New tune: recent changes in IRA laws should be music to investors' ears

Entrepreneur, March, 1997 by Lorayne Fiorillo

Not since IRA contributions were first allowed in the mid-1970s and then allowed for some but not all wage earners during the 1980s have changes been so sweeping . . . and so positive for small-business owners and other IRA investors. In fact, these tax law changes have entrepreneurs singing a whole new song. Here are 10 IRA facts you should know:

1. One perfect duet. Like the song says, IRAs used to be shared between "just the two of us." Under the old rules, families with only one wage earner could contribute a tax-deductible maximum of $2,250 annually to their IRAs. Some couples split the contribution equally between each of their IRAs; others let the nonworking spouse contribute the $250 while the wage earner put in the $2,000.

Not anymore. Starting this year, married couples who file a joint return may make a contribution of up to $4,000, with $2,000 maximum going to each spouse's IRA, no matter who has earned income. That's a big improvement over the previously allowed limit. Of course, the contribution can't exceed the couple's total earned income.

If you're making your IRA contribution now for 1996, you still have to play by the old rules. If you decide to make your 1996 and 1997 contributions now for yourself and your spouse, the total you can contribute is $6,250-$2,250 for 1996 and $4,000 for 1997, as long as those amounts don't exceed your total joint earned income for either of those years.

2. I love IRAs in the springtime. Considering making an IRA contribution for 1996? You may be able to save time in a bottle, but don't put off your IRA contribution until the last moment. You have until the due date for your taxes, not counting extensions, to fund your account.

A contribution is considered to be on time if it is mailed and postmarked by the due date of the tax return, even if the IRA custodian or trustee does not receive it until after the due date. You can claim an IRA deduction on your return before you make the contribution, but you must make the contribution before the deadline. If your tax year is the calendar year, your deadline is April 15 - so don't delay.

If you're in the mood to contribute early, statistics show that the early contributor catches more than worms. Contributions for any year to IRAs can be made as early as January 1, which gives you a full year to let your savings compound tax-deferred. Your money will have longer to compound and grow - one way of getting the most bang for your buck.

3. They're playing your song. The new rules about IRAs may be music to your ears, but you can't make a contribution unless you have earned compensation. For IRA purposes, this includes wages, tips, salaries, professional fees, bonuses and commissions. For a sole proprietor or partner in a company, compensation is the net earnings from the trade or business, reduced by your contributions to other retirement plans and the deduction allowed for one-half of your self-employment taxes.

On the other hand, you cannot make an IRA contribution based on earnings from the sale of property, dividends from securities, rental income, pension or annuity income, severance or disability pay. Earned income must be just that - earned.

4. Money makes the world go 'round. The sooner you start saving, the better. The dilemma with IRAs is should you put money away you can't access until you're 59 1/2? Yes, because the younger you start saving, the less you'll have to save - and the more you could have when you retire. Assuming a 10 percent rate of return, someone who starts contributing at age 25 and faithfully tucks $2,000 away at the beginning of every year until she's 64 will have contributed just $80,000. But compounding at 10 percent annually, that investment would be worth more than $973,000 at age 65.

No one can guarantee a 10 percent return, but compounding works - and the sooner you start, the better. In fact, why not set up an IRA for your children, too? Consider this: At a 10 percent rate of return, a person who contributes $2,000 annually from the ages of 18 to 24 - a total of $14,000 - would accumulate more than $944,000 by age 65. And someone who saved $2,000 for just five years from ages 14 through 18 (a total of $10,000) could have more than $1 million by age 65.

IRA contributions are allowed for children, provided they have earned income (from paper routes, baby-sitting or working in your business, for example) and their contribution does not exceed their reported earnings. A parent or guardian must sign the application. Getting started on your IRA early is a great way to save - and not only is your money compounding but taxes on those earnings are deferred until you withdraw them at retirement.

5. Bang the drum slowly. Beginning in 1997, individuals under age 59 1/2 may withdraw from their IRAs, penalty-free, to pay for medical expenses that exceed the itemized deduction limitation. You qualify for this benefit if you have accumulated medical expenses in excess of 7.5 percent of your adjusted gross income.