How Do You Define Rich? -- and Advice for the Near-Retiree

This week, Gail advises a "wealthy" couple — and has a few ideas for those who are nearing their retirement.

Gail

Together, my husband and I make approximately $200,000 a year. While that might seem like a lot, we live in the Washington, D.C. area, which has a very high cost of living and more millionaires than the Silicon Valley.

By some accounts we are rich, although with the cost of day care and housing in this area it sure doesn't seem like it!

Our 401k contributions are limited to $10,500 (each), and mine are further limited due to my company's inability to get lower-compensated employees to participate in the plan. According to my research, at our income levels we are not eligible for IRA, Roth IRA or Education IRA tax deductions.

We're stumped. What tax strategies are there for people in this middle layer?

Vicki

Dear Vicki,

You're absolutely right: although you feel "middle class", the federal government considers you "wealthy." That's why Congress arbitrarily chose $150,000 as the cut-off for a couple to put $4,000 into Roth IRAs, even though contributions to a Roth are made on an after-tax basis. (See my column "The Grapes of Roth," dated May 10.)

Other than your plans at work, there are no other places where you can get a tax deduction for contributing to a retirement account. And as you correctly point out, higher-paid employees are often prohibited from fully taking advantage of this.

It's not much help, but under the new tax law, contributions to most company retirement plans increase by $500 to $11,000 next year. This rises to $15,000 by 2006, when it will be adjusted for inflation, and there are also special catch-up contributions for people over age 50. While your husband should be able to take advantage of this, unless your employer can convince more people to join its plan, you will still be prohibited from contributing the maximum.

You might ask your human resources department to take a look at the provisions in the 2001 Tax Act which pertain to so-called "safe harbor" rules. In January, it will be easier for retirement plans that are "top-heavy" — those with more higher-paid employees contributing than lower-paid workers — to meet federal requirements that affect contribution limits.

In addition, even if employees remain restricted as to the amount they can contribute, depending on the type of retirement plan you have, your employer might be able to increase the contributions it makes on behalf of each employee. Of course, that assumes your company can afford this and wants to do so.

If you're looking for an account to provide additional income in retirement, Keith Downey, a financial advisor with NFP Securities in Laramie, Wyo., suggests you consider a variable annuity or variable life policy. Contributions to both are made with after-tax money. This is invested in accounts managed in a similar style to mutual funds, which means there is market risk. However, thanks to the life insurance component attached to each type of account, any growth or appreciation you get is tax-deferred.

The critical factor in your case is there is no income limit on who can have one of these accounts or how much money you can put in them. There are differences between a variable annuity and a variable life account, so I strongly suggest you work with an experienced professional who can highlight the pros and cons of each. A variable annuity, for instance, generally has a "surrender charge" if you cash it out too soon — generally if you've had the policy less than six or seven years. The big advantage of an annuity is you can choose to "annuitize"— which means the insurance company is required to pay you income for as long as you live.

The downside is when one of the insured parties dies, the life insurance portion is considered taxable income. On the other hand, Downey points out that with a variable life policy, at some point in the future you could "recover your initial investment by taking out a tax-free loan" equal to the amount you put in.

Keep in mind that any loans against the policy reduce the insurance amount. However, a variable life policy which insured both of you would provide additional coverage for the family while your children are young. Years from now, if you take out loans to supplement your retirement income, the reduced coverage might not be a major consideration because the need for life insurance generally decreases once the kids are through college and on their own.

In the meantime, if either of you were to die before then, the life insurance would go to the family tax-free. Downey, who holds two insurance designations — CLU and ChFC — stresses it's important you don't let the policy lapse, so be sure to keep your premiums current.

With either a variable annuity or variable life policy, your ability to draw income will depend upon how well the underlying investments perform. However, you're both young, and while there can be no guarantees, historically, the longer your time horizon, the more likely it is that you'll get at least an average market return.

There's much more positive news when it comes to saving for a child's college education. As you point out, although you make too much to contribute to an Education IRA (a.k.a. "Coverdell Education Savings Account") for your children, there is no income limit affecting contributions to the new 529 college savings plans. Contributions to a 529 plan are made on an after-tax basis. But some states give residents a break on their state income taxes, so check with yours. The money invested in these plans goes into accounts similar to mutual funds. So, again, there is market risk. But you can choose one of the more conservative options in the plan if you're worried about the stock market.

The reason Downey calls 529 plans "fantastic" is that your money has the potential to grow tax-deferred. Starting in January, if withdrawals are used for college expenses, there is no federal tax on the investment earnings.

With these plans, substantial amounts can be socked away — generally more than $100,000 per child. But Downey and others are skeptical this will last for long. "The 529 college savings plan might be too good a deal," he says. "Congress could decide to take it away from higher-income people at some point in the future." (Like they did with tax-deductible IRAs.) The bottom line: if you intend to set money aside for your children's education, take advantage of this while you can!

In the meantime, let your neighbors who work in the federal government know how you feel about their definition of "rich"!

Take care —

Gail

Gail,

I am 57 years old and plan to retire at age 62. Both my wife and can collect Social Security at that time (me at $12,000 per year and her at $8,500).

I am retired from the US Army with an annual pension of $34,000 per year. We have $37,000 in individual stocks and approximately $100K in equity in our house.

I have a 401K account with my employer worth $154,000 and am adding approximately $10,500 each year. Last November, after "losing" on paper my entire contribution for FY 2000, I got "nervous" about the stock market and moved the entire account into the money market option at 5.75%.

My question is this: If my wife and I plan to retire in five years, how should we invest in our 401K plan to our best advantage?

Thank you,

Jim & Elaine

Dear Jim —

As I figure it, when you and your wife retire you will receive $57,500 per year from Social Security and your military pension. Congratulations! That's quite a handsome retirement income.

The first thing you need to do is accept the fact that (assuming you're both healthy) you will probably spend almost as much time in "retirement" as you did working. Perhaps 25 years or more. This means you cannot afford to get too conservative with your investments —including those in your 401(k).

I recommend you start to move your money back into the stock market because the long-term returns there have historically offered the best protection against inflation — a retiree's biggest enemy. Unfortunately, most people don't recognize this until it's too late. In a series of focus groups held around the country, recent retirees said inflation was not a concern; but those retired for several years and living on fixed incomes rated it a major issue — especially with regard to increasing medical costs.

You should probably plan to have all of your money reinvested over the next 6-9 months. Thinking of your investments in terms of 25 years instead of 25 days should help you weather the continued volatility many expect the stock market to have. Your goal is to diversify among both stock and bond offerings in your 401(k) plan. At your age, most advisors would suggest a mix of 60% stocks and 40% bonds. But since you have a generous, stable, guaranteed source of retirement income, you can probably afford to increase your stock exposure.

In the stock section, choose a mix of large and mid-cap stocks and don't forget some international exposure — perhaps 5-10%. In addition, in each category you ideally want to diversify between "growth" and "value" type stock funds. Do the best you can given the limitations of your 401(k) choices.

When you retire, you can roll your 401(k) balance into an IRA and choose from the thousands of mutual funds available. I strongly suggest you sit down with a professional at that point and map out a long-term investment strategy that will enable your income to continue to grow so you don't see your retirement lifestyle decline because of inflation.

Good luck!

Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to moneymatters@foxnews.com along with your name and phone number.

The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.