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What’s Next For Employer-Sponsored, Tax-Advantaged Retirement Accounts?

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Everyone seems rather focused on the deficit right now. This isn't surprising, considering the fact that we have a serious budget crisis brewing in the U.S. However, a lot of the plans to “fix” the problem involve getting rid of tax incentives for the people who need them most.

One of the issues on the table is getting rid of some of the tax advantages associated with employer-sponsored retirement accounts.

Your Tax Deduction Could Disappear

One of the ways that some lawmakers hope to improve revenue is to stop providing the ability to contribute to employer-sponsored retirement accounts with pre-tax dollars. Another plan is a cap on the combined employer/employee contribution limit, reducing it to the lesser amount of $20,000 a year, or 20% of income. (Currently, the corresponding amounts are $49,000 a year and 100% income.) There are different suggestions as to how to change the tax advantages associated with retirement contributions, but all them have the possible effect of reducing the amount workers set aside for retirement.

Additionally, there are concerns that reducing the tax benefits that employers get for setting up these retirement plans would have the effect of reducing the number of plans even available. Employers are already feeling the pinch from the rising costs of health care benefits. They might not be so willing to continue offering retirement plans if the tax incentives to do so began disappearing.

Would You Still Contribute To A Retirement Account Without The Tax Benefit?

Already, there are concerns that Americans aren't saving enough for retirement — and that's with fairly decent tax benefits to do so. What happens when that incentive goes away? If you thought the retirement savings rate in America was bad already, just wait until there's no reason to sock money away in a tax-advantaged retirement account.

The flip side, of course, is that there are some people who would contribute to a retirement account no matter. If you are preparing for your future, you know that you will need to set money aside — whether or not the government gives you a tax break. While it certainly is nice to receive the tax benefits associated with retirement plan contributions, if they disappeared tomorrow, I'd still make retirement account contributions. (Of course, I contribute to a Roth IRA, so I don't get a tax deduction anyway. But we will soon be contributing to a 403b through my husband's job, so a deduction could be a very real possibility soon.)

Bottom Line

Any number of suggestions are being floated as ways to reduce spending and boost tax revenue. This means that there are a number of tax deductions and credits on the table, many of them affecting individuals and businesses. From retirement account contributions, to the mortgage interest deduction, you could soon see some of your tax breaks disappearing. This means that you will need to plan for the possibility. Decide what's important to you, and what you can handle without the tax break. Hopefully, you will decide that it's still important to make contributions to your retirement account, even if there is no tax break associated with it.

2012 401k Contribution Limits And Rules

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In the past we've talked about which retirement accounts are best for different situations, and we looked at reasons why you might want to invest in a Roth IRA, 401k, Roth 401k or A Traditional IRA.  Depending on your age, your income, your current and future tax situations and a variety of other factors, you may want to look at investing in one or several of these account types.

At our house we love the fact that the Roth IRA is done with post-tax dollars because it means that we'll never have to pay taxes on the contributions or earnings.  On the other hand, Who knows what our tax situation will be in retirement versus now – so it pays to do a bit of retirement account diversification. So we're investing in a Roth account as well as in our 401k.

This week the IRS came out with the adjusted pension plan limitations for 2012, so I thought I'd take a look at some of the changes in the 401k rules, regulations and contribution limits.

401k Contribution limits

How Did The 401(k) Start?

Background on the 401k retirement account type from Wikipedia:

A 401(k) is a type of retirement savings account in the United States, which takes its name from subsection 401(k) of the Internal Revenue Code. 401(k)s were first widely adopted as retirement plans for American workers, beginning in the 1980s. The 401(k) emerged as an alternative to the traditional retirement pension, which was paid by employers. Employer contributions with the 401(k) can vary, but in general the 401(k) had the effect of shifting the burden for retirement savings to workers themselves. In 2011, about 60% of American households nearing retirement age have 401(k)-type accounts.

401(k) Contribution Limits

In 2011 the 401k contribution limits remain unchanged from 2010 and the limit of $16,500 remained in place .   This year there was a cost of living adjustment to the 401k contribution limits, and people who use or have 401(k), 403(b), 457 and the government's Thrift Savings Plan saw an increase of $500 to the limit.  That means that next year you can contribute up to $17,000 in your account.

Here is a look at the maximum yearly contribution for the 401k account type every year since 2007.

Year401k Contribution Limit
2007$15,500
2008$15,500
2009$16,500
2010$16,500
2011$16,500
2012$17,000

Since 2007 we've seen an increase of $1500 to contribution limits.   Since there was an increase for 2012, I wouldn't expect to see one for next year.

401k Catch-Up Contribution Limits

If you're 50 years or older by the end of 2012, you can make catch up contributions to your 401k account.  Not all plans allow for this, but if yours does, you can make an additional contribution of $5,500 on top of the $17,000 limit, for a total of $22,500.

Here are the  401k catch-up contribution limits for 2012.

Year401k Catch-Up Contribution Limit
2007$5000
2008$5000
2009$5500
2010$5500
2011$5500
2012$5500

401(k) Employer Contribution Limits

There are separate contribution limits for employers in case they decide to add to your account.  Currently an employer can make a contribution of up to 6% of the employee's salary.

Do Employer Matching Contributions Affect Your Limit?

If you're employer is giving contributions or matching contributions, will those contributions count against your limit?  Thankfully it doesn't, as the employer contribution limit is a separate limit.

Example: If someone makes $100,000 in pre-tax compensation, and they and their employer both contribute the maximum, they could have $17,000 contributed by the employee, and $6,000 by the employer for a total of $23,000. If they're over 50 they could also make catch up contributions for a total of $28,500.

Maximum Contribution Limits

There are other things you may need to consider with your company's 401(k) plan. For example, if you're a highly compensated individual at your company you may be subject to separate contribution limits. Some plans may allow you to make post tax contributions to your account. Currently the max you can contribute to a 401(k) plan in 2012 is $50,000 or 100% of your compensation, whichever is less.

Are you currently contributing to a 401(k) plan through your work? Are you contributing to the maximum? Do you get a company match? Tell us what you think about the limits, and if you'll be able to reach them.

When To Take Social Security: A Question Of Cash Flow

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One of the biggest decisions you have to make as you approach retirement is when you want to begin taking your Social Security benefits. Indeed, this is an important consideration. For the most part, it depends a great deal on what you think your cash flow needs will be as you age.

Do You Need the Cash Now? Or Can You Wait?

You can start pulling on benefits at age 62. However, if you start taking benefits as soon as you can, your monthly payments will be lower than if you wait. Indeed, your payments will only be 75% of what you would get if you wait until age 66 (which is considered the “full” retirement age by the government). And, if you can wait even longer — to age 70 — you see an increase of benefits by 8% each year between 66 and 70. There is no additional benefit for waiting beyond age 70.

Timing Of Taking Social Security
Understand, though, that you aren't necessarily getting “more” in the sense that your overall total will be higher. Instead, the formula is worked out so that you should have roughly the same benefits over time if you start, no matter when you start taking Social Security, at age 66. The difference is that if you wait longer, the government will offer you a higher monthly payment amount to make up for the fact that you haven't been taking what you could for the past few years.
As you decide when to start taking social security benefits, you will need to consider your cash flow situation and any tax implications. If you are 62, and you need the money to help cover shortfalls in your tax advantaged retirement account, you might need the money now — even though you will be penalized for not waiting until the “full” retirement age. If you need the money to help you in your retirement, and you can't find other sources of income to help you, then taking Social Security earlier might be your only option.

However, if you can wait until later, it might be worth it. Later on, your expenses might increase as your health declines (and costs rise), or as your retirement fund starts to run a little lower. Being able to wait until later and receive more each month might be very helpful. If you can keep working in between, earning income and paying into the system, your benefit will increase as well. This can be a great help to you later on, when you might want a larger monthly income.

Bottom Line

Before you decide when to start taking Social Security, you need to consider your situation, and what you expect in the coming years. In some cases, you might be worried that benefits will be cut due to economic concerns and problems with the federal budget; in that case it might make sense to start receiving payments as soon as you can, in order to get what you can.

However, if you expect that you will receive your benefits as promised, you need to look at your situation. How much can you expect from various revenue streams, and your retirement accounts, and for how long can you expect to keep up the income pace? You should plan to take Social Security when it will most help your monthly cash flow.

Hedging Market Risks To Your Retirement

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The current stock market volatility has many wondering how market risks could affect their retirement prospects. Many almost-retirees found, to their dismay, that the market crashed, wiping out retirement portfolio values, just before they needed that money. While the market has been recovering since 2008, the fear of what happens “next time” has many wondering what they can do to hedge some of the market risks to retirement.

Two of the risks that you are likely to run into include the following:

  1. Market crash just prior to your retirement. This could also include a period of a down market. This means that when you withdraw from your retirement account, you are selling investments at a time when you are locking in losses — and you have to sell a higher volume to meet your needs, reducing the amount of investments in your portfolio.
  2. Maturity on some products at an inconvenient time. Your CD might mature just after interest rates plummet, leaving you no option to roll over at the same yield, or a bond might be called early (or mature), while rates are low.

While you can't completely eliminate these risks (all investment comes with risk), you can hedge against them in a way that can help you limit your losses.

Hedging Market Risks

Diversity

The first line of defense against huge market losses is diversity. When some markets are down, others are up. Consider adding a little more diversity to your portfolio in terms of real estate and commodities, in addition to stocks and bonds. You can also look at diversity in terms of foreign vs. domestic investments, and diversity across sectors, as well as adding some dividend aristocrat stocks to help with your income during retirement — even during a down market.

Stagger Your Maturities

Don't invest in a bunch of CDs that mature at the same time, or invest in Treasury securities that all mature in five or 10 years. Choose different maturity dates, and acknowledge that you might need to have a plan for short-, middle- and long-term investing. A CD ladder can help you create a system that allows you to earn the highest possible yields on long term CDs, while still having the opportunity to take advantage of higher rates when they arrive. Choose bonds of different maturities so that they aren't all coming due at the same inconvenient time. A little staggering can help you avoid having to reinvest everything at the same time — and possibly lose out because of it. Also, make sure you have some investments meant for different time frames so that you have a little more flexibility when deciding what to sell, and when.

Extra Income and Emergency Fund Padding

You can also hedge against market risk by planning your retirement income. Look for ways to build up additional income streams, especially passive income streams. That way, you won't have to rely heavily on withdrawing from your retirement investment account during a down market, and you can leave your portfolio alone to try to recover. (Some even recommend certain, carefully chosen annuities to provide income so that you don't have to deplete your investment portfolio in tough market times.) The same is true of having extra emergency fund padding. Look for ways to build up a supply of money that you can draw on without having to sell investments in a down market.

Roth IRA: Emergency Fund?

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I recently found out that one of my associates uses her Roth IRA as an emergency fund. Rather than put money into a low yield savings account, or some other cash account, she uses her retirement account as an emergency fund. Technically, the basics of a Roth IRA are conducive to this arrangement. However, you do want to be careful. Think things through before you use your Roth IRA as an emergency fund.

Why Your Roth IRA Could, In Theory, Be An Emergency Fund

In theory, your Roth IRA works as an emergency fund because of the withdrawal rules. You are actually allowed to withdraw your contributions to a Roth IRA at any time, and for any purpose – no matter your age. This means that you can take money out of your Roth IRA with no penalty or tax, as long as you are only withdrawing money that you have sent to the account through regular annual contributions. As long as your withdrawal amount doesn't exceed your overall contribution amount, you don't have to pay a penalty or taxes. Keep in mind that previous withdrawals count against your overall contribution amount.

Roth IRA Emergency Fund

You do have to be careful, though. Withdrawing from your Roth IRA can cost you if you don't do it right. If you are under 59 1/2, and you exceed your contribution amounts (except in certain cases), you might be subject to a 10% penalty and to paying income taxes on the amount. Make sure you know what you are doing before you withdraw money from your Roth IRA to shore up your finances in the case of emergency.

Opportunity Cost

While you might not have the expenses associated with penalties and taxes when you withdraw your contributions to your Roth IRA, you are still subject to opportunity cost. Remember: The money in your Roth IRA is working for you. You are earning interest at a pretty good rate (depending on your asset allocation and market conditions), and if you withdraw principal, you miss out. You can't replace the time that your money might have spent in your Roth IRA, growing with the power of compound interest.

On the other hand, though, some insist that the opportunity cost comes when you put that money in a low yielding cash account as an emergency fund. Because your money (theoretically) grows faster in the Roth IRA, the power of compounding interest at a higher rate makes up for the fact that you withdraw some of your contributions for emergencies.

Bottom Line

What you decide to do depends on what you think is likely to work best for you, and provide for your needs. If you plan ahead sufficiently, it should be possible to get quite a bit built up in your Roth IRA. Of course, for it to work, you need to make sure you only withdraw contributions in cases of true emergencies. If you use your Roth IRA as an ATM, you could easily remove all of your contributions quickly — and then move into penalty areas where it starts costing you more. Make sure you carefully evaluate your situation before adopting this emergency fund strategy.

Is Your Home Really Going To Be A Retirement Asset?

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Many of us were raised to believe that buying a home is the key to a stable financial future. It is true that your home is likely to be your biggest purchase, but it may not do to rely too heavily on your home's equity for retirement.

The theory is nice: You buy a house, pay it off over 30 years, and when it's time to retire you have this huge asset, which has appreciated in value, ready to be tapped. Before you get excited about the prospect, though, it's a good idea to take a step back and evaluate whether or not your home will really be the asset you think.

Home Equity

Will It Appreciate As Much As You Think?

The first thing you have to consider is whether or not your home will appreciate as much as you think. You will need to consider the costs of home ownership, including the interest that you pay, as well as maintenance and upkeep. You can expect to offset some of the costs of interest and property taxes with the help of tax breaks, but you can't expect those to last forever. You will have to consider the effects of inflation as well.

The other issue, of course, is whether or not a market crash happens just before you retire. Many people who had depended on their homes for retirement received a rather unpleasant surprise after the recent real estate bubble burst and home values plummeted. Suddenly, the expected value disappeared.

While your home can be an asset to draw on later, you might not want to rely too heavily on the expected equity in your home to fund your retirement. Like any other asset that we expect to appreciate in value, there is the risk of loss, and you can't predict what the market will do. A little diversity is usually in order.

Tapping Your Home Equity

One of the reasons that many buy a home is for the ability to tap the equity later. However, tapping your home's equity comes with its own costs. You will have to pay even more in interest, since you will have to borrow against the equity in your home to access it. If you are retired, you may have difficulty getting a traditional home equity loan, since you will need income. You might have to use a reverse mortgage. While you won't have to repay the mortgage until the house is sold, or you stop living in the house, many reverse mortgages have steep fees and interest rates, and can erode the amount you receive.

Of course, you can sell your home to downsize. If you have paid off your mortgage, you can sell, and then use the resulting capital to buy a smaller home, or invest the capital for income. (Or, if you have enough left over, you could buy a smaller home and invest.)

Bottom Line

If all goes to plan, it is quite possible that your home can be a place for you to live, as well as provide you with an asset to use to your advantage during retirement. However, it is important to understand that you might not end up with what you expect, and to consider making any real estate asset a part of your larger retirement portfolio, adding diversity.