serious accidents and illnesses. Also, many individuals, through determination and effort, overcome serious conditions and return to work in spite of them.

What happens to Social Security disability benefits when I reach retirement age?

If you are still getting disability benefits when you reach retirement age, your benefits will be automatically changed to retirement benefits, generally in the same amount. You will then receive a new booklet explaining your rights and responsibilities as a retired person.

If you are a disabled widow or widower, your benefits will be changed to regular widow or widower benefits (at the same rate) at 60, and you will receive a new instruction booklet that explains the rights and responsibilities for people who get survivors benefits.

What happens if Social Security turns down my claim for disability benefits?

If you disagree with SSA’s decision, you can appeal it. You have 60 days to file a written appeal (either by mail or in person) with any Social Security office. Generally, there are four levels to the appeals process. They are:

  • Reconsideration. Your claim is reviewed by someone who did not take part in the first decision.
  • Hearing before an Administrative Law Judge. You can appear before a judge to present your case.
  • Review by Appeals Council. If the Appeals Council decides your case should be reviewed, it will either decide your case or return it to the administrative law judge for further review.
  • Federal District Court. If the Appeals Council decides not to review your case or if you disagree with its decision, you may file a civil lawsuit in a Federal District Court and continue your appeal all the way to the US Supreme Court if necessary.

If you disagree with the decision at one level, you have 60 days to appeal to the next level until you are satisfied with the decision or have completed the last level of appeal.

You have two special appeal rights when a decision is made that you are no longer disabled.

They are as follows:

  • Disability Hearing. As part of the reconsideration process, this hearing allows you to meet face-to-face with the person who is reconsidering your case to explain why you feel you are still disabled. You can submit new evidence or information and can bring someone who knows about your disability. This special hearing does not replace your right to also have a formal hearing before an administrative law judge (the second appeal step) if your reconsideration is denied.
  • Continuation of Benefits. While you are appealing your case, you can have your disability benefits and Medicare coverage (if you have it) continue until an administrative law judge makes his or her decision. However, you must request the continuation of your benefits during the first 10 days of the 60 days mentioned earlier. If your appeal is not successful, you may have to repay the benefits.

Will I receive Social Security when I retire?

Retirement benefit calculations are based on your average earnings during a lifetime of work under the Social Security system. For most current and future retirees, The Social Security Administration (SSA) averages your 35 highest years of earnings. Years in which you have low earnings or no earnings may be counted to bring the total years of earnings up to 35.

You can collect early retirement benefits at age 62, but you currently can’t get full benefits until 65 for persons born in 1937 or earlier. For persons born 1938 and later, the full retirement age increases gradually until it reaches 67 for those born in years 1960 and later. Then you can collect additional benefits for every year you delay your retirement until age 70. After you begin to collect Social Security benefits, you will continue to receive them for life.

How can I find out what Social Security will pay me when I retire?

You can create a my Social Security account with SSA and view your Social Security Statement online at any time.

Can I count on Social Security being around when I retire?

With retirement on the horizon for scores of baby boomers, it’s very likely that Social Security will be in your future; however, the Social Security trust fund will less and less able to pay benefit increases, which increase annually as the taxable wage base rises without some kind of reform.

What are variable annuities?

Variable annuity contracts are sold by insurance companies. Purchasers pay a premium of, for example, $10,000 for a single payment variable annuity or $50 a month for a periodic payment variable annuity. The insurance company deposits these premiums in an account that is invested in a portfolio of securities. The value of the portfolio goes up or down as the prices of its securities rise or fall.

After a specified period of time, which often coincides with the year the purchaser turns age 65, the assets are converted into annuity payments. Although the insurance company guarantees a minimum payment, these payments are variable, since they depend on the periodic performance of the underlying securities.

Almost all variable annuity contracts carry sales charges, administrative charges, and asset charges. The amounts differ from one contract to another and from one insurance company to another.

Fixed annuity contracts are not considered securities and are not regulated by the SEC (Securities and Exchange Commission).

How do annuities work?

An annuity, in essence, is insurance against “living too long.” In contrast, traditional life insurance guards against “dying too soon.” Briefly, here is how annuities function: An investor hands over funds to an insurance company. The insurer invests the funds. At the end of the annuity’s term, the insurer pays the investor his or her investment plus the earnings. The amount paid at maturity may be a lump sum or an annuity, which is a set of periodic payments that are guaranteed as to amount and payment period.

Earnings that occur during the term of the annuity are tax-deferred and an investor is not taxed until the amounts are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.

Should I invest in annuities?

There are two reasons to use an annuity as an investment vehicle:

  1. You want to save money for a long-range goal, and/or
  2. You want a guaranteed stream of income for a certain period of time.

Annuities lend themselves well to funding retirement, and, in certain cases, education costs.

One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10 percent premature withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2, and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed “surrender charges,” and they usually apply for the first seven years of the annuity contract.

These penalties lead to a de facto restriction on the use of annuities as an investment. It really only makes sense to put your money in an annuity if you can leave it there for at least ten years, and only when the withdrawals are scheduled to occur after age 59-1/2. This is why annuities work well mostly for retirement needs, or for education funding in cases where the depositor will be at least 59-1/2 when withdrawals begin.

Annuities can also be effective in funding education costs where the annuity is held in the child’s name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax on the earnings when the time came for withdrawals. A major drawback to this planning technique is that the child is free to use the money for any purpose, not just education costs.

If an investment adviser recommends a tax-deferred variable annuity, should you invest it? Or would a regular taxable investment be better?

Generally, you should be aware that tax-deferred annuities very often yield less than regular investments. They have higher expenses than regular investments, and these expenses eat into your returns. On the plus side, the annuity provides a death benefit. You should also be aware that there may be a commission on the product an investment adviser may be entitled to a commission on the product he or she is recommending.

Should a retiree purchase an immediate annuity?

At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly or yearly payments, representing a portion of principal plus interest, and guaranteed to last for life. The portion of the periodic payout that is a return of principal is excluded from taxable income.

However, there are risks. For one thing, when you lock yourself into a lifetime of level payments, you aren’t guarding against inflation. You are also gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn’t go to your heirs. Furthermore, since the interest rate is fixed by the insurer when you buy it, you are locking into today’s low rates.

You can hedge your bets by opting for what’s called a “certain period,” which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also “joint-and-survivor” options, which pay your spouse for the remainder of his or her life after you die, or a “refund” feature, in which a portion of the remaining principal is resumed to your beneficiaries.

Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of 10 percent at three-year intervals for the first 15 years. Payments are then subject to an annual cost-of-living adjustment, with a 3 percent maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.

A few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These “variable, immediate annuities” convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.

If you want a comfortable retirement income, your best bet is a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.

How do life annuities differ from life insurance?

While traditional life insurance guards against “dying too soon,” an annuity, in essence, can be used as insurance against “living too long.” With an annuity, you will receive in return a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (there are many other options), you will have a guaranteed source of “income” until your death.

If you “die too soon” (that is, you don’t outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you “live too long” and outlive your life expectancy you may get back far more than the cost of your annuity–along with the resultant earnings. By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.

What’s the down side to buying an annuity?

You cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10 percent premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59-1/2 and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers’ penalties are termed “surrender charges,” and they usually apply for the first seven years of the annuity contract.

What types of annuities are available?

You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout).

With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.

The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and is usually purchased by retirees with funds they have accumulated for retirement.

With a deferred annuity, payouts begin many years after the annuity contract is issued. Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used in tax-deferred retirement plans and as individual tax-sheltered annuity investments, and may be funded with a single or flexible premium.

With a fixed annuity contract, the insurance company puts your funds into conservative, fixed income investments such as bonds. Your principal is guaranteed, and the insurance company gives you an interest rate that is guaranteed for a certain minimum period–from a month to a year, or more. A fixed annuity contract is similar to a CD or a money market fund, depending on length of the period during which interest is guaranteed, and is considered a low risk investment vehicle.

This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period.

All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5 percent for the entirety of the contract.

The fixed annuity is a good annuity choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. In times of falling interest rates, fixed annuity investors benefit, while in times of rising interest rates they do not.

The variable annuity, which is considered to carry with it higher risks than the fixed annuity (about the same risk level as a mutual fund investment) gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.

You can switch your allocations from time to time for a small fee or sometimes for free.

The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.

Tip: Today, insurers make available annuities that combine both fixed and variable features.

What are my options for collecting my annuity?

When it’s time to begin taking withdrawals from your deferred annuity, you have several choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible. The size of your monthly payment depends on several factors including:

  1. The size of the amount in your annuity contract
  2. Whether there are minimum required payments
  3. The annuitant’s life expectancy
  4. Whether payments continue after the annuitant’s death

Summaries of the most common forms of payment (settlement options) are listed below. Keep in mind that once you have chosen a payment option, you cannot change your mind.

Fixed Amount gives you a fixed monthly amount (chosen by you) that continues until your annuity is used up. The risk of using this option is that you may live longer than your money lasts. If you die before your annuity is exhausted, your beneficiary gets the rest.

Fixed Period pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are seeking retirement income before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.

Lifetime or Straight Life payments continue until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds.

Life with Period Certain gives you payments as long as you live (as does the life annuity) but with a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period is, the lower the monthly benefit will be.

Installment-Refund pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary.

Joint and Survivor. In one joint and survivor option, monthly payments are made during the annuitants’ joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees, monthly payments are made to the retired employee, with the same or a lesser amount to the employee’s surviving spouse or other beneficiary. In this case, the spouse’s (or other co-annuitant’s) death before the employee won’t affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants’ ages and whether the survivor’s payment is to be 100 percent of the joint amount or some lesser percentage.

What’s the tax on payouts from a qualified plan or IRA annuity?

A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (Simplified Employee Pension), or some other retirement plan.

  1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
  2. The earnings on your investment are not taxed until withdrawal.

If you withdraw money before the age of 59-1/2, you may have to pay a 10 percent penalty on the amount withdrawn in addition to the regular income tax. One of the exceptions to the 10 percent penalty is for taking the annuity out in equal periodic payments over the rest of your life.

Once you reach age 70-1/2, you will have to start taking withdrawals in certain minimum amounts specified by the tax law (with exceptions for Roth IRAs and for employees still working after age 70-1/2).

Is it a good idea to buy annuities for my IRA or qualified plan?

Though this is sometimes done, no tax advantage is gained by putting annuities in such a plan since qualified plans and IRAs as well as annuities are tax-deferred. It might be better, depending on your situation, to put other investments such as mutual funds in IRAs and qualified retirement plans, and hold annuities in your individual account.

How will my annuity payouts be taxed?

Payouts are taxed differently for qualified and non-qualified plans. These differences are summarized below.

Qualified and Non-Qualified Annuities

A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (Simplified Employee Pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefits-and penalties–that Congress saw fit to attach to such plans.

The tax benefits are:

  1. The amount you put into the plan is not subject to income tax, and/or
  2. The earnings on your investment are not taxed until withdrawal.

A non-qualified annuity, on the other hand, is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings.

Tax Rules for Qualified Annuities

When you withdraw money from a qualified plan annuity that was funded with pre-tax dollars, you must pay income tax on the entire amount withdrawn.

Once you reach age 70-1/2, you will have to start taking withdrawals, in certain minimum amounts specified by the tax law.

Tax Rules for Non-Qualified Annuities

With a non-qualified plan annuity that was funded with after-tax dollars, you pay tax only on the part of the withdrawal that represents earnings on your original investment.

If you make a withdrawal before the age of 59-1/2, you will pay the 10 percent penalty only on the portion of the withdrawal that represents earnings.

With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70-1/2.

What tax must my beneficiaries or heirs pay if my annuity continues after my death?

Taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your estate or those who take through the estate if you didn’t designate a beneficiary).

Income tax. Annuity payments collected by your beneficiaries or heirs are subject to tax on the same principles that would apply to payments collected by you.

Exception: There’s no 10 percent penalty on withdrawal under age 59-1/2 regardless of the recipient’s age, or your age at death.

Estate tax. The present value at your death of the remaining annuity payments is an asset of your estate and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.

How should I shop for an annuity?

Check Out The Insurer. Make sure that the insurance company offering it is financially sound. Annuity investments are not federally guaranteed, so the soundness of the insurance company is the only assurance you can rely on. Several services rate insurance companies.

Compare Contracts. For immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Consider the interest rate and any penalties and charges.

Deferred annuities. Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract, not just the interest rates.

Variable annuities. Check out the past performance of the funds involved.

If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.

What are the added or hidden costs in buying an annuity?

There are costs associated with annuities. Here are the most important items you should be aware of:

Sales Commission. Ask for details on any commissions you will be paying. What percentage is the commission? Is the commission deducted as a front-end load? If so, your investment is directly reduced by the amount of the commission. A no-load annuity contract, or at least a low-load contract, is the best choice.

Surrender Penalties. Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is 7 percent for first-year withdrawals, 6 percent for the second year, and so on, with no charges after the seventh year.

Tip: Be sure the surrender charge “clock” starts running with the date your contract begins, not with each new investment.

Other Fees and Costs. Ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might include:

  • Mortality fees of 1 to 1.35 percent of your account (protection for the insurer in case you live a long time)
  • Maintenance fees of $20 to $30 per year
  • Investment advisory fees of 0.3 percent to 1 percent of the assets in the annuity’s portfolios

Other Considerations. Some annuity contracts offer “bail-out” provisions that allow you to cash in the annuity if interest rates fall below a stated amount without paying surrender charges.

There may also be a “persistency” bonus which rewards annuitants who keep their annuities for a certain minimum length of time.

Is it better to take an annuity or a lump-sum distribution?

As in so many areas of retirement planning, that depends upon your particular needs and circumstances.

  • An annuity preserves the tax shelter for funds not yet paid out as annuity income, continuing to grow tax-free to fund future payouts.
  • A lump sum withdrawal may be preferable for those in questionable health.
  • Consider an annuity with a “refund feature” that guarantees a fixed sum to your heirs should you die earlier than expected.

What is a joint and survivor annuity?

A joint and survivor annuity pays a certain annuity during your life and half that amount (it could be more) to your surviving spouse for life.

In almost all cases, the annual amount you will get under a joint and survivor annuity will be less than you would get under an annuity on your life alone.

Can I change from a joint and survivor annuity if it doesn’t meet my needs?

Joint and survivor annuities are almost always required in pension plans, and sometimes in other plans. But you and your spouse can still agree to some other form.

Chief reasons for such agreement are so that your child or other family member can share in the income, or to take a lump sum distribution, or to take a larger annual amount over the participant’s life alone.

What are the steps in the investment process?

The investment process is comprised of several steps that enable you to select a portfolio appropriate to your risk tolerance and desired return. The primary steps in this process are:

  • Determine your desired return and risk tolerance
  • Develop an asset allocation plan
  • Select diversified investments within each asset class
  • Monitor your investments

Q: How are risk and return related?

A: Risk and return are positively correlated. The higher the risk of an investment, the higher a return it must offer in order to compensate for the risk. Risks come in many forms such as the volatility of the market, inflation risk, interest rate risk, and business risk. You must determine the degree of risk that you are willing to tolerate. Your investment professional can assist you in this process.

Select the level of risk that permits you to sleep at night. If you have a long investment horizon, then focus on your desired return. Year to year fluctuations should not be a concern. Over the long term, stocks have generated annual returns of about 10 to 11 percent and have had the highest level of risk while long-term government bonds have had long-term returns of 5 to 6 percent and have had the lowest level of risk. The more risk you can tolerate or the higher your desired rate of return, the higher the portion of your portfolio invested in stocks should be.

Q: What is an asset allocation plan?

A: Asset allocation is the distribution of investments among asset classes. Asset classes include different types of stocks, bonds, and mutual funds. It is a significant factor in determining your investment return relative to risk. Proper asset allocation maximizes returns and minimizes risk. This is because different classes of assets react differently to economic upswings or downswings. Allocation differs from diversification in that it balances a portfolio among different classes of assets, for example, growth stocks, long bonds, and large-company stocks, while diversification focuses on variety within an asset class. Generally, allocation among six or seven asset classes is recommended.

Q: What is diversification?

A: Diversification is the selection of multiple investments within a portfolio. For example, investing in a portfolio of 30 stocks rather than in just a few. By maintaining a diversified, varied portfolio, you are minimizing risk. You’re less likely to make that “big killing,” but when individual investments take a nose-dive, you won’t take a big hit.

Q: How can I best monitor my investments?

A: Examine carefully and promptly any written confirmations of trades that you receive from your broker, as well as all periodic account statements. Make sure that each trade was completed in accordance with your instructions. Check to see how much commission you were charged, to make sure it is in line with what you were led to believe you would pay. If commission rates have increased or will increase in the immediate future, or if charges such as custodial fees are to be imposed, then you should be informed in advance.

If securities are held for you in street name (where the customer’s securities and assets are held under the name of the brokerage firm instead of the name of the individual who purchased the security or asset), you may request that dividends or interest payments be forwarded to you or put into an interest-bearing account, if available, as soon as they are received, rather than at the end of the month or after some other lengthy period of time.

Tip: Set up a file where you can store information relating to your investment activities, such as confirmation slips and monthly statements sent by your broker. Keep notes of any specific instructions given to your account executive or brokerage firm. Good records regarding your investments are important for tax purposes, and also in the event of a dispute about a specific transaction.

Periodically, ask yourself the following questions about your investment:

  • Is this investment performing as I was told it would?
  • How much money will I get if I sell it today?
  • How much am I paying in commissions or fees?
  • Have my investment goals changed? If so, is the investment still suitable?
  • Have I decided what contingencies need to happen for me to sell the investment (i.e., a certain percentage decrease in value)?

What types of risks are involved in investing?

Nobody invests to lose money. However, investments always entail some degree of risk. Be aware that:

  1. The higher the expected rate of return, the greater the risk. Depending on market developments, you could lose some or all of your initial investment or a greater amount.
  2. Some investments cannot easily be sold or converted to cash. Check to see if there is any penalty or charge if you must sell an investment quickly or before its maturity date.
  3. Investments in securities issued by a company with little or no operating history or published information may involve greater risk.
  4. Securities investments, including mutual funds, are not federally insured against a loss in market value.
  5. Securities you own may be subject to tender offers, mergers, reorganizations, or third party actions that can affect the value of your ownership interest. Pay careful attention to public announcements and information sent to you about such transactions. They involve complex investment decisions. Be sure you fully understand the terms of any offer to exchange or sell your shares before you act. In some cases, such as partial or two-tier tender offers, failure to act can have detrimental effects on your investment.
  6. The past success of a particular investment is no guarantee of future performance.

What steps can I take to avoid unnecessary risks?

1. Never give in to high pressure. A high-pressure sales pitch can mean trouble. Be suspicious of anyone who tells you, “Invest quickly or you will miss out on a once in a lifetime opportunity.”

2. Never send money to purchase an investment based simply on a telephone sales pitch.

3. Never make a check out to a sales representative.

4. Never send checks to an address different from the business address of the brokerage firm or a designated address listed in the prospectus.

Tip: If your broker asks you to do any of these things, contact the branch manager or compliance officer of the brokerage firm.

5. Never allow your transaction confirmations and account statements to be delivered or mailed to your sales representative as a substitute for receiving them yourself. These documents are your official record of the date, time, amount, and price of each security purchased or sold. Verify that the information in these statements is correct.

What questions should I ask before making any investment?

Have this list of questions with you the next time you talk to your broker. Write down the answers you get and the action you decide to take. Your notes may come in handy later if there is a dispute or a problem. A good broker will be happy to answer your questions and will be impressed with your seriousness and professionalism.

  • Is this investment registered with the SEC and a state securities agency?
  • Does the investment match my investment goals?
  • How will the investment make money for me (dividends, interest, capital gains)?
  • What set of circumstances have to occur for the value of the investment to go up? To go down? (e.g., must interest rates rise?)
  • What fees do I have to pay to buy, maintain, and sell the investment? After fees, how much does the value have to increase by before I make a profit?
  • How easy is it for me to unload this investment in a hurry, should I need the money?
  • What are the specific risks associated with this investment, for example what is the risk that rising interest rates will devalue your investment or the risk that an economic recession could decrease its value?
  • Is the company experienced at what it is doing? How long has it been in business? What is their track record? Who are their competitors?
  • Can I get more information: a prospectus, the latest SEC filings, or the latest annual report?

What questions should I ask before making a mutual fund investment?

Here is a list of potential questions to ask before making a mutual fund investment:

  • How has the fund performed over the long run? Where can I get an independent evaluation of it?
  • What specific risks are associated with it?
  • What type of securities does the fund hold?
  • How often does the portfolio change?
  • Does this fund invest in derivatives, or in any other type of investment that could cause rapid changes in the NAV (Net Asset Value)?
  • How does the fund’s performance compare to other funds of its type, or to an index of similar investments?
  • How much of a fee will I have to pay to buy shares? To maintain shares?
  • How often will I get statements? Can you explain what the statement tells me about the investment?

What investment hazards should I look out for?

There are no magic formulas for successful investing. It takes a disciplined, reasoned approach, a commitment to follow some basic, solid rules that have proved effective over time, and to stay in it for the long haul.

Here are some specific tips.

Don’t Let Greed Cloud Your Better Judgment. A disciplined approach, taking into account your investment objectives, will pay dividends in more ways than one. Investors who are constantly chasing the jackpot usually lose in the long run.

Don’t Rely on Tips. The “hot tip” is the bane of investors. There may be short-term gain in some cases, but in this regard, it’s generally wise to follow the maxim, “What goes up must come down.”

Be Resolute. Develop a comprehensive, reasoned plan with your adviser, and stick to it, despite the temptation to “take a flyer.” When you have developed your plan, and in the absence of other factors, follow it.

Consider All Your Needs and Get a Plan That Fits. For financial planning to be truly effective, all your needs must be considered: money management, tax planning, retirement planning, estate planning, insurance, etc.

Evaluate Investments Periodically. An investment program is not static and unchanging. Your financial situation and objectives may change, as does the economic situation. Review your plan with your adviser and, if necessary, update it to reflect your current and long-term needs.

Monitor your investments. Stay informed. Don’t rely on others to “take care of” your portfolio. Keep up with your reading, whether in newsletters, magazines, or the internet.

Read Broker-Account Forms With Care. Many investors pay scant attention to the forms involved in opening and maintaining a brokerage account. As pointed out earlier, many investors are not aware that much of the paperwork is intended, at least in part, to protect the broker and the form against any complaints they might bring.

What should I invest my IRA in?

Like any other investment, you should match the portfolio with your desired return, risk tolerance and investment time horizon. The higher your desired return and risk tolerance and the longer your time horizon, the greater the portion of your portfolio should be in equity investments such as common stocks. Since IRAs are generally long-term investments, equity investments are generally appropriate for a portion of the account.

For those with a lower risk tolerance, short-term fixed income investment would be appropriate. Many people have their IRAs invested in CDs. This is appropriate only for those with a very short time horizon or very low-risk tolerance. IRA money, like any other investment, should be invested in something that will provide a decent return.

Municipal bonds should never be used within an IRA. In doing so, you sacrifice return and may convert otherwise tax-free income to taxable income when you withdraw the funds.

What are derivatives and options?

A derivative is an investment instrument whose value is based on underlying assets such as stocks, bonds, commodities, currencies, interest rates and market indexes. Options are one of the most common types of derivatives and are a useful tool for enhancing a portfolio’s income and in many cases, reducing risk. Other types of derivatives include futures contracts, forward contracts, and swaps, but these are more appropriate for sophisticated investors.

Stock options are contracts that give the purchaser the right to buy or sell at a specific price and within a certain period of time, for instance, 100 shares of corporate stock (known as the underlying security). These options are traded on a number of stock exchanges and on the Chicago Board Options Exchange.

When investors buy an option contract, they pay a premium, typically the price of the option as well as a commission on the trade. If they buy a “call” option, they are speculating that the price of the underlying security will rise before the option period expires. If they buy a “put” option, they are speculating that the price will fall.

Tip: While options trading can be very useful as part of an overall investment strategy, it can also be very complicated and sometimes extremely risky. If you plan to trade in options, make sure that you understand basic options strategy and that your registered representative is qualified in this area.

How can I avoid the most frequent money-losing mistakes?

Here are the top mistakes that cause investors to lose money unnecessarily.

  • Using a cookie-cutter approach
  • Taking unnecessary risks
  • Allowing fees and commissions to eat up profits
  • Not starting early enough
  • Ignoring the costs of taxes
  • Letting emotion govern your investing

Q: Should I use a standard asset allocation formula such as those seen in many popular finance magazines?

A: Most investors are satisfied with a one-size-fits-all investment plan. However, your individual needs as an investor must govern any plans you make. For instance, how much of your investment can you risk losing? What is your investment timetable? (i.e., are you retired or a young professional?) The allocation of your portfolio’s assets among various types of investments should match your particular needs.

Q: Can I make a decent return without taking unnecessary risks?

A: You do not have to risk your capital to make a decent return on your money. While all investments have some degree or risk, many investments that offer a return that beats inflation without unduly jeopardizing your hard-earned money. For instance, Treasuries are one of the safest possible investments and offer a decent return with very little risk.

Q: What is the downside of high fees and commissions?

A: Many investors allow brokers’ commissions, fees, and other costs to cut into their returns. Be aware of the fees you are paying and make sure they are appropriate for the services you are receiving. The more you pay in fees the lower your net return will be.

Q: When should I start investing?

A: Today. Many investors are not cognizant of the power of interest compounding. By starting out early enough with your investment plan, you can invest less, and in the long run, still come out ahead of where you would be if you start later in life.

Q: What is the impact of taxes on my investment returns?

A: Net profits on your share of your mutual funds’ stock sales are taxable to you as capital gains. Unless you are in a tax-deferred retirement account, the taxes will eat into your profits. The solution? Invest in funds where shares are bought and sold less frequently and have a low turnover rate (10 percent or less per year).

Q: Should I let my emotions affect my investments?

A: Never give in to pressure from a broker to invest in a “hot” security or to sell a fund and get into another one. The key to a successful portfolio lies in planning, discipline, and reason. Emotion and impulse have no role to play. Try to stay in a security or fund for the long haul. On the other hand, when it’s time to unload a loser, then let go of it. Finally, do not fall prey to the myth of “market timing.” This is the belief that by getting into or out of a security at exactly the right moment, we can retire rich. Market timing does not work.

Instead, use investment strategies that do work: a balanced allocation of your portfolio’s assets among securities that suit your individual needs, the use of dollar-cost averaging and dividend-reinvestment programs, and a well-disciplined, long-haul approach to saving and investment.

What is the difference between my cumulative return and annualized return?

Suppose Mr. N. Vestor invests $100 in an investment that earns 10 percent this year and 10 percent the next year. What is his cumulative return? The answer is 21 percent.

Here’s why. N. Vestor’s 10 percent gain makes his $100 grow to $110. Next year, he earns another 10 percent, leaving him with $121. His investment has earned a cumulative 21 percent return over two years. His annualized return, however, is 10 percent.

The fact that the cumulative return of 21 percent is greater than twice the 10 percent annual return is due to the effect of compounding, which means that your yearly earnings are added to your original investment before the current year’s earnings are applied.

What is the rule of 72?

The rule of 72 is a way of finding out long it will take for your investment to double. Divide an investment’s annual return into 72, and you will have the number of years necessary to double your investment.

Example: An investment’s annual return is 10 percent. Ten percent divided into 72 is 7.2, so your investment will double in 7.2 year.

What is “Total Return” and why is it important?

If you reinvest all of your gains, including dividends and interest, you will be getting the most from compounding. The percentage you achieve is termed “total return.” It includes appreciation, interest and dividends. It is particularly important in examining the past and current performance of mutual funds.

Mutual funds must, by law, distribute almost all of their capital gain and dividend income each year. Many investors reinvest these distributions, using them to buy more fund shares. Because the fund’s share price is reduced after a fund makes a distribution, the long-term price trend of a fund’s shares may not accurately reflect the fund’s performance. However, the fund’s total return, which takes into account reinvested dividends, is often a more accurate reflector of the fund’s performance.

How does “yield” differ from “total return?”

Yield is the amount of dividends or interest paid annually by an investment. The yield is usually expressed as a percentage of the investment’s current price. It does not consider appreciation.

Because certificates of deposit and money-market funds maintain the same value, their total return does not differ much from their yield. But because stocks and bonds fluctuate in price, there can be a large difference between yield and total return.

Can I measure my return as the increase in the value of my portfolio over a given period?

Investors often take the following shortcut, which often yields misleading results. Instead of looking at total return, they simply compare their year-end portfolio value with the value at the beginning of the year, and attribute the entire growth to investment gains.

The reason this shortcut may be misleading is that any additional investments or withdrawals made during the year are not taken into account.

How should I take distributions from my retirement plan?

If your assets are in a tax-favored retirement fund such as a company or Keogh pension or profit-sharing plan (including thrift and savings plans), 401(k), IRA or stock bonus plan, when it comes time to take distributions you have several options:

  • Take everything in a lump sum
  • Keep the money in the account, with regular distributions or withdrawals on an as-needed basis
  • Purchase an annuity with all or part of the funds
  • Take a partial withdrawal (leaving the balance for withdrawal later)
  • Take a rollover distribution
  • A combination of any of the above

Your retirement assets may be distributed in kind-as employer stock, or an annuity or insurance contract. Sometimes certain withdrawal options may be associated with certain retirement plans, for instance, annuities are more common with pension plans. Other types of plan favor the other options, but for the most part most of these options are available for most plans. And more than likely, you’ll want to preserve the tax shelter as long as possible by withdrawing no more than you need at any given time.

Timing your withdrawal can be a factor, too. Withdrawals before age 59 ½ risk a tax penalty. At the other end, withdrawals are generally required to start at age 70 ½ or face a tax penalty. The only exceptions are Roth IRAs and non-owner-employees still working beyond that age.

When is it best to take a lump-sum distribution from my retirement plan?

Your personal needs should decide. You may need a lump sum to buy a retirement home or retirement business. If your employer requires that you take a lump sum distribution, it may be wise to roll it over into an IRA.

What should I do about my retirement plan assets in my ex-employer’s plan if I change jobs?

There are several things you might do depending upon your needs:

  1. If you don’t need the assets to live on, try to continue the tax shelter and leave the money where it is.
  2. Transfer or roll over the assets into your new employer’s plan–if that plan allows it (this can be tricky, though).
  3. If you’ve decided to start your own business, set up a Keogh and move the funds there.
  4. Roll them over into your IRA.

Can creditors get at my retirement assets?

In general, employer plans such as your 401(k), IRAs and pension plan funds are protected from general creditors unless you’ve used these assets as securities against a loan or you are entering into bankruptcy. If this is the case, there’s a chance they could be seized, but if the money is in a registered IRA, pension plan, or 401(k), it’s more than likely they will be protected in case of bankruptcy (subject to state and federal law of course).

How will my state tax affect my retirement withdrawals?

Each state is different, but in general, consider the following:

  1. While withdrawals are generally taxable in states with income tax, some offer relief for retirement income, up to a specified dollar amount.
  2. If your state doesn’t allow deductions for Keogh or IRA investments allowed under federal law, these investments and sometimes more may come back tax-free.
  3. State tax penalties for early withdrawal (before 59 ½) or inadequate withdrawal (after age 70 ½) are unlikely.

Can moving to another state when I retire save me state taxes on my retirement plan?

Money from retirement plans, including 401(k)s, IRAs, company pensions and other plans, is taxed according to your residence when you receive it.

If you move from a state with a high income tax, such as New York, to one with little or no income tax (Texas, Nevada and Florida have none), you will indeed save money on state income tax.

However, establishing residence in a new state may take as long as one year; if you retain property in both states, you may owe taxes to both.

Will my heirs owe income taxes when they inherit my retirement assets?

Yes, generally under the same rules that would apply to your withdrawals of the same amounts had you lived–unless it’s a Roth IRA. A Roth IRA is exempt from federal income tax as long as the account was opened five years before any withdrawals were taken.

Also, your spouse can rollover your account to his or her IRA. No early withdrawal penalty applies, regardless of your beneficiary’s age, but a spouse who rolled over to an IRA may owe an early withdrawal penalty on IRA withdrawals taken before age 59 ½.

Will my heirs owe estate taxes on inherited retirement assets?

Only a small percentage of estates (based on the value of one’s assets at death, and including large lifetime gifts) are subject to the estate tax and there is no estate tax on assets passing to a surviving spouse or charity. However, if the estate is subject to federal estate tax, (except in 2010, when there was no estate tax) you can deduct the portion of the federal estate tax that is attributed to the IRA. You also won’t have to pay tax on the portion of withdrawals that are attributed to any nondeductible contributions made to the IRA.

Is estate tax deferred if my heir will get an annuity?

No. The estate is taxed on the annuity’s present value.

How can I minimize or eliminate tax on inherited retirement assets?

You can minimize or eliminate tax on inherited retirement assets by using the following methods:

  1. Leave them to your spouse. This saves money owed to estate tax and helps postpone withdrawals subject to income tax–provided your spouse takes no withdrawals before age 59 ½.
  2. Leave them to charity. Although there’s no financial benefit to the family, again, this saves income and estate taxes.
  3. Leave them to family for life, with the remainder to charity in the form of a charitable remainder trust. This reduces estate tax with some benefits to family.
  4. Provide life insurance to pay estate tax on retirement assets. The benefit of this option is that it provides estate liquidity, avoiding taxable distributions to pay estate tax.

How should I take distributions from my retirement plan?

If your assets are in a tax-favored retirement fund such as a company or Keogh pension or profit-sharing plan (including thrift and savings plans), 401(k), IRA or stock bonus plan when it comes time to take distributions you have several options:

  • Take everything in a lump sum
  • Keep the money in the account, with regular distributions or withdrawals on an as-needed basis
  • Purchase an annuity with all or part of the funds
  • Take a partial withdrawal (leaving the balance for withdrawal later)
  • Take a rollover distribution
  • A combination of any of the above

Your retirement assets may be distributed in kind as employer stock, or an annuity or insurance contract. Sometimes certain withdrawal options may be associated with certain retirement plans, for instance, annuities are more common with pension plans. Other types of plan favor the other options, but for the most part most of these options are available for most plans. And more than likely, you’ll want to preserve the tax shelter as long as possible by withdrawing no more than you need at any given time.

Timing your withdrawal can be a factor, too. Withdrawals before age 59 ½ risk a tax penalty. At the other end, withdrawals are generally required to start at age 70 ½ or face a tax penalty. The only exceptions are Roth IRAs and non-owner-employees still working beyond that age.

When is it best to take a lump-sum distribution from my retirement plan?

Your personal needs should decide. You may need a lump sum to buy a retirement home or retirement business. If your employer requires that you take a lump sum distribution, it may be wise to roll it over into an IRA.

What should I do about my retirement plan assets in my ex-employer’s plan if I change jobs?

There are several things you might do depending upon your needs:

  1. If you don’t need the assets to live on, try to continue the tax shelter and leave the money where it is.
  2. Transfer or roll over the assets into your new employer’s plan–if that plan allows it (this can be tricky, though).
  3. If you’ve decided to start your own business, set up a Keogh and move the funds there.
  4. Roll them over into your IRA.

Can creditors get at my retirement assets?

In general, employer plans such as your 401(k), IRAs and pension plan funds are protected from general creditors unless you’ve used these assets as securities against a loan or you are entering into bankruptcy. If this is the case, there’s a chance they could be seized, but if the money is in a registered IRA, pension plan, or 401(k), it’s more than likely they will be protected in case of bankruptcy (subject to state and federal law of course).

How will my state tax affect my retirement withdrawals?

Each state is different, but in general, consider the following:

  1. While withdrawals are generally taxable in states with income tax, some offer relief for retirement income, up to a specified dollar amount.
  2. If your state doesn’t allow deductions for Keogh or IRA investments allowed under federal law, these investments and sometimes more may come back tax-free.
  3. State tax penalties for early withdrawal (before 59 ½) or inadequate withdrawal (after age 70 ½) are unlikely.

I understand that I’m required to take money out of my retirement plan after I reach age 70 1/2. Why is that?

Retirement plans offer the biggest tax shelter in the federal system since funds grow tax-free while in the plan. But the shelter is primarily intended for retirement. So when you reach 70 1/2 (or shortly thereafter), you must start to withdraw from the plan.

How can I continue the tax shelter for retirement plan assets after age 70 1/2?

The shelter can continue for a large part of those assets, for a long time, assuming you don’t need them to live on. You can spread withdrawals over a period based on, but longer than, your life expectancy, for example, over a period of at least 27.4 years if you’re 70 1/2 now. You are free, however, to withdraw at a faster rate–or even all of it–if you wish. The shelter continues for whatever is not withdrawn.

Suppose there are still retirement assets in my account at my death. Can the shelter continue for those who receive those assets?

Generally, yes. Persons you have named as your plan beneficiaries can withdraw over their life expectancies (or more rapidly if they wish). The withdrawal period is generally shorter where no individual beneficiary is named (for example, where your estate is the beneficiary), but your spouse can sometimes spread withdrawals over a longer period.

Can moving to another state when I retire save me state taxes on my retirement plan?

Money from retirement plans, including 401(k)s, IRAs, company pensions and other plans, is taxed according to your residence when you receive it.

If you move from a state with a high income tax, such as New York, to one with little or no income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming have none), you will indeed save money on state income tax.

However, establishing residence in a new state may take as long as one year; if you retain property in both states, you may owe taxes to both.

What is a reverse mortgage?

A reverse mortgage is a type of home equity loan that allows you to convert some of the equity in your home into cash while you retain home ownership. Reverse mortgages work much like traditional mortgages, only in reverse. Rather than making a payment to your lender each month, the lender pays you. Most reverse mortgages do not require any repayment of principal, interest, or servicing fees for as long as you live in your home.

Retired people may want to consider the reverse mortgage as a way to generate cash flow. A reverse mortgage allows homeowners age 62 and over to remain in their homes while using their built-up equity for any purpose: to make repairs, keep up with property taxes or simply pay their bills.

Reverse mortgages are rising-debt loans, which means that the interest is added to the principal loan balance each month (because it is not paid on a current basis). Therefore, the total amount of interest you owe increases significantly with time as the interest compounds. Reverse mortgages also use up some or all of the equity in your home.

All three types of loan plans, whether FHA-insured, lender-insured, or uninsured charge origination fees and closing costs. Insured plans also charge insurance premiums, and some impose mortgage servicing charges.

Finally, homeowners should realize that if they’re forced to move soon after taking the mortgage (because of illness, for example), they’ll almost certainly end up with a great deal less equity to live on than if they had simply sold the house outright. That is particularly true for loans that are terminated in five years or less.

Should I purchase my own disability insurance policy?

Many of us have life insurance, however very few of us have long-term disability coverage. Yet according to statistics, workers are more likely to sustain a long-term disability (one lasting longer than 90 days) than die at an early age.

Long-term disability insurance is fairly expensive, and people tend to think that they will be protected by workers’ compensation or other sources. However, Social Security, workers’ compensation, and employer-offered long-term coverage are often inadequate.

How much disability insurance should I have?

A disability insurance company will usually not cover you for more than 60 percent of your income. Look for a policy that provides coverage for this level. When you shop for a disability policy, be ready to prove your income level. If you purchase the policy and pay the premiums yourself, the income received will not be taxable. Therefore, 60 percent should come close to replacing your after-tax income.

What does workers compensation insurance cover?

Worker’s compensation covers injuries that happen on the job. Benefits vary widely from state to state but typically are equivalent to 66.67 percent of the average weekly wage for the previous 52 weeks. In addition, most states pay benefits for the employee’s lifetime in cases of permanent total disability.

Tip: To get details on worker’s comp benefits, contact your state Department of Labor.

In addition to the requirement that an injury is work-related, the payments you would receive under worker’s comp may be inadequate.

How is disability defined?

The definition of disability in a policy is extremely important. It tells you under what circumstances you will qualify to receive benefits.

Own-occupation coverage pays benefits if you can’t work in your chosen field–if you are an attorney or teacher, for example. Own-occupation policies are the most expensive type of disability coverage because they provide the broadest coverage. Generally, if you cannot perform the duties of your own occupation, you can take a job in a related field, make a decent income, and still collect the benefits.

Any-occupation coverage pays benefits if you can’t work at any occupation for which your education level and training has prepared you. Therefore, if you can no longer perform the duties of a nuclear physicist, but you can teach physics at college level, you will not receive benefits.

Note: Many policies are own-occupation for a period of years, at which point they convert to any-occupation.

How does long-term care insurance work?

By 2020, 12 million older Americans will need long-term care. Most will be cared for at home; family and friends are the sole caregivers for 70 percent of the elderly. A study by the U.S. Department of Health and Human Services says that people who reach age 65 will likely have a 40 percent chance of entering a nursing home. About 10 percent of the people who enter a nursing home will stay there five years or more.

Your chances of needing long-term care vary with your age, health, family history and longevity, exercise habits, diet, smoking, and gender; however, women are often at higher risk simply because they live longer.

Long-term care insurance policies pay a set dollar amount per day for covered care during the benefit period stated in the policy.

Example: You choose a policy that pays $160 per day for five years. The maximum that policy will pay is $292,000 ($160 per day, times 365 days, times 5 years).

The older the individual covered, the higher the premium is. For instance, premiums for a set amount of coverage on a 70-year-old individual are about three times those that would apply to a 50-year-old.

Most long-term care policies are indemnity-type policies, meaning they will pay (up to the policy’s limits) for actual charges by the care provider. Some long-term care policies, instead of being based on indemnity, pay daily benefit amounts to the insured rather than paying for actual charges. The latter type of policy offers insureds greater flexibility (e.g., allowing them to pay for home care) and less paperwork.

In a long-term care policy, what is the elimination period?

This period constitutes the number of days the insured must wait after becoming eligible for benefits before coverage actually begins.

The elimination period can range from zero to 90 days, or up to one year. The longer the elimination period, the lower the premium is.

How should I select a long-term care insurance provider?

If you decide that long-term care insurance (LTCI) is your best option, it is important to shop around for the right company. Some states have enacted important consumer protections in the LTCI area, while others have not. Do not assume the company is a safe bet just because it is licensed by the state insurance department to sell LTCI.

No matter how good a policy sounds, it is worth little if the company won’t be there when it comes time to pay. Buy from a company with strong financial reserves. Unfortunately, there is no foolproof method for determining which companies are financially strong. However, it pays to look up a company’s rating by A.M. Best or Standard and Poor’s, both of which evaluate the financial health of insurance companies.

Tip: Purchase long-term care insurance from a company that has an A+ or A++ rating from Best or an A, AA, or AAA rating from Standard and Poor’s. Most public libraries have these references.

When can I qualify for Medicaid insurance?

Eligibility rules vary from state to state, but beneficiaries are generally required to “spend down” their income and assets to qualify. New laws in many states make it possible for the spouses of Medicaid nursing home residents to keep more income and assets than previously allowed.

By law, nursing homes cannot discriminate against Medicaid patients, but in reality, many keep “waiting lists” for them while enrolling patients with more income and assets. Medicaid coverage for home care is very limited in most states.

Should I buy long-term care insurance?

Long term care insurance (LTCI) is both complex and controversial. It covers certain nursing home costs and sometimes home health care. Here is a summary of some of the main points for and against purchasing such coverage.

Reasons Against:

  • Inability to afford the premiums, or not having enough assets to protect. In such case, the individual will quickly qualify for Medicaid.
  • Some LTCI policies lack sufficient home care coverage to keep an individual out of a nursing home unless family members or informal caregivers are available to help in providing care. Thus, if your goal is to avoid nursing homes at all costs, LTCI may not be the best way to go.
  • LTCI policies return from 60 percent to 65 percent of total premiums paid in benefits. This is much less than returns from other types of health insurance.
  • The fact that LTCI policies are improving: In a few years, you may be able to get a better deal.

Reasons For:

  • LTCI, although expensive, may provide protection against costly care. While the premiums may be wasted if you never need long-term care, if you do need the care the insurance can effectively pay back your premiums many times over.
  • If you have family caregivers, the extra home care coverage in LTCI might make it possible to remain at home longer.
  • LTCI premium costs increase with age. Once you develop a serious medical condition, you probably won’t qualify for coverage. Thus, it is better to buy LTCI early in the game if at all.

Some Guidelines

Do not buy long term care insurance unless all of the following apply to you:

  • Each person in the household has more than $75,000 in assets (not counting the value of the primary residence)
  • Your annual retirement income per person in the household is over $30,000
  • You can pay premiums without having to “go without”
  • You could continue to afford the premiums, even if they increased by 20 percent or 30 percent in the future

What are the alternatives to long-term care insurance?

Here are some options for paying for long-term care, along with their advantages and drawbacks:

Applying For Medicaid

Eligibility rules vary from state to state, but beneficiaries are generally required to “spend down” their income and assets to qualify. New laws in many states make it possible for the spouses of Medicaid nursing home residents to keep more income and assets than previously allowed.

Reverse Mortgage, Equity Conversion

Reverse mortgages and other forms of home equity conversion are often viable alternatives for those who wish to remain at home. Seniors borrow money against the equity in their homes and defer repayment until they die or sell their house. However, for these options to make sense, a home must have a high monetary value and be fully or mostly paid for, and the individual must intend to stay in the home for the long term.

Self Insurance

Self-insurance–paying for costs if they arise–is a gamble but is the current strategy of choice for the majority. Self-insurance makes the most sense for people with major assets; for those who can afford a long nursing home stay and; for people of modest means, who would quickly qualify for Medicaid anyway.

How much does long-term care insurance cost?

Premiums for LTCI vary greatly, depending on your age at the time of purchase, the comprehensiveness of the coverage, and the company selling the plan.

According to a 2015 report published by the American Association for Long-Term Care Insurance, a 60-year-old married couple would pay $2,170-per-year combined for a total of $328,000 of long-term care insurance coverage.

A 55-year-old single male purchasing new long-term care insurance protection can expect to pay $1,060-per-year for $164,000 of benefits according to an industry report and pay $1,765 for coverage that increases the benefit pool to $365,000 at age 85.

A 55-year-old single woman would pay an average of $1,390-per-year for the same level of benefits available to a single man for $1,060.

But, no matter how good a policy sounds, it’s worth little if the company won’t be there when it comes time to pay, so you should always buy from a company with strong financial reserves. Unfortunately, there is no foolproof method for determining which companies are financially strong. However, it pays to look up company’s rating by M. Best or Standard and Poor’s, both of which evaluate the financial health of insurance companies.

Tip: Purchase long-term care insurance from a company that has an A+ or A++ rating from Best or an A, AA, or AAA rating from Standard and Poor’s. Most public libraries have these references.

What should I look for in a long-term care insurance policy?

When you compare long term care insurance policies, consider the following:

Flexibility. A policy that covers nursing homes should also cover assisted living, a better alternative for many people who can no longer live on their own. If you want a policy with home care, look for one that offers a full range of community-based services, including adult day care, or that pays you a monthly cash allowance to spend as you please for care.

Eligibility. Look for a policy that bases eligibility on the need for help with activities of daily living. Policies that only pay for “medically necessary” care are not usually a good buy. To be sure you are covered for Alzheimer’s disease, choose a policy that covers cognitive as well as physical disability and pays benefits if you meet either criterion.

Inflation. If you purchase a policy before the age of 75, inflation protection is essential to ensure adequate coverage when you need long-term care at some point in the future. Buy a policy that has an additional cost but automatically increases benefits at the rate of 5 percent annually.

Duration. Keep in mind that the chances of needing long-term care for five years or longer are relatively small. For most people, a policy covering two or three years will be more cost-effective.

Do I need long-term care insurance?

Experts estimate that about 43 percent of us will spend some time in a nursing home at some point. But the risk of needing nursing home care before age 75 is relatively low. Also, most people will not need nursing home care for longer than a year.

Your chances of needing long-term care vary with your age, health, family history and longevity, exercise habits, diet, smoking, and gender. Women are at higher risk because they live longer.

How does long-term care insurance work?

Long-term care insurance policies pay a set dollar amount per day for covered care during the benefit period stated in the policy.

Example: You choose a policy that pays $160 per day for five years. The maximum that policy will pay is $292,000 ($160 per day, times 365 days, times 5 years).

The older the individual covered, the higher the premium. For instance, premiums for a set amount of coverage on a 70-year-old individual are about three times those that would apply to a 50-year-old.

Most long-term care policies are indemnity-type policies, meaning they will pay (up to the policy’s limits) for actual charges by the care provider. Some long-term care policies, instead of being based on indemnity, pay daily benefit amounts to the insured rather than paying for actual charges. The latter type of policy offers insureds greater flexibility, allowing them to pay for home care for example, and less paperwork.

In a long-term care policy, what is the elimination period?

This period constitutes the number of days the insured must wait after becoming eligible for benefits before coverage actually begins. The elimination period can range from zero to 90 days, or up to one year. The longer the elimination period, the lower the premium is.

How should I select a long-term care insurance provider?

If you decide that long-term care insurance (LTCI) is your best option, it is important to shop around for the right company. Some states have enacted important consumer protections in the LTCI area, while others have not. Do not assume the company is a safe bet just because it is licensed by the state insurance department to sell LTCI.

No matter how good a policy sounds, it is worth little if the company won’t be there when it comes time to pay. Buy from a company with strong financial reserves. Unfortunately, there is no foolproof method for determining which companies are financially strong. However, it pays to look up a company’s rating by A.M. Best or Standard and Poor’s, both of which evaluate the financial health of insurance companies.

Tip: Purchase long-term care insurance from a company that has an A+ or A++ rating from Best or an A, AA, or AAA rating from Standard and Poor’s. Most public libraries have these references.

Should I comparison shop for long-term care insurance coverage?

Seek independent advice before buying. You might find such guidance from a financial advisor; an elder-law attorney; government-funded counseling and information services; or consumer organizations.

Tip: Use a local independent agent or broker who has been recommended by someone reliable. Don’t buy from an agent who sells door-to-door.

Read the policy from cover to cover; don’t rely on marketing literature.

Don’t be pressured to buy the first policy you see. Compare it with at least two others.

Tip: Don’t pay more than one month’s premium when you apply for coverage. In most states, after you buy a policy, you have thirty days to change your mind and get a refund.

Is it worthwhile buying special types of health insurance?

You may receive solicitations in the mail for the following types of health insurance, or you may run across ads for them. They are to be avoided at all costs.

Note: We realize that there are worthwhile policies out there that fall into the categories we talk about. But we bring your attention to these categories so that you will be wary of them, and will not buy without careful research.

  • Dread-Disease Insurance. This limited coverage insures against only one specific disease. Further, if you already have this disease (i.e., have been diagnosed) at the time you buy the policy, you’re not covered.
  • Hospital Indemnity Insurance. “Indemnity” insurance means that the policy will pay (up to the policy’s limits) for actual charges by the care provider, as opposed to paying daily benefit amounts to the insured regardless of actual charges. The typical “hospital indemnity” policy will provide a very small amount of coverage per day, and is not worth it.
  • Medical-Surgical Insurance. This type of coverage also provides limited payments, and only for specified procedures.
  • Insurance Sold Through the Mail and On Television. Many policies sold through television advertisements and mail solicitations have the following negative attributes: They tend to cover accidents but not illness; they start out with low premiums that later rise unreasonably; they deny claims more than other types of insurance; and they tend to exclude pre-existing conditions.

Do I need disability insurance? How can I ensure I have adequate coverage?

If you have dependents, you’ve probably made sure that you have adequate life insurance coverage. But what about disability coverage? Although the incidence of permanent or temporary disability during the average individual’s prime earning years is fairly high, many people neglect to insure adequately against this risk.

Disability insurance generally provides you with an income stream in case you are unable to earn income due to illness or accident. Here are some questions that will get you started in making sure you have adequate coverage.

  • What does your employer provide? Find out what types (if any) of disability coverage are provided. If no coverage is provided, you may be able to purchase coverage through your employer.
  • Is the employer or state-provided coverage adequate? Find out how much you will receive under any existing coverage you have. If the amount you will receive is not enough to support your family during an illness or other disability, you may wish to supplement it.

If employer and government coverage is insufficient you should purchase a private disability policy.

Before you buy a disability policy, check out the following factors:

  1. Make sure the policy can be renewed every year.
  2. Make sure that if you are able to work part-time when disabled, you will still receive benefits.
  3. Choose as policy with a three to six-month waiting period, since it will be less costly, and set aside an emergency fund to cover the waiting period.
  4. Be sure the policy covers you until you reach age 65, at which time you can obtain full Social Security benefits.
  5. Be sure the policy pays when you can’t perform work in your own field.

When should I use a rollover to my IRA?

That depends on your particular needs and circumstances. Here are some reasons you might want to roll over distributions to your IRA:

  1. You want to, or have to, take a distribution from your employer’s plan and want these funds to continue to grow tax-free in your own IRA.
  2. As a self-employed, you are terminating your Keogh plan or retiring from business and want to continue the tax shelter for these distributions.
  3. You are the beneficiary of a deceased person’s retirement plan and want to continue the tax shelter for these distributions in your own IRA.

Is there a downside to an IRA rollover?

Here are some of the disadvantages of an IRA rollover:

  1. Rollovers from company or Keogh plans may take away your spouse’s right to share in plan assets.
  2. IRAs can’t claim the limited tax relief allowed on lump-sum distributions.

Tip: To avoid tax hassles, rollovers should be done between the trustees of the plans involved. In other words, the check should not be made out to you personally, but to the trustee of the rollover account.

What’s good about investing in IRAs?

There are two types of IRAs, Traditional IRAs and Roth IRAs, both of which are discussed in this Financial Guide. Traditional IRAs defer taxation of investment income and withdrawals are taxable income–except for withdrawals of previously non-deductible contributions. In most cases, however, contributions are deductible. Roth IRAs are subject to many of the same rules as Traditional IRAs, but there are several differences, the primary one being that contributions are not deductible and are made after tax. As such, qualified distributions are generally tax-free.

Can anyone have a traditional IRA?

If you have income from wages or self-employment income, you can contribute up to $5,500 in 2016 (same as 2015). As such, IRAs are available even to children who meet these conditions. Persons age 50 and older can contribute an additional $1,000 for a total of $6,500 in 2016.

Can my homemaker spouse have an IRA?

Yes. Contributions of $5,500 for each spouse are allowed in 2016 (same as 2015) if the couple’s wages or self-employment earnings are $11,000 or more.

What makes Roth IRAs so special?

Roth IRAs offer the following advantages:

  • Withdrawals, if they qualify, are completely exempt from income tax, unlike all other retirement plans.
  • You can quickly build up a Roth IRA account by converting traditional IRAs into Roth IRAs, but there is a tax cost.
  • Since there is no age requirement for withdrawals from a Roth IRA, more money can be left in an account and passed on to heirs than is allowed under other plans.

Can anyone have a Roth IRA?

Not everyone can have a Roth IRA. The following conditions apply:

  • You can’t contribute to a Roth IRA for a year with income (AGI) above $132,000 if single or $194,000 on a joint return in 2016 ($131,000 and $193,000, respectively, in 2015).
  • You must have earnings from personal services (at least $5,500 or more) to make the (maximum) contribution, although an additional contribution of $1,000 is allowed for persons age 50 and over.

Can I set up a Roth IRA for my spouse?

Yes, subject to the income conditions above. This allows contributions of $5,500 each if the couple’s earnings are at least $11,000 in 2016 ($12,000 if only one of you is age 50 or older or $13,000 if both of you are age 50 or older).

Can I set up a Roth IRA for my child?

Yes, for a child with personal service earnings, and subject to the other income conditions.

What’s the downside to Roth IRAs?

The following is a brief list of negative issues regarding Roth IRAs:

  • Roth IRA contributions are not tax deductible. There’s never a deduction for Roth IRA contributions.
  • To build a sizable Roth IRA fund, you must convert a traditional IRA (or, after 2007, funds from an employer plan). Conversions are taxable.

There is no longer an income limit for taxpayers who want to convert a traditional IRA to a Roth IRA as was the case prior to 2010. Starting in 2010, however, all taxpayers were able to convert a regular IRA to a Roth IRA without regard for income. The conversion was a taxable distribution which could be taken into income in 2010 or averaged over the next two years (until 2012). The conversion was not subject to the 10 percent early distribution penalty. Congress passed the removal of the $100,000 MAGI ceiling under unusual circumstances.

In 2011 however, the rules changed again and taxpayers who converted to Roth IRAs must pay taxes on the conversion income at that time instead of deferring it in later years as was the case in 2010. In other words, you must include in your gross income distributions from a traditional IRA the amount that you would have had to include in income if you had not converted them into a Roth IRA. These amounts are normally included in income on your return for the year that you converted them from a traditional IRA to a Roth IRA. Special rules apply for conversions made in tax year 2010.

What can I do if I converted to a Roth IRA and my income exceeds $100,000?

The income limit was permanently removed starting in 2010. Anyone, even those with high incomes, can convert from a traditional IRA to a Roth IRA.

What if my Roth IRA assets fall in value after conversion?

When you convert from a traditional IRA to a Roth IRA you pay taxes on the value of your account as of the conversion date. If your account loses value and the account is worth less money you’ll end up paying taxes on money you no longer have in your account. Fortunately, the IRS lets you “re-characterize” the account back to a traditional IRA, essentially putting you right back where you were—at least tax wise.

Say you convert $50,000 in a traditional IRA to a Roth IRA and the value drops to $35,000. If you didn’t make any nondeductible contributions, the taxable distribution would be $50,000 and that would be the amount you would be paying taxes on. However, now your account is only worth $35,000. By re-characterizing the account you can avoid paying taxes on money you no longer have ($50,000). You’ll be back to a traditional IRA, but of course, the account is now worth only $35,000.

How are my heirs taxed on inherited Roth IRA wealth?

Your heirs are taxed as follows:

  • No income tax whatever, if the funds have been in the Roth IRA at least five years.
  • The heir can spread the withdrawal over his or her life, continuing the tax shelter for amounts not withdrawn.
  • Estate tax treatment is the same as for traditional IRAs.

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