Should taxable income be sheltered? A look at an IRA.

The 1986 act's large reduction in marginal income tax rates and elimination of the deductibility of IRA contributions for some high-income taxpayers are probably the two major causes of the decline in IRA contributions. As of this writing, these circumstances have not changed. The Revenue Reconciliation Act of 1990 had little effect on marginal income tax rates and no effect on the deductibility of IRA contributions.

A closer analysis of several key factors in accumulating funds for retirement shows that many taxpayers would still benefit substantially from making deductible or nondeductible IRA contributions. This same analysis could also be applied to 401(k) or other tax-deferred plans. In addition,

[TABULAR DATA OMITTED]

if a taxpayer must make a choice between a contribution to an IRA, a 401(k) or another tax-deferred plan, transaction costs and investment option flexibility must be considered in evaluating the alternatives.

SHORT-TERM ADVANTAGES

OF AN IRA

A deductible IRA contribution has two immediate advantages over a taxable retirement fund:

1. A higher total return generally is earned on deductible IRA contributions, because the taxpayer has more funds earning interest.

2. The interest that is earned on IRA funds is sheltered from current taxation.

For example, assume a taxpayer has $2,000 of savings, is in a 33% marginal tax bracket (28% federal, 5% state) and can earn an 8% return on investment. The computations shown in exhibit 1, above, favor making an IRA contribution for such an individual.

On an annual basis, both the deductible and nondeductible IRA contributions always will show a higher rate of return than the taxable retirement fund. The difference in the annual rate of return between the IRA contribution and the taxable retirement fund increases with either a higher marginal tax rate or a higher rate of return on the invested funds.

INVESTMENT FACTORS

DURING INCOME-PRODUCING

YEARS

Eventually, taxpayers must pay taxes both on deductible IRA contributions and tax-deferred interest. Many tax experts and financial advisers warn that the current marginal tax rates are very low and contributions to an IRA might be a mistake if tax rates rise in the future. However, most taxpayers should consider a more in-depth analysis of an IRA contribition versus a taxable retirement fund.

There are three factors related to the taxpayer's income-producing years that will affect the decision to contribute to an IRA:

* Expected marginal tax rates.

* Expected rate of return.

* Expected years of accumulation until retirement.

These three factors are interrelated. For example, the extra taxes from rising tax rates may be offset by a larger amount of accumulated funds in an IRA due to tax-deferred compounding of interest at a higher rate of return.

Taxpayers in their 20s or early 30s should completely ignore the current low tax rates and, instead, focus on their expected marginal tax rates during the latter part of their career. During that period, higher marginal tax rates would substantially slow the rate of buildup of funds invested in a taxable retirement fund. However, a taxpayer close to retirement probably should not make a contribution to an IRA during a period of rising tax rates because the additional untaxes interest may not offset the increased income taxes paid later.

Exhibit 2, page 142, compares the performances of $2,000 in an IRA and $2,000 in a taxable retirement fund, based on years of accumulation and rates of return. Higher expected rates of return and longer periods of accumulation should cause the taxpayer to choose the IRA. However, factors at retirement (tax rate and method of distribution) must be considered, as explained later.

Before making a comparison of the different accumulated amounts for the two types of funds, two adjustments must be made to distinguish between a deductible and nondeductible IRA contribution. For example, according to exhibit 2, a taxpayer in the 33% marginal tax bracket who expects to earn a 10% rate of return and accumulate the interest for 20 years ears $13,455 for the IRA and $7,276 for the taxable retirement fund. The taxpayer must then determine how much of the $13,455 in the IRA is taxable (based on how much represents deductible contributions) and apply the estimated tax rate to the taxable amount before comparing the sum to the $7,276 balance in the taxable retirement fund.

The deductible IRA contribution usually will accumulate the most funds for retirement on an aftertax basis because the taxpayer needs to contribute only $1,340 of savings to the IRA, the rest ($660) comes from tax savings--deferral.

The relative difference between the IRA alternatives and the taxable retirement fund will shrink with shorter periods of accumulation. Thus, as a taxpayer gets closer to retirement, the decision to contribute to a nondeductible IRA becomes less certain because of vulnerability to rising tax rates and the complex recordkeeping demanded under current tax regulations. The IRS requires taxpayers to use form 8606 to report the amount of nondeductible contributions made during the year. Also, previous nondeductible contributions

[TABULAR DATA OMITTED]

and the total value of all IRAs must be reported.

INVESTMENT FACTORS

DURING RETIREMENT YEARS

Before contributing to an IRA each year, taxpayers also must consider their expected marginal tax rate on income before retirement. A large increase in the marginal tax rate after retirement could cause fewer funds to be available from an IRA than a taxable retirement fund, because more taxes would be paid during retirement. However, in estimating future tax rates, taxpayers must make adjustments for inflation.

Since 1937, the inflation rate has averaged about 4.4%, but the last 20 years have seen an increase in the average annual inflation rate to over 7%. Currently, the lowest marginal tax rate for married couples is 15% for income below $30,950. If that figure is adjusted for a 4.4% rate of inflation, in 30 years, income taxable at the 15% marginal tax rate would be $112,635. Unless Congress stops indexing tax brackets for inflation, most taxpayers will have to take unusually large retirement plan distributions to be concerned about being in a higher tax bracket at retirement.

In the year before retirement, taxpayers should choose a method of distribution for the IRA funds: either a lump sum or an annuity. The accumulated funds from an IRA must be distributed either in a lump sum or in periodic payments by April 1 following the year in which the taxpayer reaches age 70 1/2. If the entire balance is not distributed to the taxpayer by the April 1 date, minimum distributions must be made over the taxpayer's life expectancy or the joint lives of the taxpayer and a designated beneficiary.

The taxpayer usually will benefit if funds are withdrawn from the IRA as an annuity instead of as a lump sum. More funds are available for retirement under the annuity method of payment because of the additional years of tax-deferred compounded interest on the IRA's accumulated funds.

For example, according to exhibit 3, page 144, a retired taxpayer receiving annuity payments would more than double the amount of funds received during retirement from an IRA, assuming a 10% rate of return, a marginal tax rate of 33% and a 20-year distribution period. According to IRS Publication 590 on IRAs, the expected life of a 65-year-old taxpayer is 20 years.

CONTRIBUTE OR NOT?

A taxpayer must consider three investment factors during income producing

[TABULAR DATA OMITTED]

years and two investment factors during retirement years in deciding whether to contribute to an IRA or a taxable retirement fund:

* Expected marginal tax rate.

* Expected rate of return.

* Expected years of accumulation before retirement.

* Expected marginal tax rate during retirement.

* Method of distribution.

An analysis of these factors usually will favor the IRA contribution, but the advantages diminish as a taxpayer gets closer to retirement.

Younger taxpayers who still are eligible for a deductible IRA contribution and who expect higher incomes and tax rates during their working years should ignore the current low tax rates and continue to contribute to an IRA. Even with moderately higher tax rates at retirement, IRA tax-free compounding of interest provides a higher rate of return and better protection from inflation by accumulating funds at a faster rate for retirement.

OUTLOOK FOR THE FUTURE

The Savings and Investment Incentive Act of 1991 has been introduced in both houses of Congress. The proposed legislation would remove salary-related restrictions on deductible IRA contributions imposed by the 1986 act. The Bush administation opposes the legislation, which would primarily help those with annual incomes above $50,000.