Chapter 12
Retirement Planning
The thing I should wish to obtain from money would be leisure with security.
—Bertrand Russell
This chapter discusses retirement planning issues that are important to people with health concerns. If you have one, you should understand certain essential features about your employer-sponsored retirement plan, not only so you can understand your benefits and rights under the plan, but also so you can compare your employer’s plans to other retirement plans for which you may be eligible. A retirement plan (also known as a pension plan) is a separate entity into which money is placed to be invested until withdrawal upon becoming disabled, reaching a certain age, retiring, or other specific events.
Section 1. Why Plan for Retirement?
Although you are confronted with a life-challenging condition, you should still plan for your retirement and put as much money into pension plans as you can spare because
• you can deduct the contribution to the plan from your current higher tax bracket, postponing the tax until you are in a lower bracket due to disability, decreased income, or retirement.
• if you become disabled, you can access the funds in the retirement account without the penalty that usually accompanies early withdrawal of these funds.
• retirement assets can serve as a contingency fund that can be converted to current income as needed.
• retirement assets can serve as a legacy to your heirs.
• your condition may go into remission, you may outlive your diagnosis into retirement, or you could be cured.
• retirement assets are protected from creditors.
As you will see, retirement planning is complicated. Before you start a new retirement plan, withdraw funds from an existing plan, or even transfer funds from one plan to another, consult an expert. Mistakes in this area can be expensive.
Section 2. How Much to Save for Retirement
While the following discussion describes the ideal amount of money in the ideal retirement plan, the key is to make “what is” better, not to get aggravated over what “is not.”
As a general rule, you will need 80 percent of current expense, adjusted for inflation, to maintain your lifestyle during retirement—assuming there is appropriate health insurance coverage.
To give you an idea of how much you will need to save for retirement, complete the worksheet below.
Section 3. Types of Investments
Maximize tax-deferment. Investments outside of retirement accounts and investments in retirement accounts should be part of an overall strategy. However, a distinction between investments within retirement plans as compared to investments outside of retirement plans is that maximizing the tax-deferred treatment of these moneys in the plans becomes the primary investment objective that drives the other two objectives of maximizing income and growth.
Investments placed in retirement plans have certain tax benefits that are not available to other types of investments:
• Your investments, known as contributions, are tax deductible up to certain limits for pretax savings.
• If you invest through an employer retirement plan, your pretax contributions may be eligible for matching employer contributions—which essentially means you receive “free money” to invest for retirement.
• The earnings on your contributions (yield, also known as your investment and capital appreciation, the amount by which the value of your asset increases) are tax-deferred until distribution—which means your contributions will benefit from faster compounded growth.
• Tax-deferred compounded growth also makes after-tax contributions worthwhile given a long enough time horizon.
These tax benefits will not only help you to save and invest for retirement, they also reduce your current tax bill.
Term. As a general matter, investments made in retirement plans generally have a longer term than other investments. Normally funds in a retirement plan cannot be accessed until age 59½ without incurring income tax and penalties. However, as you will see, under certain circumstances—such as permanent disability—you can access your retirement funds before you retire, sometimes with reduced tax consequences so your investments can be shorter term than the norm for retirement plans.
Section 4. Overview of Retirement Plans
If you already have a retirement plan and are making your maximum contribution, then skip to section 8. If you don’t have a retirement plan or aren’t sure you’re maximizing the amount you can place into it—read on.
Types of plans. There are three general types of retirement plans:
• Social Security, sponsored by the federal government.
• an employer retirement plan.
• an individual retirement plan.
You may be eligible for more than one type of retirement plan, so make sure you prioritize your contributions to plans that maximize tax deductions, tax deferral, or liquidity, in the following order:
1. Employer-sponsored plans that provide matching contributions.
2. Any plans to which you can make pretax contributions.
3. After reaching your limit for pretax contributions, any plans to which you can make after-tax contributions.
4. Other retirement vehicles that provide options for tapping your retirement funds prior to retirement.
Establishing a retirement plan. You can establish a retirement account through the same channels as other types of investments, either on your own or in conjunction with a financial/investment adviser. These channels are your employer, financial/investment adviser, banks, savings and loan associations, credit unions, mutual fund companies, brokerage firms, and insurance companies.
Section 5. Government-Sponsored Retirement Plan—Social Security Retirement Benefits
Overview. Social Security provides American citizens and their families with four types of benefits: disability benefits, retirement benefits, survivor benefits, and Medicare benefits. Social Security retirement benefits are not intended to provide for all your retirement income needs—but rather to provide a subsistence level of income for basic necessities, just as Medicare covers basic medical coverage.
Who is eligible and when. Eligibility for Social Security retirement benefits requires
• work in covered employment for a minimum number of quarters. To be fully insured, you must have forty quarters of coverage (a total of ten years in covered work). Once the forty quarters are acquired, you are fully insured for life, even if you spend no further time in covered employment or covered self-employment.
• attaining age sixty-five, sixty-six, or sixty-seven depending on your date of birth, although you may elect to receive reduced benefits at age sixty-two, or slightly increased benefits at age seventy.
If you qualify for Social Security retirement benefits, then your family (i.e., spouse, ex-spouse, and certain dependents) also qualifies to receive “family benefits” while you collect retirement benefits and “survivor benefits” after you die.
Unlike other types of retirement plans, your Social Security retirement benefits are not based dollar-for-dollar on the amount you pay into the system. You may receive more or less than you pay in, depending on eligibility requirements. (If you haven’t requested an estimate of your Social Security retirement benefits from SSA, see chapter 3, section 3.)
Claims. See chapter 10 if you are filing because of disability. For any other reason, contact SSA for the forms and procedures.
Living abroad. If you are a U.S. citizen, you can travel or live abroad in most countries without affecting your eligibility for Social Security retirement benefits (unless you also work abroad).
Tax. See chapter 8, section 8.1, with respect to tax on SSD.
SSI. Note that if you don’t qualify for Social Security, or if your Social Security benefits are low, you may be eligible for Supplemental Security Income (SSI). There are strict income eligibility guidelines for SSI. See chapter 8, section 8.2, for a further discussion of SSI.
Section 6. Employer-Sponsored Plans
Employers are not required to have pension plans. If one exists, there is no requirement that it apply to all employees. However, if you are part of a plan through your employer, or if you are considering a new job, the essential features to focus on are:
• Qualified versus unqualified plans: Qualified plans qualify for tax-deductible, tax-deferred status by complying with certain IRS regulations. Examples of qualified plans include 401(k)s, IRAs, and Keoghs. Unqualified plans do not comply with IRS guidelines and therefore do not qualify for tax-deductible and/or tax-deferred status. An example of an unqualified plan is a deferred annuity (which is tax-deferred but not tax deductible).
• Defined benefit versus defined contribution plans: The traditional employer-sponsored pension plan used to be a defined benefit plan. Upon retirement, participants in the plan receive a predetermined amount of monthly benefit based on their salary and length of employment. The contribution may vary to assure there will be enough assets in the plan to pay the benefits, but the benefits do not change. Today, employers are emphasizing defined contribution plans (also known as retirement savings plans). They require a defined contribution each year (which could be a fixed dollar amount or one determined by a formula). The amount received on retirement fluctuates according to the amount in the plan.
• Contribution limits: Your annual pretax contributions are limited, based on how many and which retirement plans you participate in. The maximum contribution (combination of employee and employer amounts) cannot exceed 25 percent of your salary or $30,000, whichever is less.
• Investment options: When evaluating different retirement plans, find out what investment options are offered under the plan, whether you may transfer your retirement assets among different investment options, and whether transfers are subject to certain fees (e.g., commissions or penalties). Generally, individual-sponsored plans provide broader and more flexible investment options than employer-sponsored plans.
• Eligibility to participate in a plan: You must be in a covered category of employee. Generally, you must also be at least twenty-one and have completed one year of full-time service (more than one thousand hours of work) to be eligible for an employer-sponsored plan. Part-time or seasonal employees may also be eligible depending on the terms of the plan.
• “Accrued benefits” under a plan: Benefits, options, and rights may accrue differently depending on your years of service from the date you become a plan participant.
• Hours: Your plan may reduce your benefits if the number of hours you work is reduced. Check your plan if you are considering reducing your work hours.
• Your rights under the plan: Look at your right to borrow, make withdrawals and/or transfers from the account, early-retirement benefits, optional forms of benefit payments, and similar matters, all of which differ according to the particular plan. It is particularly important for you to identify and understand the disability provisions of your retirement plan—for example, the definition of disability, termination of contributions, vesting under disability, accessing your retirement funds if disabled, and exemption from tax or tax penalties. Many retirement plans provide that you are fully vested upon disability and may withdraw the funds in your retirement account with reduced tax consequences (such as no 10 percent premature-withdrawal penalty tax).
• Your “vested benefits” under the plan: Vesting refers to the number of years of service you must complete before you can claim nonforfeitable rights to your accrued benefits. Employer vesting schedules typically range from five to seven years. Your “individual benefits statement,” available from your plan administrator, will describe your total accrued and vested benefits. Your own contributions and their earnings are always 100 percent vested.
• The payout options for receiving your benefits: Generally, retirement benefits may be received as a lump sum or in periodic payments.
• Assessing your plan’s performance: You are entitled to receive an annual statement of your benefits as well as a “summary annual report,” which gives you general information regarding the plan’s status, including whether it is adequately funded.
• Federal protection of retirement benefits: To protect employee pensions from a private employer’s potential financial deterioration, vested benefits in defined benefit pension plans are insured by the Pension Benefit Guarantee Corporation (PBGC), which guarantees employee pension benefits up to certain limits.
• The plan’s disclosure requirements: Either automatically or upon request, the plan administrator is required under ERISA to provide you with certain disclosure documents: the Plan document and a Summary Plan Description, your Individual Benefits Statement, Summary Annual Reports, IRS form 5500, Summary of Material Modification, Notice of Plan Funding, and PBGC guarantees, if applicable. If you have difficulty obtaining copies of these documents from your employer or plan administrator, contact the Pension and Welfare Benefits Administration of the U.S. Labor Department at 202-219-8776.
For information about an employer or potential employer’s plan, ask the employer or plan administrator for a copy of the Plan document, a Summary Plan Description, and the latest annual report. As a participant, you are entitled to receive copies of these documents within thirty days of your written request (although you may be required to pay reasonable costs). If you have questions, consult a pension specialist or financial adviser. If necessary, your attorney or accountant can recommend pension specialists.
Tip. To help understand the language in pension plans, request a copy of “What You Should Know About the Pension Law,” Consumer Information Center, P.O. Box 100, Pueblo, CO 81002. The cost is $.50.
Section 7. Individual-Sponsored Plans
Retirement plans you can start on your own are:
Individual retirement account (IRA).
• Generally, if you are not an active participant in another qualified plan and you meet certain income limits, you can make an individual tax-deductible contribution up to $2,000 to an IRA. Investment gains accumulate tax free and are subject to tax only when withdrawn after you reach age 59½. Earlier withdrawals are generally subject to a 10 percent penalty.
• There are special rules for married couples.
• SEP (IRA): Intended for individuals with supplemental self-employment income (i.e., “moonlighters”) as well as for small companies and their employees. Maximum pretax contribution is 15 percent of gross income up to $22,500.
• SIMPLE (IRA): For individuals with supplemental self-employed income as well as for any company with fewer than one hundred employees. Maximum pretax contribution can be 100 percent of gross income up to $6,000, plus 3 percent of earnings.
• Roth (IRA): Contributions to the account are not deductible. Earnings compound tax free and are taxable only in a nonqualified distribution. Tax-free “qualified distributions” include those made because the taxpayer is disabled, a first-time home buyer, over age 59½, or upon death. No payment can be qualified until five tax years after the taxpayer first contributes to the Roth IRA. The maximum contribution permitted is $2,000 per year minus the taxpayer’s deductible IRA contributions. The $2,000 limit is phased out as adjusted gross income increases above $95,000 for single taxpayers and $150,000 for a married couple filing jointly.
Keogh plans.
• A retirement plan for self-employed individuals and their employees, or for individuals with supplemental self-employment income.
• There are three types of Keogh plans—profit sharing, money purchase pension, or a combination of profit sharing/money purchase pension.
• Depending on the type of Keogh plan, the maximum pretax contribution is 13.04 to 20 percent of gross income or $30,000, whichever is lower.
Tip. If an IRA or Keogh plan is funded with borrowed money, your interest payments as well as your pretax contributions will be tax deductible.
Deferred annuity. Although not a formal retirement “plan,” deferred annuities issued by insurance companies have traditionally been used as retirement investments. Unlike retirement plans, contributions are made after tax, therefore there is no limit on contribution amounts. While contributions are not tax deductible, they still benefit from tax-deferred compounded growth. A deferred annuity may be a worthwhile retirement investment for an investor who has already made the maximum annual pretax contributions and would like to make additional tax-deferred investments (provided the investor is in a high enough tax bracket to benefit). An annuity may not be a suitable investment for an investor with a shortened life expectancy, given the long-term investment required (typically ten years) to realize returns and amortize fairly high costs. Instead, after-tax contributions to an IRA may be more worthwhile.
Section 8. Ten Commonsense Tips for Retirement Planning Success
1. Investment and retirement planning are not separate activities. The essential distinction is between investments you make inside or outside of tax-sheltered retirement vehicles. Both types of investments should support a common investment strategy and result from careful financial planning.
2. Be proactive in your retirement planning, since self-reliance self-reliance is by far the most dependable retirement income source. Although it’s a long shot, certain sources may not be available when you need them (e.g., Social Security may no longer exist by the time you retire; your employer retirement plan may not be sufficient; spousal retirement benefits may no longer be available if you divorce).
3. As with any investment portfolio, make sure the funds you allocate, both within and among various retirement plans, are appropriately diversified.
4. Be careful which investments you make through retirement vehicles, because not all types of investments are appropriate for tax-deferred retirement vehicles:
• Do not place tax-exempt investments (i.e., tax-exempt bonds or money market funds) inside tax-deferred retirement vehicles. They would lose their tax-exempt status upon distribution, when they will be subject to income tax.
• Do not place tax-sheltered annuities inside retirement vehicles. The only benefit to placing a tax-deferred investment inside a tax-deferred retirement vehicle is for the annuity salesperson, who receives a commission.
• Do not roll over your employer stock to an IRA, because all IRA distributions are taxed as ordinary income even if derived from capital gains. Bear in mind that for equity held outside of retirement vehicles, capital gains are taxed at the capital gains rate—whereas for equity held inside retirement vehicles, capital gains are taxed at typically higher income tax rates. Ultimately, the decision to place certain investments inside retirement vehicles will depend, in part, on whether you have a long enough investment horizon so that the benefit of tax-deferred compounded growth outweighs the drawback of taxing capital gains at income tax rates.
5. Receive your next raise, bonus, or unused vacation pay “tax-free” by funneling it into your employer retirement plan.
• As a pretax contribution to an employer retirement plan, your compensation is not only “tax free” (i.e., the contribution is tax deductible), but also benefits from tax-deferred compounded growth.
• Your contribution may also qualify for an employer matching contribution (in essence meaning you receive “double compensation” tax free).
6. When you roll over or transfer funds among retirement accounts, never take direct possession of the funds or you may be subject to 20 percent withholding, additional income tax, and a 10 percent tax penalty for early withdrawal.
7. Consider consolidating your various retirement accounts to simplify investment management, eliminate duplicate fees, and reduce administrative burdens, or shift funds between retirement accounts to optimize your investment strategy. Don’t take these steps without considering the special rules for trustee-to-trustee transfers or IRA/Keogh rollovers.
8. Select trustees that charge low, flat fees.
Tip: Even if your retirement accounts are “self-managed,” they will still be placed with a trustee that may charge any of three types of fees—establishment fee, annual fee, and/or transaction fee. Depending on the complexity of your retirement accounts, try to avoid trustees that charge fees as a percentage of your account or per transaction.
9. Maintain accurate documentation on your retirement accounts. Keep your own copy, review it at least annually, and update it as necessary.
10. Designate your intended heirs as beneficiaries on your retirement account registration forms rather than in your will to avoid probate.
Tip. Financial and investment planning does not end when you retire. Periodic checkups are too important to ignore.