The current financial crisis has many Americans worried about their retirement, and projections for the coming year are causing many more to wonder whether they will even have jobs. As investors used to occasional corrections followed by years of steady growth, we are clearly facing difficult times and navigating in unfamiliar waters.
During past recessions, those of us who invested in the equity markets were generally urged to “stay the course” during tough economic times. The markets, we were told, would eventually recover and our account balances would eventually begin to grow. And time after time, our confidence in the power and resilience of the American economy were rewarded.
But what about today? Is “staying the course” still a viable investment strategy? For many investors, the answer is “yes”.
The current recession, while far more severe than any in recent memory, should eventually bottom out. When it does, Americans will once again be looking for ways to accumulate assets for the future. And when that happens, many will turn to Individual Retirement Accounts (IRAs) to accomplish their objectives. Please note that past results are not predictive of future results.
IRAs have long been popular among families and individuals who understand the importance of saving for retirement. They are easy to establish and maintain; there are virtually no annual fees or hidden costs; account values compound income tax-deferred; and nearly anyone who earns an income can contribute on an annual basis. If you are married, your non-working, non income-producing spouse may also contribute to an IRA.
The maximum amount you can contribute to an IRA is $5,000 ($10,000 for married couples filing jointly). Individuals who are age 50 or older by December 31 of the current tax year may also make an additional “catch-up” contribution of $1,000, bringing the total annual contribution limit to $6,000. This “catch-up” provision also applies to Spousal IRAs. In most cases, all contributions will be fully tax-deductible. Your tax deduction may be reduced or eliminated, however, if either you or your spouse contributes to an employer-sponsored retirement plan. Even so, you may still make non-deductible contributions to an IRA in order to take advantage of its tax-deferred growth and other features.
What happens at retirement?
When you begin drawing money out of your IRA at retirement, you will owe income taxes on your earnings and on any tax-deductible contributions you made. You may generally begin taking penalty-free withdrawals from your IRA when you reach age 59½. If you withdraw money prior to age 59½, in addition to any regular income taxes you may owe, you may also be subject to a 10% tax penalty. This tax penalty will be waived, however, if you use the money for first-time home buyer expenses, qualified higher education costs, to pay health insurance premiums during periods of unemployment, for medical expenses that exceed 7.5% of your adjusted gross income, or in the event of disability or death. Payments made prior to age 59½ but that are based on your life expectancy will also escape the 10% tax penalty.
Generally, you must begin taking money out of your IRA once you reach age 70½, even if you do not need the income. Such withdrawals are referred to as “required minimum distributions (RMDs).” Your financial advisor can explain the options available to you should you find yourself in this situation.
Be careful to avoid the “withholding trap”
You can also roll over money from other retirement plans you may have into your IRA, or from one or more IRAs to another. Should you decide to make such a transfer, be careful to avoid a common pitfall called “the withholding trap.” The withholding trap occurs when you are rolling money from a qualified plan (for example, from a 401(k) account) and you are forced to pay income taxes and/or penalties on the money you are rolling over. How does the withholding trap get “sprung?” It gets sprung when you request that the amount you are rolling over be made payable to you in the form of a check. Why? Because even if you deposit the entire qualified plan check into your IRA, your plan provider is required to withhold 20% of any retirement plan distribution paid directly to you. Under current tax law, once that 20% is withheld, it becomes taxable to you as regular income – even if you never receive it. And if you have not yet attained age 59½, you may also be subject to a 10% tax penalty on the amount withheld.
The best way to avoid the withholding trap is to have your assets transferred directly from one retirement plan to the other. When your funds are moved directly from one plan provider to another, you will not be subject to taxes or penalties on the amounts rolled over.
Other thoughts to consider
If you’re among the millions of people who saw their retirement account balances drop considerably this past year, you may want to consider pushing retirement back for a couple of years. By doing so, you’ll qualify for a larger social security benefit; you’ll be giving your IRA assets additional time to compound and recover; and you’ll have a couple more years to contribute on a tax-deductible basis.
Also, remember that your retirement could last for a very long time. Even if you’re within a few years of retirement, your IRA assets could still have 10, possibly 20 more years to grow income tax-deferred. To that end, remember to diversify. If the current financial crisis has taught us anything, it’s the importance of not putting all of your eggs into one basket. If possible, your IRA assets should be divided among different asset classes, including equities, bonds, money market accounts, CDs,. If you don’t feel comfortable selecting assets from each of these categories, ask your financial advisor for assistance. You should understand that there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, nor does diversification assure against market loss.
It’s no secret that we’re living in difficult times, but for most of us, the time-tested rules of investing still apply: maximize the amount you can contribute on a tax-deductible basis whenever possible; take advantage of income-tax deferral on the growth of your assets; postpone withdrawing from your assets until you absolutely need the money; and diversify your holdings. With those basics in place, you’ll be well positioned to take advantage of the growth opportunities that will abound when the markets, and economy, begin to recover.
This information is for educational purposes and should not be considered specific financial, tax or legal advice. Always consult with a qualified advisor regarding your individual circumstances.
Winfield C. Greenwood, RFC® is the owner/founder of Redstone Financial Group, LLC, an independent financial services firm based in Las Vegas. He shares his expertise on business and personal financial planning with the RJ every week. Contact him at (702) 475-6363,firstname.lastname@example.org, or connect via Facebook or Twitter.