The almost annual changes to the income tax laws have created confusion
about Individual Retirement Accounts (IRAs). This confusion has caused many
people to ignore one of the most powerful tools available to help them secure
a solid financial future.
Even with all the changes, IRAs can and should be a key part of the
foundation of most people's retirement planning efforts. Here are some of the
facts you should know to help you make fully informed IRA decisions.
1. The annual contribution limit was $3,000 for 2002 through 2004
contributions. For 2005, 2006 and 2007, the annual contribution limit is
$4000. The only requirement is that you have at least that much income from
wages or salaries.
2. Beginning with 2002 contributions, individuals ages 50 and older are
able to make catch-up contributions. These additional contributions can be up
to $500 for years 2002 to 2005 and up to $1000 after that.
3. Your contribution to a "regular IRA" is tax deductible if you
are not a participant in your employer's qualified retirement plan. If you are
a participant in a qualified retirement plan, the deductibility of
contributions to regular IRAs is determined by your adjusted gross income.
For married couples filing a joint return the deduction is phased out at
income levels of $65,000 to $75,000 in 2004. For single filers, the phase out
is from $45,000 to $55,000.
4. Earnings on funds within an IRA are not subject to income tax as they
are earned. Tax deferral allows for the funds to accumulate faster. With a
"regular IRA" earnings are taxed when withdrawn from the IRA.
5. IRAs were established to be long-term retirement planning accounts. As
such, the IRS imposes a penalty tax of an additional 10% if funds are
distributed before reaching age 59 ½. There are a few exceptions to
this rule including a first time home purchase.
6. If you have established IRAs at different institutions over the years,
you can consolidate them into one account to make it easier to keep track of
your funds. If done properly, there are no income tax consequences to this
consolidation.
7. IRAs can serve as the account to receive a distribution from your
employer's qualified plan when you change employers or retire. Tax deferral
is maintained and you may have additional investment flexibility.
8. You must begin taking distributions from a regular IRA at age 70
½.
Roth IRAs
A few years ago, a new type of IRA was created that has become an
attractive alternative to the "regular IRA." This new "Roth
IRA" (named after the Delaware senator) has the same $3,000 annual
contribution limit for 2003 and 2004 and the same tax deferral benefits on
earnings within the IRA. Similar to regular IRAs, catch-up contributions are
allowed.
The biggest differences are that the contributions are not tax deductible
and that distributions are not subject to income tax. The other large
difference is that there are some income limits for Roth IRAs. Single filers
can make full contributions if their income is below $95,000 and joint filers
can make full contributions if their incomes are below $150,000. Partial
contributions are allowed up for single and joint filers up to $110,000 and
$160,000 respectively. Contributions are not allowed for those with incomes
above those amounts.
When comparing regular and Roth IRAs, the trade-off is usually whether the
loss of deductibility on current contributions is worth the benefit of never
having to pay income taxes on the future earnings of the funds within the
IRA. Roth IRAs also provide more distribution flexibility. For many, the Roth
IRA can result in superior long-term benefits.
Some General Guidelines
1. If you can afford it, contributions to both an IRA and a 401(k) plan can
help you accumulate funds faster. If you can only do one, probably the 401(k)
should be chosen because of possible employer matches and deductibility of
contributions.
2. The value of the tax deferral on earnings within a regular IRA increases
the longer the funds are in the IRA. Non-deductible contributions to a Roth
IRA should be considered carefully.
Special rules cover the conversion of regular IRAs to Roth IRAs. The
advantages can be large but there will be a current tax liability. Be sure to
consult with a qualified advisor for an evaluation.
