What determines your life insurance need?
Life stages and circumstances
When determining your life insurance need, you should first consider your life stage and circumstances. Marital status, number of dependents, size and nature of financial obligations, your career stage, and your intentions to pass on your property are all factors to consider. Your need for life insurance changes as the circumstances of your life change.
In the "starting out" stage of life, you may be just beginning your career or family. You may not have children or other dependents at this stage, but that doesn't mean you have no obligations. For instance, if you paid for your college education with student loans, you likely had a cosigner for your loan--maybe your parents or a grandparent. The same may be true of your car loan. If you were to die before the loan is paid, your cosigner would be obligated to pay the debt. Under law, a cosigner is responsible for full payment of a debt in the event of default. Death doesn't erase the debt obligation.
A growing percentage of the population now falls into the single adult demographic group. This group covers a broad spectrum of ages, lifestyles, and obligations.
Although you may not have a spouse, your death could have a serious financial impact on other family members. If, like many adults, you are supporting your parents (either financially or with care), your death could have a major impact, both emotionally and financially. They would not only lose the support you have been providing to them, but they would also need to come up with the money for your final expenses.
If you are a single parent, the primary financial support for your children would die with you. If you are lucky, you may have family members who would step in and help your children if you died. If you are even luckier, they will be able to provide your children with the education and lifestyle you had hoped for them to have. Your need for life insurance as a single parent is even greater than that of a dual-parent, dual-income household, which would still have one income if one parent died. Life insurance is a cost-effective way to make sure that your children are protected financially should anything happen to you.
In this stage of life, you may still be paying for or even still accumulating education loans. You may have purchased a house or condo with a cosigner. If you died, your cosigner would be legally liable for the payments on the debt.
Protect your insurability
Another reason to buy life insurance at this stage of your life is to protect your future insurability. Once you buy a permanent, cash value life insurance policy, it remains in effect for your entire life (assuming the premiums are paid), even if your health changes. If you were to experience a serious change in health, you might not be able to buy additional insurance coverage, but you would still have the permanent coverage you already own.
Dual-income couple or family
If you and your spouse both earn an income, it is possible that if one of you died, the other may be able to cope financially on the remaining income. If there are mortgages, joint credit cards or other debt, or children in the picture, the loss of one income could be much more difficult to overcome. The more people who depend on your income while you are alive, the more life insurance you should own. If you died today with insufficient or no insurance, your mate could be forced to give up the residence or lifestyle for which you have both worked. When there are children involved, the loss of one breadwinner could mean a setback in the daily way of life, not to mention any plans for private school or college.
Parent of grown children
Just because your children have grown up and left the nest doesn't mean you have no need for life insurance. You may have spent your entire adult life building an estate that you intend to pass on to your children, grandchildren, or favorite charity. You can use life insurance to ensure that the bulk of your estate passes to your heirs or designated charitable organization subject to certain tax advantages.
Part of overall financial planning
Determining your life insurance needs should not be done in isolation. Instead, it should be looked at as part of your overall financial plan, with consideration given to your goals for savings and retirement, as well as tax and estate planning. As your life changes, your financial goals may change, as well as your need for life insurance, making it important to also periodically review your coverage.
Methods of calculating life insurance need
Several methods are used to calculate the appropriate level of insurance for you and your situation. While they all share common features, some methods strive to be more simplistic, while others involve more sophisticated calculations. Some of these differences are illustrated in the Table of Alternatives. You may want to determine an amount on your own, using one of the simpler methods. This can provide a basis for your discussions with your financial planner.
Before you begin calculating your insurance needs, it is important to determine insurable interest. Basically, having an insurable interest in a person's life means that you would suffer emotional or financial harm or loss if that person were to die. It is always assumed that you have an insurable interest in your own life. However, to prove an insurable interest in someone else's life, you must have a relationship to that person based on blood, marriage, or monetary interest. You must have an insurable interest before you can purchase an insurance policy.
Family needs approach
The family needs approach is one of the more comprehensive methods of calculating your life insurance needs. It assumes that the purpose of life insurance is to cover the needs of the surviving family members. This method takes into account the immediate and ongoing needs of the surviving family members, as well as income from other sources and the value of assets that could be used to help defray the family's expenses (such as bank accounts and real estate).
Capital retention approach
The capital retention approach is one of two calculation methods under the family needs approach. This approach assumes that life insurance principal will support the family indefinitely into the future. Because you will purchase more life insurance under this method, you will be in a better position if the surviving spouse lives longer than expected.
Capital liquidation approach
The capital liquidation approach is the second of two calculation methods under the family needs approach. This method does not provide as much continuing capital for the surviving spouse or for heirs after the death of the surviving spouse. However, it does allow you to spend less money by purchasing a lesser amount of life insurance coverage.
Estate preservation and liquidity needs
The estate preservation and liquidity needs approach attempts to determine the amount of insurance needed at death for items such as taxes, expenses, fees, and debts while preserving the value of the estate. This method considers all the variables of family lifestyle and the total cash needed to maintain the current value of the estate while providing adequate cash needed to cover estate expenses and taxes.
Income replacement approach
The income replacement calculation is based on the theory that the purpose of insurance is to replace the loss of your paycheck when you die. This analysis determines an economic or human life value and factors in salary increases and the effects of inflation in determining the appropriate level of coverage. While more comprehensive than the rules of thumb, this method still fails to consider special circumstances or financial needs and operates on the premise that the current level of income provides a satisfactory standard of living that will remain level throughout the future.
Rules of thumb
The rules of thumb are extremely basic calculations. They provide a starting point but fail to recognize special family circumstances or needs and focus only on the most basic components. One rule of thumb dictates that multiplying your salary by a certain number will provide an adequate level of insurance, while another calculates need based on normal living expenses.
The worst mistake you could make concerning life insurance is having a need and not having any insurance at all. Very often, people can find all sorts of excuses for not buying life insurance. It's no fun to plan for your death, for one thing. For another, there's the tendency to think that dying won't happen to you, only to some person you read about in the obituaries. But how many times have you heard about a young, apparently healthy person dying suddenly in a car accident, leaving behind a spouse, a young child, and no insurance? Sadly, it happens, and when it does, the family faces not only emotional trauma but possibly an extremely difficult financial situation, as well.
Not enough insurance
The majority of people with insurance are underinsured. Insufficient coverage can occur as a result of buying what is affordable instead of what is needed. Failure to review your coverage periodically could also result in insufficient insurance, even if you started out with adequate levels. Inflation rates, your career, and your lifestyle may have changed. Your family could be faced with a large financial gap and left unable to maintain the current lifestyle if you died today. Consequences could include loss of the family home, scaling back of college plans, and possibly years of financial difficulty.
Too much insurance
If you purchased a large policy during one point in your life and then didn't adjust your coverage when your insurance need was reduced, it is possible that you have too much life insurance. This is another good reason to periodically review your coverage with your financial planning professional. Periodic reviews of your insurance coverage can reveal opportunities to change your levels of coverage to match your current and projected needs.
What determines your life insurance need?
When you die, you leave behind your estate. Your estate consists of your assets--all of your money, real estate, and worldly belongings. Your estate also includes your debts, expenses, and unpaid taxes. After you die, somebody must take charge of your estate and settle your affairs. This person will take your estate through probate, a court-supervised process that winds up your financial affairs after your death. The proceedings take place in the state where you were living at the time of your death. Owning property in more than one state can result in multiple probate proceedings. This is known as ancillary probate.
How does probate start?
If your estate is subject to probate, someone (usually a family member) begins the process by filing an application for the probate of your will. The application is known as a petition. The petitioner brings it to the probate court along with your will. Usually, the petitioner will file an application for the appointment of an executor at the same time. The court first rules on the validity of the will. Assuming that the will meets all of your state's legal requirements, the court will then rule on the application for an executor. If the executor meets your state's requirements and is otherwise fit to serve, the court generally approves the application.
What's an executor?
The executor is the person whom you choose to handle the settlement of your estate. Typically, the executor is a spouse or a close family member, but you may want to name a professional executor, such as a bank or attorney. You'll want to choose someone whom you trust will be able to carry out your wishes as stated in the will. The executor has a fiduciary duty--that is, a heightened responsibility to be honest, impartial, and financially responsible. Now, this doesn't mean that your executor has to be an attorney or tax wizard, but merely has the common sense to know when to ask for specialized advice.
Your executor's duties may include:
- Finding and collecting your assets, including outstanding debts owed to you
- Inventorying and appraising your assets
- Giving notice to your creditors (e.g., credit card companies, banks, retail stores)
- Filing an estate tax return and paying estate taxes, if any
- Paying any debts or other taxes
- Distributing your assets according to your will and the law
- Providing a detailed report of how the estate was settled to the court and all interested parties
The probate court supervises and oversees the entire process. Some states allow a less formal process if the estate is small and there are no complicated issues to resolve. In those states allowing informal probate, the court may be involved only indirectly. This may speed up the probate process, which can take years.
What if you don't name an executor?
If you don't name an executor in your will, or if the executor can't serve for some reason, the court will appoint an administrator to settle your estate according to the terms of your will. If you die without a will, the court will also appoint an administrator to settle your estate. This administrator will follow a special set of laws, known as intestacy laws, that are made for such situations.
Is all of your property subject to probate?
Although most assets in your estate may pass through the probate process, other assets may not. It often depends on the type of asset or how an asset is titled. For example, many married couples own their residence jointly with rights of survivorship. Property owned in this manner bypasses probate entirely and passes by "operation of law." That is, at death, the property passes directly to the joint owner regardless of the terms of the will and without going through probate. Other assets that may bypass probate include:
- Investments and bank accounts set up to pass automatically to a named person at death (payable on death)
- Life insurance policies with a named beneficiary (someone other than the estate)
- Retirement plans with a named beneficiary
- Other property owned jointly with rights of survivorship
A rollover is generally a transfer of assets from a retirement plan maintained by your former employer (it may be possible to roll over certain in-service distributions from an existing employer's profit-sharing plan as well). Rollovers from an employer-sponsored retirement plan can take one of four forms:
1. A transfer from your old retirement plan directly to an IRA trustee (this is a type of direct rollover)
2. A transfer from your old retirement plan to you, and then, within 60 days, from you to an IRA trustee (this is a type of indirect rollover)
3. A transfer from your old retirement plan directly to the trustee of the retirement plan at a new employer (this is a type of direct rollover)
4. A transfer from your old retirement plan to you, and then from you to the trustee of a retirement plan at a new employer (this is a type of indirect rollover)
Generally, rollovers come from defined contribution plans. A defined contribution plan is a retirement plan in which contributions are based on a set formula (e.g., a percentage of the employee's pretax compensation), while the payout is based on total contributions and investment performance. The 401(k) plan is the most common type of defined contribution plan.
If a rollover is done properly and all rules are followed, there will be no taxes or penalties imposed on the retirement plan distribution. In addition, a rollover encourages retirement savings by allowing you to continue tax-deferred growth of the funds in the IRA or new plan. When you are eligible for a rollover from your plan, the plan administrator must send you a timely notice explaining your options, the rollover rules, and related tax issues.
Which plans allow rollovers?
An employer-sponsored retirement plan generally must allow direct rollovers to be made from the plan, but does not have to allow rollovers to be made into the plan. You are generally able to roll over funds between qualified retirement plans, Section 403(b) plans, governmental Section 457(b) plans, and traditional IRAs.
Caution: You generally can't roll over funds from an employer-sponsored retirement plan into a SIMPLE IRA. Special rules apply with regard to the 10 percent premature distribution penalty when rolling over funds into a Section 457(b) plan. Special rules also apply to the rollover of any after-tax dollars in an employer-sponsored retirement plan.
Tip: You can make a direct or indirect rollover from a tax-qualified retirement plan, tax-sheltered annuity, and governmental 457(b) plan to a Roth IRA, subject to the present law rules that generally apply to rollovers from traditional IRAs to Roth IRAs. For example, a rollover from an employer-sponsored retirement plan to a Roth IRA is included in gross income (except to the extent it represents a return of after-tax contributions), and the 10-percent early distribution tax doesn't apply. Similarly, an individual with AGI of $100,000 or more, and taxpayers who are married but filing separately, can't make a direct rollover to a Roth IRA. (Note: the $100,000 income limit and married filing separately restriction are repealed by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) after 2009.)
Tip: Special rules apply to Roth 401(k) and Roth 403(b) plans. In general, distributions from Roth 401(k) and Roth 403(b) accounts can be rolled over to a Roth IRA, or to other Roth 401(k) and Roth 403(b) plans that accept rollovers.
What can be rolled over and what cannot be?
Rollovers consist of eligible distributions made to you from your vested interest in an employer-sponsored retirement plan. In addition, your spouse may need to consent to a rollover in writing. To find out about additional restrictions your plan may impose on rollovers, consult your plan administrator. You may not be able to roll over the entire balance in your retirement plan account. Rollovers cannot include:
• Required minimum distributions(to be taken after you reach age 70½ or, in some cases, after you retire).
• After-tax contributions can be directly rolled over from a qualified plan or 403(b) plan to a qualified plan or 403(b) plan if the new plan separately keeps track of the after-tax contributions and their earnings. After-tax contributions can also be rolled over, directly or indirectly, from a qualified plan or 403(b) plan to an IRA.
• Amounts that are required to be taken as substantially equal payments over 10 or more years, over your life expectancy as the plan participant, or over the joint life expectancy of you and your beneficiary.
• Hardship withdrawals
• Retirement plan loans that are taxable because they exceed the allowable loan limit
• Life insurance coverage costs
• Dividends on employer stock
• Corrective distributions of excess 401(k) plan contributions and deferrals
Caution: If you roll over any part of a lump-sum distribution, the remaining part cannot qualify for the special 10-year averaging or the special capital gains treatment that is available in some cases.
Caution: If your retirement plan distribution includes assets other than cash (such as employer securities), your IRA trustee or the new plan trustee may, but isn't required to, accept those assets as part of a rollover. If you sell the assets and roll over the proceeds to a traditional IRA within 60 days of receiving a distribution, it is considered a nontaxable rollover. Consult a tax advisor for further details.
Caution: Special re-contribution rules may apply to distributions received by qualified individuals who are impacted by presidentially-declared natural disasters, and distributions to qualified reservists.
Are partial rollovers permitted?
Yes. However, only the portion that is rolled over qualifies as an income-tax-free transfer of funds. The remainder that is distributed to you is treated as a taxable distribution, subject to federal (and possibly state) income tax and perhaps a premature distribution tax penalty if you are under age 59½ (unless an exception applies).
Direct rollovers vs. indirect rollovers
Once you decide to roll over your retirement plan assets, you need to decide how the transfer will be made. Rollovers can be direct rollovers or indirect rollovers. The distinction is important because indirect rollovers can cost you a lot of money in some cases. A direct rollover is usually a better option.
Generally, you will want to arrange for a direct rollover rather than an indirect rollover when your retirement plan assets are moving to either another employer's retirement plan or an IRA.
As the name suggests, a direct rollover involves arranging for the transfer of your retirement plan assets directly from the old plan trustee to either:
• The trustee of a retirement plan maintained by a new employer
• The trustee of a new or existing IRA in your name
With a direct rollover, you never actually take receipt of the retirement plan funds. The funds go directly from the old plan trustee to the trustee of the IRA or new plan. For this reason, a direct rollover is often referred to as a trustee-to-trustee transfer. Direct rollovers have fewer tax complications, and you are not limited to moving the funds once a year (as is the case with indirect rollovers).
With an indirect rollover, the trustee of your old retirement plan distributes the funds to you, and then you transfer them to the trustee of your IRA or to the trustee of another employer-sponsored retirement plan. There are some complications and potential pitfalls with indirect rollovers. In general, it is best to avoid indirect rollovers and utilize direct rollovers instead.
First, with an indirect rollover, the administrator of your old plan must withhold 20 percent of the distribution to you for federal income tax. This withholding requirement exists because the IRS is concerned that you may take the money as a taxable distribution rather than complete a timely, tax-free rollover to an IRA or another plan. Because of this possibility, the IRS simply assumes that the distribution will be a taxable distribution, not a tax-free rollover.
Here is the problem with the mandatory tax withholding for indirect rollovers: In order to complete a tax-free rollover, you must roll over 100 percent of the amount distributed to you from your old plan. This means that you need to have additional funds available to replace the 20 percent withheld at the time of distribution.
Tip: You will eventually get the 20 percent back as a credit for federal income tax withheld when you file your income tax return the following year.
Caution: If you do not make up the 20 percent with additional funds, the 20 percent withheld will actually be considered a taxable distribution. If you fail to complete the rollover within 60 days, the entire distribution may be treated as a taxable distribution. Further, if you are under age 59½ and do not qualify for an exception, you will be subject to a 10 percent federal premature distribution tax (and perhaps a state penalty, too).
Example(s): Carol's vested balance in her former employer's plan is $100,000. Instead of arranging a direct rollover of funds from her old plan to her new employer's plan, Carol decides to do the rollover herself. Since it is an indirect rollover, her old plan administrator withholds 20 percent ($20,000) for federal income tax. Carol receives a check for $80,000. However, she must roll over $100,000 (the entire balance of her old plan account) to avoid tax consequences. This means that Carol has to use $20,000 of her own funds to make up the difference. Otherwise, if she rolls over only $80,000, she will be subject to income tax (and perhaps penalties) on the $20,000 shortfall.
With an indirect rollover, you may end up paying income tax (and perhaps penalties) on the entire distribution to be rolled over unless you roll over the amount of the plan distribution within 60 days (beginning with the date you received the funds) to a traditional IRA or another employer's plan.
Another reason to avoid indirect rollovers is the "one rollover per year" rule. You are only allowed to make a rollover from a particular traditional IRA to any other traditional IRA (or back to the same IRA), or from a particular Roth IRA to any other Roth IRA (or back to the same Roth IRA), once in any 12 month period. In addition, you are not allowed to make a rollover from the receiving IRA to any other IRA (or back to that IRA) until 12 months have passed. These rules are complicated, and if you violate them, your rollover may fail, your distribution may become taxable, and you may be subject to premature distribution penalties. In contrast, direct rollovers are not subject to the "one per year" rule--you can make as many direct rollovers as you wish. (Note: conversions of traditional IRAs to Roth IRAs are not subject to the one-per-year rule.)
The only real benefit of an indirect rollover is that you have the equivalent of a 60-day "loan" from your retirement plan. But there is always the danger of missing the 60-day deadline and becoming subject to income tax (and perhaps penalties) on the distribution. By using a direct rollover, you generally avoid this risk because the money never enters your hands. In addition, direct rollovers are not subject to the federal withholding requirement that applies to indirect rollovers.
Tip: The IRS is authorized to grant waivers on the 60-day rule in cases of "equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to this requirement." Consult a tax advisor for further guidance.
You may need to do a rollover from your old employer's plan to an IRA as an interim step. Your new employer's plan may accept rollovers from an IRA, but not from a former employer's plan. Or, you may be in between jobs and not have a new employer's plan in place to accept a rollover from your old plan. In either instance, a rollover to a conduit IRA may be the answer for you.
A conduit IRA is not technically a specific type of IRA. It is a traditional IRA that is being used for a specific purpose--as the term "conduit" suggests, to temporarily hold funds that you have rolled over from a former employer's retirement plan. With the funds in a conduit IRA, you may have the opportunity to roll over those funds to another employer's plan at a later date. If this opportunity never arises or you prefer to have the funds in an IRA, you can simply leave them in the conduit IRA. A rollover to a conduit IRA can be done as a direct rollover or an indirect rollover, just as with rollovers to other employers' retirement plans. Remember, if you do an indirect rollover, 20 percent of the distributed amount will be withheld for federal income tax. Should you fail to complete the rollover within 60 days of receiving the distribution, you will be subject to income tax and perhaps penalties on all or part of the distribution.
Tip: Prior to 2002, a conduit IRAs had special importance--using a conduit IRA was the only way funds could move from a qualified plan to an IRA, and then back to another qualified plan. The conduit IRA could only contain funds rolled over from an employer-sponsored retirement plan, and the investment earnings on those funds. You were not allowed to commingle those rolled over funds with regular IRA contributions and their earnings. If you violated this rule, you lost the right to later move the rolled over funds and their earnings from the conduit IRA to another employer's retirement plan. However, as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Congress passed provisions to make it easier to roll over funds between IRAs and different types of employer-sponsored retirement plans, and conduit IRAs are now largely only of historical importance with two exceptions, described below.
Caution: Certain lump-sum distributions from an employer-sponsored retirement plan (but not from an IRA) qualify for special income tax benefits. The benefits may include 10-year averaging (for participants born before 1936) and capital gains treatment (for distributions attributable to pre-1974 participation in an employer plan). If you want to preserve the possibility of these income tax benefits, you may need to maintain a separate (conduit) IRA for your plan funds until you complete a rollover to another employer's retirement plan. Consult a tax professional.
Tip: Amounts you roll over from an employer qualified plan or 403(b) plan to a traditional or Roth IRA (and earnings on those funds) are generally entitled to unlimited protection from your creditors under federal law in the event you declare bankruptcy. However, your other (non-rollover) traditional and Roth IRA assets are generally protected only to an aggregate limit of $1,095,000 (as of April 1, 2007). It may make sense in some cases to maintain a separate (conduit) IRA in order to more easily track rollovers from employer plans that are entitled to unlimited bankruptcy protection.
Advantages of doing a rollover
A rollover is not a taxable distribution
A properly completed rollover (direct or indirect) is a tax-free transfer of assets, not a taxable distribution. This means that if you complete the rollover within 60 days of receiving the distribution and follow other federal rollover rules, you will not be subject to income tax or early withdrawal penalties on the money. You will not have to pay federal or state income tax on the money until you begin taking taxable distributions from the IRA or new plan. By that time, you may be retired and in a lower income tax bracket. Also, if you are 59½ or older when you take distributions, you will not have to worry about premature distribution penalties.
A rollover allows continued tax-deferred growth
When you do a rollover, you are simply moving your retirement money from one tax-favored savings vehicle to another. This allows the money to continue growing tax deferred in the IRA or new plan, with little or no interruption. Tax-deferred growth allows your retirement money to potentially grow more rapidly than it might outside an IRA or retirement plan. To understand why, consider the power of compounding. As your IRA or plan investments earn money, those earnings compound on top of your principal and any earnings that have already accrued. As this is happening, no tax is due while the funds remain in the IRA or plan. Depending on investment performance, the long-term effect on your savings can be dramatic. In most cases, this benefit is lost if you receive a distribution from your employer's plan and do not roll it over.
A rollover may be an option every time you leave a job
You may be able to roll over your vested benefits in a former employer's retirement plan every time you leave a job (whether voluntarily or involuntarily). You generally have the option of rolling over benefits from an old employer's plan to a new or existing traditional IRA (but not a Roth IRA). In addition, if you join another employer's retirement plan and the plan accepts rollovers, you can roll over your benefits from the old plan to the new plan. There is no limit on the number of rollovers from an employer-sponsored retirement plan you can do, which is an advantage for those who change jobs frequently.
Disadvantages of doing a rollover
You cannot revoke a rollover election
Once you have elected in writing to roll over your retirement plan benefits to an IRA or another plan and received payment, you typically cannot change your mind and revoke the election. If you do try to revoke it, you will generally be subject to income tax and penalties on all or part of the distribution. Before you elect the rollover option, be absolutely certain that this is what you want.
You cannot roll over certain amounts
As mentioned, you generally may not roll over any distribution that is not included in your taxable income (direct rollovers of after-tax contributions from one qualified plan to another qualified plan and to a traditional IRA are permitted in some cases). Also, you cannot roll over amounts to be taken as required minimum distributions or as substantially equal payments.
An indirect rollover can be costly
If you are considering an indirect rollover, bear in mind the 20 percent mandatory withholding requirement. To complete the rollover, you must make up the 20 percent out of your own funds, or be subject to income tax and possibly penalties on the shortfall. This can be a problem if you do not have cash available to replace the 20 percent. Also, with an indirect rollover, you generally have only 60 days to complete the rollover. The 60-day period begins with the date on which you receive the distribution from the former employer's retirement plan. If you fail to complete the rollover within this time frame, all or part of the distribution to you will be taxable and perhaps penalized.
Loss of lump sum averaging and capital gain treatment
If you roll over all or part of a distribution from a qualified employer retirement plan into an IRA, neither that distribution, nor any future lump-sum distribution you receive from the qualified plan, will be eligible for special 10-year averaging or capital gains treatment.
Is it better to roll over to an IRA or to another employer's plan?
One of the most common questions people ask is: Should I roll over my retirement money to an IRA or to another employer's retirement plan? Assuming both options are available to you, there is no right or wrong answer to this question. There are strong arguments to be made on both sides. You need to weigh all of the factors, and make a decision based on your own needs and priorities. It is best to have a professional assist you with this, since the decision you make may have significant consequences--both now and in the future.
Reasons to roll over to an IRA
• You generally have more investment choices with an IRA than with an employer's plan. You typically may freely move your money around to the various investments offered by your IRA trustee, and you may divide up your balance among as many of those investments as you want. By contrast, employer-sponsored plans typically give you a limited menu of investments (usually mutual funds) from which to choose.
• You can freely move your IRA dollars among different IRA trustees/custodians. Unlike indirect rollovers, there is no limit on how many direct, trustee-to-trustee IRA transfers you can do in a year. This gives you flexibility to change trustees often if you are dissatisfied with investment performance or customer service. It can also allow you to have IRA accounts with more than one institution for added diversification. With an employer's plan, you cannot move the funds to a different trustee unless you leave your job and roll over the funds.
• An IRA may give you more flexibility with distributions. With some employer-sponsored plans, if you are married and your spouse does not sign a waiver, the usual form of distribution is a joint and survivor annuity. With an IRA, the timing and amount of distributions is generally at your discretion (until you reach age 70½ and must start taking required minimum distributions).
• You will not be "cashed out" of an IRA if you have a small balance. By contrast, some employer-sponsored plans may cash you out prior to the plan's normal retirement age if your vested benefits are $5,000 or less. Until your vested benefits are over $5,000, there is a risk that a new employer's plan could cash you out if you leave employment. If cashed out, the funds would have to be either rolled over to an IRA or taken as a taxable distribution.
Reasons to roll over to another employer's retirement plan
• Many employer-sponsored plans have loanprovisions. If you roll over your retirement funds to a new employer's plan that permits loans, you can generally borrow against your vested balance in the new plan if you need money. You cannot borrow from an IRA--you can only access the money in an IRA by taking a distribution, which may be subject to income tax and penalties.
• A rollover to another employer's retirement plan may provide greater creditor protection than a rollover to an IRA. Assets in employer-sponsored retirement plans that are subject to the non-alienation provisions of ERISA (for example, 401(k) plans)receive unlimited protection from your creditors under federal law. Your creditors cannot attach your plan funds to satisfy any of your debts and obligations, regardless of whether you've declared bankruptcy. In contrast, traditional and Roth IRAs are generally protected under federal law only if you declare bankruptcy. Any creditor protection your IRA may receive in cases outside of bankruptcy will generally depend on the laws of your particular state. If you are concerned about asset protection, be sure to seek the assistance of a qualified professional.
• Employer-sponsored retirement plans usually impose lower administrative costs and investment fees (e.g., minimum fees) on investors than IRAs.
• You may be able to postpone required minimum distributions. These distributions usually must begin by April 1 following the year you reach age 70½. However, if you work past that age and are still participating in your employer's retirement plan, you can delay your first distribution from that plan until April 1 following the year of your retirement. (You also must own no more than five percent of the company.) This deferral exception is not available for IRAs.
• You may prefer the investment options of an employer's plan. The choices and flexibility that IRAs provide can be a benefit for some people, but a drawback for others. If you lack investment knowledge and experience, you may make poor decisions when left to your own judgment. In this case, you may welcome the limited investment selection (and investment advice, in some cases) that many employer-sponsored plans offer.
How to do a rollover
There are seven steps that you should follow to complete a rollover:
1. If rolling over to another employer's plan, check with the new plan administrator to make sure the plan accepts rollovers.
2. Consult your tax advisor before selecting a rollover to make sure this is the right option for you. Rollovers can have a long-term impact on your retirement planning, as well as your tax liabilities.
3. Review the notice from your old plan administrator explaining the rollover rules, the direct rollover option, the consequences of an indirect rollover, the withholding rules, and the possible reduction or deferral of taxes.
4. Decide whether you want to do a direct rollover or an indirect rollover. Then, make the necessary arrangements with your old plan administrator, and either the new plan administrator or the IRA custodian/trustee.
5. Obtain your spouse's consent, if required. Some plans require written spousal consent.
6. Make sure that a check (made out properly, and in the correct amount) is sent from your old employer's plan to the new employer's plan, the IRA custodian, or you personally, depending upon the method of distribution you selected.
7. If you receive the funds personally, make sure that you roll over those funds within 60 days to an IRA or another employer's plan to avoid taxes and penalties. In general, you should avoid a distribution directly to you in order to avoid the 20 percent federal withholding requirement.
Types of rollovers: how to do it
How you accomplish a rollover depends upon the type of rollover you want to do.
Direct Rollover:Qualified Plan to Qualified Plan- You usually need to complete paperwork with the existing plan, indicating that a direct rollover is to be made and providing the name of the receiving plan administrator. The check must be made out to the trustee of the new plan, or to the new trustee for the benefit of you as the participant. If it's not, don't endorse it or deposit it. Have a new check prepared with the correct payee.
Direct Rollover:Qualified Plan to traditional IRA- You would fill out forms with the existing plan trustee, indicating that you want a direct rollover and naming the IRA custodian. You would also fill out forms with the IRA custodian. The check from your old plan must be made out to the IRA custodian, or to the new IRA custodian for the benefit of you as the participant. If it is not, do not endorse it or deposit it.
Direct Rollover:Conduit IRA to Qualified Plan- You would fill out paperwork with the new plan trustee to be sent to the old IRA custodian. The IRA custodian may also require that you fill out a form.
Indirect Rollover:Qualified Plan to Qualified Plan or Qualified Plan to traditional IRA or Conduit IRA to Qualified Plan -This type of rollover should generally be avoided because you must make up the 20 percent mandatory withholding or be taxed, and perhaps penalized, on that 20 percent. (There is no mandatory withholding on funds coming out of an IRA.)
Income tax consequences of doing a rollover-As discussed, a timely and properly completed rollover is treated as a tax-free transfer of retirement assets. However, if the rollover is not completed within 60 days, the portion of the distribution that is not rolled over will generally be treated as taxable income to you (excluding any after-tax contributions you made to your plan). In addition, if you are under age 59½ and do not qualify for an exception, you may be subject to a 10 percent federal premature distribution penalty tax on the distribution (and possibly a state penalty as well).
Estate and gift tax consequences of doing a rollover
Any amounts remaining in your retirement plans and IRAs at the time of your death are treated like the rest of your assets for federal estate tax (and possibly state death tax) purposes--they are included in your taxable estate to determine if estate tax is due.
Qualified plan automatic rollover rule
Qualified retirement plans, Section 403(b) plans, and governmental 457(b) plans often contain a provision that requires the mandatory cash out of small benefits--generally vested benefits with a present value of $5,000 or less--if you terminate employment before reaching the plan's normal retirement age. However, if the mandatory payment is greater than $1,000, the plan must make the payment to an IRA established for the you, unless you affirmatively elect to receive the payment in cash, or to roll it over into a different IRA or to an employer retirement plan. The rule doesn't apply to distributions to beneficiaries or alternate payees, to plan loan offset amounts, or to distributions that don't qualify as eligible rollover distributions.
If you recently purchased a first home, or intend to purchase a first home in the next few months, you may stand to benefit from the first-time homebuyer tax credit provisions included in the recently signed American Recovery and Reinvestment Act. When it comes to the first-time homebuyer tax credit, though, there's quite a bit of confusion. So it's worth taking a few minutes to make sure you understand how the credit works, and the time period to which it applies.
First, the credit isn't new: Back in July of 2008, the Housing and Economic Recovery Act established a temporary refundable first-time homebuyer credit equal to 10% of the purchase price of a principal residence, up to $7,500 ($3,750 if married filing separately). The credit applied to first-time homebuyers who purchased a home on or after April 9, 2008, and before July 1, 2009. Generally, you qualified as a first-time homebuyer if you, and your spouse if you were married, did not own any other principal residence during the 3-year period ending on the date of purchase. The credit was phased out for individuals with higher incomes, and had to be paid back over 15 years in equal installments (repayment would be accelerated if the home were to be sold during the 15-year period or if the home ceased to be the principal residence of you or your spouse during that time).
The new legislation extends the credit to homes purchased by qualified first-time homebuyers through November 30, 2009. The new legislation also expands the credit. The credit remains 10% of the purchase price of the home, but the dollar limit has increased to $8,000 (the cap for married individuals filing separate returns is half that amount) for home purchases made after December 31, 2008, and before December 1, 2009. In addition, if you qualify for the credit as the result of a home purchase in 2009, you don't have to pay it back over time, provided the home remains your principal residence for 36 months.
The American Recovery and Reinvestment Act continues to allow you to elect to report a qualifying home purchase made in 2009 as if it occurred on December 31, 2008 (allowing you to claim the credit on your 2008 federal income tax return). Unfortunately for many, the new legislation also continues to eliminate the credit for those with higher incomes. The credit is reduced if your modified adjusted gross income (MAGI) exceeds $75,000 ($150,000 if you're married and file a joint return) and is completely eliminated if your MAGI reaches $95,000 ($170,000 if you're married and file a joint return).
You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child's education at the same time can be a challenge. But take heart--you may be able to reach both goals if you make some smart choices now.
Know what your financial needs are
The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:
· How many years until you retire?
· Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what's your balance? Can you estimate what your balance will be when you retire?
· How much do you expect to receive in Social Security benefits? (You can estimate this amount by using your Personal Earnings and Benefit Statement, now mailed every year by the Social Security Administration.)
· What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
· Do you or your spouse expect to work part-time in retirement?
· How many years until your child starts college?
· Will your child attend a public or private college? What's the expected cost?
· Do you have more than one child whom you'll be saving for?
· Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
· Do you expect your child to qualify for financial aid?
Many on-line calculators are available to help you predict your retirement income needs and your child's college funding needs.
Figure out what you can afford to put aside each month
After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you'll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you've come up with a dollar amount, you'll need to decide how to divvy up your funds.
Retirement takes priority
Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you'll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there's no such thing as a retirement loan!
If possible, save for your retirement and your child's college at the same time
Ideally, you'll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child's college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you'd have $18,415 in your child's college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)
If you're unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you're pursuing both goals at the same time doesn't necessarily mean that the same investments will be appropriate. Each goal should be treated independently.
Help! I can't meet both goals
If the numbers say that you can't afford to educate your child or retire with the lifestyle you expected, you'll have to make some sacrifices. Here are some things you can do:
· Defer retirement: The longer you work, the more money you'll earn and the later you'll need to dip into your retirement savings.
· Work part-time during retirement.
· Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
· Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
· Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).
· Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
· Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don't feel guilty--a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.
· Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.
Can retirement accounts be used to save for college?
Yes. Should they be? Probably not. Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child's college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you're under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you'll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)
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