Monday, March 29, 1999

Guidelines may dictate IRA choice

Options offer tax relief

Gannett News Service

        Whether to contribute to an individual retirement account is a question that millions more taxpayers are likely to ask this tax season.

  Taxtime is an eight-part series by tax-law expert Gary Klott, running in The Enquirer today through April 12.
  Feb. 22: Overview of the numerous new tax breaks embedded in 1998 tax returns.
  March 1: Tax season tricks and traps: General tax-saving strategies and costly traps to avoid.
  March 8: The new child tax breaks.
  March 15: The new education breaks.
  March 22: Tax angles for investors, including new capital gains rules.
  Today: Choosing between the new IRA options.
  April 5: Tax guide for employees and the self-employed.
  April 12: Using 1998 returns to plot tax-saving strategies for 1999.
        With the creation of the Roth IRA and the liberalized eligibility guidelines for the traditional IRA, the vast majority of individuals are now eligible to make some sort of IRA contribution.

        For those who can afford to set money aside for retirement, the valuable tax benefits that both types of IRAs offer should make the decision about whether to contribute an easy one.

        What won't be so easy for those who meet the eligibility requirements for both types of IRAs is deciding which one to choose.

        Taxpayers who converted their traditional IRAs to Roth IRAs last year also have some complicated decisions to make this tax season, including whether they would be better off undoing the Roth IRA conversion and rolling the money back into the traditional IRA.

        IRA contributions for the 1998 tax year can be made up until April 15.

        All but the wealthiest of workers are eligible to contribute to a Roth IRA. Eligibility to make a full $2,000-a-person contribution to a Roth is restricted to married couples with adjusted gross incomes of less than $150,000 and single individuals with incomes less than $95,000. Smaller contributions are allowed for couples with adjusted incomes up to $160,000 and singles with incomes up to $110,000.

        Roth IRA contributions aren't deductible, but withdrawals are tax-free after the account has been open more than five years and you're over age 591/2.

        Fewer taxpayers qualify for traditional IRAs, where contributions are deductible, but withdrawals are taxed. But Congress loosened the eligibility requirements to allow many more taxpayers to take advantage of traditional IRAs than in the past.

        The Taxpayer Relief Act of 1997 raised the income-eligibility limits for taxpayers who participate in a 401(k) or are covered by some other employer retirement plan. At least a partial IRA deduction will be available on 1998 returns to joint filers with adjusted gross incomes of less than $60,000 (up from $50,000 in 1997) and to singles with incomes less than $40,000 (up from $35,000).

        In the past, a married cou ple above the income-thresholds could make deductible IRA contributions only if neither spouse was covered by a retirement plan at work.

        But this restriction has been eased for 1998 returns. If only one spouse is covered by an employer retirement plan, the other spouse will be eligible for at least a partial IRA deduction so long as the couple's joint income is less than $160,000.

        If neither spouse is covered by an employer retirement plan, then both spouses can make deductible contributions to a traditional IRA, no matter how high their income.

Decision-making time
        The decision about which type of IRA to set up will be a simple one for most higher-income taxpayers who will be eligible only for Roth IRAs.

        But the decision is complicated if you're eligible for both.

        There have been numerous articles in the financial press and advertising campaigns by financial institutions extolling the virtues of the Roth IRA. All the ballyhoo has made its advent seem like the financial equivalent of the Second Coming.

        And indeed, many people will find that the ability to make tax-free withdrawals from a Roth IRA is a more valuable tax benefit than getting an upfront deduction for contributions to a traditional IRA.

        But many people won't come out ahead with a Roth IRA.

        “I think a lot of people are going into Roth IRAs that shouldn't be going into them,” said Bob Rywick, a tax lawyer and executive editor at the RIA Group, a publisher of legal references for tax professionals.

        Whether you're likely to come out ahead with the upfront tax deduction from the traditional IRA or the benefit of tax-free withdrawals from the Roth IRA depends on your tax bracket now, your expected tax bracket in retirement, how long you plan to keep the money in the IRA and the return you expect from your investments.

Make plan fit income
        “I think the key element is to look at what tax bracket you're going to be in at retirement,” Mr. Rywick said.

        If you opt for a Roth IRA, you should expect to be in at least as high a tax bracket — preferably a higher bracket — when you retire as you are in now, he said.

        But many workers can expect to end up in a lower tax bracket when they retire, because most workers' incomes decline in retirement when they no longer are earning weekly paychecks.

        “If you're in a high tax bracket today and anticipate being in a lower tax bracket when you retire, it probably doesn't make sense to go with the Roth,” said Mark Watson, a partner in the personal financial planning practice in Washington, D.C., at the accounting firm of KPMG.

        How long you expect to keep the money in the IRA will also be an important factor.

        “For somebody with a reasonably long time period, let's say at least a 15-year time period, the best bet may be the Roth,” he said. “The longer you can let assets grow tax-free, the better you're going to be with the Roth.”

        That's why Roth IRAs can be well suited to young-adult workers who have many decades until retirement.

        Roth IRAs are also well suited for savings that you don't expect to need in retirement, Mr. Rywick said. The money can be kept in the Roth IRA and passed onto heirs free of income tax. In contrast to deductible IRAs, you aren't required to make minimum withdrawals each year from a Roth when you reach age 701/2.

Check on conversions
        If you converted your traditional IRA into a Roth IRA last year, you'll need to report the conversion and pay tax on it.

        When converting to a Roth IRA, money rolled over from your old IRA is subject to tax as if it had been withdrawn.

        Conversions made last year are eligible for a special break. Any tax due on the conversion can be spread over four years — interest-free. Only a quarter of the income subject to tax has to be included on your 1998 return.

        The option to spread the tax over four years might be an irresistible deal for most taxpayers.

        But there are some individuals who might be better off reporting the entire sum on their 1998 returns.

        Included are people who expect to be thrust into a higher tax bracket in the next several years.

        Others who might prefer reporting all the rollover income on 1998 returns are individuals who are trying to hold down their incomes in future years in order to qualify for some of the valuable new tax breaks created by the 1997 tax act. Most of the new breaks, including the child and college tuition credits, are phased out for taxpayers with adjusted gross incomes above specified levels.

Reversal option
        If you converted a traditional IRA to the new Roth IRA last year, you have the option to undo the conversion.

        So long as you roll the money back into a traditional IRA before your tax return is due (which can be later than April 15 with a filing extension), the IRS will essentially pretend as if the conversion to the Roth never happened.

        This option to reverse a conversion was primarily intended to help taxpayers who later discover that their income was too high to qualify for a Roth IRA conversion. (Only taxpayers with adjusted gross incomes of $100,000 or less are eligible to convert their traditional IRAs into Roth IRAs.)

        But you also might find that it pays to undo a conversion if the value of your Roth IRA portfolio has fallen sharply since the time of conversion. Because funds converted to a Roth IRA are subject to tax, reversing a conversion after your IRA portfolio has declined in value and then reconverting back to a Roth IRA will mean a smaller tax.

        For example, say you converted $80,000 from a deductible IRA into a Roth IRA and your Roth IRA is now worth only $50,000. If you stick with the conversion, you'll have to pay tax on the $80,000 in funds you converted, even though $30,000 of the value has since been wiped out. But if you undo the conversion and then roll the money back into a new Roth IRA, you'll only have to pay tax on $50,000 — rather than $80,000.

File for extension
        Even if your Roth portfolio hasn't declined since you converted, it could in the months ahead. That's why many tax advisers are recommending people who converted last year to get a filing extension. “I've been advising them to get an automatic extension until Aug. 15,” Mr. Rywick said.

        By so doing, you'd have four more months to see if your portfolio declines in value. If there is a sudden drop in the stock market, you might be able to save some taxes by taking advantage of the decline to undo the conversion and reconvert.


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