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Last week, I told you all about the way dividends are taxed. And I hope you were able to use that information as you prepare for the looming April 15th tax filing deadline.
As you well know, that’s now just nine days away, which means you have only a week or so to take advantage of funding an individual retirement account for 2008. Ditto for Coverdell education savings accounts, which I’m going to cover in-depth today.
Wait, 2008? Isn’t that year long gone?
Yes, but because your eligibility to participate in IRAs depends on your income, you don’t have to fund them on a calendar year. Instead, you can wait up until April 15th of the following year. In fact, if you were fastidious enough to already file your taxes, you could even use any refund you received to contribute for last year.
The next question, of course, is whether or not you’re eligible.
You can only contribute to a Roth IRA if your Modified Adjusted Gross Income (MAGI) falls within certain levels. That figure — MAGI — is roughly equivalent to the amount you enter on line 38 of the regular 1040 form, with a bunch of minor adjustments that generally don’t affect most taxpayers. Examples include foreign housing deductions, income from Puerto Rico and Samoa, and domestic production activities.
If your filing status is single, your MAGI must be $101,000 or less to make the maximum contribution, which is $5,000 (or $6,000 for anyone 50 or older). A single filer who earns between $101,001 and $115,999 can make a partial contribution. These limits will go up by $4,000 for 2009 contributions.
If your filing status is married filing jointly, your combined MAGI must be $159,000 for the maximum contribution. You’re still eligible for a partial contribution if your earnings fall between $159,001 and $168,999. Add $7,000 to these limits for 2009 contributions.
Important point: While you must have earned income to contribute to a Roth IRA, married couples can both contribute the maximum amount to their individual accounts even if only one spouse works!
A lot of people get confused on that issue, but it gives married couples a great way to save an additional $5,000 or $6,000 in a tax-sheltered account every year. That’s especially beneficial to the spouse who’s not working because they are obviously not able to participate in other tax-sheltered retirement accounts such as 401(k)s, either.
Remember, Roth IRAs are one of the most powerful places to park your investment dollars. While you don’t get any upfront tax deductions, you will never again pay Uncle Sam on any of the money you earn.
With today’s depressed asset prices, a relatively small initial investment in a Roth IRA could turn into quite a windfall 10 or 20 years from now … completely free of taxes. It doesn’t get any better than that!
Okay, but what if you don’t qualify for a Roth IRA?
First off, don’t look at it as a negative. It simply means you’re doing well.
Second, you still have other options available to you.
The most common alternative would be a traditional IRA. Like the Roth, traditional IRAs give you a huge range of investment choices and the same contribution limits (including the catch-up provision).
The critical difference is that they are funded with pre-tax dollars. The good news is that this can potentially lower the amount of taxes you pay now. The bad news is that your earnings will be taxed later. You also must begin withdrawing your funds at age 70 ½ in contrast to Roth IRAs, which have no required minimum distributions.
There is no income restriction for contributions, your MAGI just affects the tax deductibility of the money you put in. For all the details, see IRS publication 590.
But If You Have a Child in Your Life,
You Should Also Look at Coverdell Accounts!
These are a little-known alternative to the ubiquitous 529 education plans.
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| Coverdells are an underappreciated way to save for a child’s education … |
Formerly called Education IRAs, they allow you to sock away $2,000 every year for the benefit of a child’s schooling. While that’s not an eye-popping number, it’s still a nice start and will add up over time. Plus, it’s perfect for using any tax refund money you receive.
One of the really cool features of these plans is that they can be used to fund not just college, but even attendance at a private elementary or high school (along with related expenses). Currently this aspect is set to expire in 2010; however, I suspect Congress will extend it.
Either way, like a Roth IRA, the earnings on initial contributions — as long as they go for qualified expenses — won’t be subject to taxation.
What about income restrictions? That’s where it gets a little wacky … in a good way!
Technically, you cannot fund a Coverdell if you have MAGI above $110,000 filing singly or $190,000 married filing jointly. Phase-outs kick in at lower levels, too.
However, even a child with no earned income can contribute to a Coverdell!
So if you’re above the income threshold, you can just gift the $2,000 to the child under the Uniform Transfer to Minors Act, and they can put it in the Coverdell themselves. Yes, it’s a stupid formality, but if it works in your favor, go with it.
Also note that you can establish a Coverdell for not just a child or grandchild, but even a nephew, niece, or the child of a family friend. Even corporations and trusts can establish Coverdells.
The only monkey wrench is that you must be careful not to establish a Coverdell for a child who already has one fully funded for the same tax year. Only one account per child can be funded to the max every year. Contributions must also be made before the beneficiary turns 18.
A Coverdell beneficiary has to use the funds before turning age 30, or else taxes and penalties will likely be owed. However, the account can always be switched to another beneficiary before then — even if the new recipient is between ages 18 and 30.
No, you don’t get the potential for tax deductions that you do with 529 plans, but as you can see, Coverdells are a unique way to sock away a little extra money for someone special. And they can be fully funded in addition to 529 plans. So if you’re an aggressive saver and planner, they are definitely worth investigating no matter what.
Bottom line: Don’t let filling out all those tax forms get you down. Instead, take some comfort in knowing that there are still plenty of great ways to keep money out of Uncle Sam’s hands. And there is still enough time to make those contributions count for 2008!
Best wishes,
Nilus
P.S. If you want even more detail on tax-sheltered accounts … plus a WHOLE lot more … it’s not too late to grab a copy of my blockbuster report — “The Weiss Guide to Worry-Free Retirement Profits.” Click here now for all the details.
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