Pros, Cons of Flexible IRAS Aren’t Simple

One of President Bush’s lesser-noticed tax proposals is to create a flexible individual retirement account, which would offer tax benefits to middle-class people who can’t take advantage of existing IRAs.

But tax planners interviewed Wednesday said that they were uncertain whether the new accounts, called FIRAs, would catch on, in part because contributions would not be tax deductible--a feature considered popular with existing IRAs.

“Given our low interest rate environment, I think FIRAs are unlikely to stimulate the huge excitement that IRAs did when they became more widely available in the 1980s,” said Bob Wagman, a tax partner with the accounting firm of Price Waterhouse in Century City.

Under the President’s proposal, people who earn up to $60,000 a year (or couples earning up to $120,000) would be permitted to deposit up to $2,500 a year in a FIRA account, regardless of whether they have a pension or other company retirement plan. FIRA earnings that have accrued for at least seven years may be withdrawn tax free.

FIRA earnings accruing for less than seven years would be taxed at an individual’s regular rate when withdrawn. An additional 10% penalty would be assessed on withdrawals of earnings accruing for less than three years.

Existing IRAs permit individuals who earn less than $25,000 a year (and couples earning less than $40,000) to deduct IRA contributions of up to $2,000. Those earning above those amounts, and not currently eligible for company retirement plans, may also deduct contributions.

If the earnings are withdrawn before age 59 1/2, the holder of an existing IRA must pay a 10% penalty, although Bush has proposed waiving that penalty if the money is withdrawn for buying first homes or education. No matter when IRA earnings are withdrawn, however, they are taxed.

Financial advisers said existing IRAs appeal to high-income individuals who can safely afford to sock away money for a long time. Many people with large incomes can’t deduct their IRA contributions. But they are attracted by the ability to defer taxes on their IRA earnings until withdrawal at retirement, when they expect to be in a lower tax bracket.

Because investors can realize benefits from a FIRA in seven years, some investment advisers said it was a misnomer to call it a retirement account.

“This will appeal to anyone who wants to buy a house or put a child in college seven years down the road,” said Ellen R. Marshall, an attorney with Morrison & Foerster in Irvine. “This will appeal to anyone who pays taxes.”

Wagman, the Price Waterhouse tax partner, said that a back-of-the-envelope analysis suggests that a FIRA “is more advantageous than an IRA over a seven-year time frame.”

However, financial advisers said the FIRA has some features that may discourage people from using it:

* It’s complicated. FIRA earnings would only be tax free if they’ve accrued a full seven years. People who withdraw money before seven years would be taxed at their regular rate. This means that after seven years, a person who faithfully deposited $2,500 into a FIRA account each year could only tap the earnings on the first $2,500 tax free.

Stephen Corrick, a tax partner with the accounting firm of Arthur Andersen & Co. in Washington, said it was likely that financial institutions would charge more to handle FIRAs than IRAs because of the paperwork involved.

* It requires closer monitoring. Corrick also said that from an investor’s standpoint, the FIRA rules raise investment timing questions.

“If you know you want to take $10,000 out for a house in Year 4, how to invest the money so you incur the least tax penalty requires careful planning,” he said, referring to the provision that FIRA earnings could be withdrawn without penalty after three years. “You don’t have those problems with an IRA.”

* FIRAs in banks may earn lower rates. Financial planners speculated that the tax-free feature of the FIRA might cause banks and other financial institutions to offer lower rates on certificates of deposit and other investment instruments in the accounts. That’s because a tax-free investment can earn less and still yield as much, after tax, as a taxable investment.