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Creating a Nest Egg

If you haven't gotten serious about retirement planning yet, Uncle Sam is making it more enticing than ever for you to do so.

This year's big tax-law changes include a host of provisions designed to encourage Americans to save money for their golden years -- and reap significant tax benefits in the process. But don't be misled. While the legislation aimed at helping late starters has received tremendous media attention, the Economic Growth and Tax Relief Reconciliation Act of 2001 contains comprehensive retirement and pension changes that benefit individuals of any age.

Some of the people who stand to benefit the most are highlighted below. But even if you don't fit neatly into any of these categories, don't pass up the opportunity to shore up your retirement prospects. Indeed, in the aftermath of the Sept. 11 attacks -- as well as the shaky stock market for the past 18 months -- money managers say a lot more people are finally wising up to the need for planning and providing for the future.

"The whole psyche of retirement planning has been tilted," says Debra Stavis, a partner with Stavis & Margolis Advisory Services Inc. in Houston. These days, she says, "there's almost a religion about this."

Anyone contributing to an individual retirement account or 401(k)

One of the chief advantages of the new tax law is that it allows for big increases in contributions to individual retirement accounts and 401(k)s. Currently, individuals can put a maximum of $2,000 a year into an IRA. That limit will increase to $3,000 annually for 2002 to 2004, and then rise to $4,000 for the years 2005 to 2007, before reaching $5,000 in 2008.

"Today's $2,000 contribution maximum was established 20 years ago and no longer provides sufficient savings opportunities," says Matthew Fink, president of the Investment Company Institute. ICI, the mutual-fund industry's largest trade group, estimates that 42.5 million U.S. households own IRAs.

While the investment community lauds the change in IRA legislation, Bob Doyle, a personal-finance specialist in St. Petersburg, Fla., has encountered clients who incorrectly think that the new IRA limits won't make much difference.

"Some people are saying, 'What's the big deal?'" Mr. Doyle says.

He says the new law permits people to expand their nest eggs substantially. For example, if an investor socked away $2,000 annually for the next 10 years and got a 9% return, at the end of that period the individual would have $33,120 -- just over $13,000 in earnings on top of $20,000 in contributions. But with the new law's rising limits, an investor could generate $77,075 in a decade, assuming the same 9% return, based on contributions of $49,000. In this case, the investor would have more than $28,000 in earnings.

"Sure, the contributions are greater, but the earnings are a lot greater too," says Mr. Doyle.

The impact of higher contribution limits is even greater for people putting money into 401(k) plans, especially those who have plenty of time to watch their money grow and reap the benefits of tax-deferred compounding.

That's why 31-year-old Michael Shmarak, a media-relations specialist with public-relations firm Ketchum in Chicago, is looking forward to benefiting from the new law. "I will definitely max out my 401(k)," he says.

Starting next year, workers participating in 401(k) plans will be allowed to set aside from their salaries up to $11,000 tax-deferred each year, up from the current limit of $10,500. In addition, the deferral limit will increase $1,000 a year through 2006. That means the deferral limit will rise to $12,000 for 2003, $13,000 for 2004, $14,000 for 2005 and $15,000 for 2006. After 2006, all future increases to the deferral limit will be tied to cost-of-living increases and made in $500 increments.

One of the most talked-about features of the new tax law allows 401(k) plan participants age 50 and older to make annual "catch-up" contributions, which allow people to make up some ground if they have procrastinated or been financially unable to set aside money. So beginning in 2002, these people can make -- above and beyond the limits noted above -- contributions of up to $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005 and $5,000 in 2006. After that, future increases in the catch-up amounts will be tied to cost-of-living increases and made in $500 increments.

"Amazingly, many people are totally unaware of the catch-up provisions," says Ray Ferrara, a retirement-planning specialist and head of ProVise Capital Management in Clearwater, Fla.

Laid-off workers and job hoppers

The economic downturn has hit virtually every sector of corporate America, resulting in hundreds of thousands of workers -- from hotel clerks to investment bankers -- getting pink slips. Job losses following the Sept. 11 terrorist attacks have added to workers' woes, pushing the unemployment rate in October to 5.4%, the highest level in five years.

For those who have been laid off, there is some solace. The new tax law enhances the portability of retirement accounts, makes rollovers easier and encourages faster vesting. These advantages also spell good news for people who quit their jobs in search of greener pastures.

For starters, employees will soon be able to move funds among a variety of tax-deferred retirement-savings vehicles, including 403(b) plans, some 457 plans and traditional IRAs. This is an option not currently available.

These plans -- named after sections of the federal tax code -- are retirement savings plans used by employees of educational institutions, nonprofit organizations and state and local government agencies. The new law allows people in nonprofit or government jobs to carry the money in those plans to a 401(k) if they switch to the private sector, or vice versa.

Additionally, rollovers of after-tax contributions will be allowed via a direct rollover to a traditional IRA or defined-contribution plan. So people who land a new job can readily transfer assets from their old employer into a plan offered by a new employer -- and resist the temptation to take a retirement distribution that would incur taxes and a 10% penalty.

The new law also accelerates vesting options, allowing employees -- especially those who plan to change jobs -- to more quickly grab employer contributions. Currently, employees must wait at least five years to leave a company to avoid forfeiting the portion of 401(k) contributions provided by the employer. But under the amended tax law, the schedule is lowered to three years. And the seven-year graded schedule, where vesting occurs in increments over seven years, is replaced by a six-year graded schedule. The new law doesn't change vesting requirements for other employer contributions made to a 401(k) plan, such as profit-sharing contributions, that aren't considered matching contributions.

It's also worth noting that many companies require distribution of account amounts under $5,000 when employees terminate. To encourage workers changing jobs to roll over these amounts, the new law mandates that distributions of more than $1,000 be rolled over into an individual plan unless the employee specifically elects to receive the distribution. The net effect of this change is that when workers quit, get fired or otherwise leave a company, distributions into individual accounts, rather than direct payments to employees, will become the default.

Finally, the new portability provisions also apply to the spouse beneficiaries of people who died but owned IRAs or had contributed to employer-sponsored retirement plans. Husbands and wives have long been able to roll over a deceased spouse's plan or IRA into an IRA of their own. But beginning in 2002, the law will permit a spouse to roll a deceased spouse's company plan into his or her own company plan as well.

Small-business owners and employees

A handful of other amendments in the tax law aid entrepreneurs and their workers. For one thing, plan loans will be more widely available. Starting in 2002, owner-employees, such as partners, sole proprietors, and certain S corporation shareholders, may obtain loans from 401(k) plans just like other participants. (For tax purposes, an S corporation is treated as a partnership, where corporate profits and losses are passed on to the tax returns of individual shareholders.)

Small companies that want to establish pension plans will benefit from a change that allows a credit for 50% of qualified plan start-up costs. The credit is limited to $500 for each of the first three years only. The employer cannot have more than 100 employees who received more than $5,000 in compensation, and the plan must have at least one participant.

Separately, the Simple IRA, a low-maintenance alternative to a 401(k) plan for firms with 100 or fewer employees, also will enjoy higher contribution limits in future years. The current employee-contribution limit of $6,500 will rise to $7,000 in 2002, $8,000 in 2003, $9,000 in 2004 and $10,000 in 2005. Those 50 years of age and older will be able to put away an additional $500 a year into their Simple-IRA plans starting in 2002. Also, the Simple-IRA contribution limits will increase with inflation in $500 increments beginning in 2006.

People who are self-employed and use SEP-IRA and Keogh plans can contribute $40,000 annually to these retirement plans in 2002, up from the current limit of $35,000. A SEP-IRA, or simplified employee pension individual retirement account, allows small-business owners and people who are self-employed to set aside money for retirement through tax-deferred investment accounts. It's funded solely by employer contributions, which are tax-deductible as a business expense. A Keogh is a retirement plan for an unincorporated business. An individual can set up a Keogh if he or she earns self-employment income through the performance of personal services.

Employees of nonprofit organizations

For years, people who worked at nonprofit groups or in state and local government jobs couldn't contribute as much to their retirement accounts, called Section 457 plans, as private-sector workers could put in their 401(k) plans. In 2001, for example, those with 457 plans could put in a maximum of $8,500, while 401(k) participants could put in as much as $10,500.

The disparity "really hampered [retirement planning] for people who work in the public sector," says Lynne Stebbins, second vice president, advanced planning and professional services at Guardian Life Insurance Co. of America in New York.

Now, the new law will allow those working for nonprofit groups or the government to put in their retirement accounts the same amount as those in a 401(k) plan. In 2002, both sets of workers will be able to contribute $11,000. By implementing parity among public and private workers with deferred compensation plans, "Congress has finally gotten it right," Ms. Stebbins says.

Low-income wage earners

Between Jan. 1, 2002, and Dec. 31, 2006, low-income individuals will be eligible for a tax credit of as much as 50% of their contributions to 401(k) plans, IRAs and other qualified retirement plans. The maximum annual contribution eligible for the credit is $2,000. But the exact credit depends on the tax filer's income.

For married people filing joint returns, the credit gets phased out completely when the couple's income hits $50,000; singles claiming the credit can't make more than $25,000. To take the credit, the tax filer must be 18 years or older, not a dependent of others and not a full-time student.

Cash-strapped individuals and first-time home buyers

The general rule is that IRA owners face a 10% excise tax if they take distributions from their accounts before age 59½. But the new tax law nixes that 10% penalty for cash-strapped individuals "if you use the money to pay for higher-education expenses or for qualified home-buying expenses up to $10,000 for the purchase of a first home," says Robert Barbetti, a New York lawyer and senior manager in the Advice Lab at J.P. Morgan Private Bank, a division of New York-based J.P. Morgan Chase & Co. There is no income limit for hardship withdrawals.

Those in desperate need of money will discover that so-called hardship distributions from retirement accounts will be slightly less onerous. Starting next year, if an employee takes a hardship withdrawal, he or she can contribute again to the company retirement plan in six months. Right now, the law prohibits those taking a hardship distribution from resuming contributions until a year has passed.

The IRS recognizes four legitimate reasons for hardship withdrawals: some unreimbursable medical expenses, purchase of a primary residence, costs of postsecondary education, and withdrawals to prevent eviction or foreclosure of one's home. The person applying for a hardship withdrawal must show an "immediate and heavy financial need" and have no other sources of cash.