Principles of Retirement Planning/Year Of Retirement

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YEAR OF RETIREMENT

Understanding Retirement Distribution Options

Continuing or Replacing Company Benefits

Applying for Social Security Benefits

Effect of Converting Non-Retirement Assets into Retirement Funds

Understanding Retirement Distribution Options

In the year you retire, your overall planning focus should be on understanding your distributions and what you have to do to receive them. This focus begins with an analysis of the possible ways that retirement benefits can be paid or distributed.

Definition of Distribution Options

Single Life. A monthly annuity will be paid to the retired employee for life. This is usually the basic form of benefit under a pension plan.

Joint and Survivor. A reduced monthly annuity will be paid to the retired employee for life, with a percentage of that reduced benefit (e.g., 50%, 75%, or 100%) paid to the surviving spouse. The larger the continuing percentage, the smaller the initial benefit.

Term Certain. Based on a single life or joint life annuity, a reduced monthly annuity will be paid for life (or joint life), coupled with a guaranteed minimum payment period such as 5, 10, or 15 years.

Lump Sum. A single sum, rather than an annuity, will be paid to the retired employee. This amount is a present-value equivalent of the stream of otherwise available annuity payments in a pension plan or, in the case of a defined contribution plan, simply the balance accumulated.

Pension plans generally provide monthly retirement benefits. However, you may have choices regarding the period of time over which your benefits will be paid. The payments can be for your life, or for the joint life of you and your spouse. In addition, some retirement plans may allow you or your beneficiary to receive payments for a guaranteed period of time.

If you choose to receive payments over a joint life period, you will have a second set of choices involving whether the monthly payments will remain constant or be reduced by a specified amount when you die. A constant payment amount can maximize the financial security of your survivor. However, there is a cost because your initial pension payments will be smaller.

Employee savings plans, such as 401(k) plans and some pension plans may distribute your benefits in a lump sum payment. A retiree should consider several issues when evaluating whether to take a lump-sum distribution. First, the payment will have tax consequences and choices. Second, you must plan for the receipt and investment of the funds. Hundred of thousands of dollars may be received. Will you receive a check? Will the funds be wire-transferred to your bank? Do you want such a large amount in your checking account? How will you transfer funds into an investment account?

A final issue regarding distribution options can arise if you have a choice between a lump-sum and periodic monthly payments. The periodic payment alternative means the pension plan administrator continues to be involved in the investment of the funds which may be beneficial. However the monthly payments cannot be changed if your needs in retirement change. Your choice should be based upon the amount and predictability of your needs, your and your spouse's present health and family history.

Taxation of Retirement Distributions

The taxation of retirement distributions depends on whether they are paid in a annuity, a monthly installment, or a single lump-sum distribution. Annuity or monthly payments are taxed as ordinary income as they are received. If any after-tax contributions were made to the retirement plan while you were actively employed, a portion of each monthly retirement payment will be treated as a return of the investment and will not be taxed. A single lump-sum distribution may either be taxed at the time it is received or it may be transferred to a tax deferred individual retirement account (an IRA rollover).

If you decide to make an IRA rollover, you must transfer the distribution into an IRA within 60 days of the date the distribution is received. To avoid a 20% income tax withholding, this rollover must be accomplished through a "trustee-to-trustee" transfer. This choice allows you to defer the tax on the single-sum distribution until you begin to withdraw your retirement funds. In the meantime, your money will continue to grow in a tax-deferred account.

If you are considering retirement prior to age 59 1/2, you must also consider the 10% excise tax that generally applies to distributions received from retirement accounts prior to age 59 1/2. There are very limited exceptions to this excise tax, which you should explore with your tax advisor. In addition, large retirement plan distributions (amounts in excess of $150,000) may be subject to an additional 15% excise tax. This too, can be addressed with your tax advisor.

If you receive a single-sum distribution and choose to pay taxes in the year received, you may be able to calculate your tax liability using a special 5- or 10-year forward-averaging (''lump-sum distribution'') election. Special averaging reduces the effective tax rate on qualifying distributions by calculating the tax as if the taxable income were spread over several years. Although the special averaging calculation assumes that the income is received over several years, the full amount of the tax is payable for the tax year in which the distribution is received.

Most taxpayers need to project the consequences of the IRA rollover versus the lump-sum distribution decision, taking into account their personal circumstances. Consider the following example:

A married individual has a retirement accumulation of $200,000 and is going to make a decision between a special averaging election for a lump-sum distribution and an IRA rollover. If 5-year special averaging is elected, the tax will be $43,945 - leaving $156,055 to be invested at 9% (fully taxable). The IRA will be invested at 9% as well, but in a tax-deferred environment. The tax rate outside the IRA is a constant 28% throughout the entire projection period.

Considering the other financial resources available, the taxpayer does not need to withdraw any of the retirement funds during the projection period under either scenario.

In this example, the after-tax accumulation within the IRA exceeds the accumulation outside the plan between years 3 and 4. Of course, the crossover point will vary with each specific taxpayer and set of assumptions. The calculations also suggest that in year 10 the tax rate must exceed approximately 38% before the after-tax IRA accumulation would be less than the accumulation outside the IRA. Again, the break-even tax rate in a particular year will vary with each situation. Consultation with your tax and financial adviser can clarify your personal circumstances.

Choosing between an IRA rollover and lump-sum taxation is basically a function of how much and how soon the retirement funds will be needed. For many taxpayers who expect to withdraw their retirement funds gradually over their retirement years, their overall financial position will be enhanced by making an IRA rollover. The benefits of lump sum distributions are generally greatest if significant amounts will be needed within a few years of retirement.

Continuing or Replacing Company Benefits

When you retire, some of your company benefits may end or be significantly reduced while others may be available on a continuing basis at your choice and expense. You will need to evaluate each of these benefits to determine if you still need them as a part of your overall financial plan. For example, if group life insurance can be continued, is it necessary? If so how much? Is the cost competitive with other policies? How much insurance is available and for how long? Again, you should apply the planning process by first defining the goal, then quantifying the resources available, and finally determining the best strategy or alternative to ensure the achievement of the goal.

This same process should be applied to other company benefits such as health insurance and dental coverage. As a retiree, you must determine your health insurance needs by analyzing your health related risk exposure. During your retirement years, your basic health needs such as doctors visits and simple surgery will continue, while your risk of major medical expenses will generally increase. How much of the cost of these risks can be absorbed or taken on individually? While you may have an adequate retirement income to meet relatively small recurring expenses, a serious illness could put retirement funds in jeopardy. You should also look at your medical history as well as that of other family members to assess your total exposure to medical costs. Finally the retiree should ensure that all risk exposures are considered. While you may have a good understanding of doctor, hospital and dental care, you may be faced with new and additional issues related to health care. For example, insurance coverage may change from a single employer-sponsored policy to a series of coverage's.

When your individual health coverage needs have been identified, you should gather information on all available sources of insurance coverage. Start by looking at your company's post retirement group medical coverage. What is the cost of this coverage? During your working years, the cost of group insurance is generally shared with the employer. After you retire, you may be solely responsible for the cost. You should compare benefits provided by the group policy against any additional premium expense. Also consider the fact that you generally are not subject to waiting periods of limitations for preexisting conditions when covered by a group policy. You should prepare an outline which details all coverage options and the premium cost. This outline should first be used to determine if any benefits are unnecessary or can be self-insured. Then the outline should be used to determine whether there are gaps in your coverage that should be addressed with supplemental insurance.

Another form of insurance coverage is Medicare. Medicare is a federally administered health insurance program designed to help cover some, but not all, medical expenses. In general, Medicare is available to individuals who are 65 or older, people of any age who have permanent kidney failure, and some disabled individuals. Medicare is divided into two types of protection, Part A is Hospital Insurance coverage, and Part B is Medical Insurance coverage. The Medicare protection package is compulsory, and is funded primarily through Social Security payroll tax deductions. The Social Security Administration can provide additional information and publications to help answer questions regarding Medicare requirements and benefits.

A final health care issue to consider is whether you need to purchase long term care coverage. Long term care can be very expensive, ranging in cost from $5,000 annually for occasional in-home care, to tens of thousands of dollars for nursing home care. It is easy to see that the cost of long term care could quickly deplete one's assets and savings. For this reason and because Medicare and Medigap policies do not cover the costs of long term custodial care, a long term care plan should be considered. Individual policy benefits vary, but generally help cover the day-to-day costs of nursing home care, home care, and adult day care. Benefits may be limited as to the length of coverage time and the dollar amounts paid. As with most insurance policies, there may be a waiting period between the time long term care needs arise and the onset of policy benefit payments. You should carefully consider the relationship of the benefit amount, waiting period, and premium cost. By choosing a longer elimination period, the premium cost can be lowered or, alternatively, the benefit can be increased. You should select an elimination period that considers your ability to pay a portion of the cost from your own funds. If you have assets that can fund the first three or six months cost, it is usually expensive and unnecessary to also insure the same costs. In summary, careful planning at retirement can result in a combination of policies which are tailored to provide adequate medical and long term care coverage within your budget.

Applying for Social Security Benefits

Several months before your actual retirement date, you should go to your nearest Social Security Administration office to begin the process of applying for benefits. This process should include an understanding of several areas. What paperwork or documents are needed? How soon will benefits begin and how will they be paid? If you are married, what spousal benefits will be paid? How and when do you qualify for Medicare coverage? What is the financial impact of receiving retirement income benefits prior to age 65 or delaying benefits beyond normal retirement?

Finally, do you need to consider Medicare supplement polices (often referred to as "Medigap" insurance).

Effect of Converting Non-Retirement Assets into Retirement Funds

When you assess your current situation in relation to specific, defined retirement goals, you may want to analyze the tax consequences of converting non-retirement assets into additional retirement funds. Two of these assets are your personal residence and the cash-value or whole life insurance.

Where will you live when you retire? Will you remain in you current home or purchase or lease a different home? If you decide to sell your current residence and use some or all of the funds to supplement your retirement income, you must consider the tax consequences. Generally, you must pay taxes on any gain on the sale of a personal residence.

However, there are two tax provisions that can help homeowners defer and even exclude some or all the tax on the gain. First, in cases where a new home is purchased, the tax laws provide that any gain is deferred to the extent the sales price of the old home is reinvested in the new home. Therefore, if the new home cost as much or more as the old home, all the gain is deferred. However, if only a portion of the sales price is reinvested, only a portion of the gain is deferred. The second tax rule deals with the sale of a principal residence and allows you to exclude up to $125,000 of the gain from the sale of the old home if you or your spouse are over the age of 55. These two tax rules can be used together as shown in the following example:

Mr. and Mrs. Smith (age 65) purchased their old home 20 years ago for $50,000 and sell it upon retirement for $225,000. They move into a rural retirement community and purchase a smaller home for $100,000. The balance of the gain of $125,000 can be excluded if the Smith's elect to use their one-time over age 55 exclusion. Thus, no tax is paid on the gain of $175,000.

Retirees often consider moving to different locations upon retirement. Moving to a different state raises several tax issues which will impact your projected living expenses. First, what are the differences in state income tax rates from the current state of residence? Second, states tax retirement pensions differently by allowing varying amounts to be received tax-free. In addition, some states provide property tax relief for individuals over age 65. You should also consider the state sales tax rate. Finally, states vary on the taxation of social security benefits.

A second asset that may have accumulated or built-up value is cash value or whole life insurance. You should first review your continued need for life insurance coverage. Because the need to create an estate or provide liquidity often changes during retirement , your need for insurance may also change. If there is a continued need for long-term coverage, it is generally best to leave coverage in place. However, if your need for long-term coverage has changed, you may be able to use some or all of the cash value in the policy. If a loan is taken against the policy, the loan proceeds are generally not taxable income; however, the interest will generally be considered non-deductible personal interest. If the policy is surrendered for the cash value, the excess of the cash value over the cost of the policy (i.e. premium payments) is ordinary income.

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