This week Gail answers your questions about IRAs and tax credits for graduate school.

Gail,

When should you direct your savings into a Roth IRA instead of your 401(k) plan? I currently contribute 10 percent to my company-sponsored plan and my wife contributes 8 percent. Both of our employers provide matching contributions.

We try to increase the amount we’re contributing by whatever raises we get. But we’re wondering if we ought to be sending that money to a Roth instead.

What’s the rule?

Thanks,
Dana

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Dear Dana-
Ah, life would be so simple if there were clear-cut rules we could all rely upon! Unfortunately, financial planning is often more “art” than “science.”

That said, not stuffing all of your savings into tax-deferred accounts such as 401(k)s, 403(b)s, and traditional (i.e. tax-deductible) IRAs can make sense- mainly because you never know what the income tax rates will be when you’re retired and start pulling money from your accounts.

As Ben Franklin famously noted, “The only things certain are death and taxes.” If he were alive today, 200 plus years after the founding of this country, I’m quite sure he’d add, “and changes in tax rates” to that observation. Just think about how many times Congress has already tinkered with the tax rates—income, capital gains, etc.—over the span of your own life!

As I’m sure you know, money you contribute to a qualified company-sponsored retirement plan is deducted from your taxable income. Thus, it reduces the income tax you have to pay today. However, this simply delays the tax you owe. When you eventually withdraw your contributions and earnings, you will pay ordinary income tax on these amounts.

Contributions to Roth IRAs (and Roth accounts inside some 401(k) plans) are not tax-deductible today. Instead, the tax benefit comes when you take money out: all withdrawals are tax-free.

Does it make sense to give up the current tax deduction you get for your 401(k) contributions in exchange for getting tax-free withdrawals from your Roth IRA in the future? A major factor is whether your income tax rate in retirement will be less than the rate you’re currently paying.

The problem is, you can’t possibly know the answer to this! Who knows what income tax rates will be years from now?

However, given in the probability that tax rates will be different, having a choice as to which money you withdraw first—tax-deferred or tax-free—gives you more flexibility to manage your taxes when you’re retired.

For instance, let’s say most of your retirement savings is in tax-deferred accounts such as IRAs and 401(k)s. When you reach age 70 ½ you and your wife will have to take Required Minimum Distributions from each of these accounts- whether or not you need the money. And that could be just enough to push you into a higher tax bracket.

On the other hand, if some of your retirement money were in a Roth account, you could possibly avoid this problem for the simple reason that all distributions from a Roth escape income tax.

Moreover, you are never required to take a dime out of your Roth IRA, regardless of your age. So if you didn’t need the money you could simply leave your assets in the Roth where they would have the potential to continue to compound on a tax-free basis.

That said, not everyone is eligible to contribute to a Roth IRA because there are income limitations. Assuming you file your taxes “married, jointly” once your Modified Adjusted Gross Income (MAGI) exceeds $150,000, the amount you can contribute to a Roth begins to phase out. When your MAGI hits $160,000, you become ineligible.

If you meet the income requirements for a Roth IRA, consider contributing to your company retirement plans up to the point where you get the maximum company matching contribution. Then direct your excess contributions into Roths until you max them out. When you hit that point, start adding to your 401(k)s again.

Choice is good.

Hope this helps,
Gail

Dear Gail,
My father passed away in 2003, leaving his traditional IRA to me and my two sisters. I received my one-third and elected to “stretch” out the withdrawals rather than take the money out all at once. I’ve taken my RMD each year.

My question is this: What happens if I need to take a distribution that is more than the annual RMD? Are there any tax consequences or penalties? Does it make a difference if it is for a specific purpose such as my son’s college tuition or a first-time home purchase?

Thanks,
Edward

Dear Edward,
Despite the fact that they’re supposed to be a simple way for people to save for retirement, IRAs are incredibly confusing! Part of this stems from the fact that the rules that govern what you can or must do with an IRA depend upon whether you are the owner or the inheritor (beneficiary).

So, hats off to you: up to this point, you seem to have made all right choices.

As you are clearly aware, because you are a non-spouse beneficiary of this IRA, you are required to take RMD’s, or, “Required Minimum Distributions.” As this term suggests, you are only required to withdraw a minimum amount each year based on your life expectancy. However, you are always free to withdraw more than this amount.

Under these circumstances, there is no penalty for this, regardless of your age or what you spend the money on.

Since this is a traditional IRA—meaning your dad was able to take a tax-deduction for his contributions—all distributions are subject to ordinary income tax. Thus, the bigger your withdrawal, the more income tax you will owe.

Hope this helps,
Gail

Hi, Gail-
I’ve already got my undergraduate degree. But I’m thinking of going back to school to acquire a new skill set and was wondering if I can claim the Lifetime Learning Credit for the courses I need to take? CPA exam preparation courses are quite expensive and the tax credit would be a big help.

Thanks,
James

Dear James,
I hate to start my response this way, but the fact is: It depends.

The Lifetime Learning Credit can enable you to subtract as much as $2,000 from your federal tax bill, so it’s definitely worth looking into.

Of the two federal tax credits available to offset the cost of higher education, only the Lifetime Learning Credit can be applied to post-gradudate courses. The student does not have to actually be pursuing a degree; you can simply be taking courses that you are interested in. Moreover, there is no limit on the number of years you can take the credit.

But this doesn’t mean it’s easy to qualify for this tax break.

The first hurdle you have to overcome relates to your course provider. John Roth, a senior tax analyst at CCH, says in order to qualify for the Lifetime Learning Credit (or the Hope Credit in the case of undergraduate school), your instruction must be given by a school that is “eligible to participate in the Department of Education’s student aid program.”

This can be a college, university, vo-tech school, or some other type of institution.

As Roth points out, while courses designed to help you pass a professional exam are often taught at DOE-qualified schools, they are usually offered by private companies that are simply leasing the classroom space. You’ll need to check with the course sponsor to see if it meets DOE eligibility standards or not.

On the other hand, if the course is actually being offered by a college, there’s a good chance you might qualify for the Lifetime Learning Credit—as long as your income isn’t too high.

According to Roth, this year the credit starts to phase out for a single taxpayer once his/her Modified Adjusted Gross Income (MAGI) exceeds $45,000; the 2006 phaseout starts at $90,000 if you are married.

Unfortunately, if you don’t qualify for the Lifetime Learning Credit, you’re out of luck tax-wise. While educational expenses related to improving your skills in your existing job are deductible as a business expense, those incurred in order to get a new position are not.

Since you indicate that the course you took was to help you become a CPA (a new job), the costs associated with this would not be deductible as a Miscellaneous Itemized Deduction.

Best wishes in your new career!
Gail