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Feds Helping You Catch Up on Retirement Savings

By: Ellen Hoffman Source: AARP Bulletin Today Date Posted: January 2002

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This year Uncle Sam is making it easier for you to catch up on your retirement savings. As of Jan. 1, the government officially increased the amount of tax-deferred contributions you can put into your 401(k), IRA or other retirement accounts.

"The new tax provisions provide employees and individuals 50 years and older who qualify a terrific opportunity to enhance their retirement savings," says Robert Barry, a Hackettstown, N.J., certified financial planner who is president of the Financial Planning Association.

If you're 50 or older, you can put as much as $3,500 in an IRA—compared with $2,000 before—or $12,000 in your 401(k), up from $10,500 in 2001. These limits will increase further in subsequent years.

And if you earn a modest income and can't afford to put the maximum amounts into retirement accounts, you may be able to reduce your federal income tax bill by claiming a new tax credit for money you put into retirement savings.

After a roller-coaster year in the financial markets plus layoffs, a general economic slide and the war on terrorism, many Americans are left with depleted bankbooks and investments, feeling uncertain about the future.

If you're feeling financially battered and worried about meeting future or current retirement living expenses, you need to answer two questions:

• Can you actually benefit from these new savings incentives?
• What other strategies should you consider for catching up, especially if the new tax law doesn't benefit you?

To answer these questions, take a hard look at the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001.

In brief, the new law allows all individuals to make higher contributions to their IRAs and 401(k)s, permits "catch-up" contributions for people 50 and over and, of particular importance, provides lower-income investors a new tax credit if they set aside something for retirement in an IRA or other retirement plan. (See The New Law at a Glance.)

BUT THERE ARE CATCHES

The new tax incentives for retirement savings sound great, but there are two big drawbacks.

First, you can only make the higher contributions to your 401(k) or other employer plan if your employer allows you to do so. The federal government has strict rules for changing a retirement plan, and this requires an employer "to take on additional administrative issues," says Martha Priddy Patterson, director of human capital advisory services for Deloitte & Touche, employee benefits consultants.

She says that right now many employers are scrambling to stay alive, and "revising the 401(k) plan may not be the number one item on their agenda."

David Wray, president of the Profit Sharing/401(k) Council of America, a Chicago-based nonprofit association, says, "Some employers will be up and ready by Jan. 1, but a substantial number will put implementation of the catch-up provisions toward mid-2002."

Wray points out, however, that your employer's delay in setting up the system should not deter you from contributing more because you will have the rest of the calendar year to make the contributions.

The second drawback to the new law is that you cannot benefit from the higher contribution limits if you can't afford to put away the extra money. To people who have been laid off or whose business or investments have contracted in the slow economy, paying the mortgage and other bills will understandably seem more urgent than saving for retirement.

STOPPING SHORT OF THE MAX

Even during the recent economic boom years, most people did not put the maximum contribution into their 401(k). A recent study by the Employee Benefit Research Institute found that in 1999, people in their 50s with an income of $40,000 to $60,000 saved an average of 8.3 percent of their income—less than $5,000 a year—well below the 2001 limit of $10,500 for a 401(k). People in their 60s making $60,000 to $80,000 were saving 9 percent, or up to $7,200. And even employees in their 50s and 60s who make over $100,000 only contributed an average of $5,100 a year.

A 2001 analysis using 1998 data by the General Accounting Office, the investigative arm of Congress, concluded that only 721,000 people, or 11 percent of those who are eligible, would be expected to both max out their basic 401(k) contribution and add the "catch-up" money as well.

All of these numbers suggest the same conclusion: Even if they have a 401(k), most Americans won't take full advantage of the higher contribution limits.

Even if you think you can afford to make the higher contributions, Washington financial planner Susan Freed suggests that you consider two factors before writing the checks:

• whether you have enough cash or liquid investments, such as a money market account, to pay your living expenses for at least six months if you have a financial emergency; and
• whether your job is secure.

"There have been a lot of layoffs," Freed cautions. "In this economy, it would be good to make sure you have more liquidity than normal."

If you do lose your job, and you need money from your 401(k) or IRA, you'll face stiff withdrawal penalties if you take it out before you turn 59 1/2.

OTHER STRATEGIES TO SAVE

So if you're 50 or older and your investments are lagging, or you've lost income from a full- or part-time job, what can you do now to shore up your finances for retirement? Among the strategies experts suggest are re-thinking your retirement schedule, making substantial cuts in living expenses and reaping benefits from the equity in your home. So, if you're in a pinch consider the following:

Postpone your retirement date. "Clients tend to underestimate how much impact working even just one more year can have on their [retirement income] projections," says Heather Locus, a certified financial planner in Schaumburg, Ill.

Delaying retirement can help in three ways: "They'll have another year to let their assets grow," Locus says. "They'll have additional savings for that year. And they will have one less year of retirement to pay for."

Set priorities, reduce your spending. That's how Paul Grollman, 78, of Kansas City, Mo., is coping with being laid off and trying to pay off a $40,000 credit card debt. Now Grollman, as a consultant, checks engineering designs.

Although he's on Social Security and his 65-year-old wife works part time for Weight Watchers, the Grollmans depended on his salary to pay for some of the better things in life.

On Sept. 13, Grollman went to a credit counseling agency for advice on how to pay off the credit cards. The next day, he was laid off. The debt counselors helped him reduce his monthly credit card payments from about $2,500 to $1,600, but the Grollmans have also had to cut back on eating out, going to concerts and vacation trips.

"We're just reining in expenses and keeping a low profile until we see where things are going to go," Grollman explains.

Joanne Kerstetter, president of Consumer Credit Counseling Service of Greater Washington, D.C., says that to reduce expenses effectively you need to pinpoint exactly how you are spending your money. "We have people making over $500,000 a year and still in debt because they never got a handle on where their money was going," she says.

Kerstetter has a formula for controlling spending. First, list your income from all sources, and make note of automatic deductions for items such as taxes, health insurance and retirement accounts.

Make a list of what she calls "budget busters"—bills for insurance, holiday gifts or other items that you pay annually or occasionally, rather than monthly. Then add all your variable monthly expenses for items like dry cleaning, video rentals or haircuts with fixed costs such as mortgage or rent and utilities. Be honest about how much money goes to eating out, movies and other nonessentials.

Once you've determined your expenses, you will see places to save.

Identify potential savings. With interest rates at the lowest level in years, consider refinancing your mortgage. Smaller savings can add up. Brown-bagging lunch, getting rid of the family's second or third car or opting for the basic cable TV package instead of the most expensive are examples of ways to reduce spending.

If you're working, you can still contribute to an IRA (and perhaps earn a tax credit) for future use even if you're on Social Security or a pension.

(If you're 70 1/2 or older, this strategy may not help, because you can no longer contribute to and must make withdrawals from traditional, but not Roth, IRAs.)

Make your house pay. In the current economy, many retirees are finding that rather than saving for the future, they need more income now. Mary O'Neill, 77, of Cocoa, Fla., has been living on Social Security plus income from an investment portfolio she and her late husband had accumulated over the years.

"The statement in the mail yesterday said my investments had dropped another $2,000, and they have been dropping since January," she says. "The electricity has gone up, the water bill has gone up and if you want to live halfway decently, you have to turn elsewhere for funds."

The answer for O'Neill was a reverse mortgage, an option available to people who are 62 or older and have their home mortgage almost paid off. O'Neill needed about $32,000 to pay off the mortgage on her four-bedroom house and a loan for major roof repairs.

A WAY TO STAY INDEPENDENT

A reverse mortgage is most appropriate for someone who wants to remain in her or his home. With a reverse mortgage, you no longer have to make mortgage payments for as long as you live in your home, and the mortgage does not come due unless you sell the house or die.

However, when you die, lenders collect the amount owed from your estate. In most cases, the estate repays the loan out of proceeds from the sale of the home. In return, you may choose to receive cash in one of several forms —a lump sum, a monthly payment or a line of credit you can tap when you need it. O'Neill chose to take the $30,000 from the reverse mortgage as a line of credit. "That's given me some extra money, and unless something really bad happens to the house, I should be okay," she says.

A reverse mortgage entails closing costs and is not the best solution for everyone. If you're interested, visit www.aarp.org/revmort for help in deciding whether it makes sense in your financial situation.

Selling your home and downsizing is another way to generate retirement catch-up funds. Empty nesters in a house that's now larger than necessary may find themselves saddled with a lot of maintenance bills.

If you have lived in your home for at least two of the last five years, when you sell, Uncle Sam allows you to keep up to $250,000 in profit for a single person and $500,000 for a couple, tax free. You can use some or all of that tax-free profit to buy or put a down payment on a smaller home that costs less to maintain, or invest it to generate retirement income.

Many Americans have learned a crucial lesson about retirement planning in the last year: You can't just throw money into a retirement account, pay no attention to it and expect it to finance your retirement when you're ready.

The CIGNA insurance company recently interviewed both corporate human resources officials and consumers about their attitudes toward their retirement accounts. Eighty-four percent of the human resources staff said that the recent economic downturn had increased employees' attention to their account statements, and 86 percent said their employees were "frightened" about the shrinkage in the value of their portfolio. Nearly half of the consumers interviewed planned to change their investment strategy in January 2002 if their accounts were still down from a year earlier.

A NEW YEAR'S RESOLUTION

In the current economic situation, deciding where to invest your retirement catch-up money is not easy. If you're uncomfortable with investing or you don't understand the options in your company plan, make a New Year's resolution to take advantage of your employer's investment education resources. If that's not an option, consider taking a class or joining an investment club.

Even if you do have a financial adviser such as a broker or planner, you owe it to yourself to obtain as much information as you can so you can make informed decisions.

After all, when it comes time for you to retire, you want to be ready financially as well as psychologically.

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