The importance of retirement plans is so often overlooked in many of our investment decisions. It is quite alarming to find so many of my successful clients, usually business owners, who have not done any retirement plan investing for future years. Frequently, only after demonstrating the significant tax advantages of a retirement plan do many of my clients decide to invest in one.
Beginning with 1998, retirement planning has taken on an added level of complexity with the option of contributing to a traditional IRA or a Roth IRA. Each type of IRA offers its own unique tax benefits.
For 1999, you may be able to contribute $2,000 to a traditional IRA or a Roth IRA. The main difference between the two plans is that a traditional IRA is deductible, a Roth IRA contribution is not. However, if you meet specific requirements, the interest, dividend and appreciation in value that accrues in your Roth IRA is not subject to federal income taxes when the funds are withdrawn. In a traditional IRA, all the funds are taxable when you withdraw them, usually at the 20% required back-up withholding rate. You may also make contributions to a Roth after you reach the age of 70-1/2 and you do not have to withdraw funds during your lifetime, unlike the traditional IRA. Due to earnings limitations and the participation in an employer's qualified retirement plan, a Roth IRA contribution would make sense for many taxpayers.
Perhaps the greatest advantage since the IRA retirement plan was introduced is that it forces the taxpayer to save money for retirement. If a taxpayer begins contributing $2,000 each year beginning at age 30, that same taxpayer could have over $150,000 at a compounded interest rate of 7% over the next 30 years. Every individual should, at the very minimum, contribute to an IRA retirement plan, if they have no other plan available to them at work. Even if you don't receive a deduction for your retirement plan contribution, you can still obtain a tax savings because the income or gain that you realize in your retirement plan will be tax deferred. You also achieve the desirable result of having the retirement plan's income or gain grow on a tax deferred basis over a long period of time.
Pre-retirement withdrawals require a 10% penalty assessment if made before you reach age 59-1/2. But what if you are in the 15% tax bracket this year and you need the funds for current financial needs. Then you are taking the funds at a tax rate of 25% (15% tax bracket plus the 10% penalty) . This is not a bad deal, considering that you might be in a higher bracket when you retire.
This arrangement is even better if your deductions for the year exceed your other income. You may be able to acquire these funds at the tax cost of only 10%. Most tax advisors do not advocate these kinds of pre-disposed IRA withdrawals. But for all those who have neglected to contribute to a plan because they feel they may need the money later on, this is a tax strategy to consider.
The 10% penalty does not apply in the following distributions:
- Due to a death or disability
- Made in the form of certain periodic payments for the life or life expectancy of the individual or individual's beneficiary
- Used to pay medical expenses in excess of 7.5% of adjusted gross income
- Used to purchase health insurance of an unemployed individual
- Post-1997 distributions from a traditional IRA are not subject to the 10% tax on early withdrawals if you use the amounts to pay qualified higher education expenses, or pay expenses incurred for qualified first-time home buying expenses up to the first $10,000
If you have net earnings from self-employment, you may be eligible to open and contribute to a special retirement plan called a Keogh plan. You do not have to operate a full-time business in order to be considered self-employed. Thus, if you work for a salary during the day and conduct a business from your home in the evening, the net earnings from your home business are considered self-employment income. Contributions into this type of plan cannot exceed the smaller of (a) $30,000 or (b) 25% of the participant's compensation.
Keogh plans must be established by the end of your tax year. However, you may fund the Keogh plan for the prior year up to the due date of your return for that year. You may make your contributions up to April 15. If you requested an extension, your contribution does not have to be made until the extended date of August 15. Besides the time advantage to making a Keogh plan contribution, having a self-employed retirement plan allows you to save larger amounts for retirement, unlike the $2,000 IRA contribution limitations.
In addition to establishing your own plan, you may be eligible to participate in your employer's retirement plan. The rules governing employer-sponsored plans are quite complicated. In general, you should know the following:
- How your plan operates and the limits on the amounts you may contribute
- How your employer's contribution is computed
- Whether you may direct the investment of your account
- Whether you can borrow on the fund
- How and when you can begin withdrawing from the fund