Comparing Different Tax Sheltered Investment Accounts By IndexFunds.com Staff April 19, 2000

Investors have a variety of options when looking to invest their money in tax-sheltered retirement accounts. For investors with more limited income, the traditional IRA allows for an immediate tax deductions. The more recently instituted Roth IRA is available to more individuals, but does not allow for an immediate tax deduction. Unlike the traditional IRA, however, income on the Roth IRA is never taxed. Finally, for self-employed individuals, Keough and SEP plans are available to serve as tax-sheltered investment accounts. For most investors, however, the tax shelter issue boils down to one question:

Traditional or Roth IRA?

If you choose a Roth IRA, the money you place into the account will always be tax free. If you invest your money in a traditional IRA account you will benefit from a significant immediate tax break, but will ultimately pay ordinary income tax, not lower capital gains rates on the money as you withdraw during retirement. The choice boils down to whether or not it makes sense to make a deductible contribution of up to $2,000 per person to a traditional IRA. The IRA contribution must be made by the tax-filing deadline to be counted for the previous tax year. By lowering not just your taxable income but your adjusted gross income as well, a deductible contribution to an IRA may allow you to also qualify for other tax deductions and credits.

By putting money into a traditional IRA, however, you limit or eliminate your ability to contribute to a Roth IRA, which is likely to be a more attractive choice. The Roth offers no immediate tax break, but allows you to withdraw everything tax free once the account has been open at least five years and you are at least 59-1/2 years old. You can contribute a combined total of up to $2,000 a year per person to Roth and traditional IRAs. You could put the whole $2,000 in one type, or $1,000 in each a traditional and Roth IRA, or any other combination.

It is important for individuals who qualify to think carefully about the relative merits of the two types of accounts. While the immediate deduction available with a traditional IRA may make it easier for many people to save a larger amount of money earlier in their working lives, when the money comes out, it will be taxed as ordinary income, regardless of how the funds were actually invested. Ordinary income tax rates are higher than rates for capital gains, which is the rate investments are generally taxed if the buyer holds them for more than a year.

Traditional IRAs

If you are interested in making a deductible IRA contribution you must first see if you qualify. Eligibility depends on how much money you make and on whether you are covered by a pension like a 401(k) or similar retirement plan. If you're not covered by such a plan and are not married to somebody who is, you can make traditional tax-deductible IRA contributions no matter how high your income, as long as you earn enough to cover the contribution itself. A single filer who is covered by an employer pension plan could earn as much as $31,000 in annual adjusted gross income and make a fully deductible $2,000 contribution. A partially deductible contribution is allowed assuming adjusted gross income did not exceed $41,000.

The qualifying figures for couples filing jointly are between $51,000 and $61,000. Spouses of people not covered by employer plans can make deductible contributions even if they themselves have not earned income, as long as their spouse's income equals at least their total contribution. In addition, spouses of pension plan participants can make fully deductible IRA contributions as long as the couple's adjusted gross income is less than $150,000. For such spouses, partially deductible contributions are allowed up to $160,000 of income.

Roth IRAs

It is much easier to qualify for a Roth IRA. Single taxpayers are allowed to contribute up to $2,000 to a Roth IRA as long as they earn no more than $95,000. The amount they can contribute is phased out gradually as their income increases until, at $110,000, no they are not allowed to contribute. The corresponding phase out range for couples married and filing jointly is from $150,000 to $160,000. Participation in an employer plan does not limit the ability to contribute to a Roth IRA. The benefits of the Roth IRA are reaped when the money is withdrawn. Distributions from a Roth IRA simply don't count as income. Even if you withdraw tens of thousands of dollars, this money is completely tax-free, and you can still qualify for various itemized deductions that are generally limited for people with higher incomes. If you are receiving Social Security benefits, your Roth IRA distributions don't push your income up in the eyes of the IRS to make those benefits taxable. The Roth distributions are simply not ever treated as income.

Converting IRAs

Despite the advantages of the Roth, you may decide you prefer a traditional IRA now. If you already opened a Roth IRA, you still have still have until tax day in mid-April to change your previous year’s contribution back to a traditional IRA. If you realize you need the $2,000 deduction that a contribution to a regular IRA yields, you can change your mind and convert that Roth IRA contribution into a traditional IRA contribution without any penalty, as long as you beat the tax deadline date.

The opposite is also true. If you already made your contribution to a traditional IRA, you can change your mind and apply the contribution to a Roth IRA as long as you do it by the tax deadline. In either case, it is as if the original choice was never made. Similarly, you have until April 15 to back out of any Roth IRA conversion you made the previous year.

When a traditional IRA is converted into a Roth IRA, you are taxed as if you simply withdrew the amount being converted, but without additional penalties. So if you make a conversion, you may find yourself pushed into a higher tax bracket as a result. This could also deprive you of tax breaks such as the education and child credit that phase out at higher income levels. Again, by doing a recharacterization -- by contacting your IRA custodian for the proper forms and filling them out by April 15 -- you can undo any conversion you made the previous year and turn the Roth IRA back into a traditional IRA.

Tax Shelters for the Self-Employed

For self-employed taxpayers, bigger tax breaks are potentially available. The self-employed can make contributions to a Keogh or SEP plan up through the day of the tax deadline, including extensions. A four-month extension is automatically granted if you file Form 4868 by April 15 and an additional two-month extension may be granted if you can convince the IRS you need it. Although the actual contributions could wait as far as mid-October, the Keogh plan must have been established by Dec. 31 of last year for the contributions to count for that year.

The simplified employee pension, or SEP plan, on the other hand, can be established up April 15 to qualify for the previous tax year, and can be funded by the date of the last extension. Contributions to a SEP plan are based on a complicated formula and limited to roughly 13 percent of net self-employment income.

If you are eligible for a large contribution, which in 1999 could total as much as $24,000, the tax savings could be sizeable enough to justify borrowing the money to make it. If you crunch the numbers and discover you're eligible for a $12,000 SEP contribution for the previous tax year, but you don't have an extra $12,000 to invest, you can borrow the money to invest and get a $12,000 deduction for it. If you are in the 28 percent tax bracket, a $12,000 contribution would save you $3,360 in taxes. By tapping an equity line of credit, you likely will be able to deduct the interest you pay on the loan, Nelson said. What's more, whether you contribute to a Keogh, a SEP or a 401(k) or similar plan, you can also contribute to an a traditional or Roth IRA as long as you meet IRA eligibility rules.

IndexFunds.com Staff