Ensuring your retirement dreams materialize

Whatever your age, you must plan carefully to ensure your retirement dreams materialize. This means leveraging tax-advantaged savings opportunities. Starting contributions early can make a big difference; older taxpayers may need to save more to make up for lost time. It also means avoiding early withdrawals and being tax-smart with required minimum distributions.

401(k)s and other employer plans

Contributing to an employer-sponsored defined-contribution plan, such as a 401(k), 403(b), 457, SARSEP or SIMPLE, is usually the best first step in retirement planning:

Contributions are typically pretax, so they reduce your taxable income.

Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.

Your employer may match some or all of your contributions — also on a pretax basis.

See the Charts “2011 retirement plan contribution limits” and “2012 retirement plan contribution limits” for the annual limits for employee contributions to 401(k), 403(b), 457 and SARSEP plans. If you’re age 50 or older, you may be able to make an additional “catch-up” contribution. If your employer offers a match, contribute at least the amount necessary to get the maximum employer match and avoid missing out on that “free” money.

If your employer has suspended matching contributions to reduce costs, don’t use that as an excuse to suspend your own contributions. Doing so will only exacerbate the negative impact on your retirement nest egg — plus your taxable income for the year will increase compared to what it would be if you had contributed to the plan.

If your employer provides a SIMPLE, it’s required to make contributions (though not necessarily annually). But the employee contribution limits are lower than for other employer-sponsored plans. (See the Charts “2011 retirement plan contribution limits” and “2012 retirement plan contribution limits”)

Traditional IRA

If your employer doesn’t offer a retirement plan, consider a traditional IRA. You can likely deduct your contributions, though your deduction may be limited based on your adjusted gross income (AGI) if your spouse participates in an employer-sponsored plan. You can make contributions for 2011 as late as April 17, 2012.

Roth accounts

A potential downside of tax-deferred saving is that you’ll have to pay taxes when you make withdrawals at retirement. Two retirement plan options allow tax-free distributions; the tradeoff is that contributions to these plans don’t reduce your current-year taxable income:

1. Roth IRAs. In addition to tax-free distributions, an important benefit is that, unlike other retirement plans, Roth IRAs don’t require you to take distributions during your lifetime. This can provide estate planning advantages: You can let the entire balance grow tax-free over your lifetime for the benefit of your heirs.

If, for example, you name your child as the beneficiary, he or she will be required to start taking distributions upon inheriting the Roth IRA. But the distributions will be tax-free and spread out over his or her lifetime, and funds remaining in the account can continue to grow tax-free for many years to come.

Roth IRAs are subject to the same low annual contribution limit as traditional IRAs (see the Charts “2011 retirement plan contribution limits” and “2012 retirement plan contribution limits”), and your Roth IRA limit is reduced by any traditional IRA contributions you make for the year. It may be further limited based on your AGI.

If you have a traditional IRA, consider whether you might benefit from converting it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth and take advantage of a Roth IRA’s estate planning benefits.

There’s no longer an income-based limit on who can convert. But, unlike when the limit was first lifted in 2010, the converted amount is now taxable in the year of the conversion.

Whether a conversion makes sense for you depends on a variety of factors, such as your age, whether you can afford to pay the tax on the conversion, your tax bracket now and expected tax bracket in retirement, and whether you’ll need the IRA funds in retirement.

2. Roth 401(k)s, Roth 403(b)s and Roth 457s. If your plan allows it, you may designate some or all of your contributions as Roth contributions. (Employer matches aren’t eligible.) There are no AGI limits on designating Roth 401(k) or 403(b) contributions, so these plans may be especially beneficial for higher-income earners who are ineligible to contribute to Roth IRAs.

Plans for business owners and the self-employed

If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider setting one up this year. Keep in mind that, if you have employees, they generally must be allowed to participate in the plan, provided they work enough hours. Here are a few options that may allow you to make large contributions:

Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. You can make deductible contributions for 2011 (see the Chart “Profit-sharing plan vs. SEP: How much can you contribute?”) as late as the due date of your 2011 income tax return, including extensions — provided your plan existed on Dec. 31, 2011.

SEP. A Simplified Employee Pension is a defined contribution plan that provides benefits similar to those of a profit-sharing plan. But you can establish a SEP in 2012 and still make deductible contributions for 2011 (see the Chart “Profit-sharing plan vs. SEP: How much can you contribute?”) as late as the due date of your 2011 income tax return, including extensions. Another benefit is that a SEP is easier to administer than a profit-sharing plan.

Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit is generally $195,000 for 2011 and $200,000 for 2012 — or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.

You can make deductible contributions until the due date of your 2011 return, provided your plan existed on Dec. 31, 2011. Warning: Employer contributions are generally required and must be paid quarterly if there was a shortfall in funding for the prior year.

Early withdrawals

If you’re facing financial challenges this year, it may be tempting to make withdrawals from your retirement plans. But generally this should be a last resort. With a few exceptions, retirement plan distributions made before age 59½ are subject to a 10% penalty, in addition to income tax.

This means that, if you’re in the top federal tax bracket of 35%, you can lose close to half of your withdrawal to federal taxes and penalties. If you’re subject to state income taxes and/or penalties, the total of your taxes and penalties may easily exceed 50%. Even if you’re in a lower bracket, you can lose a substantial amount to taxes and penalties. Additionally, you’ll lose the potential tax-deferred future growth on the amount you’ve withdrawn.

If you have a Roth account, you can withdraw up to your contribution amount free of tax and penalty. But you’ll still be losing the potential tax-free future growth on the withdrawn amount.

So if you’re in need of cash, you’re likely better off tapping taxable investment accounts than dipping into your retirement plan. Long-term gains from sales of investments in taxable accounts will be taxed at the lower long-term capital gains rate, currently 15%, and losses on such sales can be used to offset other gains or carried forward to offset gains in future years. (See “Investing” for more information on the tax treatment of investments.)

Another option to consider, if your employer-sponsored plan allows it, is to take a loan from the plan. You’ll have to pay it back with interest, but you won’t be subject to current taxes or penalties.

Leaving a job

When you change jobs or retire, you’ll want to avoid taking a lump-sum distribution from your employer’s retirement plan because it generally will be taxable, plus potentially subject to the 10% early-withdrawal penalty. For options that will help you avoid current income tax and penalties, see the Case Study “Tread carefully with your retirement plan when leaving a job.”

Required minimum distributions

Normally once you reach age 70½ you must take annual required minimum distributions (RMDs) from your IRAs (except Roth IRAs) and defined contribution plans. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. You can avoid the RMD rule for a Roth 401(k), Roth 403(b) or Roth 457 by rolling the funds into a Roth IRA.

So, should you take distributions between ages 59½ and 70½, or more than the RMD after age 70½? Distributions in any year your tax bracket is low may be beneficial. But also consider the lost tax-deferred growth and, if applicable, whether the distribution could: 1) cause your Social Security payments to become taxable, 2) increase Medicare prescription drug charges, or 3) affect other deductions or credits with income-based limits.

If you’ve inherited a retirement plan, consult your tax advisor regarding the distribution rules that apply to you. •

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