Retirement Questions and Outrage

Dec. 2, 2008 — -- It's time to respond to the critics, the cranks and the curious.

Each week, readers respond to this column through a comments section that includes derision, outrage and sometimes just plain, simple questions. Most weeks, I scan the comments quickly to see what people are saying and then leave it at that.

This week, I decided to answer some questions and respond to the critics.

Without a doubt, the column that triggered the greatest discussion of late concerned a proposal to shake up the nation's 401(k) retirement plan system. That late October column about Teresa Ghilarducci's proposal to scrap the 401(k) system and replace it with "Guaranteed Retirement Accounts" spurred 103 responses, many of them scornful.

"This is an awful idea," wrote one reader under the name "gotamd." "It will put people's retirement savings under the control of the federal government. Just look at Social Security. It's a ticking time bomb. The government can renege on its commitments and there is no recourse."

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Someone claiming to be a 401(k) administrator added: "To make a long story short, this is the most ignorant proposal regarding savings plans I have ever heard. This is the best time to buy stock in our lifetimes."

But Ghilarducci's proposal triggered its share of support from readers worried, like her, that the 401(k) system may lead to many retirees living in poverty.

"I think it is a great idea," wrote "newamerica1." "If we were all financial geniuses, we'd all be millionaires. Unfortunately, we are not, and most 401k balances are in the toilet, especially because a lot of 401k plans don't offer a whole lot of good investment options, like my company's."

My view on Ghilarducci's proposal? It's not perfect, but it's an idea worth debating. Stay tuned. We've not heard the last of it.

Three weeks ago, I suggested individuals not covered by a traditional pension consider a plan to "buy your own pension" by purchasing an immediate annuity upon retirement.

This drew an objection from "JP Frogbottom," who wrote, "SURE, BUY my own pension. Maybe AIG sells annuities? They have HIGH commissions, high surrender charges and you get TAXED at ordinary income rates when you start to get your money back out. What idiot would want one of these? If you are young, say under 45-50 the stock market is your best long-term place (15 yrs or more) to really earn some money."

In part, I agree with many of the concerns cited by JP Frogbottom but not exactly as he outlined them.

First, yes, AIG does sell annuities through a variety of subsidiaries. But despite the parent company's financial problems, those subsidiaries continue to meet their obligations. Even in the event the subsidiaries encounter trouble, owners of immediate annuities are protected by state guaranty associations that act as financial backstops to troubled insurers.

Second, you do need to be careful when buying an annuity, but it's the variable annuity variety that I'd be most concerned about. Often, variable annuities are incredibly expensive, with their high commissions and surrender charges. Their terms can be quite confusing and seemed designed that way to make it an easier sell for the broker that's pushing it.

In my view, most retirement investors are wise to steer clear of variable annuities.

Immediate annuities, however, I like for their simplicity. You buy a guaranteed stream of income that lasts as long as you do. Yes, as JP Frogbottom states, your annuity income is taxed at ordinary income tax rates, which are higher than the capital gains rate. But the same is true for any withdrawals you make from an IRA, 401(k) plan or other retirement savings account. That's why it's best to use a retirement account to fund the purchase of an immediate annuity rather than a taxable investment account.

Also, this is a purchase I'd suggest for somebody in or near retirement, not for someone with a number of years left to work.

Finally, as I said in the original column, I would not steer all of your retirement savings into an immediate annuity but rather a portion. You want to continue to invest a good share in stocks, bonds and cash to provide growth potential.

Two columns last month looked at ways to use Roth IRAs to mitigate this year's market losses. First, I suggested retirement savers with traditional IRAs consider converting all or part of their accounts to a Roth IRA, which provides for tax-free withdrawals in retirement. The basic reason for this move is that today's lower stock prices mean the taxes owed on such a conversion done now will be lower than a conversion before the big drop.

Last week's column followed up with an explanation of a Roth IRA recharacterization, which essentially is a "do-over" for investors who converted to a Roth and then watched their account values plummet. Without a recharacterization, they would owe tax on the converted amount, not the lower current value.

The discussion of Roth IRAs prompted this question from "countylineman." "I have a question: Is there any advantage to converting an IRA to a Roth a little at a time in order to avoid paying the higher tax bracket rates? i.e., converting $25,000 would be taxed at 15 percent, but wouldn't converting $100,000 be taxed at 15 percent on the first $25,000, and the remaining $75,000 be taxed at 33 percent? So, wouldn't you want to convert only the amount of money at a time that keeps you in the lower bracket?"

Countylineman is correct.

A Roth IRA conversion could push you into a higher tax bracket if it's large enough. For a taxpayer jumping from the 25 percent tax bracket to the 28 percent bracket, it might not be a big deal. But somebody in the 15 percent bracket should be careful, as their next step might be a 10bpercentage-point jump up to the 25 percent bracket. One other warning: You'll need cash available outside your retirement account to pay the tax due on the conversion.

That leads to the final word from "Tired of Idiocy," who pointed to this need when he questioned who has the cash available to pay for a large Roth IRA conversion. Wrote this reader, "Stupid bad advice that helps no one."

Ouch.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com.