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It's Time to Think About Taxes
Which Means
It's Time to Think About IRA's

by Richard P. Halverson

The government want's you to save for retirement. To encourage you the government, in its benevolence, has established savings programs that allow you to save more of your money for you and send less of it to the government for them. Among the programs are the Individual Retirement Account or IRA and the Roth IRA. IRA's are a good idea for ordinary people. Unfortunately, because they are created by the government there are all kinds of rules and restrictions that sometimes make it harder than it needs to be to understand and use IRA's. But don't let the rules discourage you. There aren't a lot of tax shelters available to ordinary taxpayers (beyond kids, mortgages and tithing, that is). The IRA is one. One of the taxpayer friendly rules Congress established is that contributions for last year (2003) can be made up to the time you file your taxes, as late as April 15, 2004. That is why it is time to think about an IRA. You should take advantage of it.

Traditional vs. Roth IRA Comparison

IRA's have been around for decades. IRA's have significant tax advantages. Because of the tax advantages IRA's have always been a superior way to invest money versus investments in fully taxable accounts.

Because IRA's are a creation of the government, congress has found itself unable to resist meddling with them all the time. So, the rules keep changing. In 1998 congress added the Roth IRA and the Education IRA to the traditional IRA. Financial planners have heralded this legislation, particularly the creation of the Roth IRA. I'm happy for the legislation too. It does some good things for people. Unfortunately, it also complicates the entire picture tremendously.

The legislation is supposedly aimed at helping ordinary Americans. Regrettably, ordinary Americans can't understand it without the help of professionals. I believe congress could have written a law that simplified things. For example, I see no reason at all why we need a traditional and a Roth IRA or why these need different definitions of income or why there needs to be differing levels of qualifying income, etc. Both traditional and Roth IRA's have the same basic goal i.e. encourage retirement savings by offering tax incentives. But each has its own set of rules, restrictions, benefits and failings. Talk about financial bafflegab. No wonder the financial planners are ecstatic. Instead of the Taxpayer Relief Act congress might have called it the Financial Planner Full Employment Act.

Here is a summary of the basic characteristics of each.

Traditional IRA	Roth IRA
Maximum contribution is $3,000 or $6,000 for a married couple. Traditional and Roth IRA's are combined for this limit. If you are over 50 the amounts rise to $3,500 and $7,000.	Maximum contribution is $3,000 or $6,000 for a married couple. Traditional and Roth IRA's are combined for this limit. If you are over 50 the amounts rise to $3,500 and $7,000.
Eligibility to participate is substantially influenced by whether or not you are covered by a retirement plan at work.	Eligibility is not influenced by whether you are covered by a retirement plan at work.
Income is a factor in determining eligibility.	Income is a factor in determining eligibility.
<Contribution is deductible from current income thus reducing current income taxes.	Contribution is not deductible from current income thus it does not reduce current income taxes.
Earnings on investments are not subject to current income taxes.	Earnings on investments are not subject to current income taxes.
Qualified withdrawals are subject to income taxes. (Comment: This means the tax savings associated with the contributions and earnings over the years are deferred but they are not permanent.)	Qualified withdrawals are not subject to income taxes. (Comment: This means the tax savings associated with the earnings over the years are permanent.)
May begin qualified withdrawals at age 59 ½.	May begin qualified withdrawals at age 59 ½ and the account has been funded for 5 years.
Withdrawals must begin by at least age 70 ½. At that time withdrawals can either be spread out over the life expectancy of the participant or taken as a lump sum. (Comment: The theory is the individual will withdraw all the money in his/her lifetime and pay taxes on it.)	There is no maximum age at which withdrawals must begin. The earnings can continue to accumulate tax-free until death. (Comment: This is touted as one of the greatest benefits of the Roth IRA. Whether it really is depends on your personal circumstances. If you will need the money it is not a benefit.)
Qualified early withdrawals may be taken before 59½ under certain circumstances that may include first time home purchase, education, disability or medical expense. Somewhat less limited than the Roth IRA.	Qualified early withdrawals may be taken before 59½ under certain circumstances that may include first time home purchase, or disability expense. Somewhat more limited than the traditional IRA.
Unqualified early withdrawals. Subject to current income taxes and a 10% penalty.	Unqualified early withdrawals. Subject to current income taxes and a 10% penalty on earnings where taxes have not been paid. The law does allow the withdrawals to come first from contributions that have paid tax. Thus in some circumstances an unqualified early withdrawal may not trigger current tax. (Keep good records if you think you might want to do this.)
Contributions for the year may be made up to the time you file your taxes for that year or April 15.	Contributions for the year may be made up to the time you file your taxes for that year or April 15.

Qualifying for an IRA

There are several criteria that determine if you qualify to contribute to a traditional or Roth in a given year. You may qualify one year and not another. They include:

Marital status. Both your marital and your tax filing status are important.
Retirement coverage at work (covered). If you are a participant in a retirement plan at work where you and/or your employer are contributing money into an account you are considered "covered". Work coverage includes plans like pensions, profit sharing, 401k, 403b, Keogh, SEP IRA, etc. Incidentally, if you have a work plan, such as a 401k, where you can make contributions, it is nearly always better to max that out before looking at either the traditional or Roth IRA's. I have seen advertisements encouraging people to open Roth's and forgo contributions to a 401k. They are trying to sell you something. Rarely, will this be a good idea.
Income. The law looks at adjusted gross income AGI and modified adjusted gross income MAGI. AGI is essentially the figure on your tax form used to calculate your income tax. MAGI adds to your AGI things like foreign income certain foreign living expenses etc. It is complicated. If you have any of these be alert.

You may not contribute more to an IRA than your earned income from wages and salaries. Earned income does not include investment income, for example, while AGI and MAGI do. (Three different definitions for income? A good example of over complicating things.)

Depending on your level of income and other characteristics you may qualify to make a full $3,000 contribution, a partial contribution or no contribution at all. Please note, to add to the confusion some of these limits for traditional IRA's are increasing every year. The limits given below apply to 2003 contributions. Right now they are scheduled to increase again in 2005.

To get an idea if you can make IRA contributions this year find your marriage and coverage status below. Bear in mind while you may have both a traditional and a Roth IRA the amounts are combined i.e. your combined contributions may not exceed $3,000. You can not make any contribution that exceeds your earned income for the year. And remember that if you are over 50 you can add $500 to these limits. (It is called a "catch-up" contribution. I am afraid there really are a lot of 50+ year-olds who need to be doing a lot of catch-up.)

Single and Not-Covered

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

No limit

$3,000

Less than $95,000

$95,000 to $110,000

Over $110,000

$3,000

Partial ($3,000 to $0)

None

Single and Covered

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

Less than $40,000

$40,000 to $50,000

Over $50,000

$3,000

Partial ($3,000 to $0)

None

Less than $95,000

$95,000 to $110,000

Over $110,000

$3,000

Partial ($3,000 to $0)

None

Married, Filing Jointly and Neither Covered

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

No limit

Each Spouse $3,000

Less than $150,000

$150,000 to $160,000

Over $160,000

Each Spouse $3,000

Partial ($3,000 to $0)

None

Married, Filing Jointly and One Spouse Covered

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

Less than $60,000

$60,000 to $70,000

$70,000 to $150,000

$150,000 to $160,000

Each Spouse $3,000

Covered Spouse Partial

Non Covered Spouse $3,000

Covered Spouse None

Non Covered Spouse $3,000

Covered Spouse None

Non Covered Spouse Partial

Less than $150,000

$150,000 to $160,000

Over $160,000

Each Spouse $3,000

Each Spouse Partial

None

Married, Filing Jointly and Both Spouses Covered

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

Less than $60,000

$60,000 to $70,000

Over $70,000

Each Spouse $3,000

Each Spouse Partial

Each Spouse None

Less than $150,000

$150,000 to $160,000

Over $160,000

Each Spouse $3,000

Each Spouse Partial

None

Married, Filing Separately and Neither Covered (Following applies to each spouse separately)

Traditional IRA

Roth IRA

Adjusted Gross Income

Allowable Contribution

Modified Adjusted Gross Inc

Allowable Contribution

$0 to $10,000

Over $10,000

Partial ($3,000 to $0)

None

$0 to $10,000

Over $10,000

Partial ($3,000 to $0)

None

It's About Saving Taxes

So which is best for you??? As you can see that is not a simple question. However, both are designed to offer tax advantages so the critical question is which will save you the most taxes and maximize the amount you can invest? The answer depends on your current tax rate compared to what you believe will be your tax rate in retirement.

Tax Advantage Comparison

If your current tax rate is higher than your expected tax rate in retirement:	If your current tax rate is lower than your expected tax rate in retirement:	If your current tax rate and your expected tax rate in retirement will be the same:
Traditional IRA is best.	Roth IRA is best.	Draw

It is somewhat unusual to expect to be in a higher tax bracket after you retire than you are during your working years but it does happen. Further, I usually believe saving taxes up front is better than saving taxes later on. Consequently, from simple tax savings point-of-view the traditional IRA should get first consideration.

Conversion to a Roth

There is one more feature of the Roth IRA that should be discussed. The law allows you to convert existing IRA's to Roth IRA's. This includes the traditional IRA's I have been discussing as well as SEP and Simplified IRA's. The advantage in doing this goes to the greater flexibility of withdrawal during retirement associated with the Roth IRA. But there are some big barriers to consider before you get excited.

If you convert you will need to pay taxes on all the money coming out of your existing IRA. Please note this will hit your current income and may possibly push you into a higher bracket. The money will be taxed at your highest marginal rate. If you plan to use some of the money from your current IRA to pay the tax you will also trigger a penalty on those funds. Otherwise you can pay the tax out of other resources. Then even if you can swallow the immediate tax consequences you can't do it at all if your modified adjusted gross income exceeds $100,000. This feature has been getting a lot of hoopla from financial planners. But I think it takes some rather unusual circumstances to make tax sense. Use a very sharp pencil before doing a conversion.

An On-Line Calculator Can Help

IRA's are great ideas. I am all for saving and I am all for tax incentives. I do wish congress would greatly simplify everything and make them much more widely available. But if you can take advantage of them - do so. I believe you will find using an IRA calculator helpful. You can find them on-line from many big financial institutions. I am not promoting any web site - except Meridian, of course - but the calculator on Turbotax is a good one. The homepage is http://www.quicken.com or http://www.turbotax.com/calculators/iraanalyzer/index.html to go directly to the calculator. If you would really like to dig into it get Publication 590 from the IRS at http://www.irs.gov/

You have until you file your taxes to make your contribution. This is the time to think about it.

Please note this article is intended to offer information not advice. I have tried to lay out information in a manner that I hope will simplify comparisons and help people understand the advantages and disadvantages of these IRA's. I have used sources I consider reliable but I can offer no assurances of the accuracy, completeness or timeliness of the information here in. It is important that you seek qualified tax and financial planning assistance before you open an IRA and invest.

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