Personal Finances - 2017


All About IRAs - Pertinent History

By Mo Vidwans

Over the last 40/50 years, Americans have not shown any strong aptitude or penchant for saving, let alone saving for retirement. Their record is abysmal (however, I must note that most folks of Indian heritage carry a different philosophy). The Economic Policy Institute notes that the average retirement savings for all US families is just $96,776. As low as that number seems, it exaggerates the broader health of retirement savings because some high savers skew those numbers. It is not a surprise then that Congress, in the 70s, decided to do something about it (1974: ERISA introduced first IRA). There were more laws passed over the years (1978, 81, 86, 92, 96, 97, 2001, 06, 10) changing the rules of the savings plan for better. The biggest advantage of IRAs is the tax-deferral nature of these forced savings that are aimed strictly at retirement.

IRAs are only for each individual. Not for a couple or for a family.

IRAs can be viewed as compulsory savings and once contributed they are locked up for a long period; not to be touched until at least to your age of 59.5 at which time they can be withdrawn without a penalty but you need to pay the income taxes. There are, however, exceptions to the rule of withdrawal and under some hardship circumstances these funds can be withdrawn without penalty. It is not something I would recommend.

IRA document itself is a written trust or a custodial account whose trustee or custodian must be a bank, credit union or an organization that receives IRS's permission to act as trustee or a custodian. No one can be a trustee of his/her own IRA because IRS mandates arm's-length dealing between the beneficiary and those in charge of enforcing the IRA rules like the custodians.

IRAs can be invested in multitude of vehicles, running the gamut from mutual funds to individual stocks and bonds to limited partnerships with a myriad of risks and returns associated with it. Self-directed IRAs are also popular because they give the investor the flexibility in investments and ability to anticipate the market changes and act accordingly. I generally recommend self-directed IRAs to my clients, most but not all.

Investment restrictions exist but not too many. Investment in life insurance is not allowed. Collectibles such as art, oriental rugs, antiques, rare coins, stamps, rare wines and certain other tangible properties are not in the picture for investing. There are, however, some exceptions for certain coins and precious metals. There are also some other prohibited transactions. It should also be noted that penalties for failure to satisfy the investment restrictions could be severe.

TRADITIONAL IRAs

Today, a person under 50 can save up to $5,500 (over 50 can add another $1,000) of his earned money in to a Traditional IRA and then let it grow, tax-free, until the time comes to withdraw for retirement pleasures. Then the time arrives to pay the Piper; we will discuss that later. If somebody has the vision to start such a program at the earliest time, the moment he or she starts earning (say at the age of 22) and invest in an IRA to the fullest, that person can become a millionaire at the age of 70 just from these savings; such is the power of compounding effect. Of course it will depend on how and where such monies are invested.

Traditional IRAs are similar to employer sponsored retirement plans in many ways. Both are tax-sheltered savings plans that encourage the accumulation of savings for retirement because they allow contributions to be made with pre-tax dollars and earnings to be tax-deferred until your age of 70.5. Funding vehicles and types of allowable investments are the same in any conventional investments.

Unfortunately, there are many rules and restrictions we have to follow in order to comply with this savings program. There is a limitation on the highest income level. If your modified adjusted gross income (AGI: line 37 on form 1040) exceeds $98,000 for married filing jointly ($61,000 for singles) then the phase-out level begins for those who are covered by a pension plan at work. Married filing jointly, one spouse not covered by a pension plan, but the other spouse is, the limit is $184,000 for 2016.

IRA contributions will always be deductible if neither the taxpayer, nor the taxpayer's spouse, is an active participant in an employer-maintained retirement plan.

ROTH IRA

These are similar to Traditional IRAs as discussed above except they are funded by after-tax dollars and hence you cannot use them to reduce your taxable income. But there is one big advantage. Of course they grow tax-free and then the withdrawal of these funds, when the time comes, is also tax-free. Obviously you do not get the benefit of reducing the income tax but you do enjoy the fruits of your actions later because no taxes need be paid at the time of withdrawal. It is essential to project your tax level and income level at the time of withdrawal while deciding which route you may wish to take.

Many other rules for Roth are the same as Traditional IRA. However, determining whether an individual is eligible to make a contribution to a Roth IRA is simpler than a Traditional IRA. Eligibility is entirely dependent upon an individual's adjusted AGI and tax filing status. An individual's active participant status (in defined benefit plans) is not relevant. Also, unlike traditional IRA, contributions can even be made after attaining the age of 70.5.

ROLLOVER AND CONVERSIONS

There are stricter rules for both rollover and converting one IRA to another. If rollover is required I strongly suggest doing it as a custodian-to-custodian kind. You can do unlimited of these. Should you choose to do it yourself then only one is allowed per year and then you have to make sure you do the rollover within 60 days. Conversion has its own set of stricter rules especially when you have both Roth and Traditional IRAs. It also involves paying taxes, from non-IRA money, at the time of conversion.

I will continue with a question/answer session in the next two months.