Why invest for retirement?

Most people work very hard for their money. So when it comes to planning for retirement, they don't want to take chances. That's why so-called "safe" investments, such as bank savings accounts, certificates of deposit or money market funds, are popular with risk-conscious investors.

However, because these investment vehicles involve very little risk, the interest rates they pay are also very low—so low, in fact, they may not even keep up with the rate of inflation.

Inflation is the rise in the price of goods and services that a consumer must pay. It is important to consider the power of inflation because as it grows, it can have a dramatic effect on the purchasing power of your income. An income level that today seems adequate might be very low in the future as that amount of money buys less and less.

Planning your retirement using conservative investments, including bank accounts, CDs and money market funds, may not be the best idea when trying to stay in front of the inflation curve.

Stocks, on the other hand, offer the highest potential for keeping ahead of inflation. Stocks are much riskier, but over the long term, they historically have outperformed other investments. And while it's true that the past is not an indicator of future performance, it is likely that over the long term, investing in stocks will generate more money. With proper planning and informed decision-making, stocks can be a valuable tool in your investment strategy for retirement.

Historically, many people have looked toward their workplace for retirement planning. Traditional company pension plans (often called "defined benefit" plans) pay participants a fixed monthly income at retirement. The amount is usually determined by the number of years of service, average salary, position and other factors.

The popularity of defined benefit plans has been declining in recent years. One factor in this decline has been the high costs associated with these pension plans. Operating these plans also has become more complex because of increased government regulations.

Many companies have replaced their defined benefit plans with a lower cost alternative—the "defined contribution" plan. Examples include money purchase plans, 401(k) plans, 403(b) plans, profit-sharing plans and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.

In a defined contribution plan, the participant has much more flexibility and more individual choices. A defined contribution plan offers:

• The choice of how much of your own money you want to contribute to the plan. The company then generally contributes a defined amount to the plan on your behalf. In 401(k) and 403(b) plans, your pre-tax contribution is deducted from your paycheck.

• The choice of where to invest your contributions among the options offered by the company.

The amount available at retirement is dependent on how much the participant contributed to the plan, the amount his or her employer added and the rate of return the investment account earned.
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  The Benefits of Investing

When money is invested, it generally earns interest, dividends or capital gains. If these earnings are then reinvested, they generate additional earnings, which in turn can generate more earnings, and so on. This principle, called compounding, is one of the most powerful aspects of investing.

For example, if an investment returns 8 percent per year and earnings are reinvested annually, in five years the total return would be 47 percent; after 10 years, the total return would jump to 116 percent.

Compounding has its greatest effect over time. The following example shows that the sooner you begin to invest, the more money will be generated by retirement age. Look at this example:

Mary starts her 401(k) contributions immediately upon being hired, while Dave waits 10 years to start his contributions. Even if Mary stops contributing after 10 years, she still comes out ahead because she started sooner.

Taxes can take a huge bite out of your investment earnings. So the longer you can shelter your assets from taxation and keep the earnings compounding tax-free, the more you will be able to accumulate to meet your retirement goals.

Employer-sponsored plans and individual retirement accounts offer some of the best options for reducing the impact of taxes on your retirement savings.

• Employer-sponsored plans. You contribute to the plan—such as a 401(k) or 403(b)—from your pay before taxes are taken out, lowering your taxable income. Your investment earnings grow tax-deferred until you withdraw the money at retirement. Upon withdrawal, your contributions and earnings are taxed at your ordinary income tax rate.

• Deductible traditional IRAs. If you qualify, your contributions are tax-deductible. Your earnings grow tax-deferred until you withdraw the money at retirement. Upon withdrawal, your pre-tax contributions and earnings are taxed at your ordinary income tax rate.

• Nondeductible traditional IRAs. Your earnings grow tax-deferred until you withdraw the money at retirement. Upon withdrawal, your earnings are taxed at your ordinary income tax rate.

• Roth IRAs. Your earnings grow tax-deferred until you withdraw the money at retirement. Withdrawals are exempt from taxes under certain conditions.

Tax-deferred retirement plans do have certain restrictions, and you can be penalized if you withdraw money before age 59½ or fail to make the required withdrawals by age 70½.
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Factors in Planning for Retirement

In the 1950s and 60s, people typically planned on retiring at age 65. Today, many working Americans plan on retiring much earlier. That factor, combined with longer life expectancies, means that you could be living on your retirement savings longer than you might have planned.

Further, if you begin collecting Social Security benefits before your normal retirement age (as defined by the Social Security Administration), you will receive reduced payments. If you wait until after your normal retirement age, you will receive increased payments. Under current Social Security rules, the age at which individuals may begin to receive full retirement benefits is gradually being extended.

Another factor to consider is how long you are likely to live. Due to medical advances in recent years, Americans are living longer than ever. A longer life expectancy increases the likelihood that you could enjoy a retirement that lasts 20 years or longer.

No matter when you retire, the more you save and the earlier you begin saving, the better prepared you will be for the uncertainties of retirement.

Your expenses could change significantly upon retirement. Some expenses will decline or be eliminated completely, while others will appear for the first time.

Some of your current expenses that may no longer be applicable upon retirement include retirement funding, mortgage payments and work-related expenses such as work clothes, union dues and costs related to a daily commute.

However, your expenses are likely to increase for medical and dental care, prescriptions, health insurance and long-term care insurance. In addition, Medicare premiums and deductibles rise almost every year.

You may also spend more on your family, and if you remain healthy, on travel, hobbies or other interests.

All in all, to live comfortably in retirement you may need an estimated 70 percent to 80 percent of the pre-tax income you earned in your final working years. This income is likely to come from three primary sources: your employer-sponsored retirement plan, Social Security and your personal savings. You may receive additional income from any part-time work you do.
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Benefits of Tax Deferral

The benefits of tax deferral are significant. By deferring the taxes on investment earnings, including dividends, interest and capital gains, your investment money can grow much more quickly because there are more funds available to generate earnings.

Additionally, if you wait until retirement age to begin withdrawing money and paying income taxes, you may be in a lower tax bracket; therefore you may pay less in taxes.

There are also certain drawbacks to tax deferral. In general, you must begin making withdrawals at age 70½, so you will have to pay taxes on the earnings eventually. If you need money for some reason and elect to make early withdrawals (before age 59½), you will be charged a hefty 10 percent penalty in addition to ordinary income taxes.
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Traditional IRA

Traditional individual retirement accounts offer tax-deferred growth of funds and, in some cases, your contributions are also tax-deductible. The benefits of traditional IRAs include tax-deferral, which allows investment earnings to compound tax-free for years. Thus your account can grow faster than it would if it were subject to annual taxes on income and capital gains.

Additionally, traditional IRAs offer flexibility in the type of investments you choose, and your contributions may be tax-deductible if you are not an active participant in an employer-sponsored plan (such as a 401[k] plan), or if your modified adjusted gross income is below a certain threshold.

Traditional IRAs also have some drawbacks, including penalties for early withdrawals and the tax consequences of taking money out of the fund before retirement age.

The rules concerning traditional IRAs are clear cut. Anyone under age 70½ who has earned income from wages or a salary may contribute to a traditional IRA. Annual contributions are allowed up to $5,000 ($6,000 if over age 50) in 2009, or 100 percent of your earned income, whichever is less. Contributions must be made no later than the tax-filing deadline for that tax year, which for most taxpayers is April 15 of the following year.

A married couple with only one spouse working outside the home may contribute a total of $10,000 (or $12,000 if over age 50) in 2009 into separate IRAs, provided the "wage-earning spouse" has at least $10,000 ($12,000) in earned income.

Under normal circumstances, early withdrawals (before age 59½) are subject to taxes and a penalty tax of 10 percent. The penalty tax does not apply to money withdrawn for certain medical expenses, health insurance, education costs or first-time home purchase.

Penalty taxes might also be waived if funds are withdrawn under the "substantially equal periodic payment exception," which allows annual withdrawals based on your life expectancy (or the joint life expectancy of you and your beneficiary). Penalties are also voided as a result of your disability or death.

Penalties are also waived if you transfer IRA monies from one trustee to another or if money in a qualified plan is moved directly to a traditional IRA or other qualified plan. Additionally, if you roll over your retirement assets and reinvest them in another IRA or qualified plan within 60 days, you can avoid penalties.

Additional IRA information:

• You may not borrow from your IRA or use it as collateral for a loan.

• You may use IRA funds during the 60-day rollover period, but if you hold the money longer, you'll be required to pay income tax and the penalty if no exceptions apply. These funds then will no longer be eligible for deposit into an IRA.

• While you can invest IRA assets in virtually any type of mutual fund, or in banks or brokerage firms, some types of investments are prohibited, including life insurance contracts and collectibles.

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Roth IRA

The Roth IRA, developed in 1998, is a nondeductible, tax-deferred individual retirement account that allows tax-free withdrawals under certain conditions. In addition to the tax-deferred growth of funds, the Roth IRA offers other substantial tax benefits for some people.

Unlike a traditional IRA, the Roth IRA lets you withdraw your earnings tax-free if you are at least 59½ years old and your account has been established for five years or more.

Like the traditional IRA, the Roth IRA calls for penalties if you withdraw your earnings before age 59½ or contribute more than $5,000 ($6,000 if over age 50) in 2009 (or 100 percent of your earned income, whichever is less). Unlike a traditional IRA, however, a Roth IRA does not require you to take minimum distributions after age 70½.

Contributions to a Roth IRA do not qualify for an up-front tax deduction. And, when you convert a traditional IRA to a Roth IRA, you must pay ordinary income tax on the converted amount that represents deductible contributions and earnings.

You can contribute up to $5,000 ($6,000 if over age 50) of your earned income (from wages or a salary) in 2009 to a Roth IRA if you are single and your modified adjusted gross income (AGI) is less than $105,000.

Married persons who file a joint tax return and have an AGI of less than $66,000 may also contribute up to $5,000 ($6,000 if over age 50) in 2009.

Unlike traditional IRAs, you can contribute up to $5,000 ($6,000 if over age 50) in 2009 to a Roth IRA even if you are older than 70½.

Because you contribute after-tax dollars to a Roth IRA, you can withdraw your contributions tax- and penalty-free at any time. But if you withdraw earnings from an account that is less than five years old, you may pay ordinary income tax plus an additional penalty tax of 10 percent.

The tax and penalty do not apply if the account has been established for at least five years and the earnings are withdrawn after age 59½.

Taxes and penalties are also waived if withdrawals are for certain medical expenses, health insurance, education costs or first-time home purchase. Penalties are also waived if withdrawals are the result of your disability or death.

You are not required to take minimum distributions after age 70½; if you do not need income from your Roth IRA, you can let your money continue to grow tax-deferred. Your beneficiary, however, must take the minimum distributions.

You can convert your traditional IRA to a Roth IRA if you file a single or joint tax return reporting an AGI of $100,000 or less for the tax year of the conversion. Keep in mind that you'll owe taxes on the conversion.

Note: in 2010, the existing $100,000 income test will no longer apply for converting a traditional IRA to a Roth IRA. Conversions that occur in 2010 will be eligible for one-half tax payment due in 2011 and the other half tax payment due in 2012.

If you withdraw money from a converted Roth IRA within the first five years of the conversion, you will generally owe a 10 percent penalty tax on the taxable amount of your withdrawal. Under certain circumstances, you could also face an accelerated income tax bill.
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SEP-IRAs

The Simplified Employee Pension–Individual Retirement Account (SEP-IRA) is an easy-to-administer plan that permits owners of small businesses and people who are self-employed to set aside money for retirement through tax-deferred investment accounts.

A SEP-IRA is funded by tax-deductible contributions from the employer.

Employers are allowed to contribute up to $49,000 or 20 percent of an employee's compensation in 2009; whichever is less, to each employee's account.

Small-business owners must contribute the same amount for each employee as they do for themselves. They are allowed to vary the contribution amount from year to year; however they must cover all employees over age 21 who meet a minimum income requirement and who have worked for the company three of the preceding five years.

A SEP-IRA can be established by completing a simple form. A report detailing the amount of contributions must be made to the company's employees once a year.

SEP-IRAs offer real advantages to employees in that they are 100 percent vested in the fund and can withdraw the employer's contributions at any time (subject to IRS rules, which generally impose ordinary income tax and a 10 percent penalty tax on distributions made before age 59½).

Employees are limited in that they cannot contribute to a SEP-IRA themselves. However, they are allowed to contribute to a traditional IRA.
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Employer-Sponsored Plans

Employer-sponsored retirement plans are among the most utilized employee benefits available. Most midsize or larger companies offer some type of retirement plan for their employees. These plans generally can be divided into two broad categories: defined benefit plans and defined contribution plans.

Defined Benefit Plans – These generally promise a retirement benefit or pension based on an employee's salary prior to retirement and the total number of years the employee has worked for the company.

Under a defined benefit plan, the employer makes the contributions and is entirely responsible for ensuring that assets are available to fund the pension. The IRS limits the annual benefits a retired employee can receive. The government-sponsored Pension Benefit Guaranty Corporation guarantees pension benefits up to a certain amount.

Defined Contribution Plans – These have become increasingly popular in the business world recently because they are generally simpler, more flexible and less costly for companies to fund.

Under a defined contribution plan, an individual account is established in an employee's name. Benefits are determined by how much the employee and the employer have contributed and the rate of return earned by the account's investments.

Typically, a company using a defined contribution plan allows individual participants to choose from several investment options. Employees are responsible for making decisions to ensure that their investments provide adequate returns to meet their retirement needs.

Some common defined contribution plans include:

• Profit-sharing plan – Employer contributes, and can determine how much, if any, to contribute each year. Contributions typically are based on each employee's current-year compensation.

• Money purchase plan – Employer contributes, and must provide a fixed amount (or percentage of compensation) each year for each participating employee. Contributions may exceed those allowed with profit-sharing plans.

• Thrift (or savings) plan – Both employer and employees contribute, and employer matches all or a fraction of employees' contributions. (For example, an employer may contribute 50 cents for every dollar an employee puts in.)

• Employee stock ownership plan (ESOP) – Employer contributes shares of the company's stock to employees and, in return, gets special tax advantages and favorable financing opportunities.

• 401(k) plan – Popular variation of profit-sharing/thrift plan. Employees make regular, pre-tax contributions through payroll deductions, and many employers match some portion of employees' contributions.

• 403(b) plan – Variation of profit-sharing/thrift plan for employees of public schools and tax-exempt organizations. May work much like a 401(k) plan, but by law offers only two funding arrangements: an annuity contract with an insurance company, and a custodial account in mutual funds (403[b][7] account).

• Keogh plan – Self-employed individuals contribute, according to rules much like those for a qualified large-company plan.

• Nonqualified deferred compensation plan – Employers contribute, generally on behalf of highly paid employees, to supplement qualified plans. Does not meet IRS rules for qualified plans (e.g., may not be funded to ensure future benefits, or funds may not be shielded from creditors).

Employers who offer sponsored plans must provide employees with certain kinds of information. A thorough grasp of an employer-sponsored plan can help you make the most of your benefits.

The Summary Plan Description explains the plan's basic rules and features. You should receive the description within 90 days of becoming a plan participant.

The Individual Benefit Statement is not required of the company, but is often provided. This document shows account balances or accrued benefits.

The Summary Annual Report describes the plan's aggregate financial status.

The Survivor Benefits Explanation tells what types of benefits from the plan are available to spouses.

In addition, if your plan is participant-directed (that is, you decide how your money is invested), request a description of each investment option, including its risk and reward characteristics, fees and expenses.

The following tips can help you get the most benefit from your plan:

• Maximize pre-tax and tax-deferred contributions.
• Invest prudently and for the long term.
• Avoid borrowing from your plan.
• Make sure your benefits will be adequate.
• Start saving early.
• Save consistently.

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