Why the Flexible IRA Is Not for Everybody : * Savings: Which plan to choose would depend mostly on income and one’s reasons for saving.
Which is better, an IRA or FIRA?
The question will undoubtedly come up more and more in the wake of President Bush’s tax plan, which proposes major changes in individual retirement accounts that would give savers more choices.
The President has proposed a new type of IRA, the flexible IRA. FIRA contributions would not be tax deductible, but earnings on FIRA contributions held for seven years or more would not be taxed.
The President also proposed loosening the rules on existing IRAs. His plan would permit savers to withdraw without penalty up to $10,000 for education, health care or the purchase of a first home. The amount withdrawn would still be taxed, however.
While Bush’s plan could undergo changes in Congress, it is likely that a more flexible IRA will be part of a final tax package. Many Democrats favor easing IRA rules.
So which plan would be better for you?
The answer depends largely on your income, and your reasons for saving.
Only people who earn up to $60,000 a year ($120,000 for married couples) would qualify for a FIRA. While anyone can open an IRA, only people who earn up to $35,000 a year ($50,000 for a married couple), or people not covered by another retirement plan, get a tax deduction for IRA contributions.
In recent years, many people who do not qualify for deductible IRAs have opted for non-deductible IRAs, which allow earnings to build tax-deferred until they are withdrawn. According to the new math of retirement savings, people who do not qualify for the IRA deduction “are almost always better off with a FIRA,” said Philip J. Holthouse, a partner with the Los Angeles accounting firm of Holthouse Carlin & Van Trigt.
People who qualify for deductible IRAs have a difficult choice.
Take the case of someone who socks away $2,000 a year in a retirement account at 8% interest. If placed in a deductible IRA, the account balance plus tax benefit would total $6,214 after two years. A FIRA account balance would be just $4,295.68, with no tax benefit. So far, the IRA comes out ahead.
Even if the saver taps the account in two years to buy a new car, the IRA is slightly better. After taxes and early withdrawal penalties, the IRA balance is $3,968.40. The FIRA balance is $3,846.40.
If this saver decided to tap the account for college expenses after two years, the IRA would be an even better choice. That is because the Bush Administration proposes to exempt IRA withdrawals for education costs from the 10% early withdrawal penalty. Currently, the penalty is levied on all withdrawals made before age 59 1/2. When it comes to the FIRA, a 10% penalty would be assessed on any amount withdrawn after less than three years.
However, financial planners say that the longer the money is saved, the better the FIRA looks. After contributing $2,000 for 10 years, the value of the IRA (account balance and tax benefits) would be $26,210.93 after taxes and withdrawal penalties, while the FIRA balance would be $29,080.45.
How IRAs and FIRAs Compare
Whether you would be better off with a deductible IRA or a proposed FIRA depends on what you’re saving for. Those saving for a first home would be better off with an IRA, although the IRA’s edge diminishes over time. To see the difference, compare the IRA subtotal below to the FIRA total. The IRA wins out in this example because, under the Bush tax plan, first-time home buyers are exempt from penalty. The FIRA penalty stands. People willing to save a long time for a car, a second home or a big vacation would be better off with a FIRA, as can be seen by comparing the 10-year IRA total to the FIRA total. Financial planners say those saving for retirement would probably be better off with the FIRA.
After Two Years
Type of Account IRA FIRA Value of Contributions $4,492.80 $4,492.80 Plus Value of Tax Savings $1,722.00 Total Savings $6,214.80 $4,492.80 Less Tax at 40% $1,797.12 $ 197.12 Subtotal $4,417.68 $4,295.68 Less 10% Penalty $ 449.28 $ 449.28 Total $3,968.40 $3,846.40
After 10 Years
Type of Account IRA FIRA Value of Contributions $31,290.98 $31,290.98 Plus Value of Tax Savings $10,565.44 Total Savings $41,856.42 $31,290.98 Less Tax at 40% $12,516.39 $ 2,109.30 Subtotal $29,340.03 $29,181.67 Less 10% Penalty $ 3,129.10 $ 101.22 Total $26,210.93 $29,080.45
Note: Based on annual contributions of $2,000 invested at 8%
Source: Holthouse Carlin & Van Trigt
