Have you been saving for retirement? If not, you are with the majority of American households age 55 and older. According to a 2015 U.S. Government Accountability Office (GAO) report, only 48% of American households age 55 and over have some retirement savings. Of the 52% with no retirement savings, 23% have a defined benefit pension plan. However, the remaining 29% of households have neither retirement savings nor a defined benefit pension.
Because of this sorry state of savings, according to the GAO, 41% of retirees 55 and older did not stop working altogether. They had to continue to work to support themselves, even after they started receiving Social Security.
How do you stack up with your savings? Of those households over age 55 with retirement savings, the Federal Reserve reports that the median savings was $103,200 for households age 55-64, $148,900 for households age 65-74 and $69,500 for households over age 74.
These savings numbers may seem large. However in retirement, they become very small. In order to make your retirement savings last, many experts recommend that you take no more than 4% to 5% out of your retirement savings each year. So if you were average and retired at age 65 with $148,900 in retirement savings, that 5% would be $7,445. That is certainly not enough to live on. Your retirement savings should be above average.
One of the best ways to save is to use the tax shelters that the Feds gave us to save for retirement, Individual Retirement Accounts (IRAs). You may have a 401(k), 403(b), 457(b) or other qualified employer retirement plan. If you are no longer working for that employer, you should consider rolling over the funds from the employer’s plan to a traditional IRA. Most employer plans have many more restrictions than IRAs. The two most common IRAs that you can use are traditional IRAs and Roth IRAs.
Traditional IRAs. Traditional IRAs, you are generally putting in pre-tax dollars. Contributions to a traditional IRA are limited. In 2016, annual contributions are generally limited to $5,500, unless you are age 50 or older, then you can contribute up to $6,500 annually. If your annual compensation is less than this limit, your annual contributions are limited to your compensation. If you had no compensation, you still may be able to contribute to an IRA if your spouse had income and you filed a joint income tax return. The total of all your and your spouse’s IRA contributions then could not exceed your spouse’s compensation. In addition, other than rollover contributions, you can no longer make contributions to a traditional IRA after age 70½.
Your contributions to your traditional IRA may be deductible reductions of your taxable income in certain circumstances. If neither you nor your spouse are covered by an employer sponsored retirement plan, you can generally deduct on your federal individual income tax return, all your contributions to a traditional IRA. However, if either you or your spouse are covered by an employer sponsored retirement plan, then your tax deduction for your IRA contributions may be limited based upon your income.
Generally, you can start to make withdrawals out of your retirement fund after age 59½ without penalty. When the contributions and earnings come out, it is all taxable as ordinary income. Prior to age 59½, unless you qualify for certain exceptions, withdrawals carry a 10% early withdrawal penalty tax in addition to the income tax. After age 70½, you must start to take the required minimum distribution out of your retirement fund each year. If you do not take your required minimum distribution in any given year, you are usually subject to an excise tax of 50% of the shortfall.
Be careful of the investment vehicles you use for your IRAs. There is no shortage of annuity peddlers out there who will encourage you to “invest” your IRA dollars in deferred annuities, which are among the highest commission financial products available. Annuities are not investment vehicles, they are a wrapper to defer taxes on your investments, often for a fee of up to 2% per year according to industry disclosures.
IRAs are already deferring your income taxes until withdrawn. You do not need a tax deferral vehicle within a tax deferral vehicle. Also, most deferred annuities I have seen have the same or similar investments you could make outside the annuity, without the 2% fee. And in addition, annuities have surrender charge penalties which I have seen as high as 50%, if you make withdrawals before a certain time period, which I have seen as long as 20 years, and/or you make withdrawals in excess of your required minimum distribution.
I saw one case in which a husband had to cash in his wife’s IRA annuity in order to qualify her for Medicaid to pay for her nursing home care. Because the withdrawal was more than the required minimum distribution, the annuity company levied a 50% surrender charge penalty. They had had to pay income taxes on the other half of the IRA she did receive, to the tune of around 30%. After all was said and done, they only ended up with about 35% of the IRA.
Be especially wary of investment “guarantees” contained in annuities. I have seen these “guarantees” rescinded by the annuity company because of provisions contained in the prospectus, which is that several hundred page document that virtually nobody ever reads.
Roth IRAs. You can also invest in Roth IRAs. Your contributions to your Roth IRA are made with post-tax dollars which do not reduce your taxable income. The total contributions that you can make to all traditional and Roth IRAs combined cannot exceed the $5,500, $6,500, compensation and spousal IRA limits discussed above. In addition, there are further limits on how much of these amounts that can be contributed into a Roth IRA, based upon your income.
You are not required to make any minimum distributions from your Roth IRA during your lifetime. Minimum distributions are only required after your death. And you can continue to make contributions to a Roth IRA after age 70½.
Generally, if your withdrawals out of your Roth IRA occur after age 59½ and at least 5 years after your first contribution to your Roth IRA, all withdrawals are income tax free. Not only do your after-tax contributions come back to you income tax-free, all your Roth IRA earnings escape income taxes forever. For Roth IRAs, the 10% early withdrawal penalty before age 59½ is only upon the income portion of the distribution. There is also a 10% early withdrawal penalty when distributions are made within the five tax years after the year the Roth IRA is established, regardless of age.
Don’t be like the majority of Americans with no retirement savings. Be above average. Take advantage of the tax shelters that the Feds have given us. Use IRAs. We have only touched upon the general rules of IRAs. There are many special rules and exceptions to the general rules that we have not covered today. When you are contemplating these types of investments, please consult with knowledgeable investment and/or tax specialist.
By: Matthew M. Wallace, CPA, JD
Published edited January 17th, 2016 in The Times Herald, Port Huron, Michigan as: Saving for Retirement with IRAs