COLUMN:

The ABCs of IRAs

By Diane L.S. Ho

Many people mistakenly believe that once gray hairs start showing up on their heads and they start qualifying for senior discounts at stores and theaters, it’s too late to start an individual retirement account (IRA). Not so.

While opening an IRA in your 20s certainly is advisable, you’ll still be able to reap benefits by starting one after age 50 as long as you have earned income.

But which IRA — Roth or Traditional — do you choose? Is one better for you than the other? Or should you have both?

Comparing options

With a Roth IRA, you save with after-tax dollars; generally speaking, when you withdraw your money, it won’t be taxed. The idea is to pay taxes up front and never pay them again. Be aware, however, that you don’t receive a tax deduction with a Roth.

You can contribute the full amount to a Roth (outlined in the Annual Contributions section of this article) as long as your Modified Adjusted Gross Income (MAGI) doesn’t exceed $95,000 if you’re single or $150,000 if you’re married and filing a joint return. Contributions are phased out at $110,000 if you’re single and $160,000 if you’re married and filing a joint return.

A Traditional IRA allows you to save while your investments grow tax-deferred until you withdraw them. If you’re eligible and under 70½ years old, you can take a current tax deduction for all or part of your contribution. A full deduction is available if you aren’t covered by an employer-sponsored retirement plan.

If you’re covered by a plan, you can still take a full deduction against your 2007 taxes if your MAGI for 2007 is less than $52,000 if you’re single and less than $83,000 if you’re married and filing jointly. Also, if you’re married and filing jointly and either you or your spouse is covered by a retirement plan, the spouse who isn’t covered can make a fully deductible contribution as long as your combined MAGI doesn’t exceed $156,000. The deduction is phased out at $166,000.

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Which IRA is best for you?

A Roth IRA provides the most advantages, especially for those with long time horizons. You can roll over your Roth account from your employer’s 401(k) or 403(b) plan to an individual account. Your contributions can be withdrawn tax-free and penalty-free at any time.

The earnings on your contributions can be withdrawn tax-free and penalty-free if your initial contribution to the account was made at least five years ago and you meet one of the following conditions: you’re at least 59½ years old, you’re purchasing a home for the first time, you’re disabled or you die, in which case your beneficiary will receive the payments. There are no age restrictions on making contributions to the account as long as you or your spouse have earned income and you aren’t required to take withdrawals at a specified age.

There are, however, some drawbacks to a Roth IRA. You cannot withdraw your Roth earnings tax free unless you’ve held the account for five years and you’re at least 59½ years old. You may be subject to a 10 percent federal tax penalty if you’re not at least that age. And, as mentioned earlier, if your MAGI is too high, you may not be eligible to make contributions to a Roth.

One benefit of a Traditional IRA is you can roll over your retirement money from your employer’s plan to an individual plan when you change jobs or retire. It’s a good choice if you qualify for a current tax deduction or you expect to be in a much lower tax bracket in retirement.

Your IRA earnings grow tax-deferred and the current tax deduction reduces your tax liability. Penalty-free early withdrawals are allowed for a qualified first-home purchase (up to $10,000), for higher education and in cases involving disability, the payment of certain health insurance and medical bills, and death (payments would go to your beneficiary). You will, however, have to pay taxes on these withdrawals. Withdrawals can be made for any purpose without a 10 percent federal tax penalty after age 59½ or in the case of disability or death.

The Traditional IRA also has some disadvantages. Unless you meet the eligibility requirements, you cannot take a deduction on your contributions. Your deductible contributions and any earnings in the account are taxed as income when you withdraw them. You cannot take an early withdrawal without incurring taxes and a possible 10 percent federal tax penalty on some of your contributions and earnings unless a 72(t) exception applies (ask your financial consultant for details about this).

Also, unlike a Roth, you cannot make contributions after age 70½. Finally, to meet minimum IRS requirements, you’ll have to start taking withdrawals — called required minimum distributions — from your account when you reach age 70½.

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Annual contributions

With a Roth IRA and/or a Traditional IRA, you can contribute up to $4,000 combined for 2007 if you’re single and earned as much as your contribution. If you’re married and filing jointly, you and your spouse may contribute $4,000 each as long as you or your spouse earns as much as your total contribution amount.

Individuals aged 50 or older who meet the income requirements can contribute an additional $1,000 for a total of $5,000 for 2007 ($10,000 for both you and your spouse if you’re married, filing jointly and both older than 50).

So if you thought you missed the boat as far as IRAs are concerned, think again. You may be pleasantly surprised.

Diane L.S. Ho is the director of financial services at Sterling & Tucker Financial Services in Honolulu. This column provides general information only; it is not intended to replace recommendations you would receive from your tax or financial advisor, who is most familiar with your financial situation.

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