Nondeductible IRAs Can Build Up a Sizable Nest Egg

After April 17, I can no longer get a tax deduction for taking out an Individual Retirement Account (IRA) on my 1994 income. When is the best time to contribute to an existing IRA, or open a new IRA account -- anytime during the remainder of 1995, or should I wait until spring 1996, when I file my 1995 taxes?

-- S.R., Astoria, Queens

ASSUMING you can do it, always invest sooner, rather than later, say financial specialists. And that includes contributing to or opening Individual Retirement Accounts.

IRAs were among the most popular tax-shelters for small savers in the early 1980s. But now they are among the most misunderstood and little used of all investments.

IRAs were created by law in 1974 to encourage savings. But Congress imposed strict limitations on contributions when the Tax Reform Act of 1986 was enacted. Before 1986, most Americans could open an IRA and contribute up to $2,000 annually, thus reducing their tax bite for the tax year, as well as deferring taxes on interest earnings until they started making withdrawals from the account -- usually in retirement years, when taxes are lower.

But after 1986, most Americans could no longer qualify for the immediate tax deduction. To qualify for a current deduction, you cannot be an active participant in a company pension plan. The spouse of an active participant is also precluded from investing in a tax-deductible IRA, even if he or she is not in a pension plan. (Still, some taxpayers who have an adjusted gross income of less than $40,000 a year, for joint returns, or $25,000 for individual returns, may be able to open a tax deductible IRA, even if they are in a pension plan.)

IRA contributions drop

Not surprisingly, IRA contributions plummeted, from nearly $40 billion in annual contributions in 1986, to about $15 billion in 1987, and down to the $10 million range of late. That's one reason why Congress is once again toying with liberalizing IRA rules, to open them up to more savers.

But even if you can no longer qualify for the immediate tax-deduction for an IRA, some may find it advantageous to open a nondeductible IRA, experts say, because the compounding of interest plus tax deferral can build up a sizeable nest egg after many years.

A nondeductible IRA allows the taxpayer to defer total taxes on interest earnings until an individual withdraws the earnings, which is sometime after the contributor reaches 59-1/2 years old.

It is this aspect of IRAs that continue to be attractive, says Isabel Ford, retirement-plan manager for investment firm Scudder, Stevens & Clark Inc., in Boston.

''Anyone who has earned income can open an IRA,'' Ms. Ford says. What people misunderstand, she says, is that in most cases, ''deferring taxes has a bigger impact on the size of a retiree's nest egg than taking the immediate tax deduction.'' In fact, if the individual continues to make a yearly nondeductible IRA contribution, the long-term value of his or her portfolio may come close to the value of the portfolio if the individual had taken the immediate tax deduction.

Record-keeping, however, is important. You won't have to pay taxes on nondeductible contributions, since you've already paid taxes on them. But you will have to pay taxes on interest earnings.

''The advantages of deferring taxes [on an IRA] are equal to or sometimes greater than the immediate gain from taking a tax deduction,'' says Paul Collins, president of American Trust Company, a financial-management firm in Lebanon, N.H.

Mr. Collins says he generally advises anyone contemplating an IRA to put it in ''some type of stock mutual fund with a good track record, and then just sit on it over time.''

Most IRA account holders have done just that. Assets of IRAs in mutual funds were $284 billion, or 33 percent of total assets in IRAs, at the end of 1993, says John Collins of the Investment Company Institute, a Washington-based trade group.

The second-largest category is ''self-directed'' accounts, that is, IRAs in stocks sold through brokerage houses, which stood at $278 billion (32 percent total); they are followed by $134 billion in commercial banks (16 percent of the total); $77 billion in thrift institutions (9 percent); $60 billion in life-insurance companies, (7 percent); and $32 billion in credit-union accounts, (3 percent).

Buying via banks

IRAs sold through banks and savings institutions, which are usually linked to purchase of certificates of deposit, are locked in at set interest rates. They are also insured through federal insurance agencies, such as the Federal Deposit Insurance Corporation.

For the largest possible long-term return, however, some experts suggest investing in a no-load mutual fund in a family of funds, where the IRA holder can switch between funds with different investment objectives to maximize returns. Also, investors should consider making payments over time, say monthly, to reap the advantages of dollar-cost averaging. And starting as early as possible in each year, Ford says, means a greater return of interest through compounding.