Those days are long gone. Most public pensions are underfunded, and private companies can't get rid of them fast enough. Social Security's own trustees predict it will run out of money in less than 20 years. And most people haven't saved even a fraction of what they should.
Retiring comfortably today is not about saving more, it's about saving smart. In Don't Retire Broke, you will learn:
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About the Author
Rick Rodgers, CFP®, is cofounder and president of Rodgers & Associates, a wealth management firm in Lancaster, Pennsylvania. He is one of America's leading retirement specialists and has been featured in the New York Times, Smart Money, Investment News, Kiplinger's Retirement Report, and Medical Economics. He has appeared on dozens of television programs, from FOX Business to The 700 Club, and offered millions of people tips on how to plan for a successful retirement.
Read an Excerpt
Leg One: Tax-Deferred Savings Strategies
Tax-Deferred Accounts: A Refresher Course
The term tax-deferred refers to the postponement of paying taxes on earnings until a later date. There are many ways to defer taxes; rather than spend time on all of them, I'll focus this section on using retirement accounts for tax deferral.
Tax-deferred retirement accounts allow employees to save money in the present, dealing with taxes in the future. To take advantage of tax-deferred savings, an employee can choose to place pre-tax dollars, up to a certain amount, in various retirement accounts. These dollars aren't taxed when you place them in the account. They're only taxed when you withdraw them from the account.
The two main types of retirement accounts are individual and employer sponsored. Let's take a closer look at these two types.
Individual Retirement Plans
Individual retirement plans are those that can be established without an employer. Primary examples include the individual retirement account (IRA) and solo 401(k). Two other types of individual accounts — Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs — may also function as employer sponsored plans. Details on each of these plans follow.
Individual Retirement Account (IRA)
An IRA is a personal retirement account that provides income tax advantages to individuals saving money for retirement. Because the objective of creating the IRA is to assist taxpayers in providing for their retirement, tax law levies penalties on withdrawals taken before retirement age of 59½. Tax law in the area of early withdrawals is complex. The typical tax penalty is 10% of the amount withdrawn prior to age 59½, unless certain exceptions apply. You should seek professional advice whenever you need to make significant withdrawals prior to age 59½, as many times you can avoid the penalty with proper planning. You usually must begin taking money from your IRA no later than April 1st of the calendar year following the date you reach age 70½. The rules established by the government regarding these required minimum distributions (RMDs), their timing, the amounts, the recalculations, and the effect various beneficiary designations have on them are among the most complex of the Internal Revenue Code. The penalty for failing to take timely withdrawals is 50% of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date. This punitive penalty is matched only by the civil fraud penalty in severity. The necessary calculations are therefore not something that most individuals should attempt on their own.
Contributions to IRAS
You can make deposits/contributions to an IRA each year up to the amounts allowable under the tax law. The contribution or deferred limits of an IRA plan are $5,500 in 2016. Employees age 50 or older can contribute another $1,000. An income tax deduction may be available for the tax year for which the funds are deposited. The principal and earnings on these deposits aren't taxed until you withdraw the money from the account. Withdrawals from an IRA may be subject to income taxation in the year in which you take them.
A solo 401(k) plan works just like a regular 401(k) plan combined with a profit-sharing plan (see the next section for more on 401(k)s and profit-sharing plans). The difference is a solo 401(k) can only be implemented by self-employed individuals or small business owners who have no other full-time employees (the exception is if your fulltime employee is your spouse). If you have any other full-time employees age 21 or older, or part-time employees who work more than 1,000 hours a year, you must include them in any plan you set up, which negates your ability to adopt a solo 401(k) plan.
Contributions to 401(k)s
In 2016, the contribution limit to solo 401(k)s is $18,000. An additional $6,000 may be contributed by employees age 50 or older.
Simplified Employee Pension Individual Retirement Account (SEP) IRAs
An SEP IRA is a type of retirement plan an employer with less than 25 employees can establish, including self-employed individuals with no employees. SEP IRAs are adopted by sole proprietors or small business owners to provide retirement benefits for themselves and, if they have some, their employees. Benefits of this approach are there are no significant administration costs for a self-employed person with no employees, and the employer is allowed a tax deduction for contributions made to the SEP plan. The employer makes contributions to each eligible employee's SEP IRA on a discretionary basis. If the self-employed person has employees, each must receive the same benefits under the plan. Because SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA.
Contributions to SEP IRAS
SEP IRA contributions are treated as part of a profit-sharing plan. Contributions are tax deductible and the employer can contribute up to 25% of an employee's net compensation (net compensation is after the SEP contribution has been made). For 2016, only the employee's first $265,000 in gross compensation is subject to the employer's contribution, which results in a maximum contribution of $53,000 (indexed annually for inflation). Employers are not required to make annual contributions; however, if they choose to do so, all eligible employees must receive those contributions. Contributions may be made to the plan up until the date the employer's tax return is due for that year.
When a business is a sole proprietorship, the employee/owner both pays themselves wages and makes a SEP contribution that's limited to 25% of wages, which are profits minus SEP contribution. For a particular contribution rate (CR), the reduced rate is CR/(1+CR); for a 25% contribution rate, this yields a 20% reduced rate. Thus the overall contribution limit (barring limits) is 20% of 92.935225% (which equals 18.587045%) of net profit.
Participants can withdraw the money at age 59½. Prior to that, there is a 10% penalty or exercise tax. Distributions are taxable as ordinary income in the year they are received.
Savings Incentive Match Plan for Employees (SIMPLE) IRAs
The SIMPLE IRA is a type of employer-provided retirement plan available to an "eligible employer" — an employer with no more than 100 employees. An employer who has already established a SIMPLE IRA may continue to be eligible for two years after crossing the 100 employee limit. Self-employed workers with no employees are also eligible to establish these accounts.
The SIMPLE IRA is an attractive plan for employers because it doesn't incur many of the administrative fees and paperwork of plans such as the 401(k). Employers also benefit from the tax-deductible contributions to the plan. Employees may elect to establish salary deferrals to contribute to the plan like the 401(k). Assets inside SIMPLE IRAs can be invested like any other IRAs: in stocks, bonds, mutual funds, bank deposits, and so forth.
Contributions to Simple IRAS
Like a 401(k) plan, the SIMPLE IRA is funded by a pre-tax salary reduction; and, like other salary reduction contributions, these deductions are subject to ordinary taxes including Social Security, Medicare, and federal unemployment tax (FUTA). Contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans: $12,500 for 2016, compared to $18,000 for conventional defined contribution plans. Employees age 50 or older can contribute an additional catch-up amount of $3,000.
With SIMPLE IRAs, the employer has the option of matching the employee's deferrals up to 3% of the annual salary or making non-elective contributions of 2% or less to all eligible employees. For 2016, the employer match is based on compensation up to a maximum of $265,000.
Although the employer may pick the financial institution in which to deposit the SIMPLE IRA funds, employees have the right to transfer the funds to another financial institution of their choice without cost or penalty. Distributions from SIMPLE IRAs follow the same rules as regular IRAs, with one exception: If premature distributions are taken before the employee reaches age 59½, and during the first two years after the employee starts participating in the plan, the penalty is 25%, not the usual 10%. Withdrawals are fully taxable at regular income tax rates and mandatory withdrawals must begin at age 70½. A SIMPLE IRA account can be rolled over into a traditional IRA tax-free after the first two years.
Employer-Sponsored Retirement Plans
Employer-sponsored accounts are only available to employees of the business offering them. Employer-sponsored plans fall into one of two categories: defined benefit or defined contribution plans. The most common type of defined benefit plan is the pension, and the most common type of defined contribution plans are the 401(k), 403(b), and 457 plans. The Simplified Employee Pension (SEP) IRAs and Savings Incentive Match Plan for Employees (SIMPLE) IRAs I described in the previous section may also fall under this category for employers with limited numbers of employees. Keep reading to find out more about these plan types.
Defined Benefit (Pension) Plans
A defined benefit plan is commonly referred to as a pension. A pension is a steady income given to a retiree, typically in the form of a guaranteed monthly annuity. The formula for calculating the amount of pension income a retiree will receive is usually based on a combination of service and salary. For example, a pension formula may state the employee earns 1.5% for each year worked (the service portion) times their average earnings for the last five years (salary portion). In this example, a retiree with average earnings of $100,000 and 30 years of service would receive a pension of $45,000 per year.
Defined Contribution Plans
A defined contribution plan provides an individual account for each participant. The benefit received by the retiree is based solely on the amount contributed to the account plus earnings on the funds invested. The contribution formula is usually based on salary only and could be a fixed percentage each year or varied depending on the profits of the company. When the company chooses to tie the amount of the contribution to its profits, the plan is referred to as a "profit-sharing" plan. When the contribution is based on a fixed percentage, it's called a "money purchase" plan. Upon retirement, the employee's account is used to provide retirement benefits, which can be paid in a variety of ways, such as through the purchase of an annuity, to provide a regular monthly income.
In the past few decades, defined contribution plans have grown rapidly and are now replacing traditional defined benefit plans as the primary retirement savings account for most employees. This change has shifted greater responsibility for retirement income from employers to individuals. Future benefits from these accounts depend on the level of contributions from the employee and employer during their careers. I spend some time below discussing the primary types of defined contributions plans:
The most common type of defined contribution plan is the 401(k). Under section 401(k) of the Internal Revenue Code, enacted in 1978, employer and employee contributions to tax-deferred retirement accounts are excluded from wages subject to the federal income tax. Earnings within the accounts are tax deferred until they are withdrawn, when the money is taxed as ordinary income. In the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, Congress raised the maximum allowable contributions to defined contribution plans and proposals for further increases will likely remain on the legislative agenda. There are also restrictions on how and when employees can withdraw these assets, and penalties may apply if withdrawals are made while an employee is under the retirement age as defined by the plan.
In most 401(k) plans, the employee elects to have a portion of his or her wages paid directly, or deferred, into his or her 401(k) account. The employee can select from a number of investment options for the contributed funds. Most employers offer an assortment of mutual funds that emphasize stocks, bonds, money markets, or the company's stock.
Contributions to 401(k) Plans: The process for making contributions to 401(k) plans involves employees making periodic contributions from their paychecks before taxes. Any investment earnings or additional amounts matched by the company are also tax deferred until retirement. For 2016, the contribution or deferred limits of a 401(k) plan are $18,000. Employees age 50 or older can contribute an additional $6,000.
Employers that offer matching contributions usually base the amount on what the employee contributes. This matching contribution is often 25%, 50%, or even 100% up to a maximum level set by the employer. It's best for employees to contribute at least as much as the employer is willing to match to take advantage of this valuable employee benefit.
The 403(b) is a tax-deferred retirement plan available to employees of educational institutions and certain non-profit organizations as determined by section 501(c)(3) of the Internal Revenue Code. The company determines further eligibility based on an employee's salary and status (for example, full-time versus part-time). The 403(b) plan has many of the same characteristics and benefits of a 401(k). Contributions can grow tax-deferred until withdrawal, at which time the money is taxed as ordinary income.
Contributions to 403(b) Plans: The annual contribution limits for 403(b)s are the same as 401(k)s: $18,000 for 2016, and employees age 50 or older can contribute another $6,000. An additional catch-up provision may be available to employees age 50 or older. This increase is known as the 15-year-rule, a special provision that increases the elective deferral limit by as much as $3,000 more than the current $18,000 limit (as of 2016). To qualify, an employee must have completed at least 15 years of service with the same employer (years of service need not be consecutive) and can't have contributed more than an average of $5,000 to a 403(b) in previous years. The increase in the elective deferral limit can't exceed $3,000 per year under this provision, up to a $15,000 lifetime maximum.
Employees get to choose where their money is to be invested from among the plan providers offered by employers. The providers offer different investment options but employers aren't responsible for administrating the plans. 403(b) plan providers primarily offer annuities and some mutual funds. The annuities can be either fixed or variable. As with all annuities, gains aren't taxed until the participant starts receiving distributions.
A 457 plan is a tax-exempt, deferred compensation program made available to employees of state and federal governments and agencies. The 457 plan is similar to a 401(k) plan, except there are never employer matching contributions and the IRS doesn't consider it a qualified retirement plan. Another key difference is there is no 10% penalty for withdrawal before the age of 59½. However, the withdrawal is subject to ordinary income taxation.
Participants can defer some of their annual income, and contributions and earnings are tax-deferred until withdrawal. Distributions start at retirement age but participants can also take distributions if they change jobs or in certain emergencies. Participants can choose to take distributions as a lump sum, annual installments, or an annuity. Distributions are subject to ordinary income taxes and the amounts can't be transferred into an IRA.
Contributions to 457 Plans: For 2016, an employee can contribute $18,000 into a 457 plan. The 457 plan allows for two types of catch-up provisions. The first is for employees over age 50, who can contribute a catch-up amount of $6,000 into their governmental 457 (catch-up contributions aren't provided for non-governmental 457 plans). The second, which is also available only to governmental 457 plans, is much more complicated and can be elected instead by an employee who is within three years of normal retirement age. This second catch-up option is equal to the full employee deferral limit, or another $18,000, for 2016. The second type of catch-up provision is limited to unused deferral limits from previous years. An employee who had deferred the maximum amount allowed into the 457 plan each year of employment previously wouldn't be able to utilize this extra catch-up.
Health Savings Accounts
Health savings accounts (HSAs) can play an important role in your retirement savings strategy. HSAs are actually a hybrid of two legs from the New Three-Legged Stool strategy of building a tax-efficient retirement portfolio. An HSA allows you to set aside tax-deductible dollars today to provide funds for health-related expenses. The tax-deductible component acts like Leg One of the stool. The funds within the account are withdrawn tax-free if they are used for qualified medical expenses, which acts like Leg Three of the stool.(Continues…)
Excerpted from "Don't Retire Broke"
Copyright © 2017 Rick Rodgers.
Excerpted by permission of Red Wheel/Weiser, LLC.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
Table of Contents
Introduction: The Un-Funniest Story Ever Told 13
Why Would the IRS Take Your Money? 18
Who Am I to Give You Advice? 19
The New Three-Legged Stool™ Approach to Financial Security 20
Chapter 1 Leg 1: Tax-Deferred Savings Strategies 25
Tax-Deferred Accounts: A Refresher Course 25
Individual Retirement Plans 26
Employer-Sponsored Retirement Plans 30
Health Savings Accounts 35
Prevent the IRS From Touching Tax-Deferred Distributions 38
New Rule for IRA Rollovers 57
NUAs Keep the IRS Away From Tax-Deferred Stock Distributions 59
Chapter 2 Leg 2: After-Tax Savings Strategies 65
Transfer Highly Taxed Assets Into Tax-Deferred Accounts 65
Begin to Build Your Investment Plan Around Asset Allocation 69
5 Steps to Reducing the Wrong Kind of Investment Risk 74
How to Invest in a Tax-Efficient Way 88
Implement a Zero Tax Bracket Approach 95
Chapter 3 Leg 3: Tax-Free Savings Strategies 101
Understanding Roth Accounts 101
Roth Accounts for Younger People 104
Retirement Saver's Credit 105
Roth IRA Conversions: Better Than Any Tax Break 107
The Pro-Rata Rule for Roth Conversions 109
Estate Planning and Roth IRAs 110
Convert to Roth in Down Markets 112
Read This Before You Roll Over Your Company- Sponsored Plan! 116
Chapter 4 Distributions: Strike an Ideal Balance Among All of Your Accounts 119
The Retirement Distribution (R/D) Factor 119
How and When to Take Retirement Savings Distributions 124
The 4% Prudent Withdrawal Rule 138
Tips for Taking Early Retirement 141
Get Guidance From a Good Financial Adviser 154
Chapter 5 Understanding Social Security 163
Social Security: A History 163
Social Security Benefit Statements 166
How Your Benefits Are Calculated 166
When to Begin Taking Benefits 173
Suspending Social Security Benefits 176
Changes to Social Security Claiming Strategies 177
The Tax on Your Benefits-And How to Reduce It 179
Social Security Reform 186
Chapter 6 The Patient Protection and Affordable Care Act 195
Insurance Marketplaces 196
Medicare Surtax 198
9 Ways to Minimize the Medicare Surtax 199
Other ACA Taxes 205
Tax Penalty for the Uninsured 206
Healthcare Costs and the New Three-Legged Stool 207
Chapter 7 Curtail Effect the IRS Has On Your Estate 211
5 Reasons to Reexamine Your Estate Plan 211
Estate Tax Overview 213
Titling Assets Property 215
Gifting Strategies for Minimizing Estate Taxes 218
Review Existing Trust Documents 221
Estate Planning With a Roth IRA 229
Beneficiaries: Key to Any Solid Estate Plan 232
Appendix A How to Write a Personal Financial Plan 239
Part 1 Establish Clear Adviser-Client Communication 240
Part 2 Create a Detailed Investment Plan 241
About Rick Rodgers 255