Forget everything you've learned about IRAs and retirement plans over the last few years. With the stroke of a pen, the rules have been turned upside down. There are now no fewer than four different kinds of IRAs, complete with rules for moving from one to another, income limits on some and not on others, and three different classes of withdrawals.
Brokerage houses, mutual fund companies and accounting firms are rushing out new interpretations to the public--often contradicting each other.
While complicated, the new tax code (effective next year) does offer advisers many opportunities to help clients avoid numerous perils. The new tax law is likely to open a Pandora's box of tax loopholes, and there's bound to be a lot of reshuffling. Just be certain to do some homework before treading too far.
The Roth IRA The Sizzle: Put in $2,000 a year, hold it for at least five years, and pull it out tax-free for retirement. This so-called Roth IRA is not subject to mandatory withdrawals like a regular IRA at age 701/2. The contribution can be pulled out at anytime, for any reason, with no penalties or income tax. First-time home buyers can pull out up to $10,000 without penalty or tax. The $2,000 limit begins to be phased out at a relatively high $150,000 income for couples, $95,000 for single filers.
Pitfalls: Only qualified distributions are tax free. In a nutshell, tax-free distributions must be for retirement (over 591/2), disability, death or a first-time home purchase. While educational distributions do not have an early withdrawal penalty, you do pay taxes on any gains, contrary to what some mutual fund companies are saying in their new literature.
Controversy: The debate rages on in the media about which is better--a deductible IRA that's tax deferred or a non-deductible one that's tax-free. You can put money in more than one type of IRA, but there's a $2,000 total limit for all types. Most financial advisers feel the Roth IRA, with distributions tax-free in retirement, is the way to go.
Hidden Treasure: If your client makes under $100,000 a year and has a big IRA rollover, consider rolling over to a Roth IRA. There's been some controversy in recent years about the advisability of holding a large IRA rollover due to the potentially large tax bite from the combination of estate and income taxes, plus penalty taxes on large plans. A little-known provision in the new tax code allows holders of IRA rollovers to convert to Roth IRAs during 1998 only. Clients will pay taxes onwhatever they roll over, but the taxes are averaged over a four-year period. The advantage: no future income taxes on any of the gains (either to clients or their heirs) and no mandatory withdrawal at 701/2. With many estate planning attorneys advising large distributions on big IRAs anyway, the Roth IRA could be the ticket.
Educational IRAs The Sizzle: Put up to $500 a year into a child's educational IRA, and withdraw it tax-free to pay for educational expenses.
Pitfalls: Money in the child's name might hurt chances for receiving financial aid. Since the educational IRA technically is owned by the child, it would have to be reported as the child's assets on any financial aid application. Better to keep the money in the parents' name unless there is some compelling tax benefit.
Controversy: You can't fund the educational IRA and also buy a state-sponsored, pre-paid tuition plan in the same year. Also, when you withdraw money from the educational IRA, you lose the two new tax credits--Hope Scholarship Credit and Lifetime Learning Credit-- recently enacted. You give up all of this for the ability to stash $500 a year, so think twice before doing.
Hidden Treasure: Consider using a grandparent to fund the Roth IRA. Grandparents could then withdraw tax-free after five years, as long as the holder is over age 591/2.
Deductible IRAs The Sizzle: About the same as before. Make a contribution, write it off on your taxes, and don't pay taxes on the money until you withdraw it. The big differences now: You can take a deduction even if your spouse has a qualified plan somewhere else, and the income phase-out limits are now higher even if you do have a company-sponsored plan. The phase-out increases slightly every year. In 1998, the phase-out level will be $30,000 to $40,000 for individuals and $40,000 to $50,000 for couples. It will rise slightly each year until it reaches $50,000 for individuals in 2005 and $80,000 for couples in 2007. Anyone under those limits will be able to fully deduct their IRA even if they are in a corporate plan. Another change: Currently, if your spouse participates in a company-sponsored pension plan but you do not, you can't deduct your IRA. Under the new law, if your spouse participates but you do not, you can deduct a $2,000 IRA contribution, even if you are a housewife (or husband)-unless you make more than $150,000 jointly, then no deduction.
Pitfalls: A lot of numbers to memorize for a $2,000-a-year contribution. Unless someone will almost certainly be in a lower tax bracket when they retire and will earn conservative returns in the meantime, the Roth IRA seems like a better deal despite its lack of an immediate tax break.
Controversy: Some pundits think that the Roth deal is too good and will likely be repealed at some future point. This might make the immediate tax break a better deal for those who qualify. But this is a bet Roth IRAs wouldn't be grandfathered under future changes.
Hidden Treasure: None, other than the immediate gratification of a deduction available to more people.
Non-deductible IRA No sizzle or hidden treasure here. If you want something non-deductible, why not have it tax-free with the Roth IRA? Phase-out for the Roth IRA is $150,000 to $160,000 income. If you earn less than $150,000, you can contribute the full $2,000. If you earn more than $160,000, you can't deduct anything. Partial deductions are available in between. Congress has a phase-out schedule for every IRA, and it changes every year. So much for tax simplification.