Tax Act And Iras

New options for how you save for retirement became available when President George W. Bush signed into law the 2001 Economic Growth and Tax Relief Reconciliation Act. While the act affects many areas of taxation, one principal area Congress specifically addressed in the legislation is the need for individuals to save for retirement in tax-favored accounts. To encourage that, the act increased the maximum amount that taxpayers can contribute to individual retirement accounts (IRAs).
Here's a short primer on IRAs, how the tax act affects them and how you can use them to boost your retirement dollars. There are two principal types: traditional and Roth. The traditional IRA allows you to contribute a portion of your income to a retirement account and deduct the amount of this contribution from your taxable income. Neither the contribution nor the income it earns is taxable until you withdraw funds at retirement. The Roth IRA is sometimes called a "back-loaded IRA" because the tax benefits come at retirement. Contributions to a Roth IRA are not deductible from taxable income, but withdrawals, including earnings, are tax-free (if made after five years when the individual is at least age 591/2).
The tax act increases the maximum amount you can contribute annually to traditional and Roth IRAs from $3,000 in 2002 to $5,000 in 2008. After 2008, the limit will adjust for inflation in $500 increments. Beginning in 2002, if you are over 50 years of age, you also can make "catch-up" contributions of $500 per year; this amount increases to $1,000 in 2006. The catch-up amounts will not adjust for inflation. If your employer sponsors a qualified retirement plan such as a 401(k) or 403(b), the tax act also increases the annual contribution limits for these plans as well. Consult your company's compensation and benefits personnel to learn more.
If you are eligible for both a traditional and a Roth IRA, you may only contribute a total of $3,000 to both types of IRAs in 2002. The choice between investing in a traditional or Roth IRA depends on your tax rate in the contribution year and your anticipated tax rate in the withdrawal year, presumably in retirement. If you expect to be in a lower tax bracket during retirement, save in a traditional IRA; if you expect to be in the same or a higher bracket during retirement, use the Roth IRA.
Not all taxpayers can take advantage of the increased contribution limits. Various income limits affect the amount that a taxpayer can contribute, and they differ for traditional and Roth IRAs. However, the tax act does not modify these limits.
To encourage lower-income taxpayers to save for retirement, the tax act includes a new tax credit for contributions to employer-sponsored retirement plans and IRAs. A tax credit is a dollar-for-dollar reduction in the final income tax liability. Depending on your adjusted gross income, the credit ranges from 10 percent to 50 percent of the contribution. The maximum annual contribution eligible for the credit is $2,000, and you can only claim it in years 2002 through 2006. The credit cannot be claimed by anyone under 18 years of age, a full-time student or a person who can be claimed as a dependent on another taxpayer's return. This tax credit is ideal for many recent graduates. For example, a May 2002 graduate who earns less than $15,000 through December can contribute $2,000 to a Roth IRA, and the government will reduce his or her taxes by up to $1,000. 
 

Reichenstein is professor of finance and The Pat and Thomas R. Powers Chair of Investment Management in Baylor's Hankamer School of Business. He is a frequent contributor to the ,American Association of Individual Investors Journal, Journal of Investing, Journal of Financial Planning and other publications.