The 1997 Tax Act: Individual Retirement Accounts

Chapter 3
Individual
Retirement Accounts
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

Guide to
Promises Kept

Tax Cuts for Individuals

Principal Tax Increases

Other Key Provisions

Table of Contents

he Act significantly expands the opportunity for individuals to use individual retirement accounts (IRAs) in three distinct ways. First, access to the traditional IRA is increased and expanded in its flexibility and application. Second, Congress created a new nondeductible tax-free IRA called a Roth IRA. Third, Congress created Education IRAs. Taken as a whole, these three pieces of the legislation dramatically expand the application and opportunity for increasing tax-favored individual savings through the use of IRAs.

Changes to the Traditional IRA

Restoration of IRA deduction for certain taxpayers: The Act increases the income limitation of those eligible to make deductible IRA contributions. Currently, deductions for IRA contributions are gradually phased out as income increases beyond $40,000 for married taxpayers filing jointly and $25,000 for single taxpayers. Under the Act, those income levels will increase gradually to $80,000 for married taxpayers filing jointly by the year 2007 and $50,000 for single taxpayers by the year 2005. The Act also removes the restriction that prevents an individual who is not an active participant in an employer-sponsored retirement plan from making a deductible IRA contribution if his or her spouse is an active participant, provided their joint income is less than $150,000.

Effective date: This provision applies to taxable years beginning after Dec. 31, 1997.

Penalty-free withdrawals from IRAs for higher education expenses and first-time homebuyers: The Act provides new exceptions to the 10% additional tax (but not income tax) on early withdrawals from IRAs for withdrawals used to pay qualified higher-education expenses and for qualified first-time home buyers. Qualified higher-education expenses include tuition, fees, books, supplies, room and board, and equipment expenses. A qualified first-time homebuyer distribution is a withdrawal of up to $10,000 during the individual's lifetime that is used within 120 days to pay costs (including reasonable settlement, financing, or other closing costs) of acquiring, constructing, or reconstructing the principal residence of a first-time homebuyer. This exception is available for the first-time homebuyer expenses of the individual, spouse, child, grandchild, or ancestor of such individual or spouse.

Effective date: This provision applies to distributions after Dec. 31, 1997.

Establishment of the Nondeductible
Tax-Free Roth IRA

The Act creates a new category of nondeductible IRA called the Roth IRA. The Roth IRA is funded solely with after-tax (nondeductible) contributions, but unlike current nondeductible IRAs, it exists as a separate account and offers the possibility of tax-free earnings.

The principal features of the Roth IRA are as follows:

No tax deduction is allowed for contributions to the account.
Income accumulates tax-free in the account.
Qualified distributions from the account are not included in income.
Income limitations for contributions begin at $150,000 for married taxpayers filing jointly and $95,000 for single taxpayers.
The maximum contribution is coordinated with the deductible IRA and is limited annually to the maximum IRA contribution allowed for that individual.
Contributions can be made even if the individual is beyond age 70 1/2.
No distributions are required when the individual attains age 70 1/2.
Distributions are only required upon death.
Rollovers are permitted from one Roth IRA to another Roth IRA.

Nontaxable qualified distributions from a Roth IRA include distributions made at least five years after the first taxable year in which the individual made a contribution to the Roth IRA, if they are made: (1) after the individual reaches age 59 1/2; (2) after death; (3) on account of disability; or (4) for qualified first-home purchases. Nonqualified distributions are includible in income to the extent of earnings after recovery of contributions, and are subject to the additional 10% early withdrawal tax.

Effective date: The provision applies to taxable years beginning after Dec. 31, 1997.

Establishment of the Nondeductible Education IRA

The Act also provides an additional new tax-savings opportunity, the Education IRA. An Education IRA is a trust or custodial account that exists as a separate IRA account and has the intended purpose of providing funds for the attendance of a program of higher education. This account may be established for paying the qualified higher-education expenses of a designated beneficiary. Like the Roth IRA, this account is created without providing an income tax deduction for the contribution. However, the earnings of this account are subject to inclusion in gross income and the additional 10% tax upon distribution to the extent the distribution exceeds qualified higher-education expenses.

The Education IRA has the following principal features:

Contributions of up to $500 annually are allowed (which is in addition to the $2,000 limit).
Contributions may be made regardless of whether the beneficiary has gross income.
Contributions may not be made after the beneficiary attains age 18.
Distributions of income from the account are included in income and subject to the additional 10% tax to the extent they exceed qualified higher education expenses.
Income limitations for contributions begin at $150,000 for married taxpayers filing jointly and $95,000 for single taxpayers.

The following example demonstrates a likely balance of an Education IRA at age 18, assuming a maximum annual contribution of $500 is made each year on the beneficiary's birthday and the account provides an 8% annual rate of return:

Age at Contribution	Year-End Value	Total of Investment
Birth	$ 540
5	$ 3,961
10	$ 8,989
15	$ 16,375
18	$ 22,381	$ 22,381.00

In the above example, the entire investment balance of $22,381 could be used to pay qualified higher education expenses. To the extent the funds distributed exceed those expenses, the earnings on the account would be includible ratably in income and are subject to the additional 10% tax. The amount may be transferred to the Education IRA of another family member or another qualifying family member can be designated as beneficiary. Although the Education IRA is technically a nondeductible tax-deferred IRA, it is in essence a functional equivalent of the Roth IRA to the extent of qualified higher-education expenses.

Effective date: This provision applies to taxable years beginning after Dec. 31, 1997.

Choosing Your Investment Options

After-tax contributions compared: Suppose a taxpayer has saved $2,000 of after-tax funds and is looking to move those funds into one of the IRA investments. How does that person decide which of these tax-advantaged plans to use, or whether to invest in a taxable instrument such as a corporate bond? Which option is the "winner" in terms of after-tax return on investment? In answering these questions, it is important to consider the limitations still in place for investment in an IRA and determine that this is an available option. Assuming that a taxpayer is not limited, the following example demonstrates some of the differences and similarities of the possible investment options.

As Tables A and B demonstrate, all three IRA options would earn $2,318 after 10 years, leaving the taxpayer with $4,318 of gross funds. The corporate bond would earn about $900 less over that same period because of the annual taxation of interest income. The deductible IRA, Roth IRA, and nondeductible IRA all leave the taxpayer with more in net after-tax funds in year 10 than the corporate bond, but that is not the whole story. The deductible IRA is a more valuable investment than the nondeductible IRA because the $2,000 after-tax investment in the deductible IRA provides a first year tax benefit of $640 ($2,000 multiplied by the 32% tax rate). This money represents a tax savings in year one that may be invested in a taxable investment with compounding growth opportunity until the end of year 10 (the year of withdrawal in the example). Thus, the taxpayer using the deductible IRA benefits to the extent of the compounded after-tax earnings of the $640 invested for 10 years in addition to the inside tax-deferred growth of the IRA. In contrast, the nondeductible IRAs (including the Roth IRA) receive no current-year tax savings. Despite the after-tax growth of the first-year tax savings, the Roth IRA is the clear winner, assuming equal tax rates in the year of contribution and distribution, because no tax is due on withdrawal with this account.

Table A Same Tax Rate in Year of Withdrawal (32% in year of contribution and withdrawal)
	Cash Contributions	Gross Funds After 10 Years	Net Funds Available After Tax in Year 10 on First Year Tax Savings	Taxes Due in Year 10	Net Funds Available After Tax in Year 10	Winner
Deductuble IRA	$2,000	$4,318	$1,087	$1,382	$4,023
Roth IRA	$2,000	$4,318	--	--	$4,318	X
Non-deductible IRA	$2,000	$4,318	--	$742	$3,576
Corporate Bond	$2,000	$3,397	--	--	$3,397
Assumptions for Tables A and B: Cash contributions for the IRA, Roth IRA, nondeductible IRA, and corporate bond represent the contributions available subsequent to taxes being assessed at some previous time. The rate of return on the investments is 8% compounded annually. The ending withdrawals from the IRAs are not subject to the additional 10% tax. The year-one tax savings amounts shown for the deductible IRA grow at an 8% rate of return compounded annually. The growth of the year-one tax savings are subject to a tax rate equivalent to the year of contribution until the final year when the withdrawal rate applies. Although no longer a specific option under the Act because of its replacement with the Roth IRA option, the nondeductible IRA is included for comparison purposes. Tax rates were calculated as combined federal and state tax rates using federal rates of 28% and 15% and state rates of 5% and 4%, respectively. The state rates are applied to the federal rates on an after-tax basis for total combined tax rates of 32% and 18%.

On the other hand, if the tax rate in the year of withdrawal is lower than in the year of contribution, then the deductible IRA is the clear winner with the Roth IRA as the runner-up. This scenario represents a typical retirement planning expectation that tax rates will be lower in the year of withdrawal.

Table B Lower Tax Rate in Year of Withdrawal (32% in year of Contribution, 18% in year of withdrawal)
	Cash Contirbutions	Gross Funds After 10 Years	Net Funds Available After Tax in Year 10 on First- Year Savings	Taxes Due in Year 10	Net Funds Available After Tax in Year 10	Winner
Deductible IRA	$ 2,000	$ 4,318	$ 1,099	$ 777	$ 4,640	X
Roth IRA	$ 2,000	$ 4,318	--	--	$ 4,318
Non-deductible IRA	$ 2,000	$ 4,318	--	$ 417	$ 3,901
Corporate Bond	$ 2,000	$ 3,433	--	--	$ 3,433

The three types of IRAs outperform the after-tax investment in the corporate bond in both Tables A and B. However, other factors unrelated to taxes may make some non-tax-favored investments more attractive (that is, because of the flexibility to withdraw funds without incurring penalties, the ability to invest more than the IRA annual contribution limit, etc.). Therefore, when choosing an investment, many factors unique to the individual taxpayer must be considered. Those factors include, but are not limited to, applicable tax rates at contribution, expected tax rates at distribution, available rates of investment return, and desired flexibility of the investment.

Financial and Related Industries Impact of Act

Financial and related industries can expect a significant impact from the Act in the investment product development area. Life insurance companies, investment companies, banks, and other companies actively seeking individual investment funds will need to examine current financial products to measure their competitiveness with these newly created investment options. Furthermore, companies competing in this market have a fresh opportunity to design and develop new financial products that take advantage of the expanded opportunities and flexibility of IRA investments.

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Tax News & Views is produced by the Financial Counseling Specialists and the Legislative & Regulatory Services Group at Deloitte & Touche LLP.