IRA, at 30, still an appealing option for tax-deferred saving

PERSONAL FINANCE

March 28, 2004|By EILEEN AMBROSE

THE INDIVIDUAL retirement account turns 30 this year, but the birthday celebration is likely to pass without a lot of fanfare.

IRAs don't seem to generate a lot of excitement among investors these days.

The annual contribution limit is smaller than some other tax-deferred accounts. The rules are complicated. Last year's tax law reduced the tax rate on capital gains and dividends, raising the attractiveness of investing outside an IRA. And President Bush has proposed a new account to replace IRAs.

Can it be that the IRA is past its prime?

Hardly, financial experts said.

"There really aren't too many alternatives to save in a very tax-friendly manner," said Fran Kinniry, a principal with the Vanguard Group in Malvern, Pa.

The standard advice is to participate first in a 401(k) or similar workplace retirement plan that offers an employer match on top of tax benefits.

After that, the IRA is an appealing option for those who want more of their investments growing on a tax-deferred basis, experts said. At the same time, they might qualify for other tax breaks, too, depending on whether they open a traditional IRA or the newer Roth IRA.

Investors can contribute to an IRA for 2003 up until the tax deadline of April 15. Younger individuals can set aside up to $3,000 of earned income in an IRA, while those 50 and older can put away up to $3,500.

When the IRA was created in 1974, the most anyone could sock away in the retirement account was $1,500 a year, and all contributions were tax-deductible, said Ed Slott, an accountant in Rockville Centre, N.Y., who publishes Ed Slott's IRA Advisor newsletter. By the early 1980s, workers were allowed tax-deductible contributions of up to $2,000 a year.

The accounts' popularity soared. Investment firms would do an advertising blitz annually to remind workers to fund an IRA, said Gordon Bernhardt, a financial planner with Bernhardt Wealth Management in McLean, Va.

"When everyone got a tax deduction on it, everybody wanted to do an IRA. It was a no-brainer," Bernhardt said.

But the 1986 tax law changed all that by setting limits on who is eligible for a deduction.

"That killed the whole IRA," Slott said.

Investment firms stopped promoting IRAs in ads, so even middle-income households that still qualified for IRA deductions began to ignore the accounts, Bernhardt said. At the same time, 401(k)s were gaining prominence.

IRAs didn't recapture investors' imagination until 1997, when the Roth IRA was created. As of last year, one-third of U.S. households owned a traditional IRA, and about 15 percent had a Roth, according to the Investment Company Institute.

If you're not covered by a workplace retirement plan, you can contribute to a traditional IRA and deduct all contributions no matter your income.

If you participate in a work plan, you might still be eligible for a deduction. Some or all of contributions for the 2003 tax year, for which returns are due April 15, will be deductible provided adjusted gross income is less than $50,000 for singles and $70,000 for married couples filing a joint return.

For 2004 contributions, full or partial deductions are available if income is under $55,000 for singles and $75,000 for joint filers.

Those with higher incomes also can contribute to a traditional IRA, but get no deduction.

Money coming out of a traditional IRA will be taxed as regular income.

The Roth is different. There's no upfront tax deduction, but withdrawals in retirement are tax-free. To be eligible to make a full contribution to a Roth, or a partial one, adjusted gross income must be under $110,000 for singles and $160,000 for joint filers.

Many financial experts recommend the Roth over the traditional IRA.

"Certainly for young people, the Roth IRA is the best thing since microwave popcorn," said Mark Waldman, a registered principal at Securities America Inc. in Vienna, Va.

"Even though the contributions aren't deductible, the stuff builds up without tax. And when they take the money out later, it's tax free," Waldman said. So, it doesn't matter what future tax rates will be, he said.

Unlike the traditional IRA, too, the Roth doesn't require investors to start taking money out after age 70 1/2 , so they can let their money continue growing tax-deferred longer, Waldman noted.

If you earn too much to qualify for deductions or a Roth, does it still make sense to fund a traditional IRA anyway?

Some say investors would be better off putting money in tax-efficient investments to take advantage of the tax rate cut on dividends and long-term capital gains last year. The rate was reduced to 15 percent for most investors. Those in the two lowest tax brackets - 10 percent and 15 percent - pay a 5 percent rate this year.

Investing outside an IRA would also be a smart move for those whose investments are now all tied up in tax-deferred accounts, like a 401(k), Bernhardt said. For investors not in that situation, though, Bernhardt suggests funding the IRA.

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