Traditional IRAs: Still A Good Idea for 2006

Mark Twain once said, "The rumors of my death have been greatly exaggerated." Like Mr. Twain's rumored demise, the notion that the traditional Individual Retirement Account (IRA) is no longer a useful part of a financial plan has been greatly exaggerated. Contributions to a traditional IRA continue to be a viable financial and retirement planning tool despite non-deductibility for some individuals.

All you need to make a traditional IRA contribution are earnings as an employee or as a self-employed person. The amount that can be contributed for 2006 is the lesser of $4,000 ($5,000 if you have attained age 50) or your earnings from your work. There is no minimum age for making a traditional IRA contribution for tax purposes. If a 16 year old works for the summer, makes $4,000 and blows it all at the mall, the tax code permits Mom, Dad or whomever to give him/her $4,000 to contribute to a traditional IRA on his behalf. There is a maximum age for IRA contributions. No traditional IRA contributions may be made for people over 70 1/2, even if they are still working as hard as they were at 30 1/2.

An additional contribution of $4,000 is permitted if the traditional IRA participant has a spouse who doesn't work outside the home. If both spouses are under age 50, the total contribution in this situation is $8,000 and the spouses can divide the amount contributed up any way they choose, so long as neither receives more than $4,000 into his/her account.

The question of deductibility is often confusing to many taxpayers. There are two questions that may have to be answered to determine if a traditional IRA contribution is fully deductible, partially deductible or not deductible. The first question is: "Are you covered by a plan?" If the answer is "no," then the traditional IRA contribution is deductible regardless of the taxpayer's income. Whether or not you are covered by a plan depends on the type of employer-sponsored plan in place. If you're not sure, your employer can tell you because employers must check a box on every employee's W-2 stating whether they are covered.

If the answer is “yes” and you are covered by a plan but your spouse is not, then only you are exposed to the next test. Your spouse’s contribution to a traditional IRA is fully deductible up to new phase-out limits of $150,000 to $160,000 of joint income. If both of you are covered by a plan then the next test will determine to what extent both of you can deduct your contributions.

Assuming coverage by a plan, the next question that must be answered is: "How much is your income?" For 2006, taxpayers with adjusted gross income (AGI) of $50,000/75,000 (single/married filing jointly) or less, the contribution is fully deductible. For taxpayers with AGI over $60,000/$85,000 (single/married filing jointly), no IRA deduction is permitted. For those with an AGI between those levels, the amount of the deduction is phased out proportionately. There is a $400 floor to the deduction that will apply to those whose AGI is close to the upper limit.

For example, a single person who is covered by an employer's plan has an AGI (excluding the IRA deduction) of $55,000. Since that's 50% of the way from $50,000 to $60,000, the taxpayer may deduct $2,000 of a $4,000 contribution ($4,000 * 50%). The other $2,000 of the contribution is non-deductible.

The best part of the traditional IRA deal is the tax-deferred growth potential your investments can enjoy inside the account. Your earnings will grow much faster when not dragged down by the weight of a current tax bill. Your financial planner can show you whether and how a traditional IRA can fit into your retirement plan.