Navigating the Retirement Maze, Part II: IRAs

By Scott Hill C.P.A.

In my last column I talked about the advantages of company-sponsored 401(k) plans. But suppose your company doesn’t offer such a plan? Or maybe you’ve maxed out your annual contributions to the 401(k) and you still want to put more tax-advantaged money away. The much-misunderstood IRA may be the answer.

The "Traditional" IRA

Long ago, in a simpler time, IRAs were an easy way to save for retirement while gaining a double-edged tax benefit. Anyone could put up to $2,000 a year (as long as they had at least $2,000 of earned income) into an IRA account with a bank or investment firm. They received a $2,000 current tax deduction plus their money compounded tax-deferred over the years until they drew it out sometime after age 60. Even though they had to pay taxes on the amounts withdrawn, the benefits of many years of tax deferral made it a very wise way to save for retirement. And it still is. But it’s not so simple any more.

Beginning in 1987, the tax law was changed to limit the amount a taxpayer could deduct. Unfortunately, they’ve been tinkering with it ever since. Contrary to popular belief, there has never been a limit on how much you can contribute to an IRA (other than the original $2,000 per year). I don’t know how many times I’ve heard clients say "I’d contribute to an IRA, but the government won’t let me because my income is too high." Not true. If you are covered by an employer-sponsored retirement plan, you may not be able to get a current-year tax deduction for your IRA contribution, but you can still get the immense benefits of tax-deferred growth.

Time to clear up one more oft misunderstood aspect of IRAs. An IRA is not a type of investment. "How much are IRAs earning now" is not a valid question. IRAs don’t earn anything; the investments held in the IRA account are the things that earn. The IRA is a vehicle for those investments. It is a way to make otherwise taxable investments (like stocks, bonds and CDs) grow tax-deferred or even tax-free.

The Roth IRA

The Roth IRA is the newest kid on the block. For those who can’t deduct traditional IRAs because of income limitations, the Roth is great. Not everyone is eligible for the Roth, but the income limits are much more liberal than the deductible traditional IRA. This is how a Roth IRA works: you contribute up to $2,000 a year to a Roth IRA account. The contribution is not deductible, but the money you take out of the account after age 60 is tax-free. The $2,000 you deposit in a Roth in 1999, invested wisely, could easily grow to, say, $14,000 over the next 20 years (remember, it’s also compounding tax free). And none of it is taxable when you take it out.

The SEP-IRA

For the self-employed, there is yet another type of IRA available: The SEP (Simplified Employee Pension) IRA. In a SEP, you are allowed to contribute up to approximately 12 % of your net self employment income to an IRA, with a maximum yearly contribution of approximately $24,000. The "approximates" are because of an arcane formula used to compute the percentage and annual indexing of the maximum. But you get the idea. Before you actually set up a SEP-IRA, consult your accountant or financial planner to get the particulars. Like the "traditional" IRA, investments in a SEP grow tax-deferred and are taxed when they’re distributed.

Which type of IRA is Right for You?

Depending on your individual set of facts and circumstances, any one (or even a combination) of the different types of IRAs could be the best choice for you. Generally speaking, if you are not covered by a company pension plan, a traditional, deductible, IRA is probably your best bet. If you can’t deduct a traditional IRA, then a Roth is the ticket (if you qualify). If you are self-employed, a SEP-IRA would be your first choice. You could then also contribute to a Roth, if you qualify, or a nondeductible traditional IRA, if you don’t qualify for a Roth.

One more warning, then I’ll shut up: Unless your situation is clear cut, consult a tax accountant or a financial planner before committing to a particular type of IRA. If you put money into a type for which you don’t qualify, or you put too much in, the IRS could hit you with heavy penalties. But if you do things right, you can save a significant amount of money in taxes and build a sizable nest egg for your retirement.

Till later,

Scott

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Prior Months Articule: Click link below to view.

Navigating the Retirement Saving Maze: 401(k) Plans

Bio:

Scott Hill is a certified public accountant in Norcross, Georgia. He holds a Masters of Accounting degree and has over 18 years of experience. His firm, Scott Hill and Company, P.C., concentrates on accounting, income tax and financial planning for individuals and small businesses.

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