Financial Topics Newsletter Archive

November 2006

In This Issue:

• Retirement Planning Throughout Your Life
• Leave Your 401(k) Funds Alone
• Who Is Affected by the AMT?
• The Dangers of Delaying Retirement Savings
• Stick with Your Strategy

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Retirement Planning Throughout Your Life

After working 40 or 50 years, you could find yourself retired for another 20 or 30 years. To support yourself without a job for 20 or 30 years, you should probably be planning for retirement during your entire working life. However, your concerns and strategies for retirement will change as you age. Consider these tips:

In Your 20s

While you may just be getting started in your career, don't squander the long time period before retirement that can help your retirement funds grow and compound. Some strategies to consider include:

• Start saving for retirement now. Saving even small amounts can help you accumulate significant sums by retirement age. For instance, if you invest $2,000 per year from age 25 to age 65 in a tax-deferred account earning 8% per year, you could accumulate $518,113 by age 65. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment vehicle.) Try to save at least 10% of your income, but if you find that difficult to do, at least start saving something. Get in the habit of saving at a young age, before you get used to spending all your income.
• Investigate different retirement savings vehicles. If your employer offers a 401(k) plan, start contributing as soon as you can. You should at least contribute enough to take full advantage of any matching contributions offered by your employer, which can significantly increase your savings. For instance, assume you earn $50,000 per year and your employer matches 50 cents on every dollar of contributions up to 6% of your salary. If you contribute 6%, you will make a contribution of $3,000 and your employer will contribute $1,500. If your employer doesn't offer a 401(k) plan, contribute to an individual retirement account (IRA), either traditional or Roth. Investigate the differences to determine which is better for your situation.

In Your 30s

Typically, even though your income is rising, your expenses are also growing as you buy a house and start a family. However, don't lose sight of retirement, since you still have significant time before retirement to help your funds grow. Consider these tips:

• Start thinking about retirement. Give some thought to how you want to spend your retirement and how much it will cost. While you may feel that retirement is too far away to gauge these things, putting a rough price tag on your retirement and calculating how much you need to save can provide significant motivation in saving for that retirement.
• Devise strategies to keep saving. Look for ways to remain committed to saving, even as your expenses are increasing. For instance, whenever you receive a raise, put some of it into your 401(k) plan so you don't get used to spending the money. Before incurring a large new expense, such as a new car or home, look at the impact the additional expense will have on your retirement.

In Your 40s

While you still have quite a while before retirement, it's time to get serious about saving for retirement. Especially if you haven't saved much during your 20s and 30s, you need to really commit to saving. Some tips to consider include:

• Contribute the maximum to your 401(k) plan. Don't make excuses; just make sure you are saving the maximum in your 401(k) plan. Also look at saving in an IRA.
• Review your investment strategy. Take a look at all your investments, both inside and outside of retirement accounts. Does your strategy make sense, and will it help you reach your retirement goals?

In Your 50s

Retirement is no longer that far away. It's time to assess where you stand and whether your retirement plans are realistic. Consider these tips:

• Look seriously at your retirement plans. Make sure you have an accurate assessment of how much money you'll need in retirement and compare that to your estimated retirement income sources. If you are short, consider revising your plans. You may need to work longer, scale back your retirement plans, or save more.
• Take advantage of catch-up contributions. In addition to making the maximum contributions to 401(k) plans and IRAs, take advantage of catch-up contributions once you turn 50. In 2006, you can make a $5,000 catch-up contribution to a 401(k) plan, if permitted by your plan, and a $1,000 catch-up contribution to an IRA.
• Try to ratchet up your savings. By now, hopefully, some of your large expenses will be behind you, such as funding a child's college education, and you can divert those sums to your retirement savings.

In Your 60s and Beyond

This is the period when people typically transition from a working life to retirement life. Some strategies to consider include:

• Finalize your retirement plans. Go through your expenses and expected retirement income sources one more time to make sure you haven't forgotten anything. Determine when you can start drawing retirement benefits, such as Social Security, Medicare, and pension plans. Before you leave your job, make sure the timing is right and you'll be able to comfortably support yourself during retirement.
• Plan before withdrawing your retirement savings. Before you start taking withdrawals from 401(k) plans and IRAs, consider all relevant factors. You don't want to drain those funds too quickly.
• Consider working on at least a part-time basis. Even if you think you have sufficient funds for your retirement, consider working at least part-time during the early years of your retirement. This will help keep you active, while also supplementing your retirement savings. It is better to work now than to find out late in retirement, when your health may not permit you to work, that you have run out of retirement savings.

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Leave Your 401(k) Funds Alone

If you leave your employer, decide what to do with your 401(k) funds. Your worst option is to take a distribution, pay taxes and a penalty on it, and then spend the money on something other than retirement. By doing so, you use retirement funds and forego any further tax-deferred growth on those assets. In addition, you may incur a large tax bill, since withdrawals are subject to ordinary income taxes and a 10% federal income tax penalty if you are under age 59 ½ (55 if you are retiring). Don't make the mistake of thinking it's just a small amount and won't make much difference for your retirement. Over the long term, even a modest sum can grow to a significant amount.

You have three options to keep your 401(k) funds in a tax-deferred vehicle until retirement:

• Leave the funds in your former employer's 401(k) plan. Generally, you can leave the funds in your former employer's plan if your balance is at least $5,000. However, most plans will not allow you to borrow from your account once you leave the company. Until you consider all your options, you might want to at least temporarily leave the funds with your former employer's plan.
• Transfer the funds to your new employer's 401(k) plan. Find out if your new employer's plan accepts rollovers. If so, you can typically make the rollover even before you are eligible to make contributions. However, first check out the investment options offered to make sure the new plan has options that will fit your investment goals. Once the funds are in your new employer's plan, you will be able to take loans if permitted by the plan. Also, if you work past the age of 70 ½, you won't be required to take distributions from the 401(k) plan until you retire. With individual retirement accounts (IRAs), you must take withdrawals once you turn age 70 ½, even if you are still working. If you decide to transfer the funds to your new employer's plan, get the appropriate paperwork from your new employer so the funds can be transferred directly to the new plan's trustee. Otherwise, if the funds go directly to you, your former employer will be required to withhold 20% for taxes. You must then replace the 20% with your own funds within 60 days or the 20% withholding will be considered a distribution, subject to income taxes and the 10% federal penalty.
• Roll the funds over to a traditional IRA. Again, you should have your former employer transfer the funds directly to the IRA trustee to avoid the 20% withholding described above. Once the funds are rolled over to an IRA, you can invest in a wide variety of investment alternatives. With a 401(k) plan, you typically have a limited number of options. If you plan on leaving part of your 401(k) balance to your heirs, an IRA usually has more flexible options than a 401(k) plan. After the funds are transferred to a traditional IRA, you can then convert the balance to a Roth IRA, provided your adjusted gross income does not exceed $100,000 in the conversion year.

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Who Is Affected by the AMT?

The alternative minimum tax (AMT) was originally designed to ensure wealthy taxpayers paid at least a minimum amount of tax. However, due to the tax calculation, more and more taxpayers are becoming subject to the AMT. For instance, 3.6 million taxpayers paid the AMT with their 2005 tax returns, with that number projected to increase to 30 million, or 20% of all taxpayers, by 2010.

To calculate AMT, you add several common deduction items to your taxable income, subtract the AMT exemption amount ($62,550 for married taxpayers filing jointly, $42,500 for single taxpayers, and $31,275 for married taxpayers filing separately in 2006), and multiply the result by the AMT rates – 26% of the first $175,000 of income and 28% on amounts over that. If the AMT exceeds your regular income tax, the difference must be paid as the AMT.

Why are so many taxpayers becoming subject to the AMT? A primary reason is that ordinary income tax brackets are adjusted for inflation annually, while the AMT exemption amounts are not adjusted for inflation. Thus, as income levels rise, more individuals are subject to the AMT. Another reason is that regular income tax rates were recently reduced, while the AMT tax rates remained the same.

Low-income taxpayers are typically not subject to the AMT because the AMT exemption amounts shield them from the tax. Very wealthy taxpayers are also not typically affected because their overall tax rates are higher than the AMT tax rates. The Congressional Budget Office estimates that taxpayers earning between $50,000 and $200,000 will be the hardest hit by the AMT in the near future. It is estimated that if the AMT is not revised, it will affect 17% of taxpayers with income between $50,000 and $75,000, 53% of those with income between $75,000 and $100,000, 81% of those with income between $100,000 and $200,000, and 94% of those with income between $200,000 and $500,000 (Source: Urban-Brookings Tax Policy Center Microsimulation Model, 2005). By 2007, the U.S. government will receive more tax revenue from the AMT than from regular income taxes.

While you may think it is taxpayers with complicated tax returns who are subject to the AMT, the most significant preference items when calculating the AMT in 2002 were state and local tax deductions (51% of all AMT preference items), personal exemptions (22% of all AMT preference items), and miscellaneous itemized deductions (20% of all AMT preference items) (Source: Tax Policy Center, March 13, 2006).

Because so many items are added back to income in the AMT calculation, whether you are subject to the AMT can affect tax planning strategies. Consider these tips if you are subject to the AMT:

• If you are subject to the AMT every year, it may be difficult to find strategies to reduce your liability, especially when you are subject to it due to items like state and local tax deductions and personal exemptions.
• If you are subject to the AMT in one year but not the following year, you may want to accelerate income (so income is taxed at lower rates) or postpone deductions (many of which are added back in the AMT calculation).
• If you plan to sell assets with significant capital gains, review the impact this will have on the AMT. Although long-term capital gains are still subject to a maximum income tax rate of 15%, it may cause your other income to be taxed at higher rates due to the phaseout of the AMT exemption amounts.
• If you are going to exercise incentive stock options, do so in the early part of the year. For AMT purposes, the difference between your exercise price and the market price on the exercise date is considered income, even if you don't sell the stock or the value decreases after exercise. You might want to exercise stock options early in the year. Then, near the end of the year, you can sell the stock if the price goes down so you won't be subject to the AMT on the option exercise.

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The Dangers of Delaying Retirement Savings

It's a common problem. Even though we know it's best to start saving for retirement at a young age so our savings have long periods to grow and compound, it's difficult to find money to save when we are getting established and raising families. Thus, it's easy to postpone saving, waiting until your children are grown to start saving significant sums for retirement. However, if you wait until your 40s or 50s to start saving, it can be very difficult to save a large enough portion of your income to ensure adequate savings for retirement.

There may also be other obstacles that could derail your savings for retirement, based on a recent study of individuals who were between the ages of 51 and 61 in 1992. During the 10-year period ending in 2002, 40% of those individuals were diagnosed with a major medical condition, 33% developed work disabilities that curtailed employment, 20% were laid off, 10% became widowed, and 3% were divorced.

If a spouse's health problems and job loss are also factored in, 87% of married adults between the ages of 51 and 61 experienced a major problem (Source: Older Americans' Economic Security, January 2006). Especially hard hit were individuals with limited education.

The financial repercussions of these types of events can be serious. For married individuals, it was estimated that a serious medical condition reduced household wealth by 13%, a work disability by 14%, a job layoff by 19%, widowhood by 11%, and divorce by 38%. For single individuals, a serious medical condition reduced household wealth by 18%, a work disability by 30%, and a job layoff by 23% (Source: Older Americans' Economic Security, January 2006).

Thus, if you wait until 10 or 20 years before retirement to seriously start saving, you may find that unplanned circumstances, such as a health problem, job layoff, or divorce, can prevent you from saving for retirement, as well as cause you to use whatever retirement savings you do have. It could also have an impact on your other retirement resources. Benefits earned under a defined-benefit plan tend to grow rapidly during the later working years, since benefits are often tied to years of service and salary earned near career end. Social Security benefits are also tied to lifetime earnings.

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Stick with Your Strategy

We all know the basics – design an asset allocation plan, ignore market fluctuations, and stick with the plan for the long term. In other words, become a buy-and-hold investor. But in an era where everything seems to change overnight, is it realistic to expect to find investments you'll be comfortable owning for years or even decades?

Before you answer that question, you should consider whether it's possible to reliably time the market. That, of course, is every investor's dream – avoid all market losses while participating in all market gains. Unfortunately, it's a difficult strategy to implement for a couple of reasons:

• No one has been able to consistently predict where the stock market is headed. Many try, but so many factors affect the market that even professionals watching the market full time find it difficult to time the market with any degree of accuracy. In retrospect, everything seems crystal clear. Were you able to get out of technology stocks before their significant decline in 2000? While we now know that was the market top for technology stocks, very few recognized that fact in 2000. Also, significant market gains can occur in a matter of days, making it risky to be out of the market for any length of time.
• Frequent trading seems to reduce, rather than increase, returns. Several studies of investor trading have found that investors who trade more frequently generally have lower portfolio returns than those who trade less frequently. Investors tend to buy hot sectors and sell underperforming investments – the opposite of a buy-low-and-sell-high strategy. In essence, they are chasing yesterday's winners rather than tomorrow's winners. Also, trading results in a taxable event. Even with capital gains tax rates at 15% and the highest ordinary income tax rate at 35%, taxes may significantly reduce your portfolio's return.

Rather than trying to time the market, devise an asset allocation strategy that you'll be comfortable with for years, and then purchase investments compatible with that strategy. That doesn't mean you'll never sell an investment, but selling should be an infrequent part of your investment strategy.

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Copyright^�©2006. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.

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