Broker Check

March 1, 1998

Retirement and Education IRAs

          The Federal government enacted landmark legislation on August 5, 1997 called the "Taxpayer Relief Act of 1997". The provisions of the law sent a message that saving for retirement and education must become a priority for Americans.

          The Taxpayer Relief Act of 1997 is the first major tax legislation since 1981 to create a series of new incentives to save and invest for retirement and education. What can these options mean to you? Effective January 1, 1998, more individuals will have more opportunities to benefit from the tax-advantaged savings of an IRA. You will want to know if you are eligible.

The Traditional IRA
This is the IRA you are already familiar with, but effective in 1998, some significant changes will allow more peple to deduct their annual IRA contributions.

First, the current income limits for taking full or partial deductions from IRAs by individuals who are "active participants" in employer-sponsored retirement plans have been raised.

Starting in 1998, income limits will increase for a fully deductible traditional IRA: $30,000 for single filers, $50,000 for married couples filing jointly. This deduction begins to phase out for single filers with AGI (adjustd gross income) above $30,000 and for joint filers with AGI above $50,000. The limits will increase by $5,000 each year for singles until they reach $50,000 in 2005. For joint filers, the limits will increase $10,000 each year until they reach a ceiling of $80,000 in 2007.

The second change allows spouses who don`t participate in an employer-sponsered retirement plan to take a full $2,000 deductions for their IRAs, even if the other spouse is an active participant in an employer-sponsered retirement plan. The limit for full deductibility is a joint AGI of $150,000 with a full phase-out at $160,000.

Finally, the 10% penalty that applies to most IRA withdrawals before the owner reaches age 59 1/2 will not apply to withdrawals taken for qualified higher education expenses for the taxpayer, spouse, children or grandchildren after 1997, or to withdrawals up to $10,000 (per lifetime) for qualified first home purchases.

The only change for 1997 is that a spouse may contribute up to $2,000 into an IRA even if he(she) stays at home and earns no income. This means jointly a couple can contribute up to $4,000 if their limits are still met.

The Roth IRA
The feature that distinguishes this new plan from the traditional IRA is that while contributions to a Roth IRA are nondeductible, investment earnings aren’t taxed at withdrawal--as long as certain qualification requirements are met. We’ve outlined these qualifications below.

That means millions of taxpayers who don`t qualify for tax deductions under the traditional IRA may now reap the benefits provided by a Roth IRA. Also, the Roth IRA may be appealing to investors who have reached age 70 1/2 and can`t contribute to a traditonal IRA, or are required to start taking minimum distributions from their traditional IRA account.

In order to qualify for a Roth IRA you need to have an AGI of less than $95,000 and a joint AGI of $155,000. Even if you do not qualify, we suggest you fund your child`s Roth IRA as a means of estate planning if your child otherwise qualifies.

Qualified Withdrawals
With the Roth IRA, investors have easier access to their money than ever before. In fact, only two requirements must be met to take a "qualified" tax-free, penalty-free distribution.
          1. The first requirement is non-negotiable: a Roth IRA distribution is
              considered tax-free after the account is open five years. The holding
              period begins with the first tax year the individual made the Roth IRA
          2. The second requirement is that a distribution must meet one of the     
              following criteria:
                  a) distributions are used for "first-time home buyer" expenses-- 
                      $10,000 maximum; or
                  b) distributions are made to the estate or beneficiary due to the death
                     of the Roth IRA owner; or
                  c) distributions are atributable to the Roth IRA owner`s disability; or
                  d) distributions are made after the Roth IRA owner attains age 59 1/2.

Converting to a Roth IRA

          Beginning in 1998, investors (singles and married couples) who earn less than $100,00 can convert their traditional IRAs to Roth IRAs Although the converted amount is not subject to the 10% premature withdrawal penalty, ordinary income taxes will be aplied to any assets that were previously considered "deductible". In other words, any contribuitons that weren`t taxed, will be. The good news is that for conversions completed in 1998, all amounts subject to income tax will be included in income ratably over four years (1998 through 2001).

          When an IRA is converted into a Roth IRA, the "five-year holding period" begins with the tax year that the conversion was made. Since a conversion is actually a "rollover", as with any other IRA rollover, the conversion must be completed within 60 days of the distribution from the traditional IRA.

The Education IRA

          This is the other "new IRA". However, unlike the other two plans in this class, the Education IRA is not a retirement savings vehicle. Rather, it`s a plan targeted at saving for a child`s higher education--college tuition, books, room and board. This new plan offers parents, as well as children, a concrete solution to the problem of paying for the high cost of college and graduate school.

          The Education IRA allows parent, grandparents relatives and friends to make total nondeductible contributions of up to $500 annually for a child under the age of 18. While a child may have multiple IRAs, there can only be $500 in total in any one year contributed per child. Contributions are not permitted after a child`s 18th birthday. In addition, the IRA savings must be used by the time the beneficiary is 30, or may then be rolled over to an Education IRA for another eligible beneficiary in the same family.

          Withdrawals from an Education IRA used to pay for qualified higher-education expenses such as room, board and tuition are generally tax-free. However, distributions of income from the account are included in income for tax purposes and are subject to the 10% additional penalty if they are not used for qualified higher education expenses.

          Who`s eligible for an Education IRA? Singles with earned income below $95,000 or married couples filing jointly earning below $150,000 are eligible to make a full contribution. The maximum contribution that can be made to an Education IRA phases out for singles with AGI between $95,000-$110,000 and joint filers with AGI between $150,000-$160,000.

Government Repeals the "Success Tax"

          There is no longer a 15% excise tax on excess distributions or excess accumulations in tax-advantaged retirement accounts and pension plans. This tax was dubbed the "success tax" because it penalized those who succeeded in building up sizeable retirement account balances. The repeal is effective for excess distributions received after December 31, 1996 and excess accumulations as of December 31, 1996. That means beginning with your 1997 tax return, many of you can keep more of what you`ve earned.

Are you better suited to open a traditional IRA or a Roth IRA?

The traditional IRA may be a better alternative for...

  1. Individuals who expect to be in a lower tax bracket when they retire. The benefits may include an immediate tax break because contributions are deductible.
  2. Individuals with current financial constraints who could benefit from an immediate tax deduction. 
  3. Individuals who were not previusly eligible for a deduction because they or their spouses were covered by an employer-sponsered retirement plan.

The Roth IRA may be a better alternative for...

  1. Individuals who expect to be in a higher tax bracket when they retire. The after-tax contributions of a Roth IRA may provide a larger nest egg, because earnings are tax-free. These people might include young professionals who are likely to earn and save a lot for retirement. Again, age can be a deciding factor. The longer an account had to accumulate and compound before withdrawals are made, the ore sense a Roth IRA makes, since qualified withdrawals are tax-free once the account has been opened for at least five years.
  2. Individuals who expect to be in the same tax bracket when they begin to make withdrawals from the account as they are now. Assuming the account continues to grow over time, you will pay less tax now on contributions than on a larger account value in the future.  

    For example, let`s assume an individual who remains in the 28% federal tax bracket earns 8% annually in a tax-advantaged IRA. Over ten years, a $2,000 contribution in a Roth IRA will grow to $4,318--tax-free, while a traditional IRA will net only $3,109 once taxes are paid. Even if the tax savings earned from the contribution to a traditional deductible IRA were invested in a taxable account earning 8%, the tax-free advantage of the Roth IRA still wins out. 
  3. Many middle-income and upper-income taxpayers who could not make deductible IRA contributions because they are covered by a company retirement plan.
  4. People who already have traditional IRAs, but expect to remain in high income-tax brackets after retirement. They might benefit from a conversion into a Roth IRA.

Should you roll your assets from an existing IRA to a Roth IRA?

          The answer depends on whether it`s worth it to you to pay income tax now in return for tax-free withdrawal of earnings later. Some points to consider include:

  •  Do you expect to be in a higher or lower tax bracket when you retire?
  • How many years will you be investing in your traditional IRA before retirement?
  • Can you afford to pay tax on the rollover without dipping into the IRA?

          We suggest if you want to inquire or proceed further to call Howard Lisch.