Mutual Funds Interactive -- Mutual Fund News and Features

MFI presents excerpts from Dearborn Financial Publishing's new book, Love, Marriage, And Money, by Alan Lavine and Gail Liberman, two veteran mutual fund writers. Copyright 1998. Reprinted with permission. To order a copy of Love, Marriage, And Money, visit our online bookstore.

Sorting Through the Gobbledygook: IRAs, 401(k)s, and Annuities

While you may not necessarily be able to bank on Social Security, you can put money into an IRA or other type of retirement savings account to help build a worry-free retirement. In fact, more tax incentives--encouraging people to save for their retirement--were signed into law in mid-1997.

Don't get confused about these terms. They are not investments in and of themselves. Each simply refers to a type of tax shelter.

Often, you can choose which types of investments go into these tax shelters, and financial institutions often determine which of their investments they will permit under these programs. Typically, they have steep U.S. government-mandated penalties for withdrawal before age 59 1/2, as well as tough rules on when you must withdraw.

Meanwhile, inside the tax shelter umbrella, your investment itself may have its own withdrawal penalties, loads, or "surrender charges." Because these instruments are designed to be long-term investments, some financial institutions may offer special incentives to get your business. There might be better rates or lower minimums to open them than there would be if you opened the same investment outside one of these plans.

The best thing about retirement savings accounts, like IRAs, is that contributions may be tax-deductible and/or tax-deferred. Tax-deductible contributions actually are subtracted from your income in the year they're taken, so that you get to pay less in taxes that year. With tax-deferred investments, your earnings aren't taxed until you withdraw.

HOT TIP * * * * *
Call the IRS for free publications on retirement savings rules at (800-829-3676). Ask for publication number 560, Retirement Plans for Small Business, and number 590, Individual Retirement Arrangements. * * * * *

You may get to take advantage of both of these tax breaks if you open an IRA and have no other pension plan, or if you earn less than a certain amount annually. Not a bad deal!

Then, when you retire, you pay income taxes on the money you withdraw, while the remainder of the investment continues to grow tax-deferred.

In all of the above retirement programs, even if your investments are not tax-exempt, you always have the advantage of tax deferment. The savings tax deferment can bring are staggering. For example; if you're in the 28 percent tax bracket and you put $2,000 annually in a tax-deferred account for 20 years and earned 8 percent annually, you'd have $98,846.

If you save the money outside an IRA in a taxable investment, you'd have just $54,598. That's a big difference!

With an IRA, you actually control your investments, but you'll be socked with a 10 percent penalty if you withdraw before age 59 1/2--unless the withdrawal meets one of these three conditions:

1. It is used for higher education.
2. It is made for a first-time home purchase.
3. You are unemployed and need the money to pay for health insurance.

That penalty is over and above any withdrawal penalties or termination fees the financial institution might impose on your IRA. You can invest IRA money into your choice of bank CDs or savings accounts, stocks, bonds mutual funds and American Eagle gold coins, or other bullion coins. But before you consider any of these, check with your bank, broker, or investment company to make certain they have the ability to set up your desired investment as an IRA.

Fortunately, Uncle Sam allows any taxpayer who has earned income but doesn't contribute to a company pension plan to make tax-deductible contributions to an IRA. Single taxpayers can put $2,000 annually into an IRA and get a dollar-for-dollar deduction on their income taxes. Married couples that file joint returns can salt away a maximum tax-deductible contribution of $4,000.

However, the deduction is phased out or eliminated entirely, based on income, for taxpayers who already have a pension plan. The phaseout, which in 1998 starts at $30,000 for individuals and $50,000 for married couples, was slated to increase until they reach $50,000 for singles by the year 2005, $80,000 for married couples in 2007.

HOT TIP * * * * *
If your spouse has a pension plan through a job and you don't, you can still qualify for a tax-deductible IRA. * * * * *

Another type of IRA, known as the "Roth IRA," starting in 1998 allows you to invest up to $2,000 a year. Unlike the original IRA, the Roth IRA does not allow you to deduct your contribution from income taxes. However, you can withdraw tax-free if you've maintained it for at least five years and you withdraw under one of these conditions: You've turned 59 1/2; in the event of death or disability; or for a first-time home purchase. Plus, unlike the original IRA, the Roth IRA does not require you to start taking withdrawals at age 70 1/2.

Eligibility for the Roth IRA starts to phase out for individuals earning adjusted gross incomes of $95,000 and couples with adjusted gross incomes of $150,000.

If you take advantage of a one-time provision that allows you to roll over an old-fashioned IRA into a Roth IRA before 1999, you get to spread the income out over a four-year period for income tax purposes. To qualify, you must have an adjusted gross income under $100,000 in the 1998 tax year.

Simplified Employee Pension Plans or SEPs are expanded IRAs for the self-employed. As with IRAs, SEP plan holders can invest in bank accounts, stock, bonds, and mutual funds, and can deduct contributions from their taxes. If you own your own business, you can sock away more into an SEP than an IRA. Your employees also have the option of saving through the SEP plan.

This plan is called "simplified" because it's easy to set up. You fill out a form similar to that for an IRA. Like with IRAs, you control the investing. Each year, you can contribute up to 15 percent of your income or $30,000, whichever is less, into this tax-deferred retirement savings plan.

A Keogh is a more flexible retirement plan for the self-employed than a SEP. You can contribute more to a Keogh than either a SEP or IRA. Depending on how it is set up, you can contribute 25 percent of your income annually to a maximum of $30,000. Like other retirement plans, Keogh contributions are tax-deductible. A Keogh can be set up as a profit-sharing plan or a plan that pays a specified income after you retire.

To start a Keogh, though, you may have to hire a lawyer to file a written pension plan with the IRS. There also is a lot of recordkeeping to do. Annual IRS forms must be filled out. Plus, the IRS requires a lengthy report every three years.

HOT TIP * * * * *
Employee retirement programs, intruding 401(k)s, often require you to decide on an investment each year by a certain deadline. Miss that deadline and you could wind up earning a piddling 5 percent or less in your 401(k)'s money fund. * * * * *

These are all known as salary reduction pension plans because your taxable wages are reduced by your contribution; so you therefore have less income to report to the IRS. The 401(k) plans typically are used by people employed by larger companies. The 403(b)s are used by those who work for nonprofit organizations, and 457s are for state and municipal employees. Depending on the plan, workers usually agree to put up to 10 percent of their wages into their mutual fund pension plan investments. The maximum amount you can contribute is pegged to inflation. In 1997, you were able to contribute no more than $10,000 into your 401(k). Employers also are permitted to make matching contributions. Typically, employers pay from 25 cents to $1 dollar for every $1 a worker invests.

An annuity is a contract with a life insurance company. You can make periodic payments or deposit a lump sum in an account that earns tax-deferred interest until funds are withdrawn. Then you can take the money all at once from an annuity or receive a lifetime income. Annuities also are a way to avoid probate.

When you start receiving a monthly check from your annuity, you are "annuitizing" the contract. The insurance company agrees to pay you the income for as long as you live. Meanwhile, as with other types of insurance policies, you can pass on some of the proceeds when you die in exchange for lower monthly checks. With one of the most common types of contracts, called "10 year certain and life," the checks are sent to your designated beneficiary after you die for the remainder of that ten-year period. Only your earnings from the annuity are subject to federal taxes. Each annuity payment you receive is taxed proportionately, based on the value of the annuity and premiums paid. If you withdraw from an annuity before you reach age 591/2, you must pay the IRS a 10 percent penalty. In addition, you'll pay income tax on earnings.

Annuities come in several shapes and sizes. The most common are discussed below.

Deferred fixed annuities. This annuity pays a fixed rate of interest, adjusted at set intervals (e.g., annually, or every one to ten years). Fixed annuities currently yield from 5 percent to more than 7 percent, depending on the term to maturity.

With a fixed-rate annuity, the insurance company pays you interest based on the performance of its investments. Say, for example, all the assets of the insurance company earned a total of 9 percent for the year: After the company subtracts the cost of doing business and a margin for profit, it may pay you 7 percent. Remember, there's nothing to prevent the rate you earn on a fixed-rate annuity from declining after a couple of years.

Deferred variable annuities. You may invest in a stable of stock and bond mutual funds. Your funds are placed in a separate account from the insurance company's pool of assets, and the investment risk falls on you.

The advantage of this type of annuity is that you control your investment decisions. If you are willing to assume risk, you can attain higher returns over the long term. But you typically pay additional fees for this benefit. Annual charges run about 21/4 percent, according to Momingstar Inc., Chicago. In addition, you pay administrative charges, maybe a state premium tax, and mortality fees.

Meanwhile, if your mutual funds perform poorly over the longer term, you may not have the kind of retirement kitty you expected.

BET YOU DIDN'T KNOW * * * * *

An annuity can give you an additional 75 years of tax-deferred earnings when compared with a traditional IRA. With an annuity, you generally don't have to begin taking money out until age 85.

By contrast, with an IRA if you don't begin taking money out by the time you reach age 70 1/2 you get hit with stiff fines from the IRS: 50 percent of the difference between What you take out and the amount required by law. * * * * *

Immediate annuities. If you're already retired and need life-long income, you can invest a lump sum and begin receiving payments immediately over the rest of your lifetime. When you die, your beneficiaries will inherit the balance of the money if you elected that payout option when you signed the annuity contract. Immediate annuities may be fixed, paying you a flat rate for the life of the annuity, or variable, paying a return based on the performance investments you select.

Of course, there is no free lunch when you invest in deferred annuity. Both fixed and variable annuities typically have back-end surrender charges that can run as high as 6 percent in the first year if you withdraw your funds early. That's in addition to each annuity's built-in expenses.

The assets in a variable annuity are not subject to any of the insurance company's creditors' claims, while a fixed annuity investment, a direct obligation of the insurance company, could be.

Regardless of whether you select a fixed or variable annuity, the annuity's guarantees are only as good as the insurance company behind it. To insure that you are doing business with a financially strong company, make certain it has at least an A+ rating by A. M. Best.