I can remember when the legislation for the Individual Retirement Account (IRA) was being considered in Congress in 1975.
A man I worked for at the time, one Mr. Willard Weiss — most likely the top expert on pension plans in the United States at the time — said that "retirement planning just entered an entirely new age!" Looking back over the 32 years since then, I'd say that was an understatement!
I remember well the heated debates in Congress centering on the aspect that taxpayers would actually be able to keep what would have been tax payment money and then invest it with the provision that they could also totally shield the earnings from their investments from any tax collection by the IRS for many years, certainly until the taxpayer began to withdraw funds from the IRA for their retirement years — and the original investment money to be used was also to be pre-tax dollars! Incredible!
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Outrageous, preposterous, downright fiscal folly said the opponents! And, believe me, there were lots of opponents. But, the bill finally passed and today we silently wonder what the uproar was all about. To us, it is just good sense to have such plans available for all Americans.
Over the years, there has been additional legislation passed that made possible other special types of IRA retirement plans, plans that help taxpayers escape income tax payments in different ways. Of all of them, the Roth IRA and the 401(k) plan (we won't be covering this plan here) are the most widely used and well known today.
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I will tell you up front that that I will be making no final conclusion in our visit today that will say the traditional IRA or Roth IRA is better than the other.
No, instead, my purpose will be to give you a platform that will help you begin to determine for yourself which of these programs might best fit your own needs.
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No retirement plan is an all-in-all panacea in and of itself. Each in its own way just offers a wide range of benefits that, hopefully, will find a good match with your retirement needs somewhere along the line.
The "Traditional" Ira Plan
Let's begin with the basic, original Individual Retirement plan. As I said, it was made law in 1975. It provided that you could place up to $2,000 in a qualified IRA (you had to have your plan OK'ed by the IRS first in some way, either by your own application or the application of the company you worked for to the IRS).
The funds to be invested came from your pre-tax earnings, which meant that you usually had an additional 20-35 percent greater deposit for investment than if you had to use after-tax funds.
Thus, that "extra" money would work for you and earn a greater income toward your retirement than any after-tax investment could ever hope to generate.
Folks liked that idea, even though they understood that when the money was withdrawn from the IRA at retirement, the withdrawal would then be taxed. Still, most realized they would come out ahead in the long run, no matter what happened. People are much quicker to see a good deal than they are given credit for.
Over the years, a number of helpful features were added to what is now called the "traditional" IRA (to distinguish it from its later derivatives, the 401(k), the Roth IRA, and the even newer Roth 401(k) and so-called solo Roth IRA.
One of these features included a broadening of the rules to allow IRA owners who suddenly found themselves in dire need of funds, and having no source available except their IRA, to tap the IRA without penalty.
For example, you can withdraw your IRA contributions (not earnings, however) without penalty if:
you have significant non-covered medical bills;
you're using the funds to pay certain qualified higher education expenses;
you're are disabled;
you are using the withdrawal to fund for certain qualified first-time home buying needs;
you need the funds to pay medical insurance premiums after losing your job;
the funds are being used to cover expenses from some unusual event recognized by the IRS as unusual (i.e. Hurricane Katrina was one of those events); and
the funds to be withdrawn must have been on the account for at least five years.
Now, there are other specifics to this list that you should carefully review and I direct you to the IRS Publication 590 for all that data. But, these exceptions give you most of them and the flavor of the IRS's thinking — to wit — don't touch the IRA money for "unqualified" use or we will tax you PLUS apply penalties that will really make it hurt. So, be forewarned, tread lightly before you look to your IRA for financial help. But, be aware that help can be obtained here.
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Finally, you can currently deposit up to $4,000 a year into your traditional IRA, with the added benefit of adding another $1,000 if you are over 50 1/2 (called a "catch-up" feature — meaning older taxpayers get a bit of a boost toward retirement to make up for prior years when the allowed maximum investment was much smaller each year). These levels will increase next year to $5,000, plus an extra $1,000 "catch-up" and thereafter at the rate of $500 per year (with the IRS having the ability to make other adjustments for inflation if they deem it advisable).
Enter the Roth Ira
In 1986, Congress passed what was called a new "Tax Reform" measure. In that measure, the use of the IRA was (for reasons we won't get into here - mainly political pressures) restricted in many ways. The worst limitation was to restrict or eliminate the use of IRAs if your income was above a certain level.
But over the next 10-12 years, as national average income levels rose, more and more taxpayers were being excluded from using the IRA (not unlike the coming battle over the alternative minimum tax limits that, unless soon revised by Congress, will have far more taxpayers subject to it than ever before. Expect lots of heat in Congress on this one, too).
By the late 1990s, taxpayer pressure on Congressional representatives about the IRA restrictions got so great that one man (William V. Roth Jr., a senator from Delaware) introduced a bill in 1998 that lifted many of the limits on IRA usage and — hold onto your chair for this one — actually let people put after tax money into an IRA that would earn money without ever having to pay a tax on the earnings year to year!
And then, to top that one, the bill provided that at retirement you could withdraw the contributions and earned income absolutely tax free! That was a stunning development! But, in light of the pension plan defaults then beginning to dot the landscape and the clamor for something to be done to allow more folks to use IRAs, it has been a welcome and lasting gift to the taxpayer.
The Roth IRA, as it is called today, offers several substantial pluses over the traditional IRA.
First, and as I said to me the most important, you shield earnings from your post-tax IRA contributions that will never be taxed.
Second, if you ever run into a financial bind — and who hasn't — you can withdraw your contributions without any tax being incurred (logical, as you have already paid a tax on the money — duh!).
And third, you do not have to take forced withdrawal amounts from your IRA at age 70 1/2. For those with a large income in retirement, that can mean tens of thousands of dollar savings for their heirs over the years.
Today, like the traditional IRA, you can deposit up to $4,000 into your Roth IRA, plus, if you're over 50 1/2 you can deposit an additional $1,000 (that "catch-up" contribution, again) if you wish.
There are other special types of Roth IRAs that you can establish that allow you to put in as much as $20,000 a year or more, depending on your financial circumstances (most often, this is for the self-employed), but I advise you to see your advisor if you are not sure you qualify for the larger deposit levels.
And lastly, you can distribute the maximum contribution allowed each year into your IRA — to both the traditional and Roth IRAs you own (and many taxpayers own several types of IRAs) — so long as the total contributed to them is not more than your yearly allowed contribution.
A Few General IRA Cautions
You should be aware that over the years, IRAs that have been individually managed have not done as well as professionally managed IRAs. Professionals do earn their keep in this arena, it seems. Now, you may just do fine, but if you feel that your expertise is only mediocre or you are just plain scared, I suggest you find a good pro to do the job for you.
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There are many good professional managers out there, mutual funds, brokers, banks, and private consultants that, for a fee — and some without a fee — will be glad to manage your IRA. A good number of them will even pay you to deposit your IRA with them in the form of an interest payment on your deposit.
You need to look carefully at what is available. But remember, the lower the fee amount you need to pay, the better over the long haul your IRA will build its equity.
Also, be aware that there is one feature of the IRA that can "bite back" if your retirement income is high. The IRA requires that you withdraw funds from you IRA beginning at 70 1/2 whether you want to or not. If your tax bracket is high, that can be a definite downside of your IRA plan. For most IRA owners, this will not be a major problem, however. I suggest you see a tax consultant for opinions on your own retirement plan regarding this provision.
Now, I haven't mentioned it so far, but there are some income limits to being able to open and contribute to an IRA (seems somebody always spoils a good thing).
Joint filing families can only contribute to an IRA if their income is less than $156,000 this year. And only a limited partial contribution can be made if their income is less than $166,000 but more than $156,000. But over this $166,000 level, no contribution is allowed.
Single filers are allowed to make a full deposit if their incomes are under $99,000 and only a partial contribution if it is between $99,000 and $114,000. Above the $114,000 level, no contribution is allowed.
But, one small bright spot is that once your IRA is established and you have made a contribution, even if your income goes high enough to rule you out making any new contributions, your older contributions still continue to earn tax free income. Payouts at retirement and emergency withdrawal rules continue to apply without restrictions (thank God for small favors).
Well, that is all for today. I hope that if you don't presently have an IRA, our brief foray into the world of the tax-fee IRA has whetted your appetite for wanting to know more. I urge you to talk to your advisor (investment or tax) and get the lowdown on how you can take advantage of this tax-free income earner based on your own specific needs. You will not be sorry, I assure you.
As always, I hope you have a great investment week coming up. And in the meantime, you keep in touch, I do! See you next week.
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