Consider Holding Off on IRA Contributions

It’s decision time again for individual retirement accounts. The period between now and April 15 will be the peak season for IRA sales, since contributions you make before then can be counted on your 1987 tax returns.

But thanks to tax reform, which prohibits certain high-income taxpayers from deducting IRA contributions from their taxable income, many investors are more reluctant to take the IRA plunge.

Should you continue to make an IRA contribution this year?

If you can deduct your contribution, yes. But if you can’t, you may be better off--at least for this year--to hold off or place your money into such other investments as tax-free bonds, particularly if you are younger and may need access to your savings for a home or other major purchase, many experts say.

Under the previous rules, you could contribute up to $2,000 each year to an IRA and deduct that amount from your taxable income. Under the new rules, you cannot deduct that contribution if you or your spouse are covered by a pension or profit-sharing plan at work and if your adjusted gross income exceeds certain levels. Those levels are $50,000 if you are married and filing jointly or $35,000 if you are single. (You are entitled to a partial deduction if your adjusted gross income is between $40,000 and $50,000 for joint filers and between $25,000 and $35,000 for singles.)

IRAs still have some advantages. You can defer taxes on the income in them until it is withdrawn, regardless of whether your initial contributions are deductible. And the accounts can be a form of self-forced savings that could provide much-needed discipline for some investors.

But without the initial deduction, the economics of IRA investing change dramatically. Here are some of the major arguments against contributing to an IRA on a non-deductible basis, at least for this year:

- The record-keeping hassle. Tax reform requires taxpayers making non-deductible IRA deposits to keep track of how much of their IRA comes from deductible and non-deductible contributions. Over the years, this requirement may be enough to cause a run on the aspirin supplies.

“It’s just a pain in the neck,” says Sidney Kess, partner with the accounting firm of Peat Marwick Main.

Another hassle: Anyone making non-deductible contributions must file the new IRS Form 8606 with his tax return.

- New withdrawal rules. When you withdraw funds from an IRA with both deductible and non-deductible contributions, you will be taxed on a pro-rated basis, depending on what percentage of your account was already taxed and what was not taxed.

For example, let’s say a few years from now your IRA is worth $20,000 and you had made a $2,000 non-deductible contribution. If you wish to withdraw $2,000, you can’t just designate that $2,000 as the non-deductible amount and avoid tax on it. Instead, you must pay tax on 90% of the $2,000, since that is the percentage of your entire IRA yet to be taxed.

“You could be in a negative position if you have to take the money out too soon,” said Deborah Walker, a tax partner with Peat Marwick Main.

- Early withdrawal penalties. If your initial contributions are tax-deductible, the 10% penalty for early withdrawals before age 59 1/2 is tolerable. In fact, many studies show you could end up earning more, after tax, in a deductible IRA even with the 10% penalty, compared to a taxable investment outside an IRA.

But in a non-deductible IRA, the 10% penalty becomes more onerous, particularly for taxpayers under age 40. Many of these baby boomers eventually will need to draw on their savings to buy a new home or pay for their children’s college education, contends Larry Biehl of Bailard, Biehl & Kaiser, a San Mateo financial planning firm. Anything that reduces their liquidity is not a good idea, he says.

“Non-deductible IRAs are good for persons who are not going to need the money because the tax-deferral of income is always good,” Peat Marwick’s Walker said. But because she is only 37 and has lost her IRA deduction, Walker said, she is no longer making IRA contributions.

- Lack of flexibility. Once you lose the deductibility of your initial contributions, the straitjacket rules of IRAs become more burdensome. One such rule: You will be penalized if you don’t start withdrawing from your IRA once you hit age 70 1/2.

- Lower tax rates now, higher tax rates later. Today’s lower tax rates reduce the value of the tax deferral in IRAs, says William G. Brennan, editor of Brennan Reports, a Valley Forge, Pa., tax newsletter. The top rate of 38.5% for last year’s income and 33% for this year’s income compares to a top 50% rate in 1986 before tax reform took effect.

Also, the likelihood of higher rates in the future--possibly due to pressure to cut the federal budget deficit--mean that you could end up withdrawing your IRA money at a higher tax rate than now, further reducing the account’s lure, Brennan says.

- Attractive alternatives. Other attractive tax-deferral devices survived tax reform relatively unscathed. Keogh plans for the self-employed, for example, allow you to shelter up to 20% of your annual income or $30,000 per year, whichever is less.

So-called 401(k) savings plans also are better, particularly if your company matches your contributions by as much as 50%. In a 401(k), the amount of your contributions (up to $7,000 a year) are deducted from your taxable income, and earnings accumulate tax-free until withdrawn.

Yields on tax-free municipal bonds--in which your earnings are totally tax-free--compare favorably with yields on similar taxable instruments.

For example, 10-year tax-exempt bonds are yielding about 6.5% these days, compared to about 8.5% for taxable Treasury securities with 10-year maturities. (That translates into only a 5.2% after-tax yield on those Treasuries for people in the top 38.5% tax bracket for 1987 returns and a 5.7% after-tax yield for those in the top 33% bracket for 1988 returns.)

Tax expert Brennan contends that, with such spreads and with the likelihood of higher tax rates in the future, you can earn more investing $2,000 today in tax-free bonds instead of comparable taxable securities in an IRA. For example, an investor placing $2,000 in a non-deductible IRA earning 9% will end up with $6,683 after withdrawing the money in 18 years, compared to $6,760 in tax-free bonds paying 7% over that same period, Brennan argues.

His example assumes the investor will be in a 37% tax bracket 18 years from now. However, if tax rates are lower in the future, or the spread between tax-exempt and taxable yields is higher, an IRA becomes more attractive, Brennan says.

Taxpayers with only small amounts of money to invest can hold a wide variety of tax-free bonds through mutual funds or unit trusts.

Another alternative: tax-deferred annuities, which also accumulate interest earnings tax-free until withdrawn. One major advantage over IRAs: Your contributions are not limited to just $2,000 a year. However, like IRAs, holders of deferred annuities face a 10% penalty if funds are withdrawn before age 59 1/2.

Still another alternative: Series EE U.S. savings bonds. Federal taxes on them are deferred until the bonds are redeemed, and they are entirely exempt from state and local taxes. Furthermore, you can exchange them for Series HH bonds, which allow you to continue deferring tax on the interest earned on the Series EE bonds. You must pay tax on the HH bonds, however.