by Margaret Upsala
IRAs are still a great investment, just made a little more complicated though the helpful working of Congress.
Back in the 1970s, Individual Retirement Accounts were pretty simple: Put in up to $2,000 a year, take a tax deduction for your contribution, and watch your earnings grow, untaxed, until you were between the ages of 59½ and 70½. At that point, you had to start taking out the money, which would be taxed as ordinary income. Practically everyone agreed that IRAs were one of the best deals for ordinary people ever to come out of Washington.
Over the years, Congress has kept tinkering, trying to make IRAs better than ever. As a result, there is now a Traditional IRA, Non-Deductible IRA, Spousal IRA, Roth IRA, and Education IRA, each with its own regulations, limitations, and prohibitions. “The rules are much more complicated than they should be for something that is supposed to be the common man’s retirement plan,” says Peter Wheeler, a certified financial planner, chartered life underwriting and financial consultant with Wheeler Frost Associates in San Diego.
The IRA described at the beginning of this article is knows as a Traditional IRA. The rules remain basically the same, except that people who also participate in a retirement plan, such as a 401(k) at work, can deduct IRA contributions only if their adjusted gross income is less than $31,000 for a single person or less than $51,000 for a married couple filing a joint return. The deduction phases out between $31,000 and $41,000 of adjusted gross income for a single person and between $51,000 and $61,000 for a couple filing jointly, assuming both work and both participate in an employer-sponsored retirement plan. (If only one participates, the nonparticipants’s IRA contribution is fully tax deductible when joint adjusted gross income is less than $150,000 and is partially tax deductible to $160,000.) Contributions above all these levels are permitted but are not tax deductible, so folks investing on this basis are said to have Non-Deductible IRAs.
One recent rule change affects stay-at-home spouses. Previously, a nonworker had limited IRA options, but now he or she can put up to $2,000 a year into what is sometimes called a Spousal IRA. The contribution is fully deductible if the couple’s adjusted gross income is less than $150,000 and partially deductible to $160,000. This has created a nice little tax benefit for a lot of families,” Wheeler observes.
The Roth IRA, which took effect in 1998, offers a clear alternative to the Traditional IRA. For the moment, the maximum contribution to either program is $2,000 a year (although there is talk in Congress of increasing both amounts to $5,000 per person). Earnings inside both IRAs are not taxed, and penalties apply in both programs for early withdrawals. But there the similarities end. Constrictions to a Roth IRA are not deductible but withdrawals are not taxed, whereas contributions to a Traditional IRA are deductible (to certain income limits) but withdrawals are taxed.
Financial planners often suggest putting new IRA contributions into a Roth. “You give up the one-time tax deduction at the beginning in favor of years of tax-free distributions on the back end. It’s like asking a farmer, “Would you rather pay taxes on the seed or on the crop?” says David P. Robinson, a certified financial planner, credited asset management specialist, and president of Recourse Consulting Group in Austin.
Both IRAs also let you contribute longer (in a Traditional IRA you must stop at age 70½ but a Roth IRA has no age limit) and postpone distributions indefinitely if you wish (in a Traditional IRA you must begin taking distributions by 70½). “A Roth lets you keep putting money in and never take anything out, which makes it an excellent place for assets that you want to transfer to the next generation,” says Kathleen Rehl, a certified financial planner in the Tampa suburb of Lutz.
Anticipating the Roth IRA’s popularity, Congress made it possible for anyone in a Traditional IRA with an adjusted gross income of less than $100,000 to convert penalty-free to a Roth IRA. However, income tax on the amount transferred is due in the year of conversion. When does conversion make sense? “Generally, the longer you intend to leave the money alone and the lower your present tax bracket, the more attractive conversion becomes,” Robinson reports.
Several mutual fund companies and brokerage houses offer conversion comparison worksheets to see whether switching from a Traditional IRA to a Roth IRA makes sense in your own circumstances. One easy to use free program is available on the Strong Funds Web site. (www.strongfunds.com).
The Education IRA is perhaps the most controversial IRA program. It allows parents and others to contribute a total of $500 a year per child under 18, to be used for certain higher education such as costs as tuition and books. Contributions are not tax-deductible, but funds spent properly are never taxed. However, anyone who has not used all the money for education by age 30 must either pass the remainder along to a younger sibling or pay income tax plus a 10 percent penalty on whatever is left.
“An Education IRA can hurt a child’s chances of getting loans and scholarships,” Rehl cautions. The IRA will reduce the amount that financial-aid officers figure a student needs to attend their school. “If the parents put the money into their own Roth IRA instead, it won’t count on financial aid forms at all because it is their retirement asset. Then the parents can take it out of the Roth with no penalty and no tax problem because they’re using it for an educational purpose.” Rehl adds.
This curious provision exists in both Traditional and Roth IRAs. You can withdraw funds up to certain limits without penalty, even before age 59½ for non-retirement-related activities such as higher education, health insurance if you are unemployed, and buying a first home. As always, withdrawals from Traditional IRAs are taxed, while those from Roth IRAs are not. However, financial planners generally oppose such early withdrawals. “Long-term accumulation, not short term needs, is the only reason to put money into an IRA in the first place,” Wheeler says.
Note: The information in this article is intended to be general in nature. Obtain specific information about IRAs from a qualified financial professional.
Reprinted from Spirit magazine
(Note: The information in this article is intended to be general in nature. Plan to discuss your particular circumstances with an attorney for how this might apply to you.)
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