December 1, 1998

Year-End Tax Planning
The Traditional IRA

You probably understand the concept of the Individual Retirement Account (IRA). Assuming you qualify, you sock away up to $2,000 a year ($4,000 for married folks) in a tax-deferred account and most likely withdraw it during retirement. It seems that only about 5% of Americans take advantage of IRAs, though, suggesting that most people haven't thought through their many benefits.

Many Fools may think that just plopping their money into a brokerage account or mutual fund is good enough. This might not be the case, though, as IRAs offer three compelling advantages over regular investments:

-- There's an up-front tax break, which is essentially a government subsidy to your savings. For example, if you contribute $2,000 and you deduct that from the income on which you're taxed, you'll be saving $560 that you otherwise would have shelled out to the IRS (assuming a 28% tax rate). You can take that $560 and invest it. In 25 years, growing at 11%, it'll be $7,608 -- all because you took advantage of that IRA.

-- The deferral of taxes permits these savings to accumulate more rapidly since they aren't subject to capital gains taxes over the years. In other words, the stocks and/or mutual funds you buy and sell in your IRA don't generate capital gains. This is a huge difference from your regular brokerage account, where you end up paying Uncle Sam every year for capital gains. Instead of taking two steps forward and one step back, IRAs permit you to keep moving forward until you're ready to withdraw funds.

-- When the money is finally withdrawn after age 59 1/2, it's taxed as regular income. By then, though, an investor may be in a lower tax bracket. So while you might have paid 28% or 36% or more on the $2,000 of income that you diverted into an IRA, you may end up paying only 15% on it at retirement. This even tops the 20% capital gains rate.

By now you're surely convinced that IRAs are for you. Slow down, Fool -- there are still some limitations to address. For starters, there's a 10% penalty for early withdrawal (prior to age 59 1/2, that is). Also, if you participate in an employer-sponsored retirement plan, you may not be able to enjoy full deductibility of the $2,000 annual contribution. If you're covered by a 401(k) or other pension plan, IRA contributions remain fully tax-deductible only if your annual income is below $30,000 ($50,000 for married couples). Incomes between $30,000 and $40,000 ($50,000 and $60,000 for married couples) are in a "phase-out" range, where only part of a $2,000 IRA contribution would be deductible. If your annual income is above these limits, you're not exactly out of luck. You can still plunk your pesos into an IRA to take advantage of the tax-deferred accumulation of assets -- you just can't deduct the contribution from this year's income.

Things are looking even better for IRA investors. New tax laws are hiking up the income limits and easing the restrictions on withdrawals. By the year 2007, folks with annual income near $100,000 will be able to participate. And importantly, IRA savings can now be withdrawn without penalty to buy a first house or pay for education expenses.

IRS Publication 590 can give you more information on IRA rules, restrictions, and phase-out computations.

Next -- The Roth IRA


The above text is an excerpt from the Motley Fool Investment Tax Guide

What Can You Learn From the Motley Fool Investment Tax Guide?
-- How to convert your IRA and take distributions
-- Which records to keep
-- How to deal with worthless securities
-- How to avoid wash sales
-- How stock options affect your taxes
-- What to do when you can't pay your taxes
-- How to handle an audit
-- And much more

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