Since they were created, traditional individual retirement accounts (IRAs) have grown in popularity with investors. IRAs offer some very attractive benefits.
IRA Tax Advantages
For many people, IRAs offer a substantial current income tax deduction. If you qualified in 2002, you could make a tax-deductible contribution of $3,000 to your IRA (or if married, you could make a combined contribution of $6,000). The contribution limit remains unchanged for 2003, and it will gradually increase to $5,000 per year ($10,000 for joint filers) in 2008. In addition to this deduction, the assets in an IRA can grow tax-deferred. Over a period of years, this tax deferral can add up to quite a significant advantage.
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Contributions and earnings are taxed as ordinary income when they are withdrawn. In addition, withdrawals prior to age 59½ are subject to a 10 percent federal tax penalty. Because Congress has tightened the requirements for IRAs, the number of people who qualify for a full deduction has been cut in half. Congress also added a heavy burden of paperwork to anyone who makes nondeductible contributions to an IRA. Before you jump into an IRA, it’s important to determine whether it will meet your retirement planning needs.
The deductibility of your IRA contributions
The first thing to determine is whether your contributions to a traditional IRA are deductible. If you are an active participant in a qualified retirement plan — such as a simplified employee pension or a 401(k) plan — your IRA deduction may be reduced or eliminated.
For active participants of qualified plans, the IRA deduction drops by $10 for every $50 of income above the bottom figure on the phase-out ranges.
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Nondeductible contributions may necessitate some very complicated paperwork when you begin withdrawals. If your contributions aren’t deductible, you may be better served by another retirement plan.
If you qualify to make tax-deductible contributions and can leave your funds in place, IRAs often make sense. An IRA could be a valuable addition to your retirement and tax planning efforts. A financial advisor can help you determine whether an IRA makes sense for you.