Sometimes the most difficult part of planning for your financial future is knowing where to start. What follows are some of the most commonly asked questions doctors have about financial planning, including investing, taxes and retirement planning.
Q I know having to pay taxes is something that’s inevitable, but are there ways I can limit the bite they take out of my investment portfolio? What are some of my choices when it comes to tax-advantaged accounts?
A Some of the tax-advantaged accounts you can choose from include:
Traditional IRAs: With traditional IRAs, all contributions you make grow free of taxes until you make a withdrawal. What’s more, if you meet certain eligibility requirements, traditional IRAs may be fully or partially deductible. Anyone younger than age 701/2 with earned income can make IRA contributions and take advantage of tax deferral on all future investment earnings. Keep in mind that withdrawals prior to age 591/2 may be subject to a 10% IRS penalty as well as regular taxes.
Roth IRAs: Unlike the traditional IRA, you can still contribute to your Roth IRA even after you turn 701/2 as long as you have earned income. The earnings on these contributions grow and are distributed free of income tax as long as you meet certain requirements. Also, there are no required withdrawals with the Roth IRA, and when you die, you may pass on the account to your heirs. Your contributions may be limited, depending on your modified adjusted gross income.
Qualified retirement plans: Some qualified retirement plans, such as 401(K)s, SEPs or SIMPLE IRAs, let you divert a portion of your salary to a tax-deferred savings account. You can contribute a portion of your wages on a pre-tax basis and defer the tax on both the contribution amount and earnings until you withdraw the money, usually after age 591/2. Because these contributions are deducted from your paycheck before most taxes are taken out, contributions can reduce your taxable income and the current taxes you pay. Another advantage is that many organizations match employees’ contributions up to a specified amount.
Approaching things from the other direction, some tax-advantaged investments include:
- Municipal bonds: If you need federally tax-free income, municipal bonds may be a wise choice, especially if you are in a higher tax bracket. Purchasing municipal bonds may help protect your portfolio’s returns from the effect of taxes. Municipal bonds may also be free of state taxes if the buyer resides in the issuer’s state. Otherwise, state and local taxes will apply. Also, certain bonds may be subject to the alternative minimum tax.
- U.S. government bonds: U.S. government bonds are interest-bearing securities guaranteed by the U.S. government to pay a specified amount of interest for a specified time, usually several years, and then repay the bond holder the face amount of the bond. The interest from U.S. government bonds is free of state and local income taxes but subject to federal taxes.
- Stocks: Most people don’t think of stocks as tax-advantaged investments, but capital-gains taxes are deferred on stock until you sell them. Even if you sell a stock and realize a capital gain, you will pay prevailing capital gains tax rates, which are lower than ordinary income tax rates. For buy-and-hold investors, stocks represent a great way to build tax-deferred profits until you sell. Keep in mind, current income tax is due on dividends received as well as short-term capital gains.
It is important to consider the tax implications of your investments. However, keep in mind that tax implications are only one consideration when making decisions about buying or selling investments. Specific questions should be referred to your tax advisor.
Q I would like to start a retirement plan for my employees. What are my options?
A A retirement plan for your employees may be one of the most worthwhile places you can put extra business cash. There are a few retirement plans to consider, and it’s likely that one of them will suit your needs and the needs of your employees.
SEP-IRA: The SEP-IRA plan is one of the easiest plans to establish and administer. Here’s how it works. The employer signs a plan adoption agreement and individual retirement accounts are set up for each eligible employee. The maximum the employer can contribute a year is 15% eligible compensation, and the compensation must not exceed $170,000. The employer’s contributions are discretionary, so you can contribute as much as you want (up to the maximum) in any given year.
For participation in a SEP-IRA, your employees must meet the eligibility requirements specified in the plan adoption agreement. Eligible employees for a SEP-IRA include those who are age 21 and older and those employed (both part-time and full-time) by the business owner for three of the last five years. The employer may specify a lesser requirement in the adoption agreement.
SIMPLE IRA (Savings Incentive Match Plan for Employees): Sole proprietorships, partnerships, corporations, government entities and non-profit organizations may establish a SIMPLE plan. The plan is available to companies with up to 100 employees, provided that the business has no other employer-sponsored retirement plans during that calendar year. All employees who have earned at least $5,000 in compensation in the two previous years, and who are expected to earn $5,000 or more in the current year, are eligible to participate. The employer may specify a lesser requirement in the plan adoption agreement.
Participating employees can contribute up to $6,000 annually, and the employer must also make a contribution. Employers can match the contribution dollar-for-dollar up to 3% of the employee’s compensation or make a lower matching contribution (not less than 1%), but not for more than two out of five years. The other option employers have is a non-matching contribution of 2% of compensation for each eligible employee, based on $170,000 maximum annual compensation. The employer must provide eligible employee notice of the contribution at least 60 days prior to the beginning of each plan year.
Money purchase or profit-sharing plan: Many companies still refer to this plan as Keogh Plan, although it is now more commonly referred to as money purchase or profit-sharing. This plan is a tax-deferred retirement savings plan and is not limited to self-employed individuals; corporations may also participate.
Although exact contribution limits depend on the type of qualified plan, an employer generally may contribute a plan maximum of 15% (or 25% depending on the plan) of their eligible payroll. Of the amount, only $30,000, or 25%, whichever is less, can go to one individual. Your financial consultant, along with your tax advisor, can help you pick the best retirement plan that will benefit your employees, your business and you.
Q I’ve been stashing away as much as I can in an effort to retire early. Now it’s time to begin tapping into my nest egg. Can I withdraw any of my money without being hit by an early-withdrawal penalty? Should I keep my money in my current retirement plan or roll it over into an IRA?
A Most people are confused about their options because there are so many different things for them to keep in mind when they make the decision to retire early.
What many investors don’t realize is that they may be able to tap their retirement plan before age 591/2 without having to pay a 10% early-withdrawal penalty. Age 591/2 is the IRS-sanctioned age at which you can receive retirement plan distributions without penalty.
You should be aware of the following:
“55 or over exception”: The “55 or over exception” allows you to avoid the penalty if you receive some or all of your company retirement plan assets when separating from your job during or after the year you reach age 55. 20% of what you withdraw may be withheld for income taxes.
The amount you are able to receive and how that money will be distributed will depend on the rules governing your company’s plan. You should also be aware that this exception no longer applies after you roll over your assets from your company plan to an IRA.
“Annuitization exception”: If you want to retire and tap the savings in your company’s retirement plan without penalty before age 55, consider rolling over your retirement plan assets into a traditional IRA and use a provision called the “annuitization exception.” Although the term annuitization may imply that this method requires the purchase of a commercial annuity, that’s not the case. This option allows you to take substantially equal withdrawals from your retirement account based on one of the three IRA formulas. The withdrawals are not subject to the 10% IRS penalty, but are subject to income taxes.
You can modify the withdrawals or stop them altogether at the later of age 591/2 or five years. For example, if at age 50 you begin taking periodic early withdrawals that qualify for annuitization, you must continue them until you are 591/2. If you don’t start the withdrawals until you turn 58, you would have to continue them for at least five years from the date of the first payment, or until age 63, before altering your withdrawal schedule. Many people who retire early want to receive their distributions from their company-sponsored plan because they are familiar with how the plan works. Although this may appear to be the simplest option, rolling over the assets into an IRA can give you more control over how your money is invested and more flexibility on how you may withdraw your funds. You also generally can be more creative with beneficiary designations with an IRA.
Nearly everyone’s dream is to retire early. But it can become a nightmare if you and your financial consultant don’t carefully plan how you will receive distributions from your retirement fund without paying unnecessary penalties.
