Some Tips for 'IRA Season'

Dear Readers-
I get LOTS of questions with regard to IRAs and since this is "IRA season," I've devoted this week's column to the subject.

The Tax Act passed in June 2001 sweetened the incentive for certain taxpayers to contribute to a retirement plan. In addition to being able to deduct the contribution from your income, you might also qualify for a tax credit worth up to 50% of your contribution. This is free money from the government and too good to pass up.

A tax "credit" is an amount you get to subtract from the income tax you owe. For instance, say you owe $4,000 in income tax this year and because of your retirement contribution, you earn a credit of $500. Your tax bill drops to $3,500.

In other words, a $1,000 IRA conribution really costs you less than $500 because of the "double dip" tax break you get: your deductible contribution reduces your taxable income, which reduces the income tax you owe; then the tax credit gets subtracted right off your tax bill, reducing it even further.

The maximum tax credit you can qualify for is 50% of up to $2,000. In other words, $1,000 per year, per tax return. It doesn't matter how many retirement plans you contribute to: a 401(k), SIMPLE plan, Keogh,403(b), 457, and IRA all count. What's important is the total amount you contribute. If you're married, you have to file a "joint" return in order to get the credit.

This is a limited time offer! It only applies to tax years 2002 through 2006.

Here's how to figure out if you qualify:

(*Modified Adjusted Gross Income is your Adjusted Gross Income, with some deductions added back in, such as foreign income and interest paid on an education loan. For most folks, your MAGI will equal your AGI. )

Let's say you are married, file jointly, and your MAGI is $29,000. Your spouse contributes $2,000 to her 403(b) at work and you put $1,000 into an IRA. Although as a couple you have contributed a total of $3,000 to retirement plans, you can only count a maximum of $2,000. Based on your income, you qualify for a 50% tax credit, which enables you to subtract $1,000 from your income tax bill ($2,000 x 50%).

Let's say you are single and your Modified Adjusted Gross Income for 2002 was $15,800. If you contribute a total of $2,000 to an IRA or a combination of retirement plans, you will get a tax credit of $400 ($2,000 x 20%).

If you didn't put money into any company-sponsored retirement plan last year, you can still take advantage of this by contributing to an IRA for yourself and/or a spouse. The deadline is April 15 or the date you file your return, no extensions.

Let me say this again: this tax break disappears in 2007. Don't miss out! Take care,

Gail

Dear Gail,

I am confused about something in a column you wrote last summer.You said that that Anne could roll over funds from one IRA to another. I understood that you could only have one IRA per person. Was I misinformed?

Thanks,

Jim

Dear Jim,

You can have as many Individual Retirement Accounts as you want. From a practical standpoint, however, you're better off consolidating your IRAs. That's because each IRA custodian charges an annual fee. These fees can run as little as $10/year to more than $50/year. Some custodians charge you a flat fee no matter how many different mutual funds your IRA is invested in, while others charge you per fund. My point is, these fees can add up, eroding your return.

It's also easier to monitor how your investments are doing if you have your retirement assets in a single account. If you want to change an investment, all you have to do is contact one custodian.

Managing your IRA is simpler, too. Let's say your primary beneficiary passes away. If you have four IRAs, you need to contact four different custodians and fill out four sets of papers to name a new beneficiary.

There might be circumstances which warrant having multiple IRAs despite these issues, such as someone who is in a second marriage and wants to be absolutely certain their spouse and a child from their first marriage each inherit a portion of their IRA and they want to control how the money to their kid is doled out. (In that case, they could invest the IRA being left to the child in a variable annuity, while the one going to their current spouse is invested in mutual funds.)

But in most cases, you can divvy up an IRA among your beneficiaries simply by having one IRA and assigning a percentage to each person.

Hope this helps!

Gail

I was reading  your article on early withdrawal penalties and read about the "substantially equal periodic payments." I would like to know where to get more information on this type of withdrawal. Is it strictly for IRAs or would it apply to other retirement accounts such as profit-sharing retirement accounts?

Thank You.

Jimmy

Dear Jimmy-

Section 72(t) refers to the area in the Internal Revenue Code which outlines the conditions under which you can make penalty-free withdrawals from your IRA or retirement plans before reaching age 59 1/2. However, company plans such as 401 (k)s can choose not to incorporate this flexibility.

The death of the IRA owner, for instance, allows the person who inherits that IRA to withdraw the money without incurring a 10% penalty, no matter what age the beneficiary is. Other "excuses" include buying a first-time home (there's a lifetime limit of $10,000), disability, medical expenses that exceed 7.5% of your adjusted gross income, IRA assets transferred as a result of an order from the judge in a divorce case, covering the cost of health insurance premiums after you've been out of work for 12 weeks, and paying college expenses.

If none of these conditions applies, then you can make withdrawals using one of three IRS-provided formulas. This is the "substantially equal payments" approach you mention. Provided you continue the withdrawals for 5 years or until you reach age 59 1/2 -- whichever takes longer -- there would be no penalty. Of course, all withdrawals from a traditional, tax-deductible IRA are subject to income tax.

For more information, check out Publication #590 from the Internal Revenue Service. You can read or download it from the IRS website: www.irs.gov. Just type #590" in the box on the IRS home page that asks which publication you want.

There is also a website devoted to questions concerning Section 72(t) of the Internal Revenue Code: www.72t.com.

I strongly advise getting help from a financial professional before tapping your IRA using "substantially equal" periodic withdrawals. If you make a mistake, it can be costly.

Good luck!

Gail

Dear Gail,

With the Rules of 5 years withdrawal rate, can one use this plan to roll a traditional IRA into a Roth IRA? With 2 kids and a house payment, I am at the lowest tax rate I should ever be at. Is there any age limit that one can start the withdrawal process? It sound like a great idea, but am I missing something?

Roger

Roger,

If you want to take advantage of your current, low-tax bracket in order to reduce the taxes you would owe on an IRA "conversion," you don't have to concern yourself with Section 72(t). You can convert your traditional, tax-deductible IRA into a Roth at any age and any time your want.

In fact, you don't even have to convert the entire amount in your IRA. Since you will owe income tax on the amount you convert, you might just want to convert as much as you can afford to pay taxes on.

This is not considered a "withdrawal" because your money is remaining in a retirement account. You are simply moving it from one type of IRA to another. Your IRA custodian can send you the forms and instructions to accomplish this.

The benefit of a Roth IRA is that your investments grow income tax-free. You will never owe tax on the gains they earn.

Best wishes,

Gail

On the subject of avoiding the 10% penalty on IRA withdrawals, there is another exemption that allows a person who is leaving (retiring) from a company "in the year he is 55 years old" to withdraw money from his 401 (k) plan without the 10% penalty. This provides a handy option to annuitizing for five years.

Fred

Dear Fred-

The rules governing company-sponsored retirement plans such as a 401(k) often seem similar to those for IRAs, so it's easy to get them confused. However, it's very important that you follow the regulations which apply to the specific retirement plan in question.

You are correct: If, during the year that you leave your company you are at least age 55 or older, you can take withdrawals from your 401(k) plan without being hit with the 10% penalty. However, this only applies if you do not roll your 401(k) assets into an IRA.

If you roll your 401(k) balance into an IRA, then you can't access your money penalty-free until you are 59 1/2 unless one of the exceptions under Section 72(t) applies.

Take care,

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.