Create a Personal Pension Plan

(Written August 2009)

“If you ask what is the single most important key to longevity, I would have to say it is avoiding worry, stress and tension. And if you didn’t ask me, I’d still have to say it.” – George Burns

A steady stream of income will go a long way toward eliminating worry, stress and tension in one’s life. The catch however, is how to create a no stress stream of income.

Many people have pensions earned while working for a larger corporation or a government entity. Others choose to buy an immediate annuity. This involves giving an insurance company a sum of money in exchange for a defined period of income. The defined period could be for a short term like 10 or 20 years or for life.

For those of us who do not have a pension and choose to not give up control of our money, one option is to create a personal pension plan. A personal pension is not something you buy, it’s an investing strategy. And if planned properly the income from the personal pension can be tax free!

An individual investor has three choices for saving money. They are tax deferred, tax free and taxable accounts. Tax deferred accounts include IRAs and deferred annuities. There are significant differences between an IRA and a deferred annuity. An IRA is funded with pretax money and the invested amount along with the earnings is taxed upon withdrawal. A deferred annuity is funded with post tax dollars, but the earnings are tax deferred until withdrawal. Tax free accounts are Roth IRAs. With a Roth IRA, the invested money is taxed in the year earned but the growth is not taxed. Both tax deferred and tax free accounts have age limitations and other withdrawal consideration. Consult with your tax professional. The taxable accounts include bank savings account, CDs, money markets, checking accounts and similar type accounts.

How to Create a Personal Pension Plan

During the working years maximize your savings in a 401(k), IRA or Roth account. If you have the 401(k) option, try to invest at least 10-15% of your income. At a minimum, invest at least enough to meet the company’s matching contribution.

If you don’t have the 401(k) option, then your saving choice should probably be a Roth account. You can invest up to $5,000 ($6,000 for 50 & older) this year. You pay tax on the money this year but future earnings can be withdrawn tax free after reaching the age of 59½.

The tax free earnings are significant. For example, a single $5,000 deposit growing at 8% a year for 20 years will create over $18,000 of tax free income. Another example. Investing $5,000/year for 20 years at an average annual growth of 8% will grow to over $205,500. Upon reaching age 59½, this $205,500 could be invested in a combination of government and corporate bonds earning an average return of 6%. This amounts to about $1,025 of tax free income each month. Not bad for a personal pension in which the principal isn’t touched and you don’t have to retire to get it.

Portfolio Organization

When creating a personal pension look at the tax deferred, tax free and taxable categories as a holistic portfolio with distinct parts but coordinated to work together. IRA assets can be withdrawn upon reaching the age of 59½ and reinvested in the Roth account. Or the IRAs asset can be re-characterized into the Roth IRA at any time. Both the withdrawal and re-characterization are taxable events. The Roth account is invested for growth and to create a tax free cash flow. See your tax professional to discuss the re-characterization option.

Portfolio Diversification

An investment portfolio should consist of three distinct allocations of stock funds, bond funds and cash. This applies to 401(k), IRAs, Roth IRA and investment saving accounts. This approach allows for growth and cash accumulation. Stock funds include investments in US and foreign stocks. Stock funds are volatile but over time will be the heavy lifers in a portfolio. Bond funds are the monthly income generators and investors have many choices from high yield corporate bond funds to Government issued bonds both foreign and domestic. Cash has a zero correlation with stocks and bonds and works very well to reduce the portfolio volatility. The allocation percentage is variable and should be discussed with your investment advisor.

Creating growth involves moving a portion of the stock equities capital appreciation into the bond allocation. The remaining portion and any dividends allow for growth in the stock equities. This is taking some of the profits and placing it in a lower risk investment while allowing for growth. Adding equity profits to the bond allocation will increase the monthly income generated by these funds. The bonds can retain the monthly dividends or put them in the cash account.

The cash can be used to adjust the portfolio allocation or possibly flow into another account. For example, the IRA cash could flow into the Roth IRA via re-characterization. Roth IRA cash account being fed by bond funds could create a tax free monthly cash deposit into a money market or checking account. See you tax professional to discuss the tax issues with IRA re-characterization

Creating a personal pension is possible but requires planning and a saving strategy. When is the best time to start planning for a personal pension plan? Today.
© 2009 David Snellen - USA Living Financial Group