PERSONAL FINANCE

Financial Planning
Retirement
Insurance
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Investment Planning
Taxes

Retirement

As more individuals change jobs more frequently, work for smaller firms or for themselves, and retirement firms shift more and more toward self-directed defined-contribution plans, individuals must ensure for their own retirement.

Two other factors that are causing individuals, especially young workers, to take a more instrumental role in their retirement are the longer life expectancies and the uncertainty of the social security program. More years spent in retirement and less reliance on company and government-sponsored pensions, will necessitate an increased focus on individual retirement planning.

Unfortunately, many individuals still believe in retirement "fate"-that one day they will decide to retire, and there will be the necessary funds or income to keep them in their current lifestyle. Perhaps they believe that a hefty pension plan, a generous family, or social security benefits will give them the resources they'll need. Other individuals, especially older workers, may simply not want to envision how their financial future will look or are unwilling to do the work now to ensure a retirement of financial security and a comfortable lifestyle. As a result, many of these individuals feel they don't need to "plan" for their retirement. However, it's precisely because of poor planning that causes many individuals to work more during their retirement years or for more years before they can retire.

For most individuals, the best choice, both financially and emotionally, is to effectively plan for retirement. Retirement planning involves the financial vehicles and strategies individuals and families use during their working years to ensure they will meet their goal of financial security upon retirement.

Proper retirement planning will help a family or individual:

• It will identify the likely investment sources and amounts that can be expected to finance the individual's retirement years.
• Identify various options for working during retirement
• Determine a realistic standard of living
• Estimate the amount of money necessary to finance the desired retirement standard of living
• Help determine when an individual will be able to retire
• Determine whether part-time employment during retirement should be considered

Proper retirement planning is designed first and foremost for the individual client. It's unlikely that "cookie-cutter" plans and rules-of-thumb will work for most individuals in the area of retirement planning. Individuals and families have far too many different personal goals, circumstances, risk tolerances, etc., to provide an simple, one-size-fits-all retirement plan. Effective retirement planning uses inputs from the client and planner to design strategies unique to that individual or family. By working together an effective strategy can be developed that will best suit the needs of the client.

Qualified Retirement Plans
Defined Benefit Plans
Defined Contribution Plans

• Profit-Sharing Plans


• Stock Bonus Plan

Withdrawals from employer and individual retirement plans
Rollovers from Retirement Plans

Although all qualified plans must meet minimum standards, each type of plan (for example, a 401(k) plan) must meet its own individual requirements before the IRS will recognize it as "qualified".

The benefits of qualified plans to employers and employees include the following:

• Employers may claim a current business deduction for their contributions to qualifed plans
• Employees are not currently taxed on contributions made to the plan on their behalf
• Earnings and gains within the plan are tax-deferred
• Certain qualified plans may allow employees favorable tax treatment when they receive distributions from the plan
• Employees are generally allowed to roll over distributions from the plan into another retirement plan upon departure from an employer

The two major types of qualified plans are defined benefit plans and defined contribution plans, each of which have certain advantages and disadvantages from the perspective of the employer and the employee.

Defined Benefit Plans
A defined benefit plan is set up to provide a predetermined retirement benefit to employees or their benficiaries either based on a specific dollar amount or as a percentage of compensation

In contrast to a defined contribution plan, the assets of a defined plan are combined in a company account, rather than individual accounts for each each employee. As a result, employees have no say as to how those assets will be invested. After the plan is established, the employer must continue to fund the plan, even in the absence of company profits. Because the employer makes specific promise to pay a fixed amount in the future, it is the employer who assumes the investment risk of the assets.

As with defined contribution plans, contribution limits are imposed on defined benefit plans. For defined benefit plans, the maximum amount of employer-derived annual benefits for an employee is currently (for the year 2008) the smaller of:
$185,000 or 100% of an employee's average compensation for the highest 3 consecutive years during which the employee was an active participant in the plan.

Pension Plans provide for payment of definitely determinable benefits to employees over a period of years, usually for life, after retirement. The amount of benefits to be paid and the contributions that must be made in order to pay those promised benefits cannot be dependent upon an employer's profits. A Pension plan may also provide for the payment of a pension due to disability or for the payment of death benefits.

Annuity Plans are pension plans funded not through the use of a trust or custodial account but through the direct purhcase by the employer of annuity contracts from an insurance company. Note: A profit sharing plan (see below) may also be funded through the direct purchase of annuity contracts, but such a plan is not referred to as an annuity plan.

a Cash Balance Plan is a defined benefit pension plan that provides benefits for each employee participant according to an amount of the participant's "hypothetical account balance". Each participant's balance is credited with "hypothetical allocations and earnings" determined under a predetermined formula. In this way, the "allocations" mimic those under a defined contribution plan (e.g., a money purchase pension plan). However, unlike a money purchase pension plan, under a cash balance plan the interest is credited to each participant's account at a specified rate that does not vary with actual investment performance. Note: These types of plans have recently been under attack in Congress as older, longer-term employees close to retirement are seeing lower projected benefits when employers convert traditional defined benefit plans into cash balance plans.

Profit-sharing plans
Profit sharing plans allow employers to make a discretionary, tax deductible contribution on behalf of employees each year. The plan does not need to provide a specific formula to calculate the profits to be shared, but there must be "systematic and substantial" contributions There must also be a specific formula to allocate the contribution amount the participants to distribute the funds to employees upon reaching retirement age. Despite its name, contributions to a profit sharing plan do not have to come from company profits. In fact, not-for-profit (tax-exempt) organizations may actually maintain a profit sharing plan. The employer's (tax-deductible) maximum deduction is 15% of total annual salaries paid to non-owner employees (adjusted to 13.04% for a small business owner).

Stock Bonus Plan
Stock Bonus Plans are designed to provide benefits similar to those of profit sharing plans except accumulated benefits are distributed in the form of employer company stock. Otherwise, stock bonus plans are comparable to profit sharing plans with regards to allocating and distributing contributions to employees and their beneficiaries.

401(k) Plans
A 401(k) plan, also called a qualifed "cash or deferred arrangement" (CODA) is a plan in which employer contributions to the plan are not included in the income of employees. (403(b) plans, 457 plans and federal Thrift Savings Plans are substantially identical to 401(k) plans regarding contribution limits and mechanics.) These deferrals (and any earnings on them) will not be taxed until withdrawn from the plan. A 401(k) plan may be set up as part of a profit-sharing or stock bonus plan (and money purchase plans established before 1974).
Within a 401(k) plan an employee is allowed to invest in different types of investments such as company stock, mutual funds, Guaranteed Investment Contract (GICs), etc., all of which is up to the discretion of the employees. For 2008, the maximum annual limit on an employee's contribution to a 401(k) plan is $15,500, with a "catch-up" extra contribution for those age 50 and over of $5,000.

A few 401(k) tips

• Know your 401(k) - investment options, loan requirements, vesting requirements, etc. Monitor your investment holdings, options, etc. Verify that your company is making appropriate contributions according to your wishes. If there's something you don't understand about your investments or options, contact your human resources manager or a personal financial advisor to help you.
• Contribute to your 401(k). Depending on your personal tax situation, investment goals, cash flow needs etc., it may not always be wise to maximize your 401(k) deferrals. Although most employers allow employee deferrals of at least 15%, two-thirds of individuals' 401(k) contributions are between 5% and 8% of employee compensation. Depending on personal circumstances, investment options within and outside the plan, and personal cash flow needs, individual contributions should depend on an employee's unique financial circumstances.
• Diversify your 401(k). More and more companies are offering more investment selections for employees. According to the Profit Sharing/401(k) Council of America, the average employer-sponsored plan now offers 17 investment options, double that of ten years ago. Given the greater level of investment choices, it doesn't make sense to overweight your investments in your own company's stock. Use all the investment options available to you to diversify by type of investment, company size, and geographic locations.
• Roll over your 401(k). While the percentage of 401(k) participants who roll over their 401(k) into an IRA or another employer's plan, most participants still elect to cash out their 401(k). According to Hewitt Associates, 68% of participants did not roll over their benefits and elected to cash out their 401(k) despite the loss of tax deferral benefits, investment compounding and taxes and penalties that can exceed 40% of withdrawals.

SEP-IRA Plans
A simplified employee pension (SEP) is a retirement plan for self-employed individuals or employees of small companies that allow for higher levels of tax-free deferrals than regular IRAs. SEP-IRA employer contributions are limited to 25% (up to maximum of $46,000 for 2008) of employee compensation. Employer contributions are made pre-tax, and contributions and earnings can grow tax-deferred until withdrawn. Because SEP-IRA plans are quite easy to set up and administer, they are very popular plans for self-employed individuals and small business owners. In addition, the flexibility by the employer to contribute larger or smaller amounts depending on financial conditions, makes them especially attractive. And for employees, since contributions to their SEP-IRA come from their employer, they do not preclude the employee from investing in a "regular" IRA of his or her own.

SIMPLE-IRA Plans
Another retirement plan that is attractive for many small business owners because of its ease in its establishment and administration is the SIMPLE (savings incentive match plan for employees) plan. These plans are available for employers with no more than 100 employees and allow employees to contribute up to $10,500 in 2008 (and an extra $2,500 "catch-up" for those age 50 and over) with an employer match of up to 3% of each employee's pay. With the SIMPLE, there are no reporting requirements for the employer except a single report to the government when the plan is established. And as with the SEP-IRA employer are allowed a business deduction for contributions to the employees' accounts.

Note that the SIMPLE plan imposes a 25% penalty tax on distributions from these accounts within the first two years of participation (with a 10% penalty for premature distributions after that two-year period). After two years of participation in a SIMPLE-IRA, and upon separation of service from an employer, the plan may be rolled over to an individual IRA without penalty.

Tax-sheltered Annuities (TSA)/403(b) Plans
TSA's are tax-exempt retirement plans purchased by qualified employers for eligible employees. Eligible employers for 403(b)'s are: public schools, certain tax-exempt organizations, and certain employers of ministers. TSA contributions are often funded through salary reduction agreements under which an employee agrees that a portion of his or her salary will be contributed to a TSA (called elective deferrals.) The limit on elective deferrals to 403(b) for 2008 is $15,500. TSA plan assets are usually invested in annuity contracts or custodial account holding mutual funds.

Personal Annuities
An annuity is a contract normally sold by an insurance company that will pay the investor periodic payments, usually after normal retirement age. Payments may begin immediately (immediate payment annuity), or may begin after a certain period of time (deferred annuity). The payments may continue as long as one or more annuitants are alive. As its name implies, fixed annuities guarantee a series of fixed payments over a period of time. The payments from a variable annuity will vary depending upon the performance of the underlying securities. Although there are usually penalties on early withdrawal or surrender of an annuity contract, the primary benefit of an annuity is the tax-deferred earnings growth that they provide.

Individual Retirement Accounts (IRAs)
IRAs or Individual Retirement Accounts allow individual taxpayers to set aside up to $5,000 in 2008 of earned income each year, with earnings tax-deferred until withdrawals are made for retirement (usually after age 59 1/2). Individuals over the age of 50 will be allowed to contribute an additional $1,000 "catch-up" contribution. Individuals' who contribute to company-sponsored retirement plans (or are considered "active participants") may be limited to the amount that they may deduct from their income taxes. However, any individual with earned income can make non-deductible contributions that can accumulate tax-deferred until withdrawals begin.

Individual retirement accounts can be established as a domestic trust or custodial account with a bank or similar organization acting as trustee or custodian. With traditional IRA's, distributions must begin no later than April 1 of the year following the year the account owner reaches age 70 1/2. Distributions not made in a single year must be distributed over a period not exceeding the owner's life expectancy or the life expectancy of the owner and a designated beneficiary.

The Roth IRA does not allow annual contributions to be deducted from taxes, but it does allow interest to accumulate tax free and if certain conditions are met, allow tax-free withdrawals upon retirement (or earlier). See our page on Taxes for more information about IRA's.

Retirement account distributions before age 59 1/2 not subject to premature distribution tax

• Death of owner: Distributions made to a beneficiary (or estate) upon the death of the owner are not subject to this penalty.
• Distributions following disability: Distributions made to a participant who is totally and permanently disabled are not subject to the 10% penalty tax.
• Retirement (separation from service) after age 55
• Distributions not exceeding the amount of deductible medical expenses: A deductible medical expense is one that exceeds 7.5% of adjusted gross income (AGI)
Note: The following penalty exceptions apply to IRA distributions:
• Distributions as part of a series of substantially equal payments: When IRA distributions are paid at least annually based upon the life expectancy of the individual (or the joint life expectancy of the individual and a beneficiary), those payments avoid the 10% penalty tax
• Educational expenses: the 10% penalty tax will not apply if the individual uses IRA funds to pay higher education expenses (tuition, fees, books, and equipment) for the individual, his or her spouse, or a child or grandchild of the individual or the individual's spouse
• "First-time" Home purchase: A 10% penalty tax will not apply on IRA withdrawals of up to $10,000 for expenses to buy, build, or rebuild a home that is the principle residence of the individual, the individual's spouse, or any child, grandchild, or ancestor of the individual or spouse. To be considered a first-time homebuyer, the individual (and spouse if married) must have not owned their principle residence in the two-year period prior to purchase.

Rollovers from Retirement Plans
The transfer of retirement plan assets from one retirement vehicle to another that avoids taxation is called a "rollover" or "rollover distribution". These transfers can be from one qualified employer plan to another or from an employer plan to one or more individual IRAs.

Distributions from qualified plans not directly transferred to another plan are subject to a mandatory 20% withholding on the amount of assets transferred. For example, even if an employee rolls a distribution over into an IRA, if the individual ever received the distribution, the employer will still withhold 20% from the original distribution. This 20% withholding may be avoided if, before receiving the distribution, the individual instructs their plan administrator to make a direct transfer and transfer the plan assets directly to an IRA or other qualified employer-sponsored plan.

Qualified plan assets that are not transferred directly into another retirement plan may be rolled over tax-free into another IRA or qualified plan within 60 days after receiving the distribution. However, an ordinary rollover such as this will not avoid the 20% backup withholding.

Although IRAs are generally not allowed to be rolled over into an employer-sponsored qualified plan, IRA assets may be rolled over into another IRA if transferred within 60 days after received and if no similar distribution has been made in the prior 12 months.

David Alan Pace, CFP, CFA, EA, Pace Financial Services

This document is for information purposes only. No part of this report may be reproduced in any manner without permission of Pace Financial Services. The views and opinions expressed in this report are not intended to serve as specific financial planning advice or recommendations, and individuals should discuss their specific financial goals and available options with a professional advisor.