This week, Gail advises a couple that finds itself in IRA limbo and explains tax breaks for people saving for a child’s education.
My wife and I are both 31 years old. We both contribute the max to our companies’ 401(k) plans. And up until this year, we were both contributing into separate Roth IRA accounts.
The problem is that this year we will make more than the combined yearly max to be able to contribute to our Roths. We are stumped as to what to do now. There is always talk about what to do if you fall below those parameters but no one ever discusses what to do if you are over.
Although we have both worked very hard to be where we are, we are not naive or pompous enough to believe that the "financial" rug might not be pulled out from under our feet. We have always been proactive in our retirement contributions and we don’t want to stop now. What to do?
Dear Shaun —
You and your wife fall into the fortunate/unfortunate "limbo" area of IRA-land. Though I doubt either of you would describe yourselves as "rich," that’s exactly what you are considered by the tax code. If just one spouse is covered by a retirement plan at work, once a couple’s modified adjusted gross income exceeds $150,000 they can no longer put $4,000 ($2,000 apiece) into Roth IRAs.
However, there is a way to take advantage of some of the benefits Individual Retirement Accounts offer. Regardless of your income level, you can make a contribution to a traditional IRA using after-tax money. In other words, you don’t get to deduct the amount you invest (if you exceed the income limit for a Roth, you definitely exceed the limit for making a tax-deductible contribution to a traditional IRA). But the money will grow on a tax-deferred basis. That is, you will pay no income tax on the gains your account generates until you start withdrawals, presumably in retirement.
A portion of each withdrawal will be considered to have come from your contributions and a portion will be treated as earnings. Since you already paid income tax on your contributions, no additional tax is due on those dollars; but you’ll owe ordinary income tax on the earnings.
You’ll save yourself a lot of headaches later if you set up new IRAs for these after-tax contributions. In addition, Carolyn Orser, Manager of Financial Planning Support for H.D.Vest, cautions that you should file IRS form 8606 along with your tax return. This creates a paper trail that documents what taxes you’ve paid, so the IRS doesn’t try to hit you up a second time when you withdraw your contributions.
The good news is the Economic Growth and Tax Relief Reconciliation Act of 2001, enacted in June, raises the annual contribution amounts for traditional and Roth IRAs to $3,000 starting next year. This amount will gradually increase to $5,000 over the next few years. (For 2001, maximum IRA contributions remain at $2,000.)
Also, thanks to the 2001 Tax Act, you and your wife will be able to stash even more money in your company retirement plans next year. The maximum amount goes from $10,500 this year to $11,000 next year and increases by $1,000 per year until it hits $15,000. After that, it will be increased based on inflation. To take advantage of this, each of you should increase your monthly contribution by roughly $40, starting in January.
The 2001 Tax Act also allows companies to add IRA accounts to their existing retirement plans in a couple of years. Perhaps the two of you could lobby your employers to add this feature.
Orser, a CFP, suggests that you consider a variable annuity — another vehicle that allows your money to grow on a tax-deferred basis. Variable annuities offer investments similar to mutual funds inside a life insurance wrapper. Eligibility is not limited by your income and there are no limits on the amount you can invest. Congress intended variable annuities to be used as retirement savings vehicles, which is why the IRS imposes the familiar 10% penalty if you withdraw any money prior to age 59-1/2.
Shop around: Variable annuities come with all sorts of features, such as a minimum guaranteed return; an automatic increase or "step-up" in the life insurance coverage based on the value of your investments on your contract anniversary date; a waiver that allows you to access more of your money for nursing home expenses, etc. Take your time and explore the products and features different companies offer. Then decide which features matter to you.
One final option for you to consider: Invest the money you were putting into a Roth in a "tax-managed" mutual fund. While these funds don’t allow you to defer taxes on gains they do minimize them. For instance, when the fund sells a stock at a profit, the manager will try to offset this by taking a loss on another holding in the fund. The goal is to provide the best return possible on an after-tax basis. That’s why these funds are especially attractive to individuals (such as you) who are in the higher tax brackets. When you do redeem your shares, say, to generate income in retirement, you’ll be taxed at the lower, long-term capital gains rate — unlike money in a retirement account which is taxed at ordinary income tax rates.
I applaud your diligence in preparing for retirement. You’ve got a number of ways to continue the good job you’ve done so far!
I was wondering if you can make investments for your children’s college tuition that are tax deductible. Also, do you get to withdraw this money when they are 18, without any penalties, to use for their education?
Dear Don —
Another timely question! The 2001 Tax Act contains lots of tax breaks for people saving or already paying for a child’s education. Here are a few:
Beginning in January, the limit on annual contributions to an Education IRA increases from $500 to $2,000. As long as you use the money for "qualified" expenses such as tuition, room & board, and books and supplies (including a laptop computer), all withdrawals are free from federal income tax. Unfortunately, you do not get a tax deduction when the money goes into the IRA. (By the way, these accounts are changing their name to the more appropriate "Education Savings Account." They never had anything to do with "retirement," so why they had "IRA" in their name is beyond me.)
But you may have a chance at a tax deduction with the increasingly popular 529 college savings plan. Virtually every state sponsors one of these plans and unlike the Education Savings Account, maximum total contributions to a 529 account are much larger — generally in excess of $100,000, with several states’ plans capping account values above $200,000.
Don’t worry, Dad, we don’t expect you to fork this over in a single year. Maybe Grandma and Grandpa would like to make a small contribution? The tax code extends a special privilege to 529 plans, enabling contributors to gift up to $50,000 apiece in a single year to each beneficiary without triggering the gift tax, provided no other gifts are made to the child over the next 5 years. This means Grandma and Gramps could make a contribution of $100,000 ($50,000 apiece) into a 529 account on behalf of a child. Now we’re talking serious tuition assistance! After 5 years the value of the grandparents’ estate is reduced by $100,000, which could significantly cut their estate tax, yet they still retain control over the money!
It gets better. Starting in January all withdrawals will come out free of federal income tax provided the money is used for "qualified" expenses. (For the remainder of 2001 they're still taxed to the student.)
Here’s where the tax deduction may come into play: Although almost every state now offers a 529 plan, you do not have to live in a particular state to invest in its plan. In fact, your child doesn’t even have to go to college in that state. No one in your family ever has to visit that state! However, before you decide on a plan, check out what your own state offers first. A handful of states, such as New York and Missouri, give their residents a state income tax deduction if they invest in their home state’s 529 plan. (Please note: you cannot live in Florida and expect the state of Florida to give you a tax deduction for investing Missouri’s 529 plan!) In addition, some states impose no state income tax on qualified withdrawals made to residents of that state. Unfortunately, not a single 529 plan offers you a deduction on your federal taxes.
While all of these college savings programs are terrific if you’ve got time on your side, the new tax law also offers significant tax breaks to parents with a child who is already attending college or one about to enroll. Starting with this year’s tax return, parents can deduct up to $3,000 from their income to help offset the cost of tuition. This climbs to $4,000 in 2004 and then disappears after 2005. To qualify, your adjusted gross income cannot be more than $65,000 if you’re a single parent, or $130,000 if you are married filing jointly.
And don’t forget the HOPE and Lifetime Learning tax credits.
In sum, there are now a host of tax breaks available to someone who wants to help a young person become educated. To decide which one, or which combination will give you the biggest benefit, talk with a knowledgeable financial planner or tax specialist who can run some numbers for you.
Go for it, Dad!
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.