Despite the extensive information available from many sources about retirement planning, many people remain puzzled and disconnected from that type of planning. As mentioned in a previous article, there is an abundance of advice being offered by investment professionals, but not as much assistance on getting into and through the process of planning for retirement. And, not surprisingly, the advice being sought is by older people, often within a few years of retirement, when there are fewer planning options. There are some centers or think tanks observing and reporting on the retirement process, notably the Center for Retirement Research at Boston College. And as baby boomers move further toward and into retirement, the topic will be discussed even more. But all this is to say that help of some kinds is available, not that people are taking advantage of it when and to the extent they should. And some good advice and guidance is sandwiched between offers and advice that are too general to be helpful. Psychologists would describe the delay in planning for life after a long career, despite the abundance of help available, with the term avoidance.
At the Saul Ewing firm, we began several years ago to offer programs and advice on retirement planning. Clearly, retirement is not the same for everyone. At one of our recent programs, retired partners spoke on their retirement “lifestyles”. One retired partner, who had worked on corporate transactions for more than forty years, described daily life on the golf course. Another talked about retaining a few clients in the nonprofit sector and working just enough to remain involved and up-to-date on the development of the law. A third focused on family and political interests. Attitudes toward retirement are influenced by attitudes toward work. While nearly all lawyers will say that they are very busy and want to remain so until physically unable to continue, many would benefit from a change or reduction in pace. Many more will find that they are unable to continue working because of family commitments or changes in the economics of legal practice, and some will be asked to make way for younger lawyers. It’s this lack of a definite endpoint for practice that seems to make planning more difficult, and easier to put off.
The process of understanding retirement planning starts with the basic idea that you have to save for a period of time when you will no longer be working, and that you will undoubtedly have such a period of time, when you can’t or don’t want to work, full-time or part-time. Our Social Security system was created to provide a base level of income for those who reached a specified retirement age, and we have been forced to save, over our working lives, to provide those benefits. And once politicians start doing the jobs they were elected to do, the problems (not a crisis) facing Social Security will be resolved. For many people, that will be their only source of retirement income- a very modest form of retirement, but, as we used to say in math class, a non-zero amount. The purpose of this article is to begin the process of understanding issues we will all face in retirement, with some basic rules of retirement income. Having a source of income in retirement isn’t the entire answer to this puzzle; maintaining good health and positive personal relationships are also vital; but having an adequate stream of income is very important.
The Social Security Administration has made an effort to simplify the description of benefits and the application process. Despite these efforts, Social Security is a complex subject. Perhaps the most basic question is, when should I begin receiving benefits? Some people have elected to begin benefit payments at age 62, even with the reduction in benefits resulting from early commencement, on the theory that benefits are less likely to be reduced in future years for those already in pay status. It’s not an argument based in law or regulations, but on a political hunch. More people will wait to receive benefits until the normal retirement age, which for many baby boomers will be age 66. By waiting a few more years, until age 70, benefits are significantly increased. The unanswerable question is, which method works out best for the recipient. Of course, it depends on how long you live. But if you are planning to work until age 66 or thereabouts, and you have enough other income or savings such that you will not need Social Security payments until later years, there is a good rate of return in waiting until age 70. Waiting past age 70 isn’t of much value, though, as the increase in benefits for waiting past that age is far less attractive.
Despite the amount of information available on line and in newspapers and magazine articles, it is probably advisable to obtain personalized advice on this subject. Representatives of the Social Security Administration will meet with you to discuss your options, and you may also use the services of a financial planner, provided he or she has expertise in Social Security. There are some wrinkles to Social Security that repay careful study of the system, such as: if one spouse has retired, but the other continues to work, the working spouse may begin receiving a benefit at that person’s normal retirement age, based on the retired spouse’s benefit amount, without affecting the benefits payable to the working spouse at age 70.
Qualified Retirement Benefits
The term qualified refers to the fact that the retirement plan has satisfied the requirements of the Internal Revenue Code that permit contributions to the plan to be deducted for federal income tax purposes and the buildup of income within the plan to remain untaxed until distributed, which is a valuable wealth-building benefit. In an earlier era, defined benefit pension plans were the dominant retirement planning technique. A benefit was promised, which could be determined under a formula using compensation and years of service as factors. It was then the employer’s responsibility to see that the sum promised was there at retirement. Defined benefit pension plans have disappeared from most law firms and large corporations, and are most frequently observed in governmental employment and union-represented work forces.
Most employers who sponsor retirement plans now use a defined contribution plan. Amounts are contributed by the employer or the employee, or both, and then invested. At retirement, the employee receives whatever amount the contributions have grown to over the years. The risk of failure and the benefits of success are on the employee, not the employer. Within the overall category of defined contribution plans are included 401(k) plans, probably the most popular form of qualified retirement plan today.
The deferred taxation of the buildup of assets within qualified retirement plans is a valuable benefit or, to look at it from the other side of the looking glass, a substantial drain on income tax receipts. The Internal Revenue Code has “hemmed in” the benefit of qualified retirement plans by imposing penalties when those plans are not used as intended. As they are retirement plans, says the Internal Revenue Code, benefits should be paid out at or near retirement. Section 72(t) of the Code imposes a 10% penalty on distributions made before the attainment of age 59 ½. There are exceptions to that rule, such as for distributions after death or disability, or at the termination of employment after age 55. This is a complicated provision, which supports the policy of paying retirement benefits at retirement and not before.
When amounts are paid from a qualified plan, they will be considered ordinary taxable income in most cases. If there are after-tax contributions, they will be received free of tax under a statutory formula. A provision allowing some benefits to be received on a capital gains taxation basis is fading away as more time passes since the enactment of the Employee Retirement Income Security Act in 1974.
At the other end of the spectrum, the authors of the Internal Revenue Code do not want benefits to remain in qualified plans indefinitely. Instead, they should be distributed and taxed during retirement years. If benefits do not begin to be withdrawn by age 70 ½, a 50% penalty may be applied to the “under-withdrawal.” More specifically, benefit payments must begin by April 1 of the year following the year the plan participant reaches 70 ½. After that, benefit payments must continue on a specified basis, tied to life expectancies of real and imaginary persons. (A grandfather provision under the Tax Equity and Fiscal Responsibility Act permits avoidance of these rules, but under rarely achieved circumstances.) From this fairly complex statutory provision have flowed hundreds of pages of regulations, rulings and commentary. Like other provisions of the Internal Revenue Code, a sensible policy has generated an industry of interpretation and planning.
Beginning from rudimentary beginnings as promises to pay retirement benefits out of current income and assets (still the method in a dwindling number of law firms and other businesses), the provision of retirement benefits, whether through Social Security or qualified retirement plans, has become a complex system of laws and regulations, one that rewards careful planning and penalizes the lack of it, either through actual penalties or the loss of tax-saving and deferral opportunities. Navigating and planning for the retirement process includes understanding the ways and times in and at which benefits may be paid, and matching up retirement living decisions to the statutory requirements.
(This article previously appeared in the Legal Intelligencer.)