In his budget proposal for 2015, Obama is proposing that Social Security shortfalls be financed by means previously considered politically untouchable. The president will recommend that high-income taxpayers have the amount of their salaries eligible to be deferred in 401k plans, IRAs and other retirement vehicles be curtailed as a way of generating more tax revenue in the here and now. Worse, the total assets that could potentially be held in tax-deferred retirement accounts would be capped at approximately $3.4 million.
It’s worth mentioning that these proposals have little chance of getting past the Republican-controlled House, and that even many Democrats would vote against it, given that it could cost them their seat in Congress. Plus, even if the proposals were to come to fruition, they would not affect most American savers. If you have your IRA capped because you have more than $3.4 million in it, this is what I would call a “high-quality problem.”
Still, the president’s proposals are noteworthy because they break longstanding taboos about the sanctity of retirement accounts and they set a dangerous precedent. Today, IRAs are being capped. Tomorrow, will they be seized?
Personally, I don’t see that happening … but then, 50 years ago, few would have seen the traditional corporate pension plan giving way to the 401k.
Retirement planning is a practice that is constantly evolving, and we have to keep up with the times. So, let’s take a look at the current retirement landscape and go over the various investment options available to you.
401k Plans
The 401k is the lynchpin of most Americans’ retirement plan and with good reason. They are widely offered, easy to understand, and your employer takes care of most of the burdensome paperwork and even makes your contributions for you via salary deferral. You also get an instant tax break, and your dividends, interest and capital gains accumulate tax-free until you take distributions in retirement.
Plus, because of employer matching, a 401k plan often ends up offering instant returns that you simply can’t get elsewhere.
What do I mean by that? It’s hard to beat instant 100% returns. And that is precisely what you get when your employer matches your 401k contributions dollar-for-dollar. Not all employers match, and some are more generous than others. But most employers offer matching in the ball park of 3% to 6%. If you don’t take advantage of this, frankly, you deserve to starve in retirement.
If you can afford it, I recommend you max out your annual 401k contributions; in 2014, that amounts to $17,500. However, for many Americans — and particularly young Americans — $17,500 is simply too much to part with in a given year.
But you can afford to put in the 3% to 6% that your employer is willing to match. And if you can’t … well, you probably need to re-evaluate some of your lifestyle choices. That 3% to 6% compounded over a working lifetime can make the difference between retiring in style and moving in with your kids.
IRA and Roth IRA Accounts
Congress doesn’t do much right, it seems. But when it created individual retirement accounts (IRAs)in 1974, it gave Americans one of the most versatile investment vehicles ever conceived, and one that has become the fundamental building block for millions of retirement plans.
When Congress created the Roth IRA in 1997, they took a great idea and made it even better.
With a traditional IRA, you receive a tax break in the tax year in which you make a contribution, and you pay no taxes on the dividends, interest and capital gains that accumulate. You only pay taxes once you start to take distributions — in retirement. With a Roth IRA, you get no tax break in the year of the contribution, but you are able to remove the funds tax-free in retirement.
In 2014, you can contribute $5,500 to either type of IRA and $6,500 if you are age 50 or older.
If you have income from a job or from a small business, you should have an IRA or a Roth IRA — or perhaps both, depending on your situation. But if you were going to only have one, which would be right for you? The answer to this question is going to depend primarily on three factors:
- Your age
- Your income
- Whether you have access to a 401k plan or comparable retirement plan at work
Age: When you fund a traditional IRA, Uncle Sam is giving you a tax break. But he still wants his money. Hence, we have “minimum required distributions.” When you reach the age of 70½, you are required to start withdrawing from your IRA account and to pay ordinary income taxes on the withdrawals.
These days, a lot of Americans continue to work well into their 70s, whether they need the money or not. If you are approaching or already over the age of 70, it makes sense to contribute to a Roth IRA, which has no distribution requirements, because you are not permitted to contribute to a traditional IRA after the age of 70½ … and even if you could, it wouldn’t make sense as you would have to start withdrawing it immediately thereafter.
Income: Your ability to contribute to a Roth IRA gets phased out at higher incomes — and unfortunately, the income levels aren’t as high as you might think.
You can contribute the full $5,500 to a Roth IRA if you are a single taxpayer with a modified adjusted gross income (MAGI) of less than $114,000. Contribution amounts start to phase out at MAGIs between $114,000 and $129,000, and if you make $129,000 or more, you cannot contribute at all.
Married couples can make a full contribution to a Roth IRA if their combined incomes are less than $181,000. Contribution limits for a Roth IRA phase out between $181,000 and $191,000, and at incomes of $191,000 or more, you cannot contribute at all.
So, if you are considered a high-income taxpayer, the Roth IRA is not an option for you.
But let’s assume that your income makes you eligible for either a traditional or Roth IRA. There still are other income factors to consider.
Let’s say that you are married with two children and, thanks to the responsibilities of raising children, your spouse does not work. Let’s also assume you have a mortgage. If this describes you, chances are good that your dependent and home deductions put you in a very low tax bracket. In this case, the current-year tax deduction for a traditional IRA isn’t going to be worth much, and you’re going to be much better off with a Roth IRA.
But 10 to 15 years from now, your kids will have left the nest and your spouse has returned to work. You’re also paying less in mortgage interest because you’ve paid down a large chunk of your mortgage. You’re going to be in a much higher effective tax bracket. Taking an immediate deduction with a traditional IRA suddenly looks a lot better.
The questions you have to ask yourself are “What tax bracket am I in today?” and “What tax bracket do I expect to be in later?”
If your situation changes, no big deal. This is not monogamous marriage. You’re allowed to open multiple IRAs and to contribute to whichever one makes the most sense in a given tax year. Just make sure that you keep the total contribution under the $5,500 limit.
Retirement Accounts at Work: “If you have access to a 401k or comparable retirement plan at work, your ability to deduct a traditional IRA contribution on your tax return may also be phased out. This doesn’t mean that you can’t contribute, mind you. It simply means you can’t deduct the contribution.
For a single taxpayer, you can take a full deduction at MAGI of $59,000 or less. Above that, your deduction is phased out, and no deduction is allowed at MAGI of $69,000 or more. For a married couple, the phaseout starts at MAGI over $95,000, and no deduction is allowed at MAGI of $115,000 or more.
In this case, the Roth IRA clearly is going to be a better option for you.
But if you are unable to contribute to a Roth IRA due to, say, high income restrictions, the nondeductible traditional IRA is still a viable option. You just need to keep track of your basis so that you are taxed only on your earnings. (This is something you’d probably want to discuss with your accountant).
When would a nondeductible traditional IRA be appropriate? If you are aggressively saving for retirement, and you have already maxed out your company 401k plan, then tossing an additional $5,500 into an IRA can be a nice bonus.
Traditional Pensions and Annuities
The only defined-benefit pension (i.e. a retirement payout that is based on negotiated promises and not based on market returns) that most Americans get is Social Security. And while most of us cannot live on Social Security alone, it does provide a nice baseline of income to pay for you basic living expenses.
It won’t buy you a beach house in Florida or a retirement full of travel and adventure, but it will pay for most Americans’ grocery and utility bills and day-to-day expenses.
If you’re one of the roughly 20% of Americans who has a traditional pension, consider yourself lucky.
In most pension arrangements, a retiree is entitled to a defined benefit. What this means is that the pension provider is on the hook to maintain a guaranteed payout for the retiree’s life and often times the life of their spouse as well.
There are a few limits: For instance, pensions generally have some allowance for payout increases based on inflation, but generally no allowance for an increased payout due to better-than-expected investment returns. And when you and your spouse die, the payouts stop. Also, there usually is no provision for transferring your pension benefits to your children or other heirs. Nonetheless, the security and the company-sponsored facets of this type of retirement plan makes it an enormously cherished one.
But unless you work for the public sector or are a member of a union, chances are good that you will not be getting any sort of fixed payout in old age other than Social Security. Pensions have been in rapid decline for decades — specifically, private-sector pensions have declined from nearly 35% in the early ‘90s to 18% today. Businesses are increasingly shedding these cost-prohibitive plans for more corporate-friendly 401ks, making pensions the relative dinosaur of the retirement-planning world.
The good news, however, is that you can create your own pension via an immediate annuity.
An immediate annuity is essentially the opposite of life insurance. Rather than pay an insurance company a monthly premium in exchange for a lump-sum payout at death, you pay the insurance company a lump sum today in return for a guaranteed monthly payout for the rest of your life.
Note: Immediate annuities should not be confused with variable annuities. Variable annuities are a saving and investment vehicle and might be a good option for investors who have already maxed out their 401k/IRA options for the year. An immediate annuity is a distribution vehicle designed to convert existing savings into a secure payout.
But be careful here. You retirement income is only as safe as the insurance company making the promises. Depending on where you live, your annuity may (or may not) be guaranteed by your state. So, consider the financial health of any insurance company in which you’re considering trusting your savings.