Top 5 Retirement Myths

retirement-lanePlanning for retirement is a topic that is not on the minds of many people because, well it is too boring. Some people would rather spend a 1 hour extra of their day in the gym working out or socializing than talking to a financial advisor about their retirement goals. In this article, we explore 5 myths that you should get out from your head in order to practically prepare for a smooth retirement. As life expectancy continues to rise (people are living longer), you have to plan at what age will you realistically be able to retire and how much of a nest egg you will need. Will you need $1 million, $2 million or more? Well it all depends on your lifestyle, your goals, your financial obligations and more.

Myth No. 1 – You can Choose your Retirement Date

It is advisable to pick a tentative date when you would like to retire, and work towards that goal. According to a study done by the Employee Benefit Research Institute in March 2010, 9% of all American workers said they plan to retire before the age of 60 while 31% had already left the workforce before their 50s. About 24% of workers wanted to work past the age of 70 however only 8% managed to do so (keep themselves employed). 41% of all workers said they had to leave the workforce earlier than planned because of health problems, disabilities, layoffs or to care for their aging spouses. The point of this paragraph is to tell you that choosing a retirement age will not always be a choice for you, life events such as the above mentioned will either force you out of work or you just might die early.

Myth No. 2 – A $1 million Nest Egg will get me Comfortable Retirement

While it is always nice to have a $1 million net worth when you retire, $1 million now spread out over 30 – 40 years (before your retirement) will not manage to give you a life of luxury but rather a well off or comfortable life. According to Michael Farr, president of Farr, Miller, & Washington, “If you can’t live on $50,000 a year, then $1 million is not enough. You are probably going to be able to live in retirement, but not particularly well. No one will consider you rich.”

Myth No. 3 – Social Security will Not Fund your Retirement

The existing Social Security trust fund currently holds enough assets to pay out promised social security benefits until 2037 according to a recent report by the Social Security Board of Trustees report. After that, the Board estimates income tax revenues will be sufficient enough to pay out 78% of all schedule benefits leaving for a 22% shortfall. However, by doing minor tweaks & changes to the Social Security system, the U.S. Senate Special Committee on Aging report said social security benefits could be enough to pay out for the next 75 years. Examples of tweaks include tax increases, pushing back the retirement age past 65 or a cut of benefits.

Myth No. 4 – You’re too Old to Start Saving for Retirementcompound-interest

It’s not too late to do anything my friend, so this myth is just out of whack! Most people get discouraged by knowing they have to save up $1 million by the time they are 65 because they just don’t know how! Christine Fahlund, a T. Rowe Price senior financial planner says “When people hear how big their nest egg should be, they think it’s impossible and stop saving altogether or never get started. Focus on the process instead. Contribute up to the maximum amount to your 401(k) and, if you are 50 or older, you are now eligible for catch up contributions.” Would you like to have $537, 761.07 by the time you are 65? Here’s how:

We used the Compound interest calculator located herehttp://www.moneychimp.com/calculator/compound_interest_calculator.htm

Current Principal = $0

Annual Addition = $20,000

Years to Grow = 15

Interest Rate = 7%

Future Value at Retirement = $537, 761.07

As you can see folks, saving for retirement is not as bad as it looks. We assumed the following points when doing this calculation:

i) The retiree is making $80,000 annual salary and saves 25%. Thus $80,000 x 25% = $20,000 a year.

ii) Current principal is $0 meaning at the age of 50, the retiree has $0 saved up.

iii) The number of years he has to grow his savings is 15.

iv) Assuming a market rate of return of 7% (which is achievable in current markets).

How to Train for your Career / Job Using Roth IRA Funds

accreditationWith today’s down economy where there are fewer jobs and competition is more, what can do you if you lose your job? One thing many Americans are doing is going back to school! And for such people, there is good news. You can use money from your Roth IRA account to train for a new career, or to boost your chances of finding employment in your current field by upgrading your skills. For instance, if you were a computer programmer and jobs are scarce in that industry, and you would like to tackle a new career, you could withdraw money from your Roth IRA to pay for nursing / medical school, where the industry is still actively recruiting for qualified people.

IRA Money Can Pay for School

You can use your existing Roth IRA to pay for all your higher education school expenses such as:

  • Books
  • Training equipment / supplies
  • Tuition fees
  • Other school fees

If you use this approach to fund your education, there are certain advantages:

  • The arduous process of applying for and maintaining a student loan can be avoided.
  • There will not be additional debt you are taking on after graduation, unlike millions of other American university students.
  • Flexible schedules with work & school

What School can you Go to?

Higher education does not necessarily mean university education & liberal arts or accounting/computer science courses. If you would like to train to be a certified nursing assistant, a long haul truck driver, an oil/lube mechanic or even a welder, you can use your Roth IRA funds to pay for such trades. If you prefer the more liberal arts education, you can go back to University and study Law or Kinesiology, whatever you feel like! Just make sure whatever you study has an end goal, a career you can embark upon graduation.

Who Else can Train with You?

You can use your Roth IRA account not only to pay for your own education but that of a spouse, children, spouse’s children or your grandchildren. Or even so, all of you (the entire family) can go back to school and use Roth IRA money to fund the expense.

If you have been unemployed for long periods of time and have money sitting in your Roth IRA , now’s a good time to consider using a portion of that money to upgrade your career skills to make you employable again or to re-train in a new industry.

Accredited Schools

While you are free to choose whatever career you want to train for, you must select a university or college that is accredited. Accreditation is a very confusing term because there are hundreds of small private colleges in America that are not ‘accredited.’ The best way is to choose a school that qualifies for financial aid program administered by the Department of Education. You can visit their website at http://www.ed.gov

Accreditation Resources

Accreditation and Licensing – http://www2.ed.gov/students/prep/college/diplomamills/resources.html
Note: This information is derived from this above link, ed.gov.

U.S. Department of Education – A list of all postsecondary institutions that are accredited by agencies recognized by the Secretary of Education.

http://ope.ed.gov/accreditation

U.S. Department of Education – Overview of accreditation in the United States and List of Nationally Recognized Accrediting Agencies.
www.ed.gov/admins/finaid/accred/index.html

National Association of State Administrators and Supervisors of Private Schools – Provides contact information for state licensing agencies as well as links to many of them.
www.nasasps.com

Degree.net – Simple questions to ask about accreditation about earning unaccredited degrees.

How to Better Understand Roth IRA Conversions

roth-ira-conversionRoth IRAs and their sister retirement plans Roth 403b and Roth 401k offer oustanding retirement investing choices for American workers & savers. While most people have heard of these plans, they do not exactly know how to take advantage of them, or yet better understand them. This becomes even more difficult when an employee transitions from one job to another company while leaving behind his retirement plan with the old company, not knowing of the choices available. Effective 2010, the income cap of $100,000 maximum to be eligible to contribute to a Roth IRA is eliminated allowing high income earners to be also eligible to contribute to a Roth IRA. What happens if you are earning over $100,000 a year and have funds in a traditional IRA prior to 2010? Well you can easily convert that traditional IRA in to a Roth IRA and end up paying minimal taxes because of the down stock markets we have had in 2010. Below, we go over some frequently asked questions about Roth IRAs that should help you decide whether it is a good investment option for you.

1) What is the Rule on Income Limits?

It does not matter when you are filing your taxes as single or married filing joint, effective 2010, the $100,000 cap on adjusted gross income for investors will be eliminated. Thus, even if your salary is $200,000 a year, you are still eligible to contribute to a Roth IRA.

2) 2010 is the Year for Conversions, but not the Tax year

Let’s clarify this. While you would do a conversion from a traditional IRA or other plan in to a Roth IRA in 2010, the capital gains or income to be claimed on your taxes will not be done until 2011 and 2012, thus saving you from facing a huge tax bill in 2010. The IRS is aware of this and they have allowed you to claim 50% of your capital gains income in 2011, and the remaining 50% in 2012, thus splitting the bill across 2 years.
Note: You would pay taxes in 2011 and 2012 according to the tax bracket you’re in. For instance, if you made a lot more money in 2012 than 2011, you would pay more of the conversion taxes in 2012 rather than 2011. However, your total conversion tax will be prorated across the 2 years.

3) Tax Implications of a Roth IRA Conversion

Let’s assume Peter wants to convert his traditional IRA to a Roth IRA. Peter says his adjusted gross income for 2010 will be $90,000 and he wants to convert $50,000 of deductible traditional IRA funds to a new Roth IRA ccount. Deductible traditional IRA funds means he has never paid taxes on the money and in fact received a ‘tax deduction’ when he originally made the contribution; let’s just say in 2005. The number 1 test we look for is, is Peter eligible for a Roth IRA conversion? Since his income $90,000 is less than the $100,000 threshold, yes he is eligible! Since Peter would like to convert his $50,000 to a Roth IRA, what is his new tax liability?

New tax liability = $90,000 + $50,000 = $140,000

Notice the total $140k tax liability exceeds the $100,000 AGI threshold but since only $90,000 is his eligible income for that year, he is still okay to do the conversion.

Assuming Peter’s income tax bracket for the year is 25%, his taxes payable on the Roth IRA conversion would be:

Tax on Conversion = $50,000 x 25%

Tax on Conversion = $12,500

Please note that Peter did not have to pay a 10% early withdrawal penalty on his converted amount of $50,000. Before you do your conversion, it is advised to speak to a tax consultant whether you will have to pay this penalty or not. There are special tax scenarios beyond the scope of this article’s discussion.

Note: There is a misconception that some of the converted funds to the Roth IRA can be used to pay for federal taxes owed on the conversion. In the case of Peter, the $12,500 in taxes that he owes; he might think he can take out $12,500 from his $50k conversion to be able to pay for the federal taxes. Do NOT do this! If you do this, you will be taking an early withdrawal penalty and will be assessed a 20% early withdrawal penalty on the $12,500 withdrawn. In summary, Peter should have set aside an additional $12,500 to pay for the federal taxes, aside from his $50,000 conversion to Roth IRA.

4) Save for the Federal Taxes

Knowing that you will split up your federal taxes owing in 2011 and 2012, this gives you ample of time now to start saving for taxes. In the case of Peter, we can save $6,000 in 20 10 to pay for his 2011 share of taxes and save an additional $6,500 in 2011 to pay for his 2012 federal taxes due. The idea here is to start saving soon.

Tax Saving Tips for IRA Investors – After Tax Contributions (Basis), Income in Respect of Descendent, 10% Excess Tax & Substantially Equal Periodic Payments (SEPPs)

tax-dayThousands of IRA investors miss out on important tax benefits each year because they are not familiar with the Tax Act and laws. Others make crucial errors when filing their tax returns. For instance, IRA investors may pay taxes on monies that should have been tax free or pay excise taxes on IRA distributions when these distributions should be free of tax. Our aim in this article is to highlight some IRA tax laws and how you can benefit from them.

ii) Track Basis to Avoid Getting Double Taxed

After-tax IRA balances (also known as ‘basis’) grow in Individual Retirement Accounts (IRAs) from non deductible contributions and IRA rollovers of after-tax amounts. By saying non deductible contributions, we mean you pay taxes on all your earnings now, and will not be taxed when you withdraw them upon retirement, at 65. This is how a Roth IRA works. It is essential we clarify this point, so read this example below:

After-Tax Contributions?

Consider Jackson who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 a month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and would contribute $3500 – $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket upon retirement, he will have to pay $3500 x 33% = $1155 upon his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.

Distributions of after-tax balances (basis) is supposed to be tax-free. However, if you fail to keep track of these amounts that you have contributed, any distributions you take will result in you having to pay taxes to the IRS resulting in double taxation. Also, if you do not file IRS Form 8606 (Nondeductible IRAs) to the IRS, you will owe them a penalty of $50 unless you show a valid reason why you didn’t file that form. Consider this example.

Example

John made a rollover contribution of $50,000 from his 401k plan to a Traditional IRA out of which $15,000 was contributed on an after-tax basis. This means distributions of this $15,000 should be tax free because John already paid taxes on them. John, busy as he is, failed to file Form 8606 to the IRS and did not keep track of the amount. John withdrew his entire $50,000 balance from his IRA due to some emergency and included the entire amount as taxable income. This means John paid taxes on his $15,000 contributions that should have been tax-free. Had John filed IRS Form 8606 in the year the rollover occured, he would not have got double taxed on the $15,000 distribution.

Once you make a nondeductible contribution to a Traditional IRA or rollover after-tax amounts, any distributions taken from the IRA will include a prorated amount of pre-tax and post-tax assets. These assets will be broken down into pre-tax and post-tax amounts just like how John has $35,000 pre-tax assets and $15,000 of post-tax assets in his Traditional IRA. Another important point to remember is that if you have multiple traditional, SEP or Simple IRAs with different beneficiaries, you might want to maintain a separate Form 8606 for each type of IRA. Then, each beneficiary will be able to determine their basis (after-tax balances) in their inherited IRAs and file any IRS Form 8606.

Income in Respect of Decedent

Pre-tax IRA assets or balances that are not distributed before the IRA investor’s death are not taxable to the deceased IRA owner. Instead, they will be added to taxable income of the beneficiary for current tax year. However, these assets may be included in the deceased IRA investor’s estate and subject to estate tax. However, if the deceased IRA owner filed IRS Form 706 (United States Estate and Generation-Skipping Transfer form), the beneficiary might be eligible for a federal tax deduction for the total amount of estate taxes listed on form 706. This deduction is known as Income in Respect of Decedent (IRD) and is one of the most important deductions that a beneficiary could get with inherited assets or monies. Unfortunately, it is a deduction least aware of by IRA investors and owners.

Tax experts estimate that failure to claim the Income in Respect of Decedent (IRD) deduction can result in a tax rate of 80% or more on the inherited amount, broken down to a combination of estate taxes paid by the deceased IRA owner and federal/local state taxes paid by the beneficiary who inherits the assets after the death of the IRA owner. Income in Respect of Decedent (IRD) is claimed as an itemized tax deduction on IRS Schedule A and is not subject to the 2% of modified adjusted gross income (MAGI) limit that applies to miscellaneous deductions. If you don’t itemize your IRD deduction, your deduction will not be valid.

Deducting Losses on Roth IRA Investments

It makes sense when we say that greater risk has the potential of yielding greater returns. If you do not want to take risk, you would invest your money in certificates of deposit or money market funds that provide a risk-free interest rate upon maturity. However, these interest rates are lower than the percentage returns provided by riskier stocks. If you make losses on your IRA (Individual Retirement Account) investments, you can deduct them from your tax return ONLY if certain conditions are fulfilled. We look at these conditions next:

1) Withdraw Full Balance to Claim Losses

In order to be eligible to claim losses on your tax return from your IRA investments, you MUST withdraw the entire balance from that account. For example, if you faced a loss of $5000 this year on your Roth IRA account, you must withdraw the full balance from your Roth IRA in order to be eligible to deduct this $5000 allowable capital loss from your tax return. On the other hand, if you faced a similar loss from your SEP IRA, SIMPLE IRA or Traditional IRA, you must withdraw the entire balances from all these Traditional IRAs in order to deduct any losses.

2) Losses on your Traditional IRA

You can deduct losses made on your Traditional IRA only if:

  • the total balance you withdraw is LESS than the after-tax amounts (basis amounts) remaining in your Traditional IRA.
  • the IRA basis is any non-deductible contributions + after-tax IRA rollovers from 403b plans, 457 plans or other qualified retirement plans.
  • you fill out IRS Form 8606 which is used to determine the basis of your withdrawal amounts from your Traditional IRA. IRS Form 8606 is also used to calculate your actual IRA loss to be included in your income tax return, and the total amount of your IRA withdrawal.

Example of a Traditional IRA Investment Loss

  • Beginning January 1st, 2004, John had a Traditional IRA balance of $30,000.
  • $20,000 is the After-Tax balance
  • On December 31st, 2004, John’s IRA lost $13000 in value. This means his Traditional IRA balance is now: $30,000 – $13000 = $17,000
  • This $17000 is now less than the after-tax balance of $20,000.
  • This means John can claim a loss on his income tax return if he withdraws his total balance from his Traditional IRA.
  • His income tax loss deduction would be calculated as follows:

$30,000 January 1st, 2004 Balance
- $13000 IRA Investment Loss for the year 2004
$17,000 Value of his Traditional IRA at Dec 31st, 2004

$20,000 After-Tax Basis Amount
- $17,000 Value of his Traditional IRA at Dec 31st, 2004
$3,000 His Income Tax Deduction from IRA Investment Losses – 2004

Individual Retirement Accounts (IRA) and Real Estate Investments

Many savers have the idea that if they invest their IRA savings into Real Estate, they will make good profits and increase their retirement savings ultimately. However, there are many pitfalls that could get you in trouble if you do not follow the IRA rules.

Prohibited IRA Transactions

Some specific investments are prohibited in IRAs. These investments are called “collectibles” and include items such as:

  • Artwork
  • Antiques
  • Coins
  • Collectible Stamps
  • Gems

Real Estate is not prohibited, but certain rules and pitfalls can easily make your IRA Real Estate Investment into a prohibited transaction.

Prohibited Real Estate Transactions

  • You can’t sell property to your IRA, nor buy property from your IRA
  • You can’t loan money to your IRA or borrow money from it
  • You can’t use your IRA Savings as Loan Collateral
  • You can’t receive goods and services from your IRA nor provide them from your IRA

Beware, some companies promote real estate investments for IRAs by not properly disclosing all the related rules and prohibitions as stated by the law.This is because they do not want to lose business and you as a client/customer.

Examples of Prohibited Transactions

For example, imagine your IRA purchases a broken-down house that needs lots of repair work and remodelling. You use funds from your IRA to do the remodelling and add value to the house. Later, you sell it at a profit. That is NOT a prohibited transaction yet. However, if the remodelling is done by yourself, or your relative’s local shop, this means you are providing “services” to your IRA. Now THIS is a prohibited transaction.

Another example of a prohibited transaction is when you buy a rental property and also do the work of finding tenants, collecting rent and property management. If you or your relatives do this, you are providing services to your IRA.

IRA Rollovers & Transfers: Similarities, Differences & FAQs

What’s the Difference between an IRA Rollover and IRA Transfer?

An IRA Transfer is when the retirement assets of an individual are transferred from one financial institution (IRA Management & Investment Firms) to another, without the IRA owner taking ownership and risk of the assets. By Transferring their IRA Assets, IRA owners do NOT have to pay tax on these withdrawals and do not risk loss of investments if anything happens along the way. Furthermore, unlike IRA Rollovers, you can carry as many IRA transfers during the taxation year as you’d like, there’s no maximum limit.

An IRA Rollover occurs when a retirement saver rolls over his assets from a Qualified Retirement Plan (example 401k plans) into an Individual Retirement Asset (IRA). Unlike IRA Transfers though, an individual is limited to 1 IRA Rollover every 12 months. There are 3 types of IRA Rollovers, we summarize them below:

1) IRA Rollover

An IRA Rollover occurs when an individual has personally withdrawn money from his IRA Assets for personal use. If this is the case, the individual has 60 days to rollover this distribution to another IRA. If the distribution is not rolled over to another IRA within 60 days, the individual will have to pay the local state & federal taxes as well as a 10% Early Withdrawal Penalty Fee.

2) Qualified Retirement Plan Rollover

A Qualified Retirement Plan Rollover occurs when an individual takes personal possession and responsibility of his IRA assets and does NOT do an IRA Transfer within 60 days. Once the IRA assets are distributed, the plan administrator will withhold 20% of the amount for tax purposes and 80% of the assets will be distributed to the IRA account owner. This complication makes Qualified Retirement Plan Rollovers a less attractive choice.

3) Qualified Retirement Plan Direct Rollover

The Direct Qualified Plan Rollover is probably your best bet. Similar to the IRA Transfer, the IRA Asset owner can rollover his assets directly from one financial institution to another without having to pay any taxes, and the 10% early withdrawal penalty fee. The only exception is that you are allowed to do a Direct IRA Rollover once every 12 months.

Year End IRA (Individual Retirement Account) Statements

If you own a Traditional IRA or a Roth IRA, your IRA Administrator must mail you atleast one year end statement every year. The deadline for this statement is usually January 31st, of the following year. Some of the year end statements you should receive include:

  • Fair Market Value (FMV) Statement
  • IRS Form 1099-R
  • IRS Form 1099-Q
  • Required Minimum Distribution (RMD) Form

Fair Market Value (FMV) Statement

The Fair Market Value Statement, as the name implies, will tell you the fair market value balance of your IRA assets as of December 31st, of the previous year. The Fair Market Value Statement will also calculate your Minimum Required IRA Distributions (RMD) that you must take out. This statement will also include a note that the fair market value of your investments will be reported to the IRS for tax purposes.

Required Minimum Distribution Notice

If at any year you reach the age of 70 and 1/2 and above, you will receive a Minimum Required IRA Distributions notice from your IRA Administrator. For example, if you turned 70 and 1/2 in the year 2004, you will receive this notice by a maximum date of January 31st, 2004. This notice will tell you exactly how much of required distributions you must take out.

IRS Form 1099-R

IRS Form 1099-R reports any distributions over $10 from any pension plans, Individual Retirement Account (IRAs), 403b plans, annuities, etc. Any IRA Re-Characterizations (change from a Roth IRA back to a Traditional IRA) will also be reported on this form.

Roth IRA Contribution Limits & Individual(k) Limits for Self Employed People

The Roth IRA contribution limits for the years 2003, 2004, 2005, 2006 and 2007 were greatly influenced by the Economic Growth and Tax Relief Reconciliation Act of 2002, which advocated for the increase in these Roth IRA contribution limits. A provision of the act known as the “Sunset Provision” made it official these that increases in contribution limits will only last till the year 2010, so now’s a good time to get into the Roth IRA! In 2010, the Congress will look at the total decline in revenues generated from these increased Roth IRA contribution limits, and whether these increases will become permanent or not.

The Roth IRA contribution limits are summarized in the table below:

Year Traditional Roth Traditional Roth Catch Up Simple Simple Catch Up 401k and 403b Plans 401k and 403b Catch Up Plans
2005 $4000 $4500 $10,000 $12000 $14000 $18000
2006 $4000 $5000 $10,000 $12500 $15000 $20000
2007 $4000 $5000 (Indexed) (Indexed) (Indexed) (Indexed)
2010 $5000 $6000 - - - -
2009 $5000 $6000 - - - -

Starting 2005, the Roth IRA contribution limits will be $4000, and will increase to $5000 in the year 2010. After 2010, the contribution limit will be incremented by $500 a year to adjust for cost of living and inflation. Therefore, the $5000 you are seeing for the 2009 column may not be entirely accurate, we will probably see $5500 in the column.

Why Should Young People Invest in a Roth IRA?

If you follow the Roth IRA Rules, any contributions you make towards a Roth IRA will grow tax-free for years to come, and with the power of compound interest, your money will grow at even a faster pace! Upon retirement, you will NOT have to pay taxes on your Roth IRA earnings as well. Furthermore, Roth IRAs allow you to invest in many different investments such as Bonds, Stocks, Real Estate, Derivatives, Mutual Funds and more.

A Roth IRA account can be opened until April 17th of the current tax year, and contributions can made starting from the previous year. The current maximum Roth IRA limit for 2006 is $4000. From 2010, the maximum Roth IRA contribution limit will rise to $5000.

Compound Interest & Roth IRA?

If a young saver at the age of 25 invests $4000 a year into a Roth IRA and earns 8% a year on his investment, he will have a huge nest egg of $1.1 million upon retirement (at the age of 65). What’s more, none of this $1.1 million nest egg is taxable upon retirement!

Consider a contra-example scenario. If that same 25 year old young saver invests $4000 a year into a regular taxable savings account earning 8% interest, he would grow a nest egg of $800,000 upon retirement (at the age of 65) – assuming a 15% tax rate.

Characteristics of a Roth IRA Account

  • Distributions or Withdrawals on your contributions from a Roth IRA account can be taken out at any time without incurring the 10% early withdrawal penalty fee in 401k accounts, as well as no taxes payable.
    Note: A Roth IRA is meant for saving towards retirement and withdrawals from your retirement savings account are always discouraged (unless for emergencies and unexpected circumstances).
    Note: Also note that withdrawals from your Contributions are non taxable. However, any earnings you have made on those contributions (such as the 8% interest earnings) is taxable at your local state & federal taxes and subject to 10% early withdrawal penalty fee (if withdrawn before the age of 59 and 1/2).