When it's time to retire
Social Security has traditionally been regarded as the first of the three-legged stool upon which retirement income rests. Historically, Social Security has provided less than half of retirees' monthly income.
The second leg is private employer-sponsored pension plans. These provide less than a quarter of retirees' monthly income.
The third leg is personal savings and retirement funds. These will generally supply the balance of retirees' monthly income. One of the best programs available for building tax-deferred retirement funds is the Individual Retirement Arrangement accounts (IRAs).
Traditional IRAs
An IRA is not, in and of itself, an investment. It's merely a tax shelter into which investors put their investments. Although IRAs can contain a wide variety of investment instruments of investors' choosing, they are individual and should not be for the benefit of more than one person.
IRAs are personal savings plans that allow investors to set aside money for retirement, while offering tax advantages. Amounts in traditional IRAs, including earnings, generally are not taxed until distributed to investors.
To contribute to traditional IRAs, investors must be under the age of 70 1/2 at the end of the tax year and have taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment.
The most investors can contribute to traditional IRAs for any year is $3,000 (for 2002 through 2004). If an individual or spouse is an active participant in a qualified employer-sponsored retirement plan, the $3,000 IRA deduction is phased out once the annual adjusted gross income for joint filers exceeds $54,000 and $34,000 for single filers (for 2002).
The phase out limits will gradually increase through 2007 to a maximum of from $80,000 to $100,000 for joint filers and through 2005 to a maximum of between $50,000 and $60,000 for single filers.
If only one spouse is covered by an employer retirement plan, then the other spouse's IRA contribution is fully deductible if the annual adjusted gross income is below $150,000 and is subject to phase out if the adjusted gross income is between $150,000 and $160,000. No deduction is allowed for over $160,000.
Beginning in the year 2002, taxpayers age 50 or over who have earned income can contribute an additional $500 annually above the contribution limit. In 2006, this amount will increase to $1,000.
A priority for all investors should be to fund fully their IRAs each year, but only if (1) investors have paid off all credit card debt and other consumer debt; (2) have an emergency reserve equal to three to six months' income set aside in an interest bearing account; and (3) neither investors nor their spouses are active participants in pension plans at work. If they do not have such plans, IRA contributions can be tax deductible.
Amounts withdrawn from IRAs are fully or partially taxable as ordinary income in the year withdrawals are made. If only deductible contributions were made to IRAs, withdrawals are fully taxable. If nondeductible contributions were made, only the earnings on the contributions will be taxed.
Investors must begin withdrawing money from traditional IRAs by April 1 of the year in which they turn age 70 1/2. After age 70 1/2 if investors take less than the required amount, they must pay a penalty of 50 percent of the balance between what was taken and what was required.
For withdrawals before age 59 1/2, investors must pay a penalty of 10 percent. The following are exceptions to the 10 percent early withdrawal penalty.
- The penalty will not apply if investors are disabled.
- The penalty will not apply to heirs if investors die before age 59 1/2.
- Investors can choose to withdraw through the substantially equal periodic payment method in which annual withdrawals are made based on life expectancy, similar to an annuity. If this method is selected, withdrawals must continue for at least 5 years or until the investor reaches age 59 1/2, whichever is a longer period of time.
- The penalty will not apply if withdrawals are used to pay for medical expenses that exceed 7.5 percent of adjusted gross income.
- The penalty will not apply if withdrawals are made by investors who have been unemployed for at least 12 consecutive weeks and if withdrawals will be used to pay health insurance premiums for self and family.
- The penalty will not apply if the withdrawals are used to pay for post-secondary education expenses (not living expenses while attending school but the actual educational expenses).
- The penalty will not apply for first home purchases—$10,000 lifetime maximum and subject to IRS requirements.
Roth IRAs
In addition to a conventional IRA, investors might want to consider setting aside at least 5 percent of take-home pay (after tithes and taxes) for retirement investing that is not tax-deferred. Part of that plan may be accomplished through Roth IRAs.
The Roth IRA is particularly attractive to investors who fear that their tax liability at retirement may be higher than their tax liability presently. In effect, the Roth IRA allows investors to “lock-in” their tax rate today.
On the other hand, if investors expect their tax liability to be lower when retirement withdrawals begin, traditional IRAs could save more in taxes both today and at retirement.
Contributions to Roth IRAs do not qualify for up-front tax deductions because contributions are made with after-tax dollars. However, no taxes will be owed when the funds are withdrawn because taxes will already have been paid on the money contributed.
Nevertheless, investors can withdraw both contributions and their earnings from Roth IRAs, tax free and penalty free, if accounts have been established for 5 years or more. If the Roth IRA is less than 5 years old and the investor is under the age of 59 1/2, an early withdrawal penalty of 10 percent will apply.
Contrary to traditional IRAs, there is no age limit on Roth IRA investing, which means that contributions to Roth IRAs can be made after age 70 1/2. Investors may contribute to Roth IRAs as long as they have earned income and a modified adjusted gross income below $95,000 for joint filers and $150,000 for single filers.
In addition, investors are not required to take minimum distributions. If it is not needed, money can continue to grow in a Roth IRA. However, like traditional IRAs, contributions to Roth IRAs cannot exceed $3,000 per tax year.
Conclusion
Most financial planners agree that IRAs are excellent tax shelters. If there is no other retirement plan available to investors, such as a tax-sheltered annuity or pension and profit-sharing plans, the IRA is a good alternative.
IRAs help in sheltering income, and traditional IRAs are allowed to accumulate tax free; thus, it is a good savings plan, as well as an eventual supplement to Social Security.
For the most accurate information concerning IRA investment options, we suggest that investors consult with a trusted financial planner for guidance. For additional information concerning tax implications regarding IRAs, see IRS Publications 17, Your Federal Income Tax for Individuals; 590, Individual Retirement Arrangements (IRAs); and 553, Highlights of Tax Changes.
