IRAs going, going . . .but not entirely

It may have been small as such things go, but in 1981, Congress and President Reagan gave every American something we'd thought only the rich could have: a tax shelter. Maybe it didn't fit the classic definition of a shelter - a place where Uncle Sam compensates a taxpayer for losing money on an investment - but it was sure fun putting money in an individual retirement account (IRA) and being able to deduct that money on your 1040 form every year.

In the first four years, Americans poured more than $200 billion into IRAs at banks, brokerages, mutual funds, insurance companies, credit unions, and savings-and-loans. By the end of January, says James Dorsey, editor of the IRA Reporter, a newsletter, that figure had jumped past $300 billion, as record amounts of money were jammed into IRAs.

Why the rush? You can thank last year's tax reform law, which not only changed the rules for IRAs but, in doing so, changed the philosophy behind them and the strategies for getting the most out of them.

``Last year was our biggest year ever'' for IRAs, says Roger Harris, director of investors services at Strong/Corneliuson Capital Management Inc., a mutual fund sponsor in Milwaukee. ``Now we're running two or three times ahead of last year.''

Most people, Mr. Harris says, ``understand that this could be the last year they can get a fully deductible contribution to an IRA.''

Last year's tax law restricted the full IRA deduction to single people earning less than $25,000 and married couples earning less than $40,000.

For singles, the deduction is phased out, until their taxable income reaches $35,000, where it disappears altogether. For couples, the deduction is eliminated at the $50,000 level.

If neither spouse is part of a pension plan at work, these limits disappear. Of course, that means that if either spouse is working at a place with even the puniest of pension benefits, both of them might be ineligible for a fully deductible IRA.

Those who favored these changes contended that the new rules would get the IRA back to what it was originally intended to be: a way for moderate-income people who aren't covered by pension plans to get some assistance from the tax laws as they save for a more secure retirement.

That includes a lot of people. ``Only about 15 percent of those with IRAs lost all deductibility under tax reform,'' notes Dallas Salisbury, executive director of the Employee Benefit Research Institute in Washington. The rest still get a full or partial deduction for their contribution.

``We are providing a vehicle for relatively low-income people to put money away so they will not become a public charge,'' says Donald Tannenbaum, managing partner of Oppenheimer, Appel, Dixon & Co., a New York accounting firm. ``But the number of families in the US who are aggressively using it is not that great.''

The problem, Mr. Tannenbaum and others say, is that those who really need to save more for retirement - who are earning $20,000, $30,000, or less - aren't doing so. They have families to raise, rent to pay, and essentials like food, clothing, and insurance to pay for. If they have a house, they have mortgage payments, but at least they have an asset that is adding to their overall net worth.

Still, for many people, the idea of saving for an event that might be several decades away when today's financial needs are hard enough to meet is a difficult one to consider.

``People of more modest means may not be funding an IRA,'' says Alan J. Czarnecki, a broker with Prescott, Ball & Turben. Still, he feels that taking away the deduction for upper-income people was a mistake. ``I really can't see how we can get excited about a $2,000 or $2,250 tax shelter for the wealthy.''

Maybe, these experts say, the fact that lower-income people are getting a ``special '' tax break no longer available to those in upper brackets will be a new incentive to put something in an IRA.

Even if you can't deduct a penny of your IRA contribution, the advantage of tax-free investing is still available to everyone. The differences aren't so great in the early years, but after 20 or 30 years, you could have from $30,000 to $100,000 extra because of not having to pay taxes on the earnings until withdrawal.

Although financial advisers seem split on whether the IRA is worth the bother after tax reform, all agree it is worth the bother right now. Until April 15, you can still take the full deduction for your 1986 IRA contribution.

Because this could be the end of fully deductible IRAs for upper-income taxpayers and those covered by a pension plan, many banks, brokerages, and mutual funds are heavily touting this period as the ``last chance'' for an IRA with all the advantages.

That can lead to some problems. Some banks, for example, are paying extra high rates on certificates of deposit purchased for IRAs. But those high CD rates may quickly deflate. A bank may have a ``teaser'' rate of 20 percent that crashes to the normal CD rate for that term on April 15, says Robert Heady, publisher of Bank Rate Monitor, a newsletter in North Palm Beach, Fla. Or a bank will promise that if rates go up by a certain amount between now and April 15, it will match the higher rate. That isn't much of a promise, Mr. Heady notes, as interest rates have been going down or holding steady for some time.

After April 15, new rules on withdrawals could cause more problems for those with IRAs. Historically, all IRA withdrawals have been taxed at ordinary income rates. This will still apply to any withdrawals from deductible contributions and their investment earnings.

But because many people will have both deductible and nondeductible contributions after April 15, there could be some confusion about what is a taxable withdrawal and what is not. Since you've already paid taxes on a nondeductible contribution, you won't have to pay taxes on it again, when you take some money out. Only the interest on the nondeductible portion of the deposit will be taxed.

If your IRA in the future includes both deductible and nondeductible contributions, you'll have to determine which part of a withdrawal is from which type. To keep people from trying to say the whole thing is from the nondeductible side, the Internal Revenue Service has ruled that withdrawals will be considered to have been made proportionately from each.

At T. Rowe Price Investment Services in Baltimore, investors will be able to get a separate listing of both types of contributions, so they'll know how much tax to expect on a withdrawal.

In addition to this tax, of course, is a 10 percent penalty charged by the IRS on any money withdrawn before age 59. This penalty has not been increased.

Is the IRA a good deal, then? Certainly if you're still in an income level where you get the full deduction, it is. That deduction, plus tax-free compounding, means the IRA is still a great tax shelter for the not-so-rich, especially if they don't have a pension at work.

People in upper-income brackets may want to examine other savings vehicles - such as municipal bonds or life insurance - where taxes are still deferred, but there are no early-withdrawal penalties.