Friday, May 21, 2010

Budgeting for Pension cut-7 Tax Deferred Accounts

The seconds set of accounts which I watch monthly are the tax-deferred accounts which I built up over the years in Canada and the US.

When I retired I withdrew as much from my US Pension as I was allowed by the IRS rules, and placed the money into my 401K. Then when Nortel showed signs of dying I moved the contents of the 401K into an IRA. The IRA has various components within it including mutual stock funds, bond funds, CDs etc. Any gains made on the market or from dividends are reinvested and can grow inside the IRA without having to pay tax immediately.

When I withdrew my US pension some of the commuted value was not allowed to be rolled over into the 401K because of IRS rules. Nortel required that I take the rest of my pension as what they called a "Fifteen Year Certain Pension" and was considered non-qualified by the IRS. Hence the money was being paid out of Nortel's general funds and not any Pension Trust Fund. That worked fine for 7 and a half years until Nortel declared chapter 11 at which time they stopped my pension. So much for certainty.

Since I had worked in Canada for a number of years I also had an RRSP which was invested in various Canadian and International funds. I also had some money left in my 401k. So I treat these three accounts as my tax-deferred fund and in my original plan I was not going to touch them until the fifteen year certain pension stopped.

Unfortunately with the demise of Nortel I had to start taking money from my IRA to replace the money I lost from the NQ pension.

Withdrawing money from an IRA or other tax deferred vehicle like that means that you have to pay taxes on the withdrawal as if it were earned income. There are IRS rules for withdrawal which everyone needs to be aware of.

If you are less than 59 1/2 years old, there are penalties involved which will cost you an extra 10% tax penalty over and above what taxes you have to pay based on your income and deductions.

There are some exceptions to the the rule that you must wait until 59 1/2 years old before making a withdrawal.

If you roll over your IRA to another retirement plan, it is not subject to the 10 percent penalty.

If your medical expenses exceed 7.5 percent of your adjusted gross income, you can make a penalty-free withdrawal from your IRA.

If you lost your job and paid your medical premium yourself, you can withdraw that premium penalty-free from your IRA until you find another job.

If a physician certifies you cannot work, you can withdraw funds from your IRA penalty-free.

If you die with an IRA, it can be distributed to your heirs penalty-free.

You can pay college tuition with distributions from your IRA penalty-free.

You can withdraw up to $10,000 from your IRA penalty-free for the purchase of a home.

If you begin taking essentially the same amount from your IRA before you are 59 1/2, and do so for 5 or more years, those distributions will be made penalty-free.

Another rule of traditional IRAs is that you are required to begin making withdrawals when you reach 70 1/2 years of age. You have to make the first minimum withdrawal before April 1 on the year after you reach that age and the amount is based on the value of your IRA as of December in the year before you reach 70 1/2. Failure to take those distributions results in a penalty of 50 percent of that amount,so don't get caught having to pay the IRS by procrastinating.

The first distribution starts off around 3.6% of the value in your IRA and grows each year after that based on actuarial tables used by the IRS. A calculator is available at to help you determine what your minimum withdrawals over your lifetime would be given various interest rates and values in your IRA. You can find that at:

In terms of RRSPs in Canada, they don't last forever. By December 31st of the year in which you turn 69, Canada's Revenue Agency requires that you have to move the money out of your RRSP.

There are three basic options:

You can close your RRSP, cash out your savings, and pay a huge amount of tax on it at the highest marginal rate. This option is absolutely the least desirable and should be avoided.

You can buy an annuity with your savings.

You can roll your savings into a Registered Retirement Income Fund (RRIF).

Most people buy an annuity or roll their savings into a RRI but there are pros and cons with each approach.

Buying an annuity

An annuity is a contract between an investor and a financial institution. The investor turns over a non-refundable lump sum and, in exchange, receives a pre-determined stream of income for a set period. The type of annuity chosen will depend on your specific situation and your plans. There are three main types of annuities: single-life, joint-and-survivor and fixed-term.

A Single-life annuities provide buyers with an income stream for life. But when the holder dies, the payments cease and nothing goes to the estate.

A joint-and-survivor annuity is geared toward couples and provides income protection for the surviving spouse. The annuity payments continue after one spouse dies. The annuity can be set up to provide the same payment to the spouse or reduced on the death of the first spouse.

A fixed-term annuity provides a benefit to a specific age, or for a set period, such as 10 years. If the person dies before the end of the term, the remaining payments go to her estate or a designated beneficiary.

Annuities are tied to the interest rate at the time of purchase of the annuity, so there is no way to take advantage of rising rates, and there is no protection from inflation.

So, in a low-rate environment like today, where rates are expected to start rising, few people are choosing annuities. The best choice is to roll RRSP savings into a RRIF.

Rolling into a RRIF

A RRIF operates much the same way as an RRSP. The primary differences are that you can't contribute more money to it once it's established, and you must withdraw a minimum annual amount from it starting in your 70th year.

Like IRAs, yearly withdrawal vary according to a formula established by the Canadian federal government. The amount of money you must withdraw each year is determined by your age. So if you have a younger spouse, you should designate her as the beneficiary because it will lower the minimum withdrawal.

When the RRIF is established you need to take steps in advance to accommodate the minimum withdrawals you'll have to make. Otherwise you may need to sell investments before their maturity in order to meet your withdrawal obligations. This will probably decrease your total return on the RRIF.

The minimum RRIF withdrawal may be based on your age,or your spouse's age. So you can choose the lower number to keep your RRIF building. Minimum withdrawal at age 55 is 2.86%, at 60 it is 3.33%, at 65 it is 4.0%, at 70 it is 5.0%, at 75 it is 7.85%, and it continues growing until it reaches 20% at age 94.

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