INDIVIDUAL RETIREMENT ARRANGEMENTS

What is an Individual Retirement Arrangement - or IRA? Notice it's called an ARRANGEMENT. An IRA is not an "account". You cannot buy one. You cannot invest in one. What is it, then? When you make an investment and you want the TAX TREATMENT allowed by the tax code for IRAs, then the money you put in and the earnings you earn will be taxed in accordance with the IRA tax rules. So, an IRA is a way to define the tax treatment of investments and their earnings and is, therefore, intended to be an investment to be used to build a so-called retirement nest-egg.

There are, currently, three ways to get IRA tax treatment of investments:

Deductible Contribution IRA
Non-Deductible Contribution IRA
The Roth IRA

A deductible contribution IRA means that, if you meet certain limits of income, all or part of the annual contribution limit is deductible toward the adjusted gross income (AGI) amount on your federal income tax return. That is, it is a reduction of the AGI amount. In addition, all of the earnings, regardless of source, will not be taxed until the money is withdrawn. We would be happy to give you numbers for the income limits, but as soon as we would, Congress would change them and many of them change each year for inflation effects, also known as indexing. Any good tax advisor can get you these and many of the websites on our LINKS page will have them. Therefore, all things being equal, if you have already done as much you can to maximize your 401(k) contribution (see our page on this subject), the next step, money permitting, is to make contributions to a deductible IRA.

If your income exceeds the limits for deductibility, you still may make contributions but they will not be deductible from gross income. The earnings will still be allowed to accumulate tax-deferred, just as in the deductible IRA. In addition, you are required to file IRS Form 8606, telling the IRS the amount you contributed. This is one of your last resorts for any tax deferral treatment if you are not eligible for a deductible IRA or a Roth IRA.

The Roth IRA was created with the Taxpayer Relief Act of 1997 (That name is a sad sorry joke!!). This baby has the potential of making a lot of money for people who can take advantage of it. The younger you are, the more of an advantage this IRA can be. Again, if you meet certain income limits, and the rules are way more generous than the other IRAs, you can make non-deductible contributions to a Roth IRA. All the earnings and all the money you put in comes out in retirement with NO TAX DUE!! You just need to be in the IRA for five years and be 59 1/2 years old when you start making withdrawals.

Great!! I've invested in these IRAs and now I want to retire. What's going to be the tax bill? If it's a ROTH, and you started it five years ago or more, AND you are now at least 59 1/2 years old, all the money you take out will be tax-free. Of course, in a Roth, you can take out the contributions you made at any time, since they have been already taxed. If it was a deductible IRA, then all the money you take out each year will be subject to tax. If it was a non-deductible IRA, then you have a computation based on the amounts in the IRA that are contributions and earnings. If you have more than one IRA, or commingled deductible and non-deductible contributions, you have a nightmare of tax math that we suggest you take directly to a trusted tax advisor...do not pass GO...etc...

Then there's the whole issue of ROLLOVERS. It means taking money you have in one IRA and putting it in a different one. Or, taking money you have, say, in a 401(k) plan at a former employer and putting that into an IRA. You can do all this, but you must keep your eye on the tax ball (uh...bill) or you can get some nasty surprises. Here's some possibilities:

Roll a traditional IRA over into a Roth.
Roll a 401(k) or other tax-deferred plan over to an IRA
Roll an existing IRA over to a different custodian (That's the guy who holds the money and does all the reporting to the IRS)

Here's some questions you must consider in making the rollover decision:

Can you pay the taxes due on a Roth rollover without using money from the IRA you're rolling over? This is easier to answer if the IRA was funded with nondeductible contributions. Most of the money rolled will not be taxed since it was already taxed before the contribution was made.
When are you retiring? If it's soon, you will have a good idea what your tax bracket will be in retirement. If you don't need the income now, rolling the money will relieve you of the regular IRA's requirement of forced withdrawals after age 70 1/2. There is no requirement to ever take any money out of a Roth. Just remember that you must have had the Roth for at least five years and be 59 1/2 years of age when you do take money out of a Roth.
What will your tax bracket be in retirement? This is a major issue. If you really expect that retirement tax brackets will be lower, it doesn't pay to roll now and pay higher taxes now, instead of lower taxes later.
Are there estate planning issues? A Roth is a good tool for passing money on to susequent generations. If you pay taxes now on a rollover, then your heirs will not have to when the Roth passes to them. Check with your estate planning experts on this to make sure you also take advantage of the estate tax exemption rules.
Will you collect Social Security? The money you withdraw from IRAs may or may not cause tax problems depending on the taxable portions of the money coming out. This could affect the taxability of Social Security income. Sit down with your tax advisor to sort it all out and do all the math.

This is obviously a complex area, but we don't have to be intimidated by it. If you don't trust your own understanding, then you have to trust someone else's. Check out some of the links we have provided. Ask your friends and co-workers. And, of course, have the best and most satisfying retirement possible. We do now!!!

Rainbow

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INDIVIDUAL RETIREMENT ARRANGEMENTS

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