You are probably familiar with Traditional IRAs introduced by Congress in 1981. You deduct contributions from your taxable income in the year that you make them. The earnings grow tax deferred until you withdraw the money, at which time, you then pay the taxes on your withdrawals. In 1986, Congress limited the amount of income you could earn and still get the IRA deduction. For 1997, if you are an active participant in an employer retirement plan, you are subject to phase out rules. For married filing joint the phase out begins at $40,000, for single taxpayers it begins at $25,000. Beginning in 1998, this phase out is raised to $50,000 for married individuals and $30,000 for single individuals. This phase out gradually increases to $80,000 in the year 2007 for married individuals, and $50,000 in the 2005 for single individuals.
Additionally, if your spouse is covered by a pension plan at work but you are not, you can now deduct the full $2,000 contribution as long as your combined adjusted gross income is under $150,000. This is a new, long awaited change. If neither of you has a retirement plan and only one of you has earned income, you can each deduct up to $2,000 as an IRA contribution, assuming your total income is in excess of the amount deducted.
Individuals who have retirement plans and whose income is over the above levels, can still put $2,000 each in a non-deductible IRA. This type of IRA gives you tax deferred earnings, but no up-front write off.
With the traditional IRAs, moneys which have not been taxed will be
subject to 10% penalty if withdrawn prior to age 59. However, there is
a new, important provision. Money withdrawn from an IRA to pay for school
expenses for family members is taxable but not subject to the 10% penalty.
Additionally, withdrawals by a first time home buyer up to the maximum
of $10,000, again, are subject to income tax but are not subject to the
10% penalty. The expenses can be for you or your spouse or a child, grandchild,
or ancestor of you or your spouse.
Beginning in 1998, each spouse of a married couple with a total AGI of under $150,000 and single individuals under $95,000 can make a $2,000 annual contribution to a Roth IRA whether or not he or she has a retirement plan at work. While the money you put into a Roth IRA is not deductible from your taxable income, the Internal Revenue Service never gets a dime of the earnings you build up when you take out the money as long as you are 59 years of age and you withdraw the money after it has been in the account for over five years. Should you take the money out prior to age 59 or before the account is five years old, the earnings are taxed and you may face a 10% penalty. The five year period begins January 1st in the year of conversion. In effect, your retirement assets can grow fully tax free.
As with all IRA's you can withdraw cash without owing the 10% early withdrawal penalties if you are a first time home buyer subject to the $10,000 limit, funding a college education for yourself, your spouse, your children, or your grandchildren, or by paying for medical expenses that are in excess of 7.5% of your AGI. These withdrawals would be subject to tax on the non-taxed dollars but would offer penalty free withdrawals.
The Roth IRA has two key withdrawal advantages. Deductible and non-deductible IRAs require you to start pulling your money out at age 70. With Roth, you may leave your money untouched as long as you like. Also, since you contribute after-tax money to a Roth IRA, you can withdraw your contributions (but not your earnings) without a penalty or further taxes at anytime no matter what your age.
What type of IRA should you open? If your IRA is a non-deductible IRA and your adjusted gross income is within the prescribed limits the decision is a no brainer. The Roth IRA is your best deal. With a non-deductible IRA you defer paying taxes on the earnings but with a Roth IRA, you never have to pay tax on the earnings, assuming you meet the holding provisions.
The longer you wait to withdraw your IRA, the more attractive a Roth IRA becomes. since the Roth IRA needs no beginning distribution at age 70, you can get a huge financial break by keeping your retirement in a Roth IRA well beyond the required distribution of the traditional IRA. Likewise, if you are over 70, you can continue contributing to a Roth IRA as long as you have earned income.
Both IRAs are wonderful for children with part time jobs, since you
can make penalty free withdrawals from a Roth IRA to pay children's college
bills. Opening one in your child's name as long as you have $2,000 in earned
income per year, permits withdrawal without penalty and the retirement
savings account is not currently factored into the Federal Financial Aid
formula. Unless the rules are changed in the future, your children's
IRAs will not reduce the amount of Federal aid that you qualify for. If
they do not use the money for college, the money will continue to accrue
tax fee and at withdrawal after 59 the earnings would be totally tax free.
One in three American households already has an IRA. While these IRAs are accumulating tax deferred the contributions made, the income earned will be fully taxable when it is withdrawn. Another provision in the 1997 Act permits a one year window of opportunity to convert an existing IRA into the new Roth IRA. This conversion is without the 10% penalty; however, one-fourth of the amount converted will be taxable per year over the four year period beginning with the 1998 tax year. If your money is converted into a Roth IRA after 1998, the full amount will be taxable in the year of conversion. Once the conversion has been made, assuming you leave your moneys in the Roth IRA for a minimum of five years and until age 59, all withdrawals from the Roth IRA are totally tax free.
There is a gross income restriction for the Roth IRA conversion. The conversion can be made if your adjusted gross income is not more than $100,000 excluding the amount of the conversion. If your adjusted gross income excluding the conversion is over $100,000, you are ineligible for the conversion. The $100,000 limit applies to both joint and single filers. Taxpayers filing as married filing separately are not permitted to convert to a Roth IRA.
You can convert money from a traditional IRA to a Roth IRA in multiple transactions, but each transaction will trigger a new five-year period for purposes of determining whether those withdrawals are tax-free. The five-year period begins on January 1 of the year of the conversion.
SEP IRAs and SIMPLE IRAs can also be converted into Roth IRAs. However, it is currently unclear whether the 25% premature withdrawal penalty for SIMPLE IRA distributions made in the first two years would apply.
If you are eligible to convert your regular IRA into a Roth IRA in 1998
and you can afford to pay the additional taxes which will spread over the
next four years and you plan on leaving the money in the Roth IRA for a
minimum of five years and until your are over age 59, then the Roth Conversion
is desirable, since all funds withdrawn from the Roght IRA in future years
will be totally tax free.
Beginning in 1998, you can make a non-deductible contribution of up to $500 per year to an Education IRA to pay the qualified higher education expenses of a person chosen by you. This $500 contribution is available if your AGI is less than $150,000 for a married couple filing jointly or less than $95,000 for a single individual.
Qualified higher education expenses include tuition (eligible post secondary educational institution) as well as room and board fees, books, supplies and equipment required for enrollment or attendance. Expenses for graduate level courses are also covered.
An Education IRA is generally exempt from income tax. Your designated beneficiary of the IRA does not include in his or her income either contributions to, or earnings on and Educational IRA. Your Educational IRA contributions must be made in cash, must be made before a designated beneficiary reaches age 18, and no more than $500 per year, per beneficiary is permitted.
If your income is close to the limit earlier described, you would be wise to wait until the year-end before making the contribution in order not to have an invalid contribution.
A distribution from an Educational IRA is not included in taxable income to the extent the amount is transferred into another Educational IRA for a designated beneficiary within 60 days of the distribution. Only one distribution from an Educational IRA can be rolled over into another Educational IRA in a 12-month period. A change in the Educational IRA's designated beneficiary is not a distribution as long as the new beneficiary or Education IRA transferee is a member of the family of the old beneficiary.
At the child's age 30, the Educational IRA must be distributed. Assuming
it has not been used for the purpose designed, the distribution amount
is taxable plus a 10% penalty. Therefore, it is important to monitor this
Educational IRA and change the beneficiary to children under age 18 or
family members of your children should the need arise.
HOPE Scholarship Tax Credit is one of two non-refundable credits available beginning in 1998. The HOPE Credit is equal to 100% of the first $1,000 of expenses for the first two years of post secondary education. For tax years beginning after 2001, the $1,500 maximum HOPE Credit amount will be indexed for inflation. This credit is available for each qualifying student.
Expenses include qualified tuition and related expenses, but not room, board, or books. The qualified tuition or related expenses must be incurred on behalf of the taxpayer, the taxpayer's spouse or a dependent. The credit phase out for married individuals with adjusted gross income over $80,000 and for single individuals with adjusted gross income of over $40,000. The credit is not available to married taxpayers filing separately.
The HOPE credit can be claimed for only two tax years. The individual
must be at least a half-time student for at least one academic period that
begins during the year. The HOPE Credit is permitted only for the first
two academic years of post secondary education. The Credit is disallowed
if the student is convicted of a felony.
The Lifetime Learning Credit is equal to 20% of qualified tuition and fees incurred during the tax year on behalf of the taxpayer, taxpayer's spouse or any dependent. The Credit is available for expenses paid after June 30, 1998 and before January 1, 2003. Up to $5,000 of qualified tuition and fees per taxpayer return will be eligible for the 20% Lifetime Learning Credit. AGI and marital status limitations apply as the before mentioned HOPE Credit. For expenses paid after December 31, 2002, up to $10,000 of qualified tuition and fees per taxpayer return will be eligible for the 20% Lifetime Learning Credit.
Unlike the HOPE Credit, a taxpayer may claim the Lifetime Learning Credit for an unlimited number of tax years. The maximum amount of a Lifetime Learning Credit that can be claimed on a taxpayer's return is $1,000. For expenses paid after December 31, 2002, the maximum credit is $2,000.
Qualified tuition and fees for the Lifetime Learning Credit include amounts incurred for undergraduate or graduate level courses. The Credit is available for the tuition and fees of a student who attends classes, on at least a half-time basis, as part of a degree or certification program. It is also available for any course of instruction and eligible educational instution whether a student is enrolled on a full-time, half-time, or less than a half-time basis if the course is takes as required by or to improve the student's job skills.
While the HOPE Credit is effective for expenses paid after December 31, 1997 for academic periods beginning after that date, the Lifetime Learning Credit is effective for expenses paid after June 30, 1998 for education furnished in academic periods beginning after such date. Under both Credits, expenses must be paid for classes beginning during the tax year or during the first three months of the following tax year. Therefore, prepayments are not permitted. Taxpayers cannot use both the HOPE Credit and the Lifetime Learning Credit for the same student. They must calculate and decide which Credit would be to their best advantage and use that Credit.