June 1999

IRA Advantages:
Too Good to Ignore

by Ted Rice

Puzzled by IRAs? Unfortunately, you are not alone. IRAs are ignored or under-utilized by many people partly because they are not understood. They are supposed to be simple, long-term investment accounts. However, after constant legislative changes since their creation in 1974, IRAs now confuse many taxpayers.

After cutting back fully deductible IRA contributions during the budget deficit-plagued 1980s, Congress in recent years added favorable features to IRAs to address continuing low national savings rates. Since savings rates continue to lag and the budget deficit is gone, Congress is now considering several favorable IRA proposals.

The two main categories of IRAs are those established by individuals and those established by employers.

Traditional IRAs. These are the original IRAs. Deductible or nondeductible (i.e., after-tax) contributions may be made to a Traditional IRA up to an annual maximum of $2,000. Regardless of deductibility, investment earnings are tax-deferred, meaning they are taxed upon withdrawal. Tax-deferral of investment earnings is a key feature of Traditional IRAs. Traditional IRAs may also receive rollover contributions from employer-sponsored retirement plans.

Beginning in 1982, the entire annual contribution to an IRA was deductible regardless of participation in an employer-sponsored retirement plan. This fully deductible contribution lasted until the Tax Reform Act of 1986 limited deductible contributions. Deductibility is now dependent on (1) participation in an employer-sponsored retirement plan; and (2) adjusted gross income if participating in such a plan. Deductible contributions are now more available than most people realize. Non-deductible contributions are not limited by adjusted gross income or participation in an employer-sponsored retirement plan. Non-deductible contribution amounts later withdrawn from a Traditional IRA are not taxed upon withdrawal.

To encourage the use of Traditional IRAs as long-term investment accounts, Congress established a 10 percent premature distribution penalty tax applicable to withdrawals before age 59 1/2. However, exceptions to the 10 percent penalty tax include: disability; higher education expenses for the individual and family members; first-time homebuyer amounts; regular and substantially equal payments made at least annually; significant unreimbursed medical expenses; medical insurance premiums after job loss; and death.

Roth IRAs. First available in 1998, Roth IRAs have caused a great deal of excitement because of the availability of tax-free withdrawals, but they have also added to the confusion about IRAs. Annual contributions are not deductible, i.e., they are after-tax contributions, and may be made up to $2,000 if adjusted gross income is under a certain level. An individual’s annual contributions between Traditional and Roth IRAs are limited to a total of $2,000. Investment earnings withdrawn from Roth IRAs are tax-free under certain conditions, providing an obvious advantage over taxable withdrawals of investment earnings from Traditional IRAs. Roth IRA contribution amounts, because they are made after-tax, are not taxed upon withdrawal.

Generally, to receive withdrawals tax-free requires an individual to have established a Roth IRA for the longer of five years or attainment of age 59 1/2. A qualifying first time home purchase allows for a tax-free withdrawal before age 59 1/2 if a Roth IRA has been established for at least five years.

An important Roth IRA feature allows the conversion of a Traditional IRA to a Roth IRA if a single individual or married couple has modified adjusted gross income of no more than $100,000. Taxes are paid on the conversion amount for the year in which such conversion occurs, and no premature distribution penalty tax applies to the conversion amount. Therefore, if the initial tax impact is addressed and the potential after-tax return merits it, qualifying individuals can benefit greatly from such a conversion.

Another beneficial feature of Roth IRAs is that, unlike Traditional IRAs, minimum distributions at age 70 1/2 are not required.

Education IRAs. These IRAs were first available in 1998. An individual can make nondeductible contributions up to $500 annually to an Education IRA for a child’s benefit. Adjusted gross income of the individual or married couple must be under a certain level for contributions to be made. Funds can be withdrawn tax-free to pay the child’s qualified higher education expenses. Contributions to Education IRAs do not affect the $2,000 annual contribution limit for Traditional and Roth IRAs.

Ted Rice is senior corporate counsel with U.S. Bancorp. He received his J.D. from Hamline University School of Law in 1983 and has practiced employee benefits law for 16 years.

"IRAs are ignored or under-utilized by many people"

Simple IRAs. First available in 1997 and as suggested by their name, these plans offer a small business employer (with fewer than 100 employees and no other employer-sponsored retirement plan) the opportunity to adopt a fairly simple retirement plan. Employees may make tax-deferred contributions up to $6,000 per year if the employer either makes a deductible matching contribution up to the first 3 percent of an employee’s compensation or makes a deductible employer contribution of at least 2 percent of each employee’s compensation. Required documentation includes employer and employee versions of Simple IRAs.

Other than being treated as an employer-sponsored retirement plan for purposes of determining whether a Traditional IRA contribution may be deductible, Simple IRAs do not restrict an individual’s ability to make qualifying Traditional or Roth IRA contributions. Simple IRAs are ideal retirement plans for many self-employed individuals and other small businesses.

Simplified Employee Pension ("SEP") IRAs. These plans are also fairly simple. The employer adopts a SEP plan and makes deductible SEP contributions to the employees’ Traditional IRAs. A SEP allows an employer to make a contribution for employees of up to 15 percent of total compensation limited to $30,000 for each employee.

Other than being treated as an employer-sponsored retirement plan for purposes of determining whether a Traditional IRA contribution may be deductible, SEP contributions do not restrict an individual’s ability to make qualifying Traditional IRA or Roth IRA contributions. SEPs are also ideal retirement plans for many self-employed individuals and other small businesses.

Employer Sponsored IRAs. Essentially, under this arrangement, the employer makes an employee’s Traditional IRA contribution.

Several exciting IRA proposals are pending in congressional bills or have been presented to Congress for consideration. Key proposals include the following changes:

1. Return to the fully deductible Traditional IRA, or increase the availability of deductible contributions.
2. Raise the annual contribution limit for Traditional and Roth IRAs to $5,000, raise the annual contribution limit for Education IRAs, and index all IRA contribution limits for inflation.
3. Allow individuals age 50 and older an increased contribution limit to "catch up" on amounts they were unable to make in earlier years.
4. Allow for modified adjusted gross income of up to $1 million to convert to a Roth IRA.
5. Extend the ability to pay the Roth IRA conversion tax over four years, as was permitted for Roth IRA conversions in 1998.
6. Use some of the budget surplus to fund Roth IRAs or new IRA-like "private retirement accounts" or "USA" accounts.
7. Increase the Simple IRA deferral amount to $10,000, and create a salary deferral-only Simple IRA.
8. Simplify and relax the age 70 1/2-required minimum distribution rules applicable to Traditional and Simple IRAs.

Whether any of these proposals will become law remains to be seen. As always, international events or national politics may sidetrack legislative initiatives. In any event, IRA advantages are likely to be expanded in the future.

Don’t let IRAs puzzle you. The advantages they offer are too great to be ignored. Take time to learn the tax and investment advantages of IRAs, or consult your tax or financial advisor.