© by Lita Epstein

Even if you have a retirement plan at work, there is at least one type of IRA into which you can make additional contributions so you can shelter retirement savings from immediate taxation and allow the money to grow tax-deferred or tax-free depending on the option you choice. You have until the day you actually file your tax return to make these contributions, so it isn't too late to contribute for the year 2002 and take a deduction.

The allowable contribution amounts are increasing through 2008. After that time they will be adjusted for inflation in $500 increments. If you are 50 or over, you can make additional catch-up contributions as well. Here's a chart that shows the allowable IRA contributions:

What does get confusing when it comes to IRAs is the rules about who can contribute to what. There are basically three types of IRAs - traditional tax-deductible IRA, traditional non-tax deductible IRA, and the ROTH IRA. Let me review the contribution rules for each:

The traditional tax-deductible IRA is primarily for people who do not have a retirement plan at work. Any contributions you make to this type of IRA can be written-off as a tax deduction. If you or your spouse has a retirement plan at work things get a bit more confusing. If both of you have a retirement plan at work, then your income in 2002 must be no higher than $64,000 (married filing jointly) or $44,000 (single). The deduction allowed begins to phase out at $54,000 (married filing jointly) or $34,000 (single). If only one of you has a retirement plan at work, then the person without the plan can still contribute and deduct the contribution from taxes provided your adjusted gross income is below $160,000. The allowable contribution is phased out for couples with adjusted gross incomes between $150,000 and $160,000.

Even if you are not able to deduct your contribution, the tax-free or tax-deferred savings of the other two IRAs certainly make it worthwhile to open and fund an IRA. Your next best choice if you are not able to deduct the contribution is a Roth IRA, because all funds withdrawn from an IRA after age 59½ are tax-free - even your capital gains and dividends. The only catch is that your Roth IRA must be established at least five years before you begin taking money out to get the tax-free advantage. You may even want to take advantage of the Roth's tax-free status and use this instead of a tax-deductible IRA.

Unfortunately, Congress didn't give this tax-free savings away. You have to jump through lots of hoops to qualify. There are stricter income limits to qualify - a modified adjusted gross income (MAGI) of no more than $160,000 for married couples and $110,000 for singles. The modified gross income for Roth eligibility is figured as follows:

1. Subtract any income resulting from the conversion of an IRA (other than a Roth) to a Roth IRA (conversion income).
2. Add the following deductions and exclusions:
   1. a. Traditional IRA deduction
   2. Student loan interest deduction
   3. Foreign earned income exclusion
   4. Foreign housing exclusion or deduction
   5. Exclusion of qualified bond interest shown on Form 8815.
   6. Exclusion of employer-paid adoption expenses on Form 8839.
   7. Qualified tuition and related expenses.

Now that you know your MAGI, you then have to use this rather complicated IRS table to figure out whether you can contribute to a Roth:

The Roth rules are confusing, but it is certainly worth getting that tax-free savings to take the time to sort out the difficulties. Roth's have other advantages too. For example, while with other IRAs you must start taking the money out at age 70½, there are no withdrawal requirements for the Roth. If you don't begin withdrawing money at age 70½ from traditional IRAs there will be a 50 percent excise tax on the money you didn't withdraw as required. See withdrawal options for more information on these rules.

All is not lost if you earn too much to qualify for a Roth, you can still use the non-tax-deductible IRA, which has no income caps. If you do chose to use this IRA, be sure to carefully track the money you contribute. Since you've already been taxed on that money you don't want to be taxed again as you withdraw it. All the money taken out of a tax-deductible IRA is taxed at current income tax rates, but only the gains from a non-tax-deductible IRA are taxed at current income tax rates. Your contributions have already been taxed and are withdrawn tax free after age 59½.

If you withdraw funds earlier, there are taxes and penalties. You can avoid the penalties, but may still have to pay taxes before age 59½ if you withdraw funds for one of these reasons:

1. You become disabled.
2. You're buying your first home and want to use $10,000 or less.
3. You must pay off significant medical expenses.
4. You lost your job and need the money to pay for medical insurance.
5. You want to go back to school and use the money for qualified higher education expenses (the Coverdell IRA is a better choice for this).
6. You have reached age 55 and retired or were terminated from your job.

If you have a Roth IRA for at least five years, you can withdraw your contributions without tax or penalties, but you will have to pay taxes at current income tax rates on any gains withdrawn. You can avoid taxes completely with early withdrawals from a Roth IRA if they are being used to buy your first home or if you become disabled.

Previous Article | Next Article

List of Articles by Lita Epstein

Copyright 2003, by Lita Epstein.
Website: http://www.litaepstein.com
E-Mail:

Lita Epstein is the author of:

• The Complete Idiot's Guide to Social Security
• Complete Idiot's Guide to Tax Breaks and Deductions: Get the Most Out of Uncle Sam
• Streetwise Retirement Planning: Savvy Strategies and Practical Advice for a Secure Financial Future
• The Complete Idiot's Guide to the Federal Reserve

Lita Epstein has also coauthored:

• Teach Yourself Retirement Planning in 24 Hours

Lita Epstein Main | Authors Row Main | Home