Understanding Taxes

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Healthier lifestyles and improved medical technology mean people are living longer than ever before, and that means they're retired longer than ever, too. Today, the average American spends eighteen years in retirement, but less than half of all Americans have put aside money specifically for retirement.

Many of those people are in for a rude awakening. Retirement is expensive: Financial experts estimate that most people will need about 70 percent of their pre-retirement income to maintain their standard of living when they stop working. A secure retirement requires planning--and money.

1. What are the basic approaches to retirement planning?

2. What is the first step in developing a retirement plan?

3. Contributing money to a retirement plan is a start, but how should that money be invested?

4. What is a 401(k)?

5. How do the latest tax changes affect Individual Retirement Accounts (IRAs)?

6. Are IRA contributions tax deductible?

7. What are the rules for withdrawing funds from an IRA?

8. What happens if you need to tap into your IRA before age 59 1/2?

9. How much do you have to withdraw from an IRA each year once withdrawals become mandatory at age 70 1/2?

10. Are there any limits on how much one can withdraw from an IRA each year?

1. What are the basic approaches to retirement planning?
Retirement savings have traditionally relied on a three-legged support: Social Security benefits, pensions, and personal savings. For many people, that stool is getting pretty wobbly. The long-term stability of the Social Security system is in doubt, and more employers are offering pension plans that require employee contributions. Yet, in 1993, one-third of the workers who were covered by their employer's tax-deferred 401(k) plan did not participate. Unless workers begin contributing to those 401(k)s, Individual Retirement Accounts, and other investment vehicles, a lot of future retirees will be living on a shoestring.

2. What is the first step in developing a retirement plan?
Individuals and couples should first think about the type of lifestyle they'd like in retirement, then estimate how much money they'll need to support that lifestyle. Financial experts suggest that most people need 60 to 80 percent of pre-retirement salary adjusted for inflation. Next, consider likely sources of income. Will you be able to collect full Social Security benefits at retirement? Will you receive a pension from any of your employers? Will you be able to supplement your income with part-time earnings or rental income? Then subtract the expected cost from the total expected income. The difference is your retirement savings goal.

Now you have to develop a realistic financial plan to reach that goal. Remember, the combination of time and compound interest means that even a small contribution can make a big difference.

3. Contributing money to a retirement plan is a start, but how should that money be invested?
When choosing among different investment instruments, whether in an employer-sponsored retirement plan or in your own IRA, it is important to keep a time horizon in mind--that is, the amount of time before retirement. People should invest as aggressively as their time horizon allows. Many people worry about the risk of investing in stocks or mutual funds. But stocks traditionally outperform bonds and fixed-interest investments over the long run. It is usually smart to allocate at least a portion of a portfolio to an investment that will grow over the years.

4. What is a 401(k)?
A tax-sheltered savings plan such as a 401(k) enables people to contribute pretax dollars directly from their paychecks and often offers several choices regarding how contributions are invested. But first the employee must sign up to participate in the plan. Taxes will be lower, the company may kick in more, and automatic deductions make it easy. If a company doesn't offer a retirement plan, employees can suggest that it start one. New tax laws make it easier than ever for companies, even small ones, to offer a 401(k) plan for their employees.

5. How do the latest tax changes affect Individual Retirement Accounts (IRAs)?
IRA rules have undergone some major changes, thanks to recent tax law changes. The net effect is to make IRAs more flexible and powerful retirement-planning tools. Beginning January 1, 1997, married couples in which one spouse does not work were put on an even footing with two-income couples. Both spouses can now contribute up to $2,000 per year to their IRAs for a total of $4,000 per couple, compared with the previous annual contribution limit of $2,250 for a one-income couple. For individuals, the maximum contribution stays at $2,000 of earned income per person per year. Also beginning in 1997, people under age 59 1/2 can tap into their IRAs penalty-free if they use the funds to pay large medical bills or to purchase medical insurance if they are unemployed.

Starting in 1998, underage IRA owners will also be able to make penalty-free withdrawals to pay for college expenses or to contribute up to $10,000 toward a down payment on a first home for themselves, their children, or their grandchildren. In addition, Congress has created an entirely new kind of IRA, called a Roth IRA, which will permit tax-free withdrawals after five years. Roth IRAs will be available starting in 1998.

Finally, the 15 percent excise tax on large IRA distributions, which had been temporarily suspended through 1999, has been permanently eliminated.

6. Are IRA contributions tax deductible?
Whether an IRA contribution is tax deductible is determined by gross income level and whether the individual or spouse participates in an employer-sponsored retirement plan.

A person can claim a full tax deduction for IRA contributions if he or she is single or head of household with an adjusted gross income of up to $25,000. If he or she earns between $25,000 and $35,000 and is covered by an employer's retirement plan, he or she may claim a partial tax deduction. A person may not deduct any portion of an IRA contribution if he or she earns over $35,000 a year and is covered by an employer's qualified retirement plan.

Under the 1997 Tax Act, the income limit for individuals to make tax-deductible contributions to an IRA will be raised gradually to $50,000 by the year 2005. For married couples, the current income limit for full deductibility is $40,000. Partial deductibility is allowed for couples earning up to $50,000; that figure will gradually increase to $80,000 by the year 2007.

7. What are the rules for withdrawing funds from an IRA?
Funds that have been growing tax-deferred in an IRA over the years are subject to federal income taxes at the regular tax rate when they are withdrawn.

An IRA holder can begin withdrawing funds from an IRA as early as age 59 1/2 without penalty. However, at age 70 1/2, the individual must begin to withdraw a prescribed minimum amount from the IRA each year. Delaying IRA withdrawals until they become mandatory makes sense for most retirees because it allows their nest eggs to continue to grow tax free as long as possible.

The withdrawal rules are different for the tax-free Roth IRAs, which were created by the Tax Act of 1997. This new type of IRA will be available starting in 1998. Contributions to this new type of IRA will not be deductible from income taxes, but withdrawals will be tax-free if the IRA has been held for at least five years and the account holder is at least 59 1/2 years old. Contributions to Roth IRAs can be made beyond age 70 1/2 and distributions are only required upon death, unlike traditional IRAs which require distributions to begin at 70 1/2 and forbid contributions beyond that age.

8. What happens if you need to tap into your IRA before age 59 1/2?
In some cases, IRA holders need access to their money fast--even if it means paying a 10 percent penalty for early withdrawal. This penalty does not apply if the distribution is due to death or disability, or if early distributions are taken in substantially equal payments based upon your life expectancy or that of you and your beneficiary.

Further exceptions to the early-withdrawal penalty were added starting in 1997. IRA holders who tap their accounts to pay for qualified medical and dental expenses that exceed 7.5 percent of their adjusted gross income (AGI) will not be subject to the 10 percent penalty. Although the amount withdrawn from the IRA would be subject to regular income tax, it will be offset by the fact that medical expenses in excess of 7.5 percent of AGI can be deducted from income taxes.

In addition, someone who is out of work and has received unemployment compensation for at least 12 consecutive weeks will be able to withdraw funds from his IRA penalty-free to help pay for medical insurance premiums. Under IRA regulations, an unemployed person younger than 59 1/2 can withdraw money from an IRA to pay for medical insurance premiums penalty-free but would still be responsible for the regular income tax on the withdrawal.

Beginning in 1998, IRA funds used for college expenses or up to $10,000 of IRA funds used to purchase a first home for the account holder or a family member will not be subject to the early withdrawal penalty.

9. How much do you have to withdraw from an IRA each year once withdrawals become mandatory at age 70 1/2?
To calculate minimum distribution, divide the IRA balance as of December 31 of the previous year, by life expectancy as determined by IRS actuarial tables. For example, a 70 1/2-year-old who has a 16-year life expectancy according to IRS tables and $100,000 in his IRA, would have to withdraw at least one sixteenth of the amount in his first IRA distribution. Taxpayers who wish to stretch out their IRA tax shelter can base their minimum withdrawal on the combined life expectancies of themselves and their named beneficiaries. For help in calculating this figure, visit ThirdAge's IRA Minimum Withdrawal Calculator.

10. Are there any limits to how much one can withdraw from an IRA each year?
Previously, a 15 percent excise tax was imposed on large distributions from qualified retirement plans, tax-sheltered annuities, and IRAs in excess of $155,000, or lump-sum distributions in excess of $775,000. That excise tax has now been eliminated.

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