Navigating the Water of IRAs

Navigating the Water of IRAs

Here’s how to avoid a minefield of penalties

When tax laws limited the tax benefits of Individual Retirement Accounts in 1986, investors abandoned IRAs by the droves. Contributions tumbled from nearly $40 billion in 1986 to around $19 billion in 1994. Investors may have bailed out too soon, though. Even though some IRA contributions are not deductible, tax deferral on the account’s earnings still make IRAs a pretty good deal over the years.

According to Scudder, Stevens & Clark Inc., a global investment management firm, and investor who put $2,000 in an IRA from 1982 to 1986 would have savings worth $16,888 in five years. By comparison, another saver who continued to pump money into the IRA, would have a cache worth more than $32,000 in five years, even without the tax deduction.

Many mutual fund companies lure IRA funds by setting low minimum initial investments and by allowing free automatic withdrawals every month or so. But first, you need to get past the deduction requirements. Well-heeled taxpayers who are covered by an employer-sponsored pension plan or whose spouses are covered by one and can contribute to an IRA but cannot deduce the contributions from their taxes. If neither you nor your spouse is covered by a retirement plan at work and if you each earned a determined sum, you can contribute and deduct the same amount each. If only one of you works, you can contribute and deduct more.

If you or your spouse are covered by an employer’s pension plan, your IRA contribution is fully deductible, as long as your modified adjusted gross income corresponds to a limit established by the government or is less for a single taxpayer. You get a partial deduction if you are married and your joined income is between some established sums. You can calculate modified adjusted gross income by adding your salary and other taxable income and subtracting any adjustments made on your 1040 income tax forms. Then turn to the worksheet included in your form 1040 instructions to figure your modified adjusted gross income.

Once your money is in an IRA, you’ll have to tread gently to get it out without triggering huge penalties. Some rules to keep in mind:

Breaking out early: If you are younger than 59-and-a-half and want to pull out money for a non-medical reason, the IRS gets 10 percent off the top. There is an exception. You can make penalty-free withdrawals if they are part of a series of roughly equal annual payments linked to your life expectancy and expected rates of return. To take advantage of this exception, you must take withdrawals for at least five years or until you are 59-and-a-half, whichever comes first. You can then take out as much or as little as you like without paying a penalty.

The IRAs Maze. Photo by Elena

There’s some leeway in calculating your equal payment schedule. One method is to divide your account total by your life expectancy and estimate the expected return on your account. If you want to take out as much money as possible early, use the highest interest rate that the IRS will consider reasonable. Ths IRS has accepted rates not more than 120 percent of the long-term federal rate published monthly by the IRS. The faster your account is projected to grow, the more you can withdraw annually.

Switching IRA funds: You can move from one IRA to another without paying taxes with either a direct transfer or a rollover. In a direct transfer, your IRA holder transfers funds directly to the new custodian without releasing the money to you. You can make an unlimited number of transfers and don’t need to report the switch to the IRS, but you do face costly transaction fees.

In a rollover, your IRA holder sends you the funds, which you reinvest into an existing or new account. You are allowed one rollover every 12 months and must complete I within 60 days, or you’ll trigger taxes and the 10 percent early withdrawal penalty. You must report rollovers to the IRS. If you intend to switch the funds to a future employer’s retirement plan, don’t add more money to the IRA. Otherwise, the IRA will be tainted and you won’t be able to roll it over again.

Tapping too little too late: If you withdraw from your IRA after age 70-and-a-half and you take out too little based on your life expectancy, you face a 50 percent penalty. If you should have withdrawn $1,000 but you took out only $600, for example, you’ll pay $200 in penalty taxes.

Planning for your golden years

These books, pamphlets, and retirement kits can help you make wise decisions as you devise a retirement strategy. Many are free.

The Dreyfus Personal Retirement Planner (Dreyfus Investments)

Retirement Planning Guide (Fidelity Investments)

Can You Afford to Retire? (Insurance Marketing and Research Association)

Retirement Planning Guide Kit (Retirement Planning Software)

Shaping Your Financial Fitness (National Association of Life Underwriters)

A single’s person guide to retirement planning (American Association of Retired Persons)

Vanguard Retirement Planner (A software kit by Vanguard Group)

The Consumer’s Guide to Medicare Supplement Insurance and the Consumer’s Guide to Long-Term Care Insurance (The Health Insurance Association of America)

Understanding Social Security (Social Security Administration)