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403(B) PLANS WAVE OF FUTURE FOR MANY WORKERS

Millions of new teachers and health-care workers expected to be hired in the coming decade will need to become familiar with a retirement plan they may know little about: the 403(b), commonly called a tax-sheltered annuity.

403(b) plans are salary-deferral plans designed for teachers, college professors, health workers at nonprofit facilities, and employees working for churches and charitable groups. As with 401(k) and similar defined-contribution plans for the private sector, contributions and earnings in a 403(b) are tax deferred.

For 2005, the maximum an employee generally can defer out of pay into the 403(b) is $14,000 ($15,000 in 2006), or up to 100 percent of the employee’s compensation for that year, whichever is less. (Some plans may limit contributions to less than these maximum amounts.) Employers can kick in up to another $28,000 as long as the employer and the employee’s combined contributions don’t exceed 100 percent of the employee’s compensation. In 2005, employees 50 and older can make an additional “catch up” contribution of up to $4,000 (indexed annually).

403(b) rules do allow a special additional deferral contribution for workers who have underfunded their plan. If you’ve worked for the same 403(b) employer for 15 years or more (not necessarily consecutively) and your plan contributions have averaged $5,000 or less annually, you can boost contributions as much as another $3,000 a year.[403bwise, computer file] But these special additional contributions cannot exceed a lifetime total of $15,000. Got all that? You may want to see your financial planner or other tax expert to make sure you do it right.

As is the case with individual retirement accounts, and usually with 401(k) plans, the worker typically must begin making minimum taxable withdrawals from the 403(b) account when the worker turns 70 1/2. But from there, 403(b) plans tend to differ from similar private-sector plans.

For one thing, 403(b) plans typically supplement the pension plans that government and nonprofit organizations use, unlike the private sector, where employers rely more on employee-funded plans such as 401(k)s. While it’s still important to fund your 403(b) plan as much as possible, because it probably won’t be your main source of retirement income, you may want to handle your investment allocations differently than you might a 401(k) plan that is your primary retirement account.

Historically, 403(b) plans have been more restricted in their investment options than 401(k) plans, though that has improved over the years. While still referred to as tax-sheltered annuities, and although annuities still serve as the predominate investment vehicles, many of the 403(b) plans, especially larger ones, now offer other investment options.

Still, overall, choices can remain limited and 403(b) participants commonly complain about high fees. But some participants have an alternative. Federal law allows participants in 403(b) plans that are not subject to a federal law known as ERISA to shift money out of the plan and into a custodial account at a financial institution of their choice where ideally they’ll have lower fees and more investment choices (not individual stocks, however).

But before making such a move, consider several factors.

·        Because a custodial alternative is cheaper doesn’t mean it’s better. Evaluate performance and other services.

·        Your plan may not allow a switch even though the law does.

·        You may have to pay a surrender or exit fee to annuities or other company that you’re leaving. You and your advisor will have to determine whether it’s worth paying the fee to switch.

·        You can only move to the custodial account money you’ve already accumulated in the 403(b); you can’t contribute new money to the custodial account. Thus, you may have to leave new contributions in for a while in order to allow time for any surrender fees to shrink.

·        Ask your employer to add more or better investment choices with lower fees, so you don’t need to switch.

The IRS recently proposed new rules for 403(b) plans. The rules (or modifications of the rules) won’t become final until 2006, but in the meantime you can operate as if they’re adopted. Several of the rules primarily affect plan administrators, but some will have a direct impact on participants, such as the ability to take loans, the application of certain divorce rules to 403(b) plans, and the transfer of funds to or from 403(b) plans from 401(k)-type plans.

February 2005 - This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bill Mullen, CFP^R, a local member in good standing of the FPA.

IRS EASES RETIREMENT ACCOUNT ROLLOVER NIGHTMARES

BUT TAXPAYERS NEED TO REMAIN CAUTIOUS

The IRS is easing some of the nightmare financial consequences of mishandled tax-free rollovers from individual retirement accounts and retirement plans—but taxpayers need to remain vigilant to avoid unnecessary taxes and penalties.

A rollover occurs when you take money out of either an IRA or qualified retirement plan such as a 401(k) or 403(b) and move it into another IRA or qualified plan—or return it to the IRA or plan you took it from.

The rollover is free of tax, and free of the 10 percent early withdrawal penalty (which would apply if you are younger than age 59 1/2), as long as you follow two rules: (1) You must complete the rollover within 60 days of the initial withdrawal; (2) you can do only one rollover from each account within a one-year period starting from the day of the withdrawal. If you fail to complete the rollover within 60 days of the withdrawal, you risk owing income taxes and penalties, though that’s where the IRS is carving out some exceptions.

Before we get to the exceptions, though, realize that you can avoid rollover problems by doing what’s called a direct trustee-to-trustee transfer. That’s where the money is moved directly between the financial institutions without you ever personally controlling the funds at any point. With this process, you don’t face the 60-day issue or the once-in-a-year rule.

Direct transfers also avoid another major problem with some rollovers. In cases where you take money out of a qualified retirement plan (but not an IRA), a mandatory 20 percent of the withdrawal is withheld for taxes. The withholding will be refunded when you file your next tax return as long as you make up that 20 percent with new money in time to complete the full rollover within 60 days. Otherwise, the withheld 20 percent will be treated as a taxable withdrawal!

While direct transfers are usually the preferred method, you may still end up, for a variety of reasons, making a rollover. So what happens if there’s a problem and you fail to complete the rollover within 60 days? Are you automatically stuck with the taxes and possible penalties? That depends on the cause of the problem.

Until 2001, the 60-day rollover rule was pretty inflexible.. Other than rollovers involving military personnel in combat or taxpayers caught up in a presidentially declared disaster area, exceptions were rare. In the 2001 tax act, Congress gave the IRS more leeway in waiving the 60-day rule. Since then, the IRS has issued a Revenue Procedure and numerous private letter rulings (PLRs) that provide some guidance for when and how exceptions can be made. (Technically, a PLR applies only to the taxpayer involved, though tax experts generally agree they provide insight into IRS thinking on the issue.)

So what exceptions has the IRS allowed? If a financial services institution involved in handling the rollover makes an error, the taxpayer is typically off the hook. Perhaps the institution gives the taxpayer erroneous advice (in one case, the taxpayer was told the rollover period was 90 days, not 60), mistakenly distributes the funds to the wrong account, or fails to follow the account holder’s instructions. If the taxpayer can show such failures, the IRS has been sympathetic about waiving the 60-day rule. The same relief has applied where the plan administrator has made an error.

The IRS has granted exceptions to taxpayers who failed to make timely rollovers due to physical problems or mental problems, such as confusion or memory loss resulting from an accident. If the account owner dies before completing the rollover, an exception also might be made.

The IRS has been far less willing to grant relief where the taxpayer took out money as a short-term loan instead of with the objective of rolling it into another account, though even here the IRS has made exceptions. Thus, taxpayers must be very careful of the circumstances if they hope to gain IRS relief.

To obtain a waiver, taxpayers usually must request a private letter ruling, though in the case where it is the sole fault of the financial institution, they can automatically get relief without requesting a PLR.

February 2005 - This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bill Mullen, CFP^R, a local member in good standing of the FPA.

INSURANCE FOR EARLY RETIREES

Workers retiring early typically worry about how much they’ll have to stretch their limited retirement dollars so as not to run out of money. That’s certainly an important concern. But many early retirees overlook another major issue: adequate insurance, particularly medical.

Workers retire early for two major reasons: they are psychologically and financially ready, or they are forced into early retirement due to unemployment or poor health. Whatever the reason, they need to review their insurance, preferably before retirement, to be sure they are adequately covered.

Medical insurance. The biggest insurance challenge for early retirees is medical insurance, namely because they won’t be eligible for Medicare until they reach age 65. Early retirees have several options, depending on their age and working situations.

First, your former employer may provide health benefits for early retirees, particularly if it is encouraging early retirement. This option is rapidly becoming less common, but it still exists, particularly among larger companies. The retiree policy may not be as comprehensive as the one you had as an employee, and you may pay a larger share of the cost—or even all of the cost.

If your spouse is still working, you may be able to join his or her employer’s plan. The employer may allow you to join only at open enrollment, so you may want to try to time your retirement to match the enrollment period.

Another option may be to continue your former employer’s group coverage through COBRA. You’ll have to pay the entire premium, and probably your employer’s administrative fee as well (around 2 percent). Beyond the expense, the biggest problem of COBRA for early retirees is that it extends coverage only 18 months for most workers. If you retire well before age 65, as many people do, you’ll be left with a gap.

Regardless of whether you can be covered under the above options, check out private coverage. In some cases, it can actually be less expensive for the same level of benefits. Of course, private coverage may be the only option left to you. If you are forced into early retirement due to poor health, however, you face the challenge of finding a private insurer willing to cover you at an affordable price. So it’s important to review federal and state law regarding what rights you have to access private insurance.

If you can’t afford private coverage, you may qualify for Medicaid or coverage through the Veterans Administration. Your state also may offer a high-risk health insurance pool for people in poor health.

Long-term care insurance. Early retirement means you probably are in your mid-fifties to your early sixties, and if you haven’t already considered buying long-term care insurance, don’t wait any longer. You may still be in good or excellent health and qualify for LTC coverage at standard or preferred rates. But the more you delay, the more expensive premiums become and the greater the risk you won’t qualify due to deteriorating health.

Why consider LTC insurance? An annual nursing home stay averages over $50,000, and nursing home costs have been rising about 5 percent a year. A multi-year stay in a nursing home could decimate your retirement savings. LTC insurance also pays for many alternatives to nursing homes, such as assisted living and at-home nursing care.

Life insurance. Upon retirement, your need for life insurance may diminish, since one of the major purposes of life insurance is to replace income lost should you die while still working. You may want some minimal insurance to cover debts and funeral costs, or you may feel you can do without entirely, and put those premiums toward long-term care coverage or other insurance needs.

On the other hand, you may want to maintain a significant amount of life insurance if you want to pass the death benefits on to your adult children, or to pay for estate taxes.

Whatever your needs, don’t cancel your existing insurance until you’ve thoroughly explored all avenues.

Homeowner’s. Retirees often can get a discount on their homeowner’s coverage because they’re home more to keep an eye on the house. Early retirees also might get some reduction in auto rates because they don’t drive as much (rates will go up when you get older, because older drivers pose higher risks).

February 2005 - This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bill Mullen, CFP^R, a local member in good standing of the FPA.