There are plenty of ways to save for retirement. And come January 2006, many Americans will be faced with evaluating and deciding whether to use a new tax-sheltered way of investing for retirement -- the Roth 401(k).
Starting next year, employers sponsoring 401(k) and 403(b) plans will be able to offer “it” to participants as an added option, in accordance with the Economic Growth and Tax Relief Reconciliation Act of 2001, which President Bush signed into law on June 7 of that year and which was much better known for its major income tax reductions. While the Treasury Department has yet to release its final regulations, major elements of Roth 401(k)s are known, based on the 2001 act, on the Treasury’s proposed regulations which were released for public comment last March 2, and on the retirement plan concepts long associated with the terms, “Roth” and “401(k).”
“Roth” IRAs were named in honor of the late Sen. William V. Roth, Jr., (R-DE), chairman of the Senate Finance Committee from September 1995 to January 2001, at whose initiative they were made available to individuals in 1998 as an alternative to traditional IRAs. Traditional IRAs generally permit individuals to (1) invest a sum of their pre-tax earned income, which means they may be able to deduct the contribution from their current taxable income, and (2) let the money grow tax-deferred, but (3) require them to pay taxes on withdrawals at then-prevailing tax rates (and with potential penalties for withdrawals before age 59 ½). Roth IRAs, on the other hand, enable individuals to (1) invest after-tax earned income (no tax deduction on contributions), (2) let it grow tax-deferred, and (3) take entirely tax- and penalty-free withdrawals (provided certain conditions are met). One additional major difference between a traditional IRA and a Roth IRA is that owners of a Roth IRA do not have to take required minimum distributions or RMDs. Those are the distributions that traditional IRA owners must take after reaching age 70 ½.
401(k) plans, long available to eligible employees of companies that offer them, more closely resemble the traditional IRAs. Participants may (1) have pre-tax income withheld to invest in employers’ stock and/or a menu of mutual funds and other alternatives (employers may partially match contributions but the matched funds will be taxed as traditional 401(k) contributions), and (2) enjoy tax-deferred growth in their accounts, though they must pay taxes on the total amount of their pre-tax deferrals and any account growth at the time of distribution. 403(b)s, also known as Tax-Sheltered Annuities (or TSAs), are available to employees of schools and universities, churches, public hospitals, and charitable tax-exempt organizations. Some 403(b)s allow for employers to match contributions (similar to a 401(k) plan.)
Participants in these plans may be able to contribute (and deduct from taxable income) significantly more than the current $4,000 ($5,000 if age 50 or older) they are generally permitted when investing in IRAs. Thanks to the 2001 law, they may contribute and deduct $15,000 in 2006—up from this year’s $14,000—plus an additional $5,000 under a “catch-up provision” for individuals 50 or older.
Employers interested in sponsoring Roth 401(k) and 403(b) plans are presently (as of August 31, 2005) waiting for the Treasury to issue its final regulations—after completing its review of comments on its proposed set—so that they can know all they need to know to complete their plan designs and ensure that payroll and recordkeeping systems are ready for the additional work.
How many are likely to add Roth 401(k)s to their plans? No one knows, of course, but surveys of two overlapping groups of 450 and 200 large employers by Hewitt Associates, a major human resources services firm, have indicated that about 30 percent are somewhat or very likely to add such accounts to their plans in January. A Vanguard survey of its 401(k) plan clients indicates a similar level of interest.
Who should consider using a Roth 401(k)? Candidates include those who want to avoid required minimum distributions and those who predict that using the Roth will produce tax savings after factoring current and future income and current and future tax rates. In essence, participants – especially younger employees and low- to middle-income employees (those taxed at 10 or 15 percent) – who expect their tax rates to be higher during retirement (when they are likely to take a distribution from a retirement plan) could benefit from a Roth 401(k). Older employees who may be in the peak earning years and those who expect to be in a lower tax bracket during retirement might consider using the traditional 401(k), which allows them to defer taxes at high rates now and pay them at lower rates in the future. Of note, a person can contribute in aggregate no more than the $15,000 (in 2006) maximum allowed, no matter which account is used - Roth 401(k) or traditional 401(k). But you can invest a portion of your deposits in both types of accounts, if both are available.Also of note, the Roth 401(k) has RMDs, but a rollover to a Roth IRA would avoid the RMD requirement.
According to the Vanguard Center for Retirement Research, participants who do get the chance to evaluate whether to use a Roth 401(k) may fall into other categories, including:
Maximum savers, mostly earning high-income or having high net worth, who will be contributing at the limit of $15,000 (or $20,000 including the age 50 catch-up of $5,000) and who may account for 10 percent of 401(k) participants. By keeping the maximum limits the same for pre-tax and Roth plans, Congress has effectively increased the savings that individuals can shelter from taxes in their retirement plans.
Participants who are well prepared for retirement by saving more than the 6 percent median contribution rate, who are likely to be in the same tax bracket in retirement as today, and who face a risk of being in a higher bracket, in part because withdrawals from pre-tax plans would accelerate taxes due on Social Security benefits.
Those broad categories notwithstanding, 401(k) participants faced with the opportunity to use a Roth 401(k) should definitely consult a financial planner, asking them to prepare an analysis that incorporates likely tax rate and income scenarios. To be sure, the Roth 401(k) is likely to be an excellent retirement savings vehicle. But using it without proper analysis could lead to unintended consequences, namely this: choosing to make after-tax deposits now (i.e., paying taxes immediately) to get tax-free growth in the future may be a losing proposition if you’re actually going to be in a lower tax bracket in the future - you will have voluntary paid high tax rates to avoid low ones. In a nutshell, the choice boils down to paying taxes now (Roth IRA or 401(k)) or paying taxes later (Traditional IRA or 401(k)), with the variable being what the individual thinks their tax rates will be in the future compared to now.
September 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bold Financial Planning, LLC, a local member of the FPA.
It used to be enough for financial planners to help clients minimize losses by making them aware of the risks inherent in various financial assets—even securities backed by the U.S. Treasury—and by steering them away from imprudent asset allocation and unsuitable investments.
If these seemed like challenges, they were relatively easy to defend against when compared with the potential for losses of money and credit standing which virtually anyone may face today when Social Security numbers or other personal data fall into the hands of criminals and are used for illegal gains at their owners’ expense.
“Identity theft” is, to boil down the definition of the 1998 law that made it a federal criminal offense, the unauthorized transfer or use of “a means of identification of another person with the intent to commit…any…activity (which violates federal, state, or local law).”
It can result in losses of money and reputation which may not be discovered for weeks and which may require more time, at possibly significant costs, to recover, if possible at all.
Increasingly vulnerable to such dire circumstances, clients of financial planners have much to do to help themselves, of course, but would surely welcome advice from planners going beyond their traditional responsibilities when opportunities arise.
To help clients to be protected against identity theft, it is important for them to have a sense of the many ways in which it may occur.
Incidents typically involve the unauthorized use of Social Security, bank account, credit card, charge account, driver’s license, and telephone calling card numbers; Personal Identification Numbers (PINs), user IDs and passwords, whether unknowingly given to the wrong people or obtained in other ways. A mother’s maiden name, a favorite pet’s name, or the last four Social Security digits, which are often used to verify identity, are also subject to abuse.
They may be copied from plastic cards, statements (presumably including financial planners’ statements), charge slips, or other documents. They may be discerned when criminals watch people punching numbers into ATMs or public telephones, or when they eavesdrop on people giving numbers over phones. They may be retrieved from discarded checks, statements, other records—or discarded forms sent with “pre-approved” credit cards, which are activated without the recipients’ knowledge.
According to a U.S. Justice Department advisory on identity theft, the Internet has become an appealing place for criminals to obtain identifying data, such as passwords or banking information. Many people respond to unsolicited e-mail that promises them some benefit, but requests identifying data.
“With enough identifying information about an individual, a criminal can take over that individual’s identity to conduct a wide range of crimes: for example, false applications for loans and credit cards, fraudulent withdrawals from bank accounts, fraudulent use of telephone calling cards, or obtaining other goods or privileges,” says the Justice Department advisory.
Criminals’ e-mails also “lure their targets into a false sense of security by hijacking the familiar, trusted logos of established, legitimate companies,” says a Securities and Exchange Commission advisory.
Whatever the technique, illegally obtained personal information can result not only in withdrawals of money or in large debts but also in crimes that are traced to the victims. How can such incidents be minimized?
Do not give anyone—on the phone or Internet—a Social Security or other personal number unless sure that the request is legitimate.
Do not carry your Social Security card or number with you. If your state uses your Social Security number on your driver’s license, ask them to change it to a random number.
Be cautious when pressing ATM or telephone buttons or dictating numbers on telephones in public.
Retrieve sales and charge slips, safely retain them, and shred them before discarding them.
Check statements for charge, bank, brokerage, and other accounts for unauthorized transactions, retain them, and shred them when they are no longer needed.
Shred unneeded cancelled checks and “pre-approved” credit card offers.
Delete unsolicited e-mails requesting information from firms you do not know, and verify—by phone, not by e-mail response—the legitimacy of those appearing to be from firms you know.
Log out when finished with a secure Web site before going to the next.
Consider using a lockable mailbox or a P.O. Box.
For optimum security, a cross-cut shredder should be used (not any shredder will do).
Contact the credit bureaus to opt out of solicitation credit offers via the mail.
Do not offer personal information over the phone, unless you initiated the call, and the number called is from a reliable source.
Make your computer safer.There are free programs that can do the trick.For a firewall, zonealarm (www.zonealarm.com) is free.For spyware, adaware (www.lavasoftusa.com) or spybot search and destroy (www.safer-networking.org) are both free. A firewall can keep intruders from pulling information from your hard drive. Spyware is necessary because there are spy programs that can track the Web sites you visit and track your keystrokes on those sites.
Also, do not carry a checkbook in your wallet or purse.
If identity theft occurs, notify:
The fraud department of one of the three major credit bureaus (Equifax, 800.525.6285; Experian, 888.397.3742, and Trans Union, 800.680.7289), the police (and obtain a copy of their report), and the Federal Trade Commission (877.438.4338).
Postal Inspection Service, if an unauthorized change of address form has been filed to redirect mail.
Social Security Administration (800.269.0271), if a Social Security number has been fraudulently used.
Creditors and financial institutions, if fraudulent transactions are suspected.
September 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bold Financial Planning, LLC, a local member of the FPA.
Baby boomers, as they move toward retirement, are beginning to question how they will maintain their standard of living during their golden years. For many, the need to create lifetime income will require the use and integration of many investment products, perhaps including variable annuities.
For those of whom variable annuities are a suitable solution, the big question to answer is “which one?” Variable annuities today come with a variety of riders, all of which are designed to address specific investment objectives and risk profiles, but especially principal risk and longevity risk. Most of those features come in the form of guarantees, chief among them the guaranteed death benefit and the guaranteed living benefit. What are some of those guarantees and what are the risks and benefits associated with those guarantees?
Variable annuities with a guaranteed death benefit are suitable for individuals who would like to be heavily invested in the market, yet would like to have guarantees about the amount of money that their heirs will receive even if the market declines, and who want at least some access to the cash value in the meantime. In other words, they do not plan to or need to “annuitize” their variable annuity. Often, the basic death benefit is equal to the greater of (1) the contract value, and (2) purchase payments less withdrawals (or what is also called a “return of premiums” guarantee)and is made to the beneficiary upon the death of the owner and/or annuitant, according to RetireOnYourTerms. Nearly all contracts sold these days have additional death benefit features, including guaranteed accruals on premiums and/or so-called “high water marks” that pay the highest value on any previous contract anniversary date, according to “The Annuity Advisor” by John Olsen and Michael Kitces, MSFS, CFP®, CLU, ChFC.
Some variable annuities also have guaranteed living benefits, which are designed for investors who desire current protection of principal, income, or the ability to take withdrawals, while they are still alive. In some cases, obtaining the protection features may require them to “annuitize” their investment. In other cases, principal may be recovered through guaranteed withdrawals over a specified period, and annuitization is not required. Other forms of living benefits guarantee a floor of principal that will be restored if the annuity has experienced losses over a set time period. With a guaranteed living benefit, the owner or annuitant is purchasing protection against investment risk or the risk of not being able to generate an adequate amount of income, and the variable annuity contract will either guarantee the level of account values which may be accessed through current withdrawals or the amount of annuitized payments that can be received in the future.
Typically, these guarantees come with some restrictions of one form or another depending on the guarantee. What’s more, variable annuities with guarantees may be confusing. Contracts, for instance, may make a distinction between the payout base of a variable annuity that can be used to generate guaranteed income (but not available for withdrawal) and the actual contract cash value that can be surrendered at any time.
The most popular forms of guaranteed living benefits features are guaranteed minimum income benefit (GMIB) riders, guaranteed minimum accumulation (or account) benefit (GMAB) riders, and guaranteed minimum withdrawal benefit (GMWB) riders. Immediate annuities with for-life guarantees can be nice retirement income tools, but may not always be the best fit for your client.
The variable annuity with a GMIB rider ensures that under certain conditions the owner may annuitize the contract based on the greater of (1) actual account value or (2) an adjusted 'payout base' equal to premiums credited with a specified minimum interest rate or a step-up in value based upon the maximum annual anniversary value of the account value prior to annuitization. In essence, these products are designed to provide a steadily growing base for generating annuitized income, even in the face of a large or extended bear market. Most GMIBs provide an annuitization value based on the greater of premiums accumulated at a 5 or 6 percent return, or an annual step-up of the contract value. Some contracts require a waiting period of as much as 10 years prior to the implementation of the guaranteed payments.
These annuities have several restrictions. An annuity owner must annuitize in order to exercise the guarantee; there may be a minimum exercise age; and the guaranteed annuity payout rates are typically much lower than current rates on new immediate annuity contracts. What’s more, the annuity owner, after annuitizing their investment under the guarantee, may not participate in any stock market gains (if a fixed annuitization is required or selected). And, the annuity owner who dies after annuitizing the contract may not be able to pass any money to beneficiaries, depending on the form of benefit selected or required under the guarantee Also of note, the contract for these products should always be read carefully since it contains language that defines exactly how the GMIB payout base is determined, as well as disclosure of additional fees resulting from the GMIB benefit. These fees directly reduce the performance of the contract and may range from 25 to 65 basis points.
The variable annuity with a GMAB rider promises that, at specified periods, the account value will not be less than purchase payments, sometimes with an additional minimum rate of interest.
After a specified waiting period the annuity owner’s losses are immediately restored to the guaranteed minimum account value, without any annuitization requirements. Thus, even if investment losses are otherwise incurred, the annuity owner will at least get back their original investment. A drawback is that investors who purchase a GMAB cannot take current income from the product during the waiting period without a potential reduction in the guarantee. Companies offering GMABs typically reserve the right to reallocate unilaterally the annuity owner’s investments.As with the other benefits, the fees incurred in exchange for the GMAB should be carefully considered.
The variable annuity with the GMWB rider allows contract holders to take a set percentage of the original investment, usually from 5 to 7 percent, as distributions per year, regardless of investment performance. Thus, even in a period of declining stock prices where the account value goes to $0, an annuity owner will eventually get back their entire principal a bit at a time. In addition, in a bull market, some riders allow the annuity owner to step up their guaranteed amount to the highest contract value, usually every three to five years, but sometimes annually. As with the other benefits outlined, the cost of the benefit may be “wasted” if the guarantee isn’t actually utilized. On the other hand, the psychic support provided by the guarantee may allow a particular investor to subject long-term assets to market risk (and the prospect of higher returns) when otherwise she would not do so. Withdrawals in excess of the guaranteed amount reduce the amount of principal protected or may forfeit the guarantee. Of note, the annuity owner doesn’t have to annuitize as they do with the GMIB and they may have to wait to withdraw money as they do with the GMAB.
With a GMWB, there are specific restrictions. This form of guaranteed benefit does not provide permanent income and it will take a specified time period, usually 14 or more years (at 7 percent withdrawals per year), to get the initial investment back. In some cases, there may be a waiting period of up to five years before withdrawals can be exercised. Typically, taking out any withdrawal in excess of the GMWB allowable amount can substantially reduce or completely lose the underlying guarantee.
Regardless of the rider, an investor must understand what costs are incurred in order to manage the risk negated.Generally, the insurance companies who provide these benefits do so in order to support investors that want to take on market risk when they otherwise might not do so, and expect few contract holders to exercise the benefit. And since some companies were hurt by mistakenly priced products during the last bear market, few benefits are now likely to be offered without corresponding, fully priced costs.Fully informed investors will select benefits carefully based upon their priorities and after a full consideration of the cost and associated risks.
September 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided byBold Financial Planning, LLC, a local member of the FPA.
