The Power of Tax-Deferred Savings

Over long periods of time, it can really boost wealth creation.
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Editor's note: As a special feature for April, is offering a seven-part series on maximizing your IRA. This installment is Part 1. Click here for Part 2, Part 3, Part 4, Part 5, Part 6 and Part 7.

Americans are terrible savers, and most people approaching retirement age don't have enough assets to maintain a comfortable lifestyle once they leave the workforce.

Add to this the potential looming problems with Social Security and Medicare and you can see that any attempt to save for retirement is probably a good thing.

IRAs and other retirement plans give the investor a great advantage -- tax-free or tax-deferred savings. Over long time periods, this can really boost wealth creation. For example, a portfolio growing at 10% a year that isn't taxed will grow substantially faster than a taxed portfolio growing at the same rate. If the tax rate on a portfolio's return is 25%, the portfolio will be 25% bigger after 10 years if it is not taxed.

Traditional IRAs have the added advantage that contributions to it are not subject to tax if your income falls below a certain threshold. This gives investors the ability to use money that would otherwise go to the government to partially finance their own retirement portfolios. The higher the tax rate, the better the bargain for the traditional IRA investor.

While withdrawals from traditional IRAs are taxed at ordinary income tax rates, many people are in lower income tax brackets when they retire than when they're in the workforce. If your income is low enough (less than $50,000 for joint filers for 2006), Uncle Sam may give you a direct credit on income tax of up to $1,000 if you invest $2,000 in an IRA.

One critical requirement for contributing to an IRA is that the IRA's owner must have earned income. If you spend most of your time sitting on the veranda clipping municipal bond coupons and adding up your oil and gas royalty checks, you probably won't qualify. Then again, you probably won't need one.

However, if you're like most people who go to work every day or toil at your own business, you should be eligible. (For those who are self-employed in a business with no other employees, I have found that the self-employed 401(k) is a better option.) By the way, husbands and wives can each have their own IRA even if only one has earned income.

The other limitations to IRA contributions relate to income level and whether the participants are already covered by a retirement plan at work. There is no income restriction on deductible contributions to a traditional IRA if neither husband nor wife is covered by a plan at work. However, you can't contribute to a Roth IRA if your joint income exceeds $160,000, and traditional IRA contributions are not deductible for plan participants if joint income exceeds $85,000, and are not deductible for spouses of plan participants if joint income exceeds $160,000.

Nondeductible contributions to traditional IRAs can still be made at any income level, though. Those nondeductible contributions will still grow tax-free until withdrawals commence, at which time there is a formula for deciding how much of any withdrawal is taxable. Speaking of formulas, the details of all aspects relating to IRAs are available in IRS

Publication 590

. If your situation is complex, IRS publications or a good tax adviser are other places to look for answers.

For tax year 2006, total IRA contributions are limited to $4,000 per person (or $5,000 per person if age 50 or more). If your earned income is below the appropriate threshold, then this earned income would be the limit for any IRA contribution. IRA contributions can be made to traditional IRAs or Roth IRAs in any combination up to the total contribution limit.

Coming up: Part 2 will look at the differences between traditional and Roth IRAs and the possibility of converting a traditional IRA into a Roth IRA.

Richard Moore, CFA, has 40 years of experience in various facets of the investment business. He has been employed by banks, mutual funds and investment advisory organizations during his career and has also owned retail and service businesses. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Moore appreciates your feedback;

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