The promise of longer life spans brings with it the guarantee that you'll need more money to sustain a comfortable life-style in retirement. The tax law is filled with incentives to encourage and help you save for your golden years. This section focuses on the most popular do-it-yourself retirement plans: individual retirement accounts.
It's no wonder IRAs are so attractive. They strike a blow for two of our most cherished goals: avoiding taxes and providing for a financially secure retirement. When IRAs first became widely available in the 1980s, the accounts were immediately dubbed "everybody's tax shelter." Money deposited in an IRA could be deducted on your tax return, and earnings inside the account were protected from the IRS.
Before moving deeper into the details, pause for a moment to appreciate the glories of the traditional IRA. If you're among the lucky group, every dollar you deposit can be deducted on your tax return. In the 28% bracket, a $4,000 deduction saves you $1,120 immediately—money that would otherwise go to the IRS. (You get this write-off even if you don't itemize other deductions.) An added bonus is that most states bestow similar tax benefits on IRAs. If you live in a state with an 8% income tax and you get to deduct the $4,000 IRA deposit on your state return, you save another $320.
You get a tax break even if you make nondeductible contributions to a Roth IRA. As long as funds are tucked inside the IRA tax shelter, earnings accumulate tax-free. Holding off the IRS gives the power of compound interest added magic.
Consider this example: You put $4,000 aside each year in a taxable investment yielding 8%. Each year, the IRS demands 28% of the earnings and, at the end of 20 years, your account holds a total of $151,662.
Now put that same $4,000 a year in an IRA—traditional or Roth—where growth won't be interrupted annually by Uncle Sam. Assuming the same 8% yield, at the end of 20 years your account will total $197,692. The $46,000 difference is the power of the IRA tax shelter Although all the traditional IRA earnings would be taxable when withdrawn—while the tax bill has already been paid on the non-IRA investment—you still come out well ahead. The Roth is even sweeter, of course: all the earnings inside the tax shelter can come out tax-free.
With those advantages, the decision of whether or not to use an IRA was a cinch—the epitome of a "no-brainer" investment decision. You didn't have to be a financial wizard—or pay one for advice—to understand the value of an IRA deduction or the power of tax-deferred earnings inside the tax shelter. Promoters promised us the chance to retire as IRA millionaires, and millions of us believed. The threat of a penalty if you tap your IRA before age 59 1/2 seemed a small price to pay.
First, consider the rules for what we'll call the old or traditional IRA (both deductible and nondeductible versions) which are still available and then look at the Roth IRA that first became available in 1998. Finally, we'll tackle the really tough question: How in the world do you choose between them?
The old IRA tax shelter is open to anyone under age 70 1/2 who receives compensation, which is earnings from a job rather than income from investments. Income that counts for IRA purposes includes:
Income that does not count as compensation for IRA purposes includes:
The annual limit on IRA contributions is gradually increasing. For 2006, the maximum annual contribution is $4,000 or 100% of your compensation, whichever is less. Thus, if you earn just $1,000, your maximum IRA contribution for the year is $1,000. The compensation limit still stands but the dollar cap will rise to $5,000 in 2008. The limits are even higher for taxpayers age 50 and older. Congress decided to let older taxpayers put away extra for their retirement with something the lawmakers call a "catch-up" contribution. For taxpayers 50 and older at the end of the year, the IRA contribution limit is $5,000 in 2006, $5,000 in 2007, and $6,000 starting in 2008.
There is no minimum age for IRA participation. If your 10-year-old has compensation—from a paper route, say, or from working in a family business—he or she can stash up to the annual limit ($4,000 in 2006) of that pay in an IRA. (The extended period of time such a contribution would have to grow inside an IRA accentuates the power of this tax shelter. A single $4,000 investment at age 10 would grow to more than $275,000 by age 65, assuming an average 8% annual yield.)As explained later, the law demands that you begin withdrawing from a traditional IRA by April 1 of the year after you reach age 70 1/2. That age also brings an end to your IRA deposits. Starting with the year you reach age 70 1/2, you can no longer contribute to your account. By that time you're supposed to be enjoying your retirement nest egg, not continuing to use tax breaks to build it up. For taxpayers born between July 1, 1936, and June 30, 1937, for example, 2006 is the final year for IRA contributions. (Those deposits can be made as late as April 15, 2007 and written off on 2006 returns filed in the spring of 2007.)
There's an exception to the annual limit contribution limit for couples in which one spouse does not have a paying job. You can open an account for a nonworking spouse and contribute up to $4,000 to each of the accounts in 2006. Before 1998, if the working spouse was not allowed to deduct contributions, the nonworking spouse was automatically disqualified, too. Now, however, most nonworking spouses will be allowed to deduct contributions. Also, you may continue contributing up to annual limit of your compensation to a nonworking spouse's account even after you reach age 70 1/2, assuming he or she is under that age.
The government is serious about the annual limits. Excess contributions are hit with a 6% penalty tax. Say, for example, that you work part-time and, expecting to earn more than $4,000 in 2006, you deposit $4,000 in your IRA at the beginning of the year. Because you have a bad year, though, your earnings total just $1,500. Your deduction is limited to $1,500, and the extra $2,500 is subject to the 6% penalty. That will cost you $150. The penalty applies each year until the excess is either withdrawn or absorbed by the unused portion of a future year's contribution. If you qualify for a $4,000 contribution the following year, for example, depositing just $1,500 would absorb the $2,500 excess contribution and avoid another 6% penalty. You could deduct the extra $1,500 in the second year.
It's possible to dodge the first-year penalty, too, by withdrawing the extra money before you file your tax return for the year involved. Because you had not yet deducted the IRA deposit, you don't have to report the withdrawal as income. Any earnings on the extra $2,500 should be withdrawn from the account, too. That amount would be taxed, and if you are under age 59 1/2 at the time, the earnings would also be hit with a 10% early-withdrawal penalty, discussed later.
The deadline for making your IRA contribution each year is the day your tax return is due for that year. That's usually April 15, of course, but it can be a day or two later if the 15th falls on a weekend. If you mail your IRA contribution, you meet the deadline if it's postmarked on the due date.
Although you may be tempted to hold off as long as possible to make your deposit, making it sooner rather than later can pay off handsomely. The earlier you make your contribution, the sooner your money begins earning in the supercharged environment of the IRA, as the following table indicates. In each case, an annual deposit of $3,000 and a yield of 10% is assumed. (Although 10% may seem high considering the lackluster — to say the least — performance of the stock market in recent years, that's still the long-term average return since the 1920s — a period that included the Great Depression.)
Total at end of:
If annual deposit |
If annual deposit made at beginning of year: |
|
Year 5 |
$18,315 |
$20,147 |
Year 10 |
$47,812 |
$52,954 |
Year 15 |
$95,317 |
$104,849 |
Year 20 |
$171,825 |
$189,007 |
Year 25 |
$295,041 |
$324,545 |
Year 30 |
$493,482 |
$542,830 |
Year 35 |
$813,073 |
$894,380 |
Year 40 |
$1,327,778 |
$1,460,555 |
This is one area that the arrival of the new Roth IRA actually simplifies. Nondeductible contributions to traditional IRAs would be an idiotic blunder for anyone who qualifies to use a Roth—and that's almost everyone. As discussed later, the right to use a Roth is phased out—but only as AGI rises between $95,000 and $110,000 on a single return and between $150,000 and $160,000 on a joint return.
Even though Roth contributions are nondeductible, too, the new-style IRA has many advantages over the traditional, nondeductible variety. In rejecting the traditional nondeductible IRA, however, you need to consider just one: Earnings inside a traditional nondeductible IRA will be taxed when withdrawn; earnings inside a Roth can be completely tax free.
The old nondeductible account is such a bad deal in comparison that Congress considered simply abolishing it. Instead, the lawmakers retained it as an option for those whose incomes are too high to use the Roth.
If you used a nondeductible IRA in the past, you're still stuck with all the accounting headaches that go along with it. You must keep track of your "basis" in the account—which is basically the total of your nondeductible contributions—to protect yourself from paying tax on that money again when you withdraw it. Remember, when Congress created the first nondeductible IRA, it forbade taxpayers from segregating deductible and nondeductible accounts and choosing whether to withdraw taxable funds from a deductible IRA or tax-free money from a nondeductible account. Instead, the law demands that an ever-changing percentage of each withdrawal be taxed. You have to determine what's what. Here is how you do that:
1. Find the total amount in all of your IRA accounts at the end of the year.
2. Find the total that you withdrew from the accounts during the year.
3. Add (1) and (2).
4. Find your basis in your IRAs—the total of your nondeductible contributions over the years minus any tax-free withdrawals made in previous years.
5. Divide (4) by (3). That's the percentage of your year that is tax-free. The rest is taxable.
The prospect of that hassle alone was enough to keep most taxpayers away from nondeductible IRAs.
Here's the fly in the traditional IRA ointment, which, because of the confusion it has caused, has led an untold number of taxpayers to stop adding to their IRAs. As one of many ways Congress has concocted to raise taxes without raising tax rates, the law now denies millions of taxpayers the right to deduct their IRA contributions. There are two tests that determine whether you can deduct IRA contributions:
First, are you an "active participant" in a company pension plan? You are, as far as the law is concerned, if you are eligible to participate in any of the following types of plans, whether or not your benefits are vested:
If you're eligible for such a plan during any part of the year, you're considered covered for the entire year as far as the IRA test goes. (If you are in a profit-sharing plan but no contribution is made to your account for the year, however, you are not considered covered for that year.) The Form W–2 you receive from your employer should indicate to you—and the IRS—whether you are an active participant in a company plan.
Note this: If you are married and either you or your spouse is covered by an employer-sponsored plan, both of you are regarded as covered for purposes of this test and your spousal IRA deductions are in jeopardy. Thanks to a change that went into effect in 1998, however, the risk is greatly diminished. In the past, if your spouse's right to the deduction was squeezed by the income test discussed next, so was yours. Now, a much higher income limit (discussed next) applies to spousal IRAs than traditional IRAs, so it's much more likely you'll get to deduct spousal contributions even if your husband or wife is denied the write-off.
If you are not tripped up by the company-plan test, you can continue to deduct your IRA contributions regardless of how high your income is.
If you are covered by a plan, however, a second test will determine whether you can write off your contributions. The traditional IRA deduction is phased out for active participants in company plans whose "modified" adjusted gross income (AGI)—which is basically AGI before subtracting IRA contributions—exceeds certain levels.
Here are the phase-out zones for single and joint returns.
Rising Phase-out Zones for Traditional IRA Deductions
Year |
Single Returns |
Joint Returns |
2006 |
$50,000-60,000 |
$75,000-85,000 |
2007 |
$50,000-60,000 |
$80,000-100,000 |
If your AGI is below the threshold, you can deduct your full IRA contribution, even if you are a member of a company retirement plan. As AGI passes the trigger point — $50,000 for single returns and $75,000 on joint returns in 2006 — the maximum deduction is reduced by $10 for each $50 of additional AGI. (If you exclude from income any interest on U.S. savings bonds used to pay college costs, that amount is included when figuring AGI for this test.) Note that beginning in 2007, on joint returns the deduction will phase out at a rate of $10 for every $100 of income over the trigger point.
Until then, though, AGI of $5,000 over the threshold would cut the maximum annual deduction to one-half of its otherwise allowable amount—to $2,000 in years when the max is $4,000, for example. You could still contribute up to $4,000, but no matter how much you deposit, no more than $1,500 would be deductible. On a joint 2005 return reporting AGI of $75,000, each spouse could write off up to $2,000 of IRA contributions.
There is a $200 floor under the deductible IRA. When your AGI is between $9,000 and $10,000 over the threshold, the permissible deduction stays at $200, rather than sliding to a laughably low $10 before disappearing.
Since 1998, a higher trigger point is used to figure whether spousal IRA contributions are deductible by the nonworking husband or wife of someone who is covered by a retirement plan at work. In that case, the right to the deduction is phased out as AGI rises between $150,000 and $160,000.
You almost certainly will not get an IRA deduction if you and your spouse file separate returns. The phase-out range for married taxpayers who file separate returns is $0 to $10,000, so the right to any IRA deduction disappears when AGI on the separate return hits $10,000. However, if you are married but you and your spouse didn't live together during the year, you are considered single as far as the IRA rule goes.
This retirement savings vehicle is named after William Roth, a senator from Delaware who was a champion of the idea. It's often called a "back-loaded" IRA because the key tax break comes at the end of the line, not at the beginning. Contributions to a Roth IRA are not deductible but withdrawals can be totally tax free in retirement.
In lots of ways, Roth IRAs are the same as traditional IRAs:
In many other ways—beyond the fact that earnings can be tax-free rather than simply tax-deferred—the rules for Roth IRAs differ, and most of the differences work in your favor:
More on these differences and what they mean to you later.
Although higher-income taxpayers can't deduct contributions to traditional IRAs, anyone can use the tax shelter to save tax-deferred for retirement. Not so with Roth IRAs. If your AGI exceeds a certain level, you can't use a Roth IRA—period. Fortunately, the income cut-offs are significantly higher than those that squeeze the deductibility of traditional IRAs.
The right to a Roth disappears as AGI rises between $150,000 and $160,000 on a joint return and between $95,000 and $110,000 on the return of a single person, whether filing as an individual, head of household or surviving spouse. Married taxpayers who file separate returns may not contribute to Roth IRAs, unless the spouses did not live together during the year.
If your AGI on a joint return is $155,000, for example, that's halfway through the phase-out zone, so your maximum contribution would be cut in half: to $2,000 in 2006. If you report $105,000 AGI on a single return—two-thirds of the way through the phase-out zone, your top Roth pay-in for the year would be $1,334 in 2006 (one-third of $4,000). When AGI passes the top of the phase-out zone, you may not contribute to a Roth at all.
Note that these phase-out zones apply whether or not you are covered by a retirement plan at work.
There's another income limit for Roth IRAs, too. If your AGI is $100,000 or less, you can convert your old-style IRA to a Roth, so that all future earnings inside the account would be tax-free. That $100,000 trigger point applies to all kinds of returns, except married filing separately. If you are married and file a separate return, you are forbidden to convert an old IRA to a Roth.
Although rolling old IRA money into a new-fangled Roth sounds great, there's a catch: To do so, you have to pay tax on the amount rolled over—except to the extent, if any, that you have made nondeductible contributions to the old IRA. Say, for example, that your IRA now holds $100,000, all of it from deductible contributions and tax-deferred earnings. To convert that IRA to a Roth, you'd have to report and pay tax on that $100,000 in your top bracket. Ouch!
To encourage taxpayers to make the conversion—and raise revenue to help balance the budget—Congress decreed that those who converted by December 31, 1998, could spread the tax bill on the extra income over four years. (Those who did so paid the last installment of the tax on 2001 returns.) For conversions after 1998, the full amount that is converted must be reported for the year of the conversion. There is no requirement, however, that you convert your entire IRA at one time. You could cover one-tenth of it each year and spread the tax bill over ten years, for example. (Note: Old IRA money that's included in your income doesn't count when figuring whether your AGI is over $100,000 for purposes of whether you qualify to make the conversion.)
You don't really have to take your money out of an old IRA and put it in a new account to get the benefits of a Roth. You should be able to simply direct the trustee of the account to change its designation. By the way, this is not an all-or-nothing deal. If you have several old IRAs, you may convert one or more to Roths and maintain the others.
So, how on earth do you choose between a traditional IRA and a Roth IRA? Which set of tax advantages is best for you? Which tax shelter will help you build the biggest retirement nest-egg? Does it make sense to pay the freight necessary to convert an old IRA to a Roth?
Good questions, and tough to answer.
First, if you have a company retirement plan and your income is too high to deduct traditional IRA contributions, the Roth IRA is a great addition to your retirement-savings arsenal. Fund it to the max if you can afford to.
But what if you can deduct traditional IRA contributions, as more taxpayers can thanks to the new, higher income limits? The Roth has clear advantages, primarily the fact that there's no mandatory withdrawal schedule to worry about and that money in a Roth can go to an heir tax free. Another plus is that there is no way tax-free withdrawals will trigger extra tax on your social security benefits.
What about the financial advantage of getting tax-free versus taxable withdrawals?
Believe it or not, there's no guarantee that—when all else is equal—the Roth will beat the traditional IRA. You need a crystal ball as much as a financial calculator to know whether it makes sense to give up tax deductions today in exchange for tax-free income tomorrow. It really depends on what your tax bracket will be when you retire. If you're in a lower tax bracket, the traditional IRA will prove to have been a better choice; if you're in a higher tax bracket, the Roth will shine.
Again, that assumes that all things are equal and, since rates are scheduled to decrease gradually over the next few years, it might seem that the traditional IRA is the way to go. But there are ways to give the Roth a leg up.
For an apples-to-apples comparison, assume that you deposit $4,000 a year in a traditional IRA and just $3,000 in a Roth—since that's all the IRA really costs you if you're deducting contributions in the 25% bracket. Assuming the money in the accounts earns at the same rate, at the end of any period, the "spendable" amount in the accounts will be identical. Sure, the old, deductible IRA will hold more money. But you'll owe tax on withdrawal. Assuming a 25% rate, the after-tax amount will be the same as the tax-free amount coming out of the Roth IRA.
As noted, however, there is a way to give the Roth a big advantage. Put a full $4,000 into the account each year rather than a stunted $3,000. That costs you more than a traditional IRA contribution, and you'll come out way ahead in the end.
So, if you can afford a $4,000 contribution without the help of a tax-deduction, the Roth will help you grow a bigger nest-egg. Think about it this way: With a traditional IRA, part of the money in your account isn't really yours. It's Uncle Sam's—the tax you did not pay—and he considers part of each year's earning his, too. With the Roth all the money and, more importantly, all the earnings are yours.
Assuming there will still be an income tax when you retire (which is a pretty good bet), how can you know whether you'll be in a higher or lower bracket? You can't. In the past, it was generally assumed that retirees would fall into a lower tax bracket because they'd have less taxable income. Now, however, it's increasingly likely that retirees will maintain their income levels. Ironically, because opting for a Roth will reduce taxable income in retirement, it's more likely that you'll be in a lower bracket (which is a plus for the Roth); conversely, using a traditional IRA will boost taxable income in retirement, possibly pushing you into a higher bracket (which is a minus for the traditional IRA).
Be sure to visit our H&R Block IRA Advisor in the Planning section. In the Planning section select Retirement Planning.
If your AGI is $100,000 or less, you can convert an old-style IRA to a Roth, so that all future earnings would be tax-free rather than simply tax-deferred. Of course, all earnings so far, plus all contributions you deduct in the past, will be taxed at the time of the conversion. But does it make sense to pay a hefty tax bill now to avoid taxes in retirement? The dollars-and-cents answer turns on your tax bracket now and what it will be when you retire.
That win/lose analysis assumes you pay the tax on the conversion with money that's inside the traditional IRA now. If you can pay the tax bill without tapping your IRA, switching to a Roth account can put you far ahead because it lets you keep more money in the tax shelter, where it will grow faster than it would on the outside.
There's a big catch to using IRA money to pay the tax on a Roth conversion, too. If you're under age 59 1/2, you'll have to pay a 10% penalty on the amount that's not rolled over into the Roth or rolled into a Roth and then pulled out to pay the tax. Adding 10% to your tax rate makes it more likely that you'll face a lower rate in retirement—and therefore you'd be better off skipping the conversion.
Be sure to visit our Roth IRA Assistant in the Planning section. On the Review tab, click the Planning button, and select Compare Roth and Traditional IRAs.
You have almost unlimited choices of where to invest, and a slight difference in investment performance can make a major difference in how comfortable your retirement will be.
You can choose a bland—but predictable— investment, such as a bank account, or go for spicy, speculative stock in a new company. You can buy high-grade corporate bonds, zero-coupon bonds or junk bonds. You can choose all sorts of mutual funds, buy into a shopping center or sign up for an annuity contract. About the only place you can't put your money is in collectibles, which the law defines to include art work, antiques, gems and stamps. In the past, the law banned IRA investments in precious metals. An exception was carved out to allow investments in gold and silver American Eagle coins issued by federal and state governments and thanks to another exception, IRA money can now also be invested in platinum coins and in gold, silver, platinum or palladium bullion.
Where you put your money depends in part on your temperament or, put another way, how much risk you can take and still sleep at night. Your age comes into play, too. Someone with decades to go before retirement may choose more volatile investments, figuring there's plenty of time to make up any loss in the early years. (Losses inside an IRA are almost never deductible; the one exception is if cashing in all your IRAs would produce less money than you've invested via nondeductible contributions.) One nearing retirement, on the other hand, may be drawn to investments with guaranteed yields. Even at age 65, though, remember that some of your retirement money could be invested for another 20 or more years.
Whether you use a traditional or a Roth IRA and regardless of how you decide to invest your money, you must do it through a trustee or custodian approved by the IRS. Although you can't be the trustee of your own IRA, you can retain complete total control over the investments inside the account.
There's no shortage of qualified trustees:
When choosing a trustee for your IRA, pay particular attention to the fees charged. Some IRA sponsors offer IRA accounts free, others impose annual fees. Such charges for traditional IRAs are considered miscellaneous itemized expenses, which means you might get to deduct them. But, such expenses can be written off only to the extent that your total costs in that category exceed 2% of your adjusted gross income. To earn a chance at the deduction, you have to pay the fee directly, rather than allowing the sponsor to deduct it from your IRA.
You can have as many IRA accounts as you want. You can use a single traditional IRA for all your contributions over the years, open a different account with each year's deposit or split each year's contribution among several accounts. You can put part of your money in a traditional IRA and part in a Roth. It's up to you, so long as your total contributions for the year don't exceed $4,000 in 2006 (plus catch up contribution if you are eligible). Although the IRS doesn't care how many IRAs you open, trustee fees and bookkeeping chores put a damper on having too many.
Although a key trade-off for the IRA tax breaks is the threat of a 10% early-withdrawal penalty—discussed later— you are not locked into the same investment from the time you put your money in the tax shelter until you retire. You may move your money around freely to take advantage of changes in market conditions or your investment philosophy. There are, of course, rules to be followed. And you don't want to switch your IRA around willy-nilly. Some investments, such as CDs and annuities, can carry early-withdrawal penalties that have nothing to do with the IRS.
Although you can move your money from a traditional IRA to a Roth account—a move that demands you pay tax on the rollover, as noted above—you can't move money from a Roth to a traditional IRA. (You wouldn't want to, of course, since it would entail giving up the tax break on withdrawals.)
Here, assume that you are moving money from a traditional IRA to another traditional IRA, or from a Roth to a Roth. In either case, you have two ways to do it.
This involves telling your current IRA sponsor to transfer the funds to a new account. The sponsor you are switching to should be able and willing to help expedite the move. The first step is to set up a new account for your money to go to. You may have to stay on top of the transfer because institutions giving up IRAs are sometimes less than speedy. Before you begin the process, be sure you know how long it's likely to take and that you understand any exit or setup fees involved.
You can use the direct-transfer method as frequently as you wish, and it is usually the most convenient way to go.
The alternative is to use a rollover. This choice may be quicker, which could be important if you're trying to lock in a certain investment.
With a rollover, you actually cash in one account and personally serve as the go-between, shepherding the funds to the new IRA. Within 60 days of the date you receive the money, it must be reinvested in the new IRA. Miss the deadline and you forfeit the right to a rollover; as far as the IRS is concerned, you have liquidated the IRA. If a traditional IRA is involved, the full amount is taxable (except to the extent it represents nondeductible contributions. If you are under 59 1/2, the 10% early-withdrawal fine will be due, too. If a Roth is involved, the rules are more complicated, but also more gentle.
If you use a rollover, be sure to tell the sponsor you are leaving not to withhold any part of your money for income taxes. Otherwise, 10% of the amount withdrawn will be withheld and sent to the IRS, as though a taxable distribution rather than a tax-free rollover was involved. You won't be able to get your money back until you file your tax return for the year and get a refund of the amount overpaid.
The rollover method can be used only once every 12 months for each account you have. If you have three separate IRAs, for example, you may roll over each of them once a year.
Although the law forbids borrowing against your IRA, the rollover provision offers an opportunity to use IRA money temporarily. You can withdraw funds from the account and use them for whatever purpose you choose—such as a bridge loan when buying a new home, for example. As long as the same amount you withdrew is safely tucked back into an IRA within 60 days, there is no adverse tax consequence. (The money can be rolled back into the same account from which it came.)