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Individual retirement accounts: something for everyone

While there have been some changes in how much you can contribute to individual retirement accounts (with more to come in the next few years), the basic advantage of these accounts remains unchanged. IRAs can help you avoid some taxes and get a jump-start on retirement too.

The IRA was originally developed in 1974 for people not covered by a company pension plan. "The individual retirement account legislation allowed the average person a chance to put money in to a tax-advantaged account," says Bruce Grace, a Chartered Financial Analyst and Assistant Professor of Finance at Morehead State University.

This is a considerable benefit for individuals, regardless of whether they have company-established pension plans. "The Roth IRA may be even a better deal for those who think they will be in a higher tax bracket at retirement," Grace added.

Since the original enactment of IRA legislation, several types of IRAs have been developed with a variety of characteristics that can meet your investment and retirement needs.

Traditional IRA:
Contributions may be fully deductible, partially deductible or not deductible, depending upon your income and other retirement coverage.

  • The maximum contribution for the 2003 tax year is $3,000. People 50 or older can make an additional contribution of $500 for a total of $3,500.
  • Full allowable contribution generally is allowed if the account holder (or spouse) is not covered at any time during the tax year by a retirement plan, including a 401(k) account, at work.
  • If you are a single or head-of-household taxpayer with annual adjusted gross income (AGI) between $40,000 and $50,000 and are eligible for a company retirement plan, your deduction will be reduced. Deductions also are limited for married couples filing jointly or qualifying widows or widowers who earn between $60,000 to $70,000 per year.
  • Even if you do not have a retirement plan at work, your deduction also may be limited if your spouse, with whom you file a joint return, does have a company pension plan. In this case, your deduction will be reduced if your joint income is between $150,000 and $160,000. No deduction is allowed if your AGI exceeds $160,000.
  • If you have a non-working spouse, he or she can contribute up to $3,000 ($3,500 if 50 or older) to an IRA also as long as the two of you together make at least as much in annual income as you contribute.
  • Profits and income from investments are not taxed until you retire and begin withdrawing funds.
  • You can withdraw funds, without penalty, when you reach age 59. If you take out money before then, you usually will face a 10 percent penalty, plus taxes on the withdrawn amount.
  • Under certain circumstances, you can take penalty-free distributions before age 59.
  • In the year that you will turn 70 you can no longer make contributions to your account. In fact, at that age you must start withdrawing the account money or face additional penalties.

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Roth IRA:

  • For 2003 returns, you can contribute up to $3,000 to a Roth IRA if you are single and make $95,000 or less or are married earning less than $150,000 in adjusted gross income.
  • You can still contribution but not the maximum amount if you're single and make up to $110,000 or married and earn up to $160,000. Once you're over these limits, you can't put any money into a Roth IRA.
  • There is no tax deduction per se for Roth IRAs. Contributions are made with money that has already been taxed, so there is no immediate tax break. But when Roth money is taken out, it is a tax-free distribution.
  • This type of IRA is ideal for individuals in a lower tax bracket now, but anticipate being in a higher tax bracket at retirement.
  • You may make contributions at any age, even after you reach 70.
  • You must have your Roth account for at least five years before you can take a penalty free distribution of earnings. Distributions of earnings without penalty can be taken after age 59. If you are a first-time home buyer or become disabled, you can take distributions earlier.
  • If you exceed the income limits you can neither contribute to nor roll over other IRA money into a Roth account. If you opened a Roth while you were under the income limits but then later earn more, your Roth account still will earn money tax-free that you can take out later without tax implications, but no new contributions are allowed.

Education IRA/Coverdell ESA:

  • These plans are now called Coverdell Education Savings Accounts in honor of the late U.S. Sen. Paul Coverdell. Individuals can make annual contributions of up to $2,000 per child into an account that's exclusively for helping to pay higher education costs.
  • The money contributed to a Coverdell account doesn't count against the $3,000 ($3,500 if 50 and older) annual total individuals may contribute to their combined persoanl individual IRAs. The earnings and withdrawals from a Coverdell account are tax-free, but you can't deduct the contributions from your income tax because the account is for the benefit of the child, not the contributor.
  • If your child received a Coverdell ESA distribution, you now can also claim Hope Scholarship or Lifetime Learning credits. Just make sure you don't use Coverdell money to pay for the same expenses you use to claim an education credit.
  • The beneficiary of the education IRA must withdraw the funds by age 30 and pay taxes and penalties on it. However, the account can be transferred to a sibling or the beneficiary's child.

SEP-IRA (Simplified Employee Pension):

  • A company-sponsored IRA, it can be opened by the smallest of businesses, the sole proprietor.
  • Under the SEP-IRA plan, an employer can contribute to an employee's existing IRA. The penalties for early withdrawal remain the same as with the traditional IRA. Contributions are deductible.
  • If you are a small business owner, IRS Publication 590, Individual Retirement Arrangements, explains the contribution limits for these plans. Self-employed taxpayers have a different standard for contribution limits than employees of a firm that offers a SEP-IRA plan.
  • SEP-IRAs are flexible for employers. An employer does not have to contribute every year. The contributions are tax-deductible.

SIMPLE IRA (Savings Incentive Match Plans):

  • Like the SEP-IRA, the SIMPLE IRA is company-sponsored.
  • As a small business owner, for 2003 you can match each employee's pay up to 3 percent or $8,000, whichever is less.
  • SIMPLE IRA contributions are fully deductible.

In addition to these IRA accounts, individuals and small businesses have a number of options to sock away money toward future retirement educational needs.

Small businesses, which cannot afford to sponsor a 401(k) or 403(b), can also offer employees basic retirement plans established for the benefit of their employees. Sole proprietors also now can open individual 401(k) plans.

Examine the options and pick the one that maximizes your long-range savings goal. And don't wait. Take advantage of compound earnings and start socking away cash now for tomorrow.

-- Updated: Oct. 21, 2003

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See Also
Traditional IRA pays off for some
The rules of Roth IRAs
Managing your IRA just got easier
More tax stories
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