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IRAs Aren’t Glamorous; They’re Good Deals

Bad deals are almost always more exciting than good ones. Flashy promoters offer tremendous rates of interest. They tell you that you’ll be investing in something glamorous, such as racehorses or oil wells. And then they take your money and flee to an exotic foreign location.

Then there are good deals, such as individual retirement accounts. They’re often sold by bankers. You get a modest rate of interest, a slight tax savings and a bank statement. If you want to see your money in an exotic location, you might be able to drive to the bank’s branch in San Diego. Not exactly the stuff dreams are made of.

Nevertheless, you should consider investing in an IRA and doing it before April 15.

Already hundreds of people are putting the paper down, saying, “This doesn’t apply to me. I make too much money for an IRA.”

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Do you make too much money to earn an effective yield of 9.7% in these days of 6% and 7% interest rates? Do you make too much to shelter the capital gains you earn on stock investments until after you retire? If not, read on.

In the Tax Reform Act of 1986, Congress eliminated IRA deductions for more affluent taxpayers. Now, if you are single, you must earn less than $35,000 to deduct any part of your IRA. If married, your IRA contribution is only deductible if your combined adjusted gross income is under $50,000. And at these income levels, you get only a partial deduction. Adjusted gross income must be less than $25,000 for single taxpayers and $40,000 for married couples to get a deduction for every dollar put into the account.

If you qualify for the tax deduction, the benefit of an IRA is clear. The federal government is essentially giving you 15 cents for every dollar you save. If you live in California, the state government will kick in a few cents more.

But even if you do not qualify for the up-front deduction, IRAs offer tax-deferred interest accruals, which can greatly improve the return you earn on your account.

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Right now, banks and thrifts are offering IRA certificates of deposit at rates varying from about 6% to 7%, which is roughly the same rate you could get if you deposited your funds into a normal, taxable CD.

However, once tax benefits are factored in, the effective rate on a 6.3% IRA is roughly equivalent to about a 9.7% yield, said Phil Holthouse, partner at the accounting firm Parks Palmer Turner & Yemenidjian. You will have to pay tax on the account once you start withdrawing the funds, which will have the effect of slightly reducing that yield at the back end. But in the interim you are earning interest on money that would otherwise have been spent on taxes. And that can be a powerful tool.

Consider what happens to a $2,000 taxable deposit. In 10 years, that $2,000 would grow to $2,960 if you earned a 6.3% rate and paid tax on the interest year after year, Holthouse said.

If that same $2,000 were in an IRA account, it would be worth $3,684 at the end of 10 years. Assuming you pulled the whole amount out at that point and paid federal and state taxes amounting to 35% on the $1,684 earnings, your net profit would be $1,095 versus $960 for the taxable investment.

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In other words, you are $135 richer for having saved through an IRA account. Considering that your initial investment was only $2,000, that $135 is significant.

If you can leave the money in longer, of course, your return gets better. A $2,000 IRA deposit would grow to $6,787 in 20 years, versus $4,382 in a taxable account. After you pay 35% tax--about $1,675--on the IRA, you end up with an account worth $5,112--or $730 more than you would have earned in the taxable CD.

IRA money can also be invested in the stock market through “self-directed” accounts. How much you earn on such an account, of course, depends on how good you are at picking stocks or mutual funds. But the benefit is you don’t pay tax on the capital gain until you retire.

With all this said, some people should not invest in an IRA.

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If you cannot put the money aside and forget about it until retirement, you should forgo the IRA contribution. Why? Aside from having to pay taxes on the withdrawal, the federal government will charge you a 10-cent penalty for every dollar you take out early, and California will charge you an extra 2.5 cents.

What does that do to your return?

In the case of the person who deposited the $2,000 for 10 years, he (or she) would need to pay a penalty of about $210 in addition to his tax if he pulled it out at that point and was not yet 59 1/2 years old . Because his profit was only $135 greater on the IRA than on the taxable investment, he would lose $75 with the IRA.

It is important to note that there are several proposals being kicked around in Washington that would make IRAs, or similar savings accounts, attractive to everyone. One such plan is the Bush Administration’s “family savings account.” It would allow tax-free interest accruals for those who wanted to save to buy a first home, finance a child’s college education or to pay for their own retirement.

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Better still is a Senate proposal that would bring back IRA deductions for everyone, regardless of income. The Senate has also proposed a second option: Those willing to forgo the up-front deduction could get greater access to their money, and they wouldn’t have to pay tax on the interest accruals if they kept the money in their account for more than five years.

Neither proposal is yet law, and both are expected to face heavy opposition. But it is possible that sometime soon, the government will turn an already good deal into a great one.


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