Even if US takes off your tax deduction, IRAs won't disappear

If the Senate Finance Committee and the full Senate have their way, you won't be able to claim a deduction for your individual retirement account after this year. But that does not mean the IRA will disappear. What does it mean for your retirement savings? And why did the Finance Committee propose the change, anyhow? Here are some questions and answers that may help people understand these issues.

What changes have been proposed for the IRA?

There are two tax breaks in the IRA. The Finance Committee proposal would take away one of them.

The first is the tax deduction. When you put money into an IRA, you can deduct the entire amount, up to $2,000 for an individual, from your taxable income. This deduction is recorded on the front of the Form 1040 to help you arrive at the ``adjusted gross income.'' At present everyone can take the deduction, even without itemizing.

It's this deduction that will be eliminated if the Senate version of tax reform passes. With a top tax rate of 27 percent as another key feature of the bill, the Finance Committee apparently felt the deduction had become unnecessary, as well as too costly.

The deduction would still be available, however, for people who don't have a company pension. This is actually a return to the IRA rules that were in effect before 1982.

What about the other tax break?

This is the tax-free-interest feature, and it makes your money grow faster. Most of the time when you save or invest, you're expected to pay taxes on any interest earned or capital gains you get every year, even if you don't actually receive the money but reinvest it. But if that money is in an IRA, you don't have to pay taxes on the gains until you take the money out, whether at retirement or earlier.

This way, savings accumulate and compound tax-free every year. With this rule alone, a two-earner couple putting $4,000 in an IRA earning 9 percent a year over 30 years would still have $93,420 more in after-tax dollars than if they put the same amount in taxable savings, according Ernst & Whinney, the accounting firm.

As the proposal stands, this tax break would still be available.

Will this be enough to preserve the IRA as a useful retirement-savings vehicle?

It probably will, although opponents of the change contend that the deduction is needed as an incentive to keep people making their IRA contributions every year. A recent survey by Market Facts Inc., a research firm, indicated that about 80 percent of those questioned felt that the immediate deduction was a significant incentive in using the IRA.

The survey was conducted for the Investment Company Institute, a trade organization representing the mutual fund industry. The ICI has been strenuously lobbying to keep the deduction, since its members have come to count IRAs as a major source of business.

But those who argue for eliminating the deduction say it has been mainly used by upper-income taxpayers who are simply shifting money from taxable accounts to the tax-free IRA, which costs the government revenue and does not increase the nation's savings.

Also, the financial services industry has become a much stronger marketing force since the universal IRA was introduced in 1982. As long as the tax-free-interest feature remains, you can expect lots of charts and tables and claims of big returns, all trying to show how much money tax deferral will give you at retirement. As long as the ads don't assume high interest rates over a long term, most of these claims will prove accurate.

Should I keep contributing to my IRA, then?

Yes. In fact, you should put as much money into your IRA this year as you can afford. If you're married and your spouse is working, try to get in the full $4,000. Assuming that the Finance Committee's version of tax reform becomes law, tax rates for many people will be substantially lower next year. So with higher taxes this year, the deduction will help a lot. Then with lower rates next year, most people won't need the deduction so much, but they'll still have tax-free compounding.

If you also have a 401(k) or 403(b) employer-sponsored retirement savings plan, keep shoveling money in that, too. A new tax law may reduce the amount you can put in an IRA by the amount you're putting in a 401(k). With this offset feature, if you put $2,000 in a 401(k), you would not be able to put anything in an IRA after this year.

What happens to the IRA proposal after this?

After the Senate is through, the bill goes to a Senate-House conference committee to work out the differences. The IRA question is only one of many parts of the full bill. The House bill, passed late last year, called for keeping the full IRA deduction, and it included the 401(k) offset. It's also possible that Congress could give a partial deduction. You might, for example, be able to deduct half your IRA contribution.

It seems fairly certain, though, that the tax deferral feature will remain, so the IRA should continue to be a very useful vehicle for building up retirement savings, and get a tax break.

If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.