Personal Business: INVESTING
THERE'S MORE TO A NEST EGG THAN A 401(k)
So you got the promotion. The new job is everything you hoped for. And the raise that comes with it is finally going to let you max out your 401(k) contributions. The federal government says you can shelter up to $9,500 a year in pretax income in a 401(k) retirement plan. But you haven't been setting aside anything close to that. Now you can. Or can you?
The problem is, if you're making $66,000 or more a year, the Internal Revenue Service classifies you as a highly compensated employee. And if not enough lower-paid workers at your company are participating fully in the 401(k) plan, the IRS limits what you can kick in. Technically, the IRS restricts your contributions to the average percentage of salary forked over by those making less than $66,000, plus 2%. So if most employees are salting away just 4% of their income, you will be held to 6%.
PENDING BILL. That could still leave you far short of the $9,500 maximum. It could also leave you worried that you're underfunding your retirement. So what do you do? Relief may be on the way. A bill passed on May 22 by the House of Representatives and now awaiting action by the Senate could let "highly compensated" employees put more pretax money into their 401(k)s. "That's one we think will pass," says Robert Liberto, a vice-president at Siegal Co., a benefits consultant based in New York.
Even if the rules don't change quickly and your 401(k) contributions are capped, remember that increasing your savings for retirement is still a sound goal. Too many people who run up against a wall in their 401(k)s fail to consider other options, says Will Bashan, president of Cigna Financial Services, a Hartford-based retirement-advisory company. They include aftertax contributions to company plans, individual retirement accounts, or tax-deferred annuities. The goal, planners say, is to save enough during working years to generate 60% to 80% of your income for every year past retirement. Even if they now deposit the $9,500-a-year maximum, people making $200,000 or more will need added savings to reach that target.
Start by asking the benefits manager if your company has a nonqualified savings plan separate from the pension or 401(k) plan that allows you to defer income until resignation or retirement. Because of the cost of setting up and maintaining these plans, they are typically available only at big corporations such as Exxon, IBM, and McDonald's, and they're restricted to highly paid management. The Profit Sharing/ 401(k) Council of America estimates that 50% of corporations with 1,000 to 5,000 employees now offer nonqualified savings plans. However, "if your company doesn't have one, ask to put one in," suggests the council's president, David Wray. "The IRS has issued regulations in the last year that make it very easy to coordinate a 401(k) with a nonqualified plan," he says.
One type of nonqualified plan lets eligible employees put their $9,500 401(k) pretax limit into a "wraparound" or "mirror-401(k)" account that mimics the fund choices of the regular 401(k). At yearend, the company calculates how much can be legally shifted into the 401(k) and how much must remain in a nonqualified plan. The money that's left out of the 401(k) essentially becomes deferred compensation. Since it's invested in the same funds as the 401(k), it will generate income tax-deferred until the employee is ready to withdraw it. At that point, ordinary income taxes will be due. Another type of plan allows only aftertax contributions. However, the potential risks of putting aftertax money into such nonqualified accounts has sharply limited their use.
RISKY. Indeed, because companies set their own rules on withdrawal and investments, nonqualified plans aren't for the fainthearted. They lack the protection and regulatory oversight of 401(k)s. So if the company goes bankrupt or mismanages the money, you could lose everything. And unlike 401(k) or IRA money, these savings cannot be rolled over to another outside plan. If you leave the company, you'll most likely have to liquidate the account and pay the taxes. Experts say participants must know enough about how the money will be invested and the company's financial health to benefit. "You've got to do your homework on a nonqualified plan to make it work for you," says Bashan.
On the positive side, nonqualified plans have no penalties or time limits on withdrawals. Also, because the IRS tests overall retirement-plan participation at midyear, the exclusion of contributions by highly paid executives until yearend boosts the amount of pretax money they can set aside in any given year.
Whether you have access to a nonqualified plan or not, one way you should supplement your 401(k) is by funding an IRA. Of course, you won't be able to use pretax money because the IRA restricts such contributions to those making less than $50,000 a year and who aren't already covered by a pension plan. But you still have the advantage of tax-deferred growth on your yearly aftertax contribution of up to $2,000 (or $4,000 for you and your spouse). IRAs are inexpensive, widely available from banks and mutual-fund companies, and easy to move. Growth-stock mutual funds that kick off plenty of capital gains make good IRA investments. The one bookkeeping chore you'll have is to file Form 8606 with your income tax return every year you make a nondeductible IRA contribution.
A tax-deferred variable annuity set up to allow for automatic deductions is another way to augment your retirement savings. Like 401(k)s and IRAs, taxes on annuity income don't come due until the money is withdrawn. By then, you should be in a lower bracket to reduce the tax bite. But annuities carry some significant fees, so consider them only after fully funding a lower-cost IRA. Count on forking over 1% to 1.4% of assets each year. And be aware that you might have to pay penalties of 5% to 8% for withdrawing money from an annuity in the early years. That's why they're best for people with 15 to 20 years to go before retirement. "If you're not in for the long term, there's no benefit," cautions Cigna's Bashan.
Many of the newer annuity products offer multiple investment options that act like an asset-allocation mutual fund. Cigna's Accrue Annuity, for instance, allows customers to direct contributions by percentage to a variety of fixed-income, growth-stock, and small-cap stock accounts. American Skandia Marketing's Advisor's Choice II offers 23 investment choices. Start an account with Putnam Investment's Capital Manager for $1,000, and you can make followup deposits of as little as $100 a month with automatic monthly deductions from a bank account or paycheck.
If you're over 55 and an annuity doesn't make sense, you might be better off creating a taxable investment account earmarked specifically for retirement savings. Any mutual-fund company will let you set up a system for regular automatic contributions. And while you'll have to pay yearly taxes on capital gains, you still have time to accrue a sizable sum before you're ready to retire. That should come in handy when you crack your 401(k) nest egg and find it's not as rich as you had hoped it would be.EDITED BY AMY DUNKINReturn to top