Whats An IRA

It’s time for a brief discussion of Individual Retirement Accounts. There is a lot of information available for these, but most of us don’t have the time to read IRS Publication 590. So I’m going to give you a brief summary and some encouragement to look further if you think this is for you.

There are two basic kinds of IRAs: the traditional IRA and the Roth IRA. Contributions to a traditional IRA are deductible from taxable income. Contributions to Roth IRAs are not deductible from income, however the withdrawals from a Roth IRA are not included in taxable income. So here is the dilemma facing many taxpayers: do I establish a traditional IRA or a Roth IRA. There is no easy answer to that question. Let me give you an example to help in your decision making process. Let’s assume you have $2000 to contribute to your IRA. If you contribute the entire amount to a traditional IRA, leave it in the account for a period of years, earning five percent interest, compounded annually for thirty years, then withdraw it and pay the income tax at 15%, the balance after the tax payment is approximately $7,350.00. If on the other hand, you pay the tax first, then put the money in a Roth IRA., when you withdraw the funds they aren’t taxable. And the balance in the account will be approximately $7,350.00. No difference. So how do you make the decision? Well, both accounts have the same contribution limits. But with a Roth IRA you can start with $2,353, pay the tax and be left with $2,000 to contribute. Then, when withdrawal time comes, the balance is $8,643 and none of it is taxable. Another factor in the decision is the tax rate. If you anticipate that in the future you will be in a higher tax bracket, make the Roth IRA contribution this year and take advantage of the lower rate. If, on the other hand, you are in higher brackets now, contribute to a traditional IRA and hopefully you will be in a lower tax bracket later. Anytime you are trying to take advantage of tax rates you are basically guessing, but you’re not alone. Everyone else is guessing, too.

One of the interesting factors here is that you can make contributions to both traditional and Roth IRAs in any one year. The combined contributions cannot exceed the contribution limits established by law. For example, in 2002, the maximum contribution is $3000. Individuals over 50 years of age can make an additional $500 for a total of $3,500. There are no restrictions on how little you must contribute. Just contribute what you can.

Almost everyone is eligible for an IRA. The most important qualification may be that you have to have compensation that is included on a tax return. For IRA eligibility, compensation has a very broad definition. It includes wages, tips and other compensation from forms W-2, as well as self-employment income from schedule C. Commissions are included, as is alimony. What isn’t included is income received from the use of property such as rental income and royalties, income from other retirement plans, and income from partnerships where you don’t perform services for income. The intent here is that you are being compensated for your personal efforts. The amount of your compensation is another limit on how much you can contribute to the account each year. You can go up to the legal limits above or the total of your compensation.

Once you’ve decided that you are eligible, you can set up an account anytime. At the end of the year when you’re doing your tax return, it’s often hard to come up with the entire contribution at once. But you can make contributions anytime up until the original due date of the return or the day you file the return, whichever is earlier. With an IRA, you don’t get the extended due dates. Depending on where the account is established, there are different rules for minimum contributions and other rules as well. If you can’t make the entire contribution in one year, you can’t contribute more in a later year to make up the difference.

I think the most important thing that you have to remember is that once the funds have been contributed to an IRA, either traditional of Roth, the funds cannot be withdrawn without penalty except in certain circumstances. The penalty is 10%. There are several exceptions, the most important are distributions to an unemployed individual to make health insurance payments, distributions due to death, distributions due to total and permanent disability, distributions for higher education expenses and distributions made for the purchase of a first home (up to $10,000). There are other exceptions as well, and your tax adviser can tell you whether you qualify for one of these.

We still have a couple of months before the end of the year. Now is the time to be considering whether or not to set up your IRA. If you need more information, you can send me an email, call or write. But what I’m going to tell you is to talk to your investment adviser about establishing an account. If you don’t have an investment adviser, talk to your banker. He knows the rules and can help. You can move funds later from one account to another as the situation dictates. It’s hard to go wrong in establishing a first account. Where you go wrong is not making the effort.