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THE NEW IRAS. WHAT DOES IT MEAN TO ME?
Originally, Individual Retirement Accounts were a device for everyone to save $2,000 tax-free every year. The IRS then limited who could take the IRA deduction to those people without pension plans at work and those persons with pension plans making less than $35,000. Recent legislation has created some new options on using IRA's to save money and save taxes.
Under the Taxpayer Relief Act of 1997 and other legislation three new types of IRAs were created: The Roth IRA, The SEP (or SIMPLE) IRA, and the educational IRA. Also some of the rules relating to Traditional IRAs have changed.
Beginning in 1998 there are several changes to the rules for traditional IRAs. Generally you can now do the following:
1) Ignore, in most situations, your spouse's participation in an employer plan in determining your IRA deduction.
2) The amount you may earn and still deduct your IRA if you are covered by a retirement plan at work increase to $40,000 if your single and $60,000 if your married filing jointly.
3) Make penalty free withdrawals from your IRA for higher education expenses of you, your spouse, your children or your grandchildren. This includes the expenses for tuition, books fees, supplies, and equipment required, and, if the student is at least half time, the students room and board are also eligible. This is just an elimination of the penalty, tax will still be due on the amount withdrawn from the IRA.
4) Make penalty free withdrawals from your IRA to purchase your first home. The distribution must be used to buy, build, or rebuild a first home that is the principal residence of you, your spouse, your child, your grandchild, your parent or grandparent. Again, this is just an elimination of the penalty, tax will still be due on the amount withdrawn from the IRA.
ROTH IRA's
The money you put into a ROTH IRA account, like a traditional IRA is money you can't touch until retirement but it is not deductible on your tax return. However, you won't have to pay any tax when you take the money out of the account at retirement. This means that all of the interest, dividends and gains the money earned while it was in the IRA will be tax free to you. This is different from the traditional IRA in that you pay taxes when you take money out of a traditional IRA.
The limit on contributions to a ROTH IRA is $2,000 per person per year. The contribution is not deductible. And the $2,000 limit is on all IRA contributions, so the total you can contribute to your Roth IRA and your traditional IRA in 1998 is $2,000.
Roth IRA's do not require that you start taking distributions at any age, where the traditional IRA required that you begin taking distributions at age 70 1/2. Plus even if you are 70 1/2 you can still contribute to a ROTH IRA. Finally, distributions to a beneficiary after death are tax free. A traditional IRA is taxable to the person who inherits the money.
There are of course limitations on IRA contributions if you make more than $95,000 as a single and $150,000 if you are married filing jointly.
You may contribute to a ROTH IRA whether you have a retirement plan at work and how much you contribute to a ROTH IRA account does not affect how much you can contribute to your 401k plan.
If you take money out of your ROTH IRA before you 59 1/2 whether the withdrawal is taxable will depend on the size of the withdrawal and the purpose. Funds withdrawn are deemed to have been taken first from contributions made, which because they were non deductible, are not taxes when withdrawn. Withdrawals of earnings though, will be taxes as ordinary income and subject to the 10% penalty for early withdrawal.
You may convert your traditional IRA to a ROTH IRA under certain circumstances. But you will be taxed on the conversion. It can be done if your income is under $100,000 (single or married filing jointly). If you are married filing separately you cannot convert. You must hold the converted IRA for another five year before taking tax and penalty free distributions. You will be taxed on the conversion with two exceptions, the full amount will be taxed as ordinary income in the year of the conversion. The first exception is that for year 1998 conversions, the amount to be taxed will be added to income over the next four years at 25% per year.. The second exception is that non-deductible amounts contributed to the traditional IRAs will not be taxed on the conversion.
Your tax advisor will be able to calculate which IRA is best for you, however some of the factors in favor of conversion are: you have a lot of years until you retire, significant non-deductible contributions in the past, expected tax bracket in retirement close to or higher than while working and or expecting lousy income this year and the next three years. Essentially a thirty year old with five year of non-deductible contributions to a traditional IRA should convert. A sixty fiver year old with a large IRA should probably not convert.
California has conformed their tax laws to comport with the federal IRA legislation.
SEP or SIMPLE IRA's
These are a type of written agreement (salary reduction arrangement) between and employer and an employee that allows an eligible employee (including a self-employed individual) to choose to reduce their compensation by a certain percentage each pay period and have the employer contribute the salary reduction to a SIMPLE IRA on behalf of the employee. The amount that may be withheld and contributed to a SIMPLE IRA is $6,000 and an employer is required to make certain matching contributions to the employee's SIMPLE IRA.
EDUCATIONAL IRA's
Beginning in 1998 you may be able to make nondeductible contributions of up to $500 annually to an education IRA for a child until he or she reaches age 18. Earnings in the IRA accumulate free of income tax.
Distributions from an education IRA during the year are tax-free unless distributions from the education IRA are more that qualified higher education expenses during the year.
PLANNING IDEAS
If you contribute $166 a month to an IRA account you will accumulate your $2,000 deduction by the end of the year. If in the past you were ineligible for the deduction because your spouse had a pension plan or 401k plan at work you are may now able to take the IRA deduction on your 1998 tax return. A deduction worth at least $300 of tax savings in 1998.
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