Tax Law Creates New Options for Funding Retirement

As a tax professional with experience in the vending and refreshment services industry, I believe that changes in retirement contributions are the most important aspects of the new tax law that took effect beginning in 2006 and for changes taking effect in the next few years.

Individuals have until April 15 of 2007 to change their contributions for 2006.

Assuring financial security in retirement has long been the responsibility of the individual. What many do not realize is that this responsibility will become greater as individuals are expected to provide more of their retirement funds.

In addition, it is unlikely that people will be able to retire solely on their Social Security payments. For individuals who are less than 45 years of age, it is even more important not to depend on Social Security. In the not-too-distant future, more people will be taking money out of Social Security and fewer people will be paying into it. The politicians have a big job ahead of them in fixing this problem, and in the meantime, individuals should not depend on the politicians.

Although federal programs such as Social Security and Medicare will be around in the future, they will need to be restructured in order to keep them solvent. The restructuring will most likely come in two primary ways.

The first change will occur when a person reaches the government's predetermined retirement age. The age limit has steadily increased over the past several decades. The second change reduces the benefits that individuals receive. The restructuring will mean the individual will assume more financial obligation for a longer period of their life.

Additionally, the safety net of pensions, which many in the country have enjoyed in the past, is being reduced or eliminated by employers.

Maximum Deduction Calculation
Single taxpayer Adjusted Gross Income (AGI) is $58,000 in 2006.
What is maximum IRA deduction for 2006?
AGI
$58,000
Less
-$50,000
Excess over $50,000
$8,000
Divided by $10,000 (Phase-out range)
$10,000
Phase out percentage
80%
Times maximum IRA deduction
$4,000
Amount of IRA phased out
$3,200
2006 maximum deduction
$800

Given this information, strategies need to be employed to ensure that a person's standard of living may be maintained into their retirement years. The federal government has recognized this and provides opportunities to prepare for the future.

One vehicle that is available is the Individual Retirement Account (IRA).

Traditional IRAs are funded by pre-tax earnings while Roth IRAs are funded by "post tax" earnings that can be withdrawn tax-free. Many financial professionals believe it is important today for individuals to have both types of funds, pre- and post-tax.

When the government created the traditional IRA in the 1980s, tax rates were high compared to the present time. The thinking then was to contribute funds on a pre-tax basis, then withdraw the funds in later years when the individual presumably would be in a lower tax bracket.

This is why so many companies sponsored retirement plans funded using pre-tax contributions. However, many experts are now questioning the assumption that individuals will be retiring in lower tax brackets. This is why many experts see new importance in plans funded by "post tax" contributions, such as Roth IRAs.

First, let's consider the more common, traditional IRA. The contribution to this IRA is deductible from gross income to arrive at adjusted gross income. The adjustment is allowed only if the contribution is made by the due date of filer's return. No extensions are allowed.

Excessive Adjusted Gross Income
Filing Status
Single/Head of House
Joint
$50,000-$60,000
2006
$75,000-$85,000
$50,000-$60,000
2007
$80,000-$100,000

There are two additional conditions that if both are met, can disallow an individual from taking the deduction.

The first condition is excess adjusted gross income (AGI). The box at the bottom of page 40 shows the levels of income that gradually phase-out the IRA deduction if the other condition is met.

Rules Summary: Traditional IRA Versus Pension
Earned Income
Pension
 
IRA
Spouse 1
Spouse 2
Spouse 1
Spouse 2
2006 AGI
Spouse 1
Spouse 2
Yes
Yes
No
No
Unlimited
Yes
Yes
Yes
No
No
N/A
Unlimited
Yes
Yes
Yes
No
Yes
N/A
Under $70,000*
Yes
Yes
Yes
No
Yes
N/A
$80,000-$150,000**
No
Yes
Yes
No
Yes
N/A
Over $160,000
No
No
*For AGI between $70,000 and $80,000, the IRA for the working audlt phases out.
** For AGI between $150,000 and $160,000, the IRA for the working adult phases out.

For instance, a single filer will begin to lose a total deduction at $50,001 and completely lose the capability at $60,000, if the other condition is met. In the chart above is an illustration of how the deductibility of the IRA is lost as income increases.

The second condition that disqualifies a deduction is met when a taxpayer or spouse actively participates in another qualified plan. There is an exception and a related phase-out of the exception.

The exception is when an individual is not considered an active participant in an employer-sponsored plan merely because the participant's spouse is an active participant.

The maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with modified AGI between $150,000 and $160,000.

The chart above gives a good break down of when a person can or cannot take a deduction.

As mentioned above, when certain conditions are met, an individual can deduct their IRA contribution. However, there are provisions in the tax code that exclude some from participating in deducting their IRA contribution.

Even though this is the case, a person should not abandon the opportunity that the IRA provides. The IRA, in conjunction with an overall investment strategy, can be a great vehicle to build wealth.

The IRA allows the individual to accumulate tax-free (deferred) the earnings on the contributions. Taxes are paid on the earnings when withdrawals are made for the account. The rate at which the withdrawals are taxed is at a person's ordinary rate. Although currently most individuals' ordinary rates are usually higher than the capital gains rate, withdrawals are normally taken when a person retires and their income has been reduced.

Contributions to an IRA are not taxed as long as they were not deducted when they were made. One final point is that non-deductible IRAs can be contributed to even in higher income levels.

The Roth IRA brings new options
The Roth IRA has some features that are beneficial to the investor in different ways than the traditional IRA.

A contribution to a Roth IRA is not deductible on an individual's 1040, regardless of their income level. The beauty of the Roth IRA is that all the withdrawals from the account are tax free. This includes both the initial contribution and the earnings.

Roth IRA Phase Out
Filing status AGI phase out
Single or head of household $95,000 to $110,000
Married filing jointly $150,000 to $160,000
Married filing separately $0 to $10,0000

 

Why is this possible? The reason is that the individual paid the tax on the contribution before it was put in the account.
The Roth IRA is similar to a traditional IRA in that earnings are treated the same way. Both can be withdrawn with no tax consequences.

As with the traditional IRA, there are limits in which an individual or a couple can contribute to an IRA. The general contribution limits are the same as the traditional IRA, $4,000 for the individual and $8,000 for a couple. The Roth, however, has different phase out criteria.

New rules impact IRA benefits
There are two new rules that may be used with IRAs to potentially save taxes or help with an overall investment strategy.

The first is a rule that allows individuals who are over 70½ to make a charitable contribution from their IRA to a charitable organization. The main stipulation is that the money contributed is sent directly to the charitable organization and is not routed through the individual.

The benefit the contributor receives is that the withdrawal, which is normally part of their annual income, is no longer counted as such. A person can make this type of contribution up to $100,000. The rule, as it stands now, is only available in 2007.

Who would want to use this?

Many people who are over 70½ no longer have mortgage payments. If they are healthy and do not have medical expenses that are more than 7.5 percent of their AGI, they have few itemize deductions. Therefore, the incentive to give to charitable organizations from a tax perspective is negligible.

For example, under the old rule, if you made a withdrawal from your IRA to give to a charitable organization, the gift you make would increase your income with no offsetting itemized deduction. The new rule allows you to give to your charity, not increase your taxable income, and take the standard deduction.

A person might also be concerned about Social Security payments. If a person can keep their income low, the Social Security payments are also taxed at low levels. As your income increases, taxes on Social Security payments increase. The maximum rate at which Social Security is taxed is 85 percent. By transferring a portion of an IRA directly to a charity, a person might be able to avoid increasing their income. The gift qualifies as a required distribution and could save substantial taxes on Social Security.

Transferring from a traditional ira to a Roth ira
This past Spring, Congress passed a law that starting in 2010, regardless of income, an individual can transfer their traditional IRA to a Roth IRA. What is great about this is that there were restrictions placed on how much income you could make in order to transfer money.

Currently, if you make over $100,000 a year, whether single or married, you cannot transfer money from a traditional IRA to a Roth. In 2010, that rule goes away.

So you might be saying to yourself, "Well that's great but I have to wait until 2010 to do something different than I'm doing now?" Not really!

Following is a strategy for a person with a qualifying income. The strategy can start this year in anticipation of the change coming in 2010.
As mentioned above, contribution to a traditional IRA is not prohibited, even at higher income levels.

Let's say you're a vending business owner with an income that did not allow you to deduct your contributions to a traditional IRA. However, there is an opportunity with the rule change. You make contributions to an IRA in 2006 and 2007. Each year, you will be able to contribute $4,000. In 2008, the maximum contribution increases to $5,000. So in 2008, 2009 and 2010, you put away another $15,000, for a total $23,000.

Let's say that at the end of 2010 the value of account is $30,000. At that point, you roll the traditional IRA over to a Roth IRA. You'll only owe taxes on the $7,000 in earnings. From that point forward, all earnings will be growing tax free. It's a simple strategy, but one that could pay off handsomely if employed early enough.

Although the future financial burden that most of us will face is greater than recent past generations, there still are opportunities to prepare if one has discipline. There are many other strategies that can be used for other kinds of future needs. The rules change frequently. It's an exciting and daunting challenge all the same. Be vigilant in learning about what choices you have available to you.

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