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Frequently asked questions about retirement planning

What kind of income will I need when I’m retired?
It’s impossible to say exactly how much you’ll need when you retire, in part because the amount will be based on so many variables. Someone who owns a home debt-free and is in perfect health, for example, will have lower expenses than a frail person who must live in a nursing home with round-the-clock care. As a general rule, some experts say you will need about 75% percent of your current gross monthly income to maintain a similar lifestyle after you quit working. Others say you will need 100% , so, if you’re grossing (before taxes) $4,000 a month now, figure on needing perhaps $3,000 to $4,000 a month when you retire. Better yet, do a retirement budget. If you are like most people you’ll want to spend enough money on travel and leisure to offset any reduced living expenses. If you plan to do a lot more traveling or take up an expensive hobby, you might need considerably more than that.

What is inflation risk, and how can it affect my retirement income?
If a person is living on a fixed income of $20,000 per year and inflation is 5%, the purchasing power of the $20,000 declines over time. That is to say, the prices of the goods the person buys increase by 5% each year but the income does not. After 15 years the $20,000 income that seemed comfortable will be worth only $9,600 in purchasing power. To say it another way, the goods the person bought for $20,000 the first year of retirement will cost $41,600. The risk imposed even by "guaranteed" fixed-income investments is that the income won’t keep up with price increases due to inflation.

I pay a lot of money into Social Security. Why can’t I depend on that for my retirement?
You can probably depend on some form of Social Security when you reach retirement age, but you cannot afford to rely solely on Social Security to fund all of your retirement expenses. Americans are living longer, which means they are draining the system by collecting payments longer. The first of the Baby Boomers haven’t even begun drawing Social Security benefits yet, and there are fewer young people to pay the taxes that fund payments to older retirees. A cut in future Social Security benefits is inevitable.

I have established a life insurance policy as a retirement planning vehicle. How do I access my money at retirement?
After you retire, there are several ways to turn the built-up cash value of your life insurance into cash. Here are some of your options: 1. You can withdraw your "basis" free of tax. Your basis is the amount of premiums you paid, less any withdrawals you have made. 2. You can take a policy loan. Loans are not generally taxable because they are seen as an advance of the death benefit. 3. You can combine both techniques. Often, a combination of withdrawing your basis down to zero and then borrowing the remainder offers the best method of accessing your life insurance cash value at retirement. If you lapse the policy with the basis withdrawn and a full loan outstanding, there will likely be a significant tax bill, so be careful and consult with those who understand the method and its risks. You’ll probably want to discuss your options with a financial planner or similar professional.

How can I use a reverse mortgage to get funds for retirement?
A reverse mortgage is a loan against the equity in your house, based on that equity alone and not on your income, which provides a cash advance without requiring repayment until some future date. It is used to extract an income stream from the equity in a home and in most cases does not require repayment of the loan until the borrower dies, at which time the balance owed is paid by selling the house. AARP is an excellent source of information on this concept. Contact AARP, Home Equity Information Center, 601 E. Street, NW, Washington, DC 20049, or visit the AARP Web site.

Why would someone in their 20s want to contribute to a retirement plan?
It's never too early to begin saving for retirement, regardless of which savings vehicle you use.
It's tempting to avoid saving for retirement, especially for people under 30. After all, they reason, they'll have 30 or 40 years to build a retirement nest egg. But one of the most powerful reasons to start saving early is that the earnings on your retirement funds will begin compounding sooner. Consider this example:
Jo Anna, 28, deposits $2,000 to a tax-deferred retirement plan for 7 consecutive years and then at age 35 makes no additional contributions to the plan. Her friend, Ted, thinks saving for retirement at age 28 is ridiculous and waits until he is 35 before making retirement plan contributions. He then makes $2,000 annual contributions for the next 30 years. Jo Anna has made total contributions of $14,000, and Ted has contributed $60,000.
If both earn an average of 10% on their investments, which one of them has the greater retirement fund? Through the magic of compounding, Jo Anna's balance has grown to $331,000; Ted's is $329,000. By starting to save early, you will ultimately need to save less to have the retirement lifestyle you want.

What is the full retirement age for Social Security?
The full retirement age for Social Security benefits is 65. You can retire sooner, but your monthly benefits will be reduced. It’s worth noting that 65 is the full retirement age only for those who plan on retiring relatively soon. For younger workers, Congress already has cut back the benefits. . . . Those born after 1959 are not eligible for full Social Security benefits until age 67. Those younger workers can start receiving benefits at 62, but they will get 30% less than if they wait until 67 -- not 20% less, like those retiring today. Considering the sorry shape that the Social Security system is in today, it’s probable that further cutbacks will have to be made.

Should I begin my Social Security benefits at age 62, 65 or 70?
The longer you wait to begin collecting Social Security payments, the higher your monthly checks will be. Most Americans are eligible to begin drawing full benefits at age 65. But you can start drawing benefits as early as 62 if you’re willing to accept smaller monthly payments. Although people who wait until age 62 get 20% lower payments, they also get 36 more monthly checks than they would if they waited the additional three years to collect. If they continue working, their earnings over $10,680 in 2001 will reduce their benefit $1 for every $2 in excess earnings. Because of this complication, we need to consider two cases: 1. You will not need to work and you will save the benefit checks until the latest age in the comparison (either 65 or 70). 2. You will need or want to continue working as long as possible and you will save the benefit checks until the latest comparison age(either age 65 or 70). For case 1, the the time weighted value of the income stream for beginning early (62) exceeds the value of beginning at 65 or 70 until an assumed age of death at 90. Thus, for case 1, beginning at 62 is the preferred choice. For case 2, we assume that the need to work creates enough income to reduce the early retirement benefit to zero (assuming a $12,000 benefit and earnings greater than $34,680). Therefore, the comparison is between beginning at 65 or delaying until 70 since earnings prior to 65 reduces the benefit to zero. Because there is no longer a benefit reduction for earnings after age 65 and because the time weighted value of the benefit income stream is greater for beginning at age 65 even though the benefits at age 70 are 40% larger we must conclude that beginning benefits at 65 is the best option for case 2.

How much of my annual pay should I be saving for retirement?
Exactly what percentage of your annual salary you should earmark for your retirement years depends on a variety of factors. Two key factors are your current age and the lifestyle you hope to lead when you quit working. As a general rule, financial experts say you should take at least 10% of your annual pre-tax income and set it aside for retirement. You should put even more than 10% away if you plan on lots of travel, expensive hobbies or other extravagances. You will also need to save more than 10% of your annual income for retirement if you are already middle-aged and haven’t been saving much. If you reach age 50 and don’t have much of a nest egg, experts say you must begin tucking away at least 20% of your pre-tax earnings for retirement to have even a hope of maintaining your current lifestyle when you quit working.

Why should I save for retirement when I plan to work until I die?
Working until you die. Doesn’t that sound jolly? Younger people often don’t think much about saving for retirement, because they can’t even imagine what life will be like 40, 50 or 60 years from now. Even older people sometimes shrug off saving because they plan on working forever. You may plan to work until you die, but life has a way of disrupting such plans. Health problems or disabilities may prevent you from working until you die or earning sufficient income.

What is the best way to build up a retirement account?
Religiously putting a little money into an investment account month after month is one of the best ways to painlessly build a retirement nest egg, and there’s no need to pay a financial planner or broker to help you do it. The problem with most contractual investment plans is that up to half of your investment in the first year or two is gobbled up by fees that the mutual fund pays to the broker who signed you up. Losing 50 cents of every dollar you put in is hardly the best way to start saving for retirement. On top of that, most plans charge hefty sales loads, annual management fees, or both. Sponsors of many of these plans must earn an average of 10% or even 15% yearly just to cover the customer’s expenses. Don’t be fooled by the plan’s "guaranteed" average return of at least 5% annually. That’s a paltry figure, and it probably doesn’t include sales loads and management fees. A better way to go would be to contact a true no-load fund directly and arrange such a program yourself. Nearly all funds offer automatic investment plans. You simply sign a few forms, and the fund will automatically debit your checking or savings account every month. There’s no reason to pay a financial planner or other middleman big fees to do such simple paperwork for you, and you’ll avoid costly sales loads in the future.

Is there an insurance product I can use to put away money for retirement?
A flexible-premium life insurance policy may be a good savings alternative, especially if you also need life insurance. If the funds you put into the policy are within certain Internal Revenue Service limits, you can access this money free of income tax with a combination of withdrawals and policy loans at your retirement. The interest earned by the policy will accumulate on a tax-deferred basis similar to an IRA. In addition, it will provide life insurance protection for your beneficiaries.

What is endowment life insurance?
Endowment life insurance is unusual because it’s designed to pay you benefits while you are still alive rather than pay your beneficiary after you have died. Endowment life insurance pays the face value of the policy either at the insured’s death or at a certain age or after a number of years of premium payment. A whole life insurance policy is an endowment at age 95 (or 100) policy. Unlike whole life, an endowment life insurance policy is designed primarily to provide a living benefit and only secondarily to provide life insurance protection. Therefore, it is more of an investment than a whole life policy. Endowment life is a method of accumulating capital for a specific purpose and protecting this savings program against the saver’s premature death. Many investors use endowment life insurance to fund anticipated financial needs, such as college education or retirement. Premiums for an endowment life policy are much higher than those for a term life policy, so you might be better off simply buying term life and investing the savings by yourself. However, endowment life often appeals to people who don’t have enough discipline to do so. They know that they will lose their policy if they don’t pay their annual premium, so it acts as a forced savings plan. Another alternative to an endowment life policy is term insurance combined with a deferred fixed annuity. It may be cheaper than an endowment life policy.

If I’m saving money that I plan to use before I retire, does it make sense to do it with after-tax 401(k) contributions?
If you’re saving money that you plan to use before you retire, it’s usually better to save it outside your 401(k) plan. It’s true that usually you can withdraw your after-tax 401(k) contributions at any time without taxes or penalty, but remember, you’ll owe taxes on any interest they earned, as well as a 10% early withdrawal penalty if you’re under age 59 1/2. The 10% penalty is an expense you wouldn’t have if you saved on an after-tax basis outside your 401(k) plan. But there are situations where it can make sense to use after-tax contributions for short-term savings: if your employer matches your after-tax contributions and if you’re fully vested in the matching contributions by the time you withdraw the money, you may wind up with more money by saving in the 401(k) plan, even after taking the 10% early withdrawal penalty into account.

Can I open a Roth IRA for my 10-year-old daughter?
Not unless she's a child actor, a model, or is otherwise gainfully employed. To open a Roth or a regular IRA, you need earned income from a job (an allowance doesn't count). If your daughter meets that criterion, she can contribute up to $3,000 a year or the amount of her annual earnings, whichever is less.

I'm worried about retirement. How do I know if I'm saving enough?
To be on the safe side, you should limit annual withdrawals in retirement to 5% of your nest egg. Suppose you're planning to retire in 20 years and figure you'll need $30,000 a year from savings to supplement your pension, social security and other sources of income ( estimate your social security benefits ; use the retirement-planning calculator at RBC Centura). That means you'll need an initial nest egg of $600,000.

While it may sound like a lot, you could be well on your way to meeting that goal. If you have $50,000 in your 401(k) account right now and it grows at an average annual rate of 7%, it will be worth nearly $200,000 in 20 years. That means you need to save $400,000 more, or about $790 a month, assuming a 7% annual return. That would include your current 401(k) deferrals and any employer match.

As your salary grows and family expenses decline, you'll be able to accelerate your savings. And you might be able to count on other sources of retirement income, such as the equity in your home or an inheritance.

Should I rebalance my 401(k) account?
Absolutely. How often? Once a year should do the trick. It's easy to make changes to your 401(k) without triggering tax consequences, so you can move money from one fund to another or leave current allocations alone and direct future contributions to the sectors that need beefing up.

Should I save in my 401(k) or prepay my mortgage?
Your 401(k) wins, hands down. The typical "k plan" adds an additional 50 cents to your account for every dollar you contribute (up to 6% of your salary), and you'd be crazy to pass up free money. Moreover, 100% of the cash you contribute to your 401(k) reduces your taxable income; mortgage prepayments are 100% nondeductible because they apply only to principal. And your finances will be healthier because your investments are more diversified.

I plan to retire 15 years from now. When should I start shifting part of my stock portfolio to fixed-income investments?
Once you're within five years of retirement, your portfolio should be at least 30% in fixed-income investments, rising to 50% when you retire. Depending on your tolerance for risk, you should always keep 20% or more of your assets in stocks.

I can't afford to max out both my 401(k) and my IRA. What should I do?
First, put enough into your 401(k) to take advantage of any employer match. Then fund your Roth IRA if you meet the income requirements (your right to contribute to a Roth begins to be phased out once your adjusted gross income is more than $150,000 on a joint return, or $95,000 if you're single). If you still have money left over, put it into the 401(k).

Is your income too high to qualify for a Roth? Max out your 401(k) and then invest in a traditional IRA.

How much will my social security income be taxed?
It all depends on how much money you earn. Taxes on social security benefits are based on your combined income -- your adjusted gross income plus any tax-exempt interest plus half of your social security benefits.

Your benefits will be tax-free if you're single and your combined income is less than $25,000 ($32,000 if married filing jointly). No more than half of your benefits can be taxed if your combined income is between $25,000 and $34,000 if single (or $32,000 and $44,000 if married filing jointly). And up to 85% of your benefits can be taxed if you're single and your combined income is more than $34,000 (or $44,000 if married filing jointly). The worksheet in IRS Publication 915 can help you figure out how much of your benefits are taxable.