It's IRA Day minus eight, and counting. Banks and brokerages are staging an advertising blitz, and offices are full of customers trying to beat the April 15 deadline for making contributions to an Individual Retirement Account for tax year 1984. Unlike past years, no extension will be permitted this time.
Contributions are tax deductible in the year for which they are made, even for taxpayers who do not itemize. For example, a $2,000 IRA contribution reduces taxes by $600 for someone in the 30 percent bracket. Taxes on the earnings are deferred until funds are withdrawn at retirement. They are taxed as ordinary income, but five-year income averaging can reduce the impact of a lump sum distribution.
The maximum contribution for a wage earner remains $2,000 ($4,000 if both spouses work) and $2,250 for an employed person with a nonworking spouse. However, smaller sums can be put aside. Most institutions have a minimum amount required to open or add to an account.
Anyone with income earned from wages, commissions, tips and even alimony is eligible to set up an IRA. Income from interest and dividends is ineligible for sheltering. A person can establish an IRA even if he or she has another retirement program, such as an employer-sponsored 401(k) deferred compensation plan or a Keogh plan for self-employment.
Borrowing to make an IRA contribution is permitted, but the amount cannot surpass the amount earned in the given year. Interest on the loan also is tax deductible.
An IRA holder may begin withdrawing the funds at age 59 1/2 and must start withdrawing by age 70 1/2. The distribution may be stretched out to coincide with a person's life expectancy, recalculated annually. The remainder of an IRA becomes part of the deceased's estate and, in general, must be distributed within five years.
Any number of IRA accounts is permitted. Persons are allowed to change accounts as often as they want to, provided the funds are rolled over from one institution to another. Penalties for premature withdrawal, however, frequently are levied by the institutions holding the funds. Some mutual funds allow unlimited switching without penalty. Persons can elect to receive distributions themselves, but they must put the money back into an IRA account within 60 days. After that time, the Internal Revenue Service considers withdrawal permanent and puts a 10 percent penalty on the taxpayer.
New and existing IRA funds may be invested in a variety of vehicles, such as certificates of deposit at banks and savings institutions, common stocks, bonds, money market funds, mutual funds and insurance annuities. New this year is an IRS ruling that management fees paid separately are tax deductible and do not have to be subtracted from the IRA contribution itself.
Most people will benefit from opening an IRA, but some will not. If someone knows that he or she will have to withdraw the funds within five years to pay for college tuition, for example, the IRS 10 percent penalty would leave less money in the IRA account than if the money had been put into a non-tax-deferred account. Also, if a taxpayer is subject to the alternative minimum tax, deferring from the 20 percent bracket to higher future brackets defeats the purpose, notes Atlanta financial planner Harold W. Gourgues Jr.
Capital gains, which are taxed at a maximum of 40 percent of the ordinary tax rate, sometimes can be a better investment. This becomes true the shorter the period before retirement withdrawals begin and the lower a person's tax rate, especially if the rate is expected to go up in retirement, according to Robert Krughoff. In "The IRA Book," Krughoff and the Center for the Study of Services, the publishers of Consumers' Checkbook, also note that ordinary investments can be leveraged, thus increasing the chance for a greater return, whereas IRA funds cannot be used as collateral.
The bulk of IRA funds are invested in commercial banks and thrift institutions. However, as these funds increase, interest grows in investing them elsewhere, such as in self-directed stock accounts. Many people prefer to be more conservative in placing funds to finance their future than in investing disposable income they can afford to lose. The risks for tax-deferred investments, however, are the same as for non-tax-deferred.
Historically speaking, the highest average return on investment in the past 20 years has been on common stock, but this also has the highest risk. On the basis of past performance, Krughoff recommends the common stock no-load mutual fund for a top rating for expected long-term growth. Savings certificates and Treasury securities also surpassed inflation during that period.
As for money market-related investments, Krughoff says that money market funds can be expected to follow the low-risk, relatively high-return pattern of three-month Treasury bills, as would money market separate accounts under variable annuity contracts. Furthermore, banks and savings institutions tie their rates to Treasury securities, resulting in the same low-risk pattern.
According to Savers Rate News, which monitors depository institutions around the country, the highest yields in this area paid on certificates of deposit for IRAs are in the 11 to 12 percent range, with one yielding 13.03 percent on 18- to 23-month CDs. The accompanying chart gives rates offered by federally insured institutions that allow additions at the original rate. If interest rates decline, this can be of great value for future deposits, but make sure it is written into the contract.