IRAS Do Or Die? If your IRA contribution is no longer tax deductible, you probably shouldn't make it.
(MONEY Magazine) – IRAS: STILL A GREAT IDEA. That's the hopeful theme of this year's advertising blitz by banks, mutual funds and other financial institutions as the April 15 deadline approaches for making contributions to Individual Retirement Accounts for the 1987 tax year. But millions of Americans are not listening. Despite the marketers' prodigious efforts, experts say IRA contributions will be down by 50% from about $36 billion in the '86 tax year. And for good reason: because of tax changes that took effect in 1987, investing in an IRA could be a mistake. The main problem is that Congress eliminated the full deduction for contributions by middle- and upper-income taxpayers. In their zeal to raise revenues, lawmakers cut in half the number of people who qualify for the full deduction, from the 16 million who were expected to take an '87 IRA write-off under the old rules to 8 million today. Congress additionally burdened people who make contributions to nondeductible IRAs with a lifelong snarl of paperwork. Then too, 1988's lower tax rates dilute the remaining nondeductible IRA benefit of tax-deferred compounding of investment earnings -- an advantage that could be wiped out entirely if, as many economists believe, tax rates rise by the time you start withdrawing the money. The net result? ''Congress has virtually eliminated the IRA as an effective tool in tax and retirement planning for middle- and upper-income people,'' says William E. Taylor, a partner at the accounting firm Deloitte Haskins & Sells in Chicago. Putting the maximum $2,000 in an IRA -- plus $250 in a nonworking spouse's account -- still may make sense if you can deduct the money. The value to you: an investment for your retirement as well as more cash in your pocket from tax savings -- $560 if you are in the 28% bracket. Those who now qualify for the full deduction include couples filing jointly with adjusted gross incomes of less than $40,000; singles with incomes of less than $25,000; and anyone who is not covered by a pension, profit-sharing or other tax-advantaged retirement plan, including simplified employee pensions and Keoghs. Partial deductions are allowed for couples earning between $40,000 and $50,000 or singles earning between $25,000 and $35,000. Their write-off drops $10 for every $50 they earn above $40,000 if married or $25,000 if single. Whether the twin advantages -- a current write-off and tax-deferred earnings -- are sufficient to make a partially deductible, or even a fully deductible, IRA worthwhile depends on how soon you may need the money. If you take it out of your IRA before age 59 1/2, you will have to pay a 10% penalty plus income tax on the withdrawal. When those factors are taken into account, a person taxed at the maximum 33% who contributes $2,000 annually to a deductible IRA earning 8% would have to leave his money untouched for more than 11 years before he turns 59 1/2 to beat the return he would have earned in a taxable investment at 8%, according to Paul Westbrook, a financial planner in Watchung, N.J. The break-even point for taxpayers in the 28% bracket: 12 years. The bottom line? Even if you can take the full deduction, an IRA is sensible only if you are sure that you won't need to tap it for at least a decade. But if your contributions are not deductible, the case against making them can be overwhelming, unless you're within 10 years of retirement. Without the write-off, the real cost of your contribution rises sharply, to an aftertax $2,560 if you put in $2,000 and are in the 28% bracket. Combined with the new lower tax rates, this higher real cost lengthens the time required for tax- deferred compounding to offset taxes and penalties on early withdrawals. A taxpayer in the old top bracket of 50%, for example, who put $2,000 each year into an IRA earning 8% would have had to leave his money untouched for 10 years before age 59 1/2 to equal the return he would have earned in a taxable investment yielding the same 8%. But that taxpayer now must leave his money untouched for nearly two decades to match the return from a comparable taxable investment. Yet another disincentive is the load of record keeping that now accompanies nondeductible IRA contributions. Each year you must fill out a new IRS tax form -- No. 8606 -- to keep track of your deductible and nondeductible contributions. These forms must be saved for the life of your IRA. The information on them will determine the tax on your withdrawals when you begin taking money out of your account. The nondeductible contributions will not be taxed upon withdrawal; the deductible contributions, plus all earnings in your IRAs, will be taxed at your regular income tax rate. Nor will your bookkeeping headaches end once your withdrawals begin. Consider this migrainemaker: Every time you take money out of your IRA, you must calculate the proportion of nondeductible to deductible contributions and earnings in all of your accounts combined. Your withdrawal must then contain this proportion of nondeductible contributions and will be taxed accordingly. Say that your combined IRAs total $20,000, $2,000 or 10% of which represents nondeductible contributions. The other $18,000, or 90%, represents deductible contributions plus earnings. If you withdraw $1,000, you will owe taxes on 90% of that amount, or $900. Some financial advisers argue that the disadvantages of nondeductible IRAs are outweighed by the benefits of tax-deferred compounding of earnings in your account over the long term. But James B. Cloonan, president of the American Association of Individual Investors, a nonprofit educational organization, disagrees. He calculates that deferring taxes on an investment for 15 to 25 years is equivalent to earning an additional percentage point of annual yield. But you could lose that extra yield if your tax rate when you retire is higher than it is today. ''The current 33% top rate is probably the lowest maximum we'll see for a long time,'' Cloonan says, ''and so the yield advantage is almost certain to disappear.''
Fortunately, there are attractive alternatives to nondeductible IRA contributions. Topping the list: tax-advantaged company-sponsored savings plans such as 401(k)s or 403(b)s. In fact, in most respects a 401(k) is actually superior to an IRA, even the fully deductible kind. A typical 401(k) allows you to put away more than an IRA (up to a maximum of $7,000 a year). Moreover, 401(k)s often offer other advantages such as matching contributions by your employer -- as much as $1 for every dollar you put in -- and the ability to borrow against your account balance for any purpose. If you do not have access to a 401(k), top-rated tax-exempt municipal bonds and muni bond funds, both recently yielding about 7.5%, also can serve well as investments for retirement. As taxpayers feel the bottom-line loss of their IRA write-offs when they file their returns in coming weeks, pressure to restore deductibility may mount. Unfortunately, with Congress anxious to reduce the deficit, there is little prospect for success. Nonetheless, Republican Representative David Dreier of California has introduced a bill that would restore the full * deductibility of IRA contributions up to $2,000 for all working taxpayers, as well as raise the top contribution for nonworking spouses from $250 to $2,000 a year. Dreier contends that the loss of revenues would be outweighed by the benefits of increased savings, which would provide much-needed capital for American business, and less reliance by retired Americans on the strained Social Security system. His arguments were recently supported by a study sponsored by the National Bureau of Economic Research, a Washington, D.C. think tank, documenting that only 20% of the $32 billion in IRA contributions made in 1983 represented transfers from existing savings; the other 80% were new savings. Still, Dreier anticipates an uphill battle -- unless his bill gets strong public support. Says he: ''If enough people sent letters to their congressmen urging them to support the bill, there would be some hope of bringing the IRA back to life.'' In the meantime, if you already have IRAs built with contributions that were deductible in the past, be grateful that you can continue to enjoy tax- deferred growth in them through retirement. One exception: if you anticipate making an early withdrawal from your IRA, do it this year to take advantage of 1988's low tax rates.
BOX: Check It Out When IRAs make sense
Consider putting money in an IRA if: -- You are among those whose contributions are fully deductible -- couples filing jointly with gross income of less than $40,000, singles who make less than $25,000 or anyone who is not covered by a pension, profit-sharing or other tax-advantaged retirement plan. -- You qualify for a partial deduction and are sure that you will not need the money in your IRA before age 59 1/2.
When IRAs do not
Contributing to an IRA is probably not worthwhile if: -- You are ineligible for a deduction, especially if you think that your tax rate when you retire will be higher than now. -- You can use other tax-favored retirement savings plans such as a 401(k). -- You don't want to worry about the lifelong burden of paperwork required to document a nondeductible or partially deductible IRA for the IRS.