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Getting to Know IRA's

In our continuing series on the four investment quadrants, let's tackle the tax issues with some proven investment vehicles that shield your money from the clutches of Uncle Sam.

First up -- individual retirement accounts (IRA's):

Individual Retirement Accounts (IRAs)

Contributing to any kind of IRA is a good idea, even if you can't deduct your contributions. That's because the earnings in the account grow tax-free until you withdraw them. With a traditional IRA, you may be able to deduct your contributions, too:

* If you are single and participate in an employer-maintained retirement plan, you can deduct the full amount of your traditional IRA contributions if your adjusted gross income (AGI) is less than $33,000. You can deduct a portion of your contributions if your AGI is between $33,000 and $43,000. If your AGI is $43,000 or more, you can't deduct any contributions. If you do not participate in an employer-maintained plan, you can deduct all of your contributions, no matter how high your AGI is.

* If you are married and filing a joint return, the rules are a bit more complicated. If neither you nor your spouse participates in an employer-maintained retirement plan, your traditional IRA contributions are fully deductible. If you participate in such a plan, your contributions are fully deductible if your AGI is less than $53,000, partly deductible if your AGI is between $53,000 and $63,000, and nondeductible if your AGI is $63,000 or more. If your spouse participates in an employer-maintained plan but you don't, your traditional IRA contributions are fully deductible if your AGI is less than $150,000, partly deductible if your AGI is between $150,000 and $160,000, and nondeductible if your AGI is $160,000 or more.

When you take money out of a traditional IRA, much—if not all—of it is taxable. As you consider a withdrawal around year-end, weigh the potential advantage of holding off until the New Year arrives. If you can wait to put your hands on the money, you can make Uncle Sam wait an extra year before he gets his share. But if you find yourself in a higher tax bracket in the future-due to higher income or increases in the tax rates-you may want to speed up IRA withdrawals to avoid the stiffer tax bite.

In the year you reach age 70 1/2, the law demands that you begin withdrawals from your traditional IRA. But the first mandatory distribution—the one for the year you turn 70 1/2—can be put off until as late as the following April 1. Holding off trims your taxable income and your tax bill in the current year. But you must double up in the second year. In addition to the withdrawal made by April 1, another withdrawal has to be made by December 31. If the resulting boost in taxable income shoves you into a higher tax bracket, your income-deferral strategy could backfire. Note that withdrawals from a traditional IRA are taxable unless you made nondeductible contributions in which case a portion of the withdrawal will be nontaxable.

Roth IRAs

Another IRA option is the Roth IRA. Contributions to this type of IRA are never deductible, but qualified withdrawals from a Roth IRA are nontaxable.

With Roth IRA’s, earnings are non-taxable when withdrawn, provided you meet the holding requirements. Another advantage is, unlike traditional IRAs, the IRS does not require you to take a distribution from a Roth IRA when you reach age 70 1/2. Roth IRAs are not without some restrictions, however. As with traditional IRAs, distributions of earnings are taxable and subject to a 10-percent penalty if taken out prematurely. With a Roth, you must leave your money in for five years. If you’re eligible for both a deductible traditional IRA and a Roth IRA, your choice can be a difficult one. You’ll need to balance your need for current deductions with your desire for tax-free retirement income.

Next up to bat, 401(k) plans.

Published Nov 27 2006, 09:16 PM by moneycoach
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