BY GREG MERMEL, CPA
That headline got your attention, didn’t it? I don’t write often about non-taxable income, because it’s pretty rare. U.S. income taxes are based on the premise that all income is taxable unless specifically exempted, but no expense is deductible unless specifically permitted. (Of course, the phrase "ordinary and necessary business expenses" creates a rather broad "specific" permission.) This column is about two of these rare creatures, because they have some timely applications.
Roth IRAs
Roth IRAs, you may remember, were introduced in 1998 as an alternative to the long-standing traditional IRAs. In a traditional IRA, you generally invest pre-tax dollars (that is, you get a deduction for your contribution), and pay taxes on whatever you draw out at retirement age. Roth IRAs turn this around: you invest after-tax dollars and the money you eventually take out is tax-free. This means that whatever your investment earns is never taxed. Before you say "so what," let me remind you of the power of compound interest: A big chunk of that retirement nest egg will be the earnings on these investments.
One of the major limitations of Roth IRAs as retirement savings vehicles has been the low annual contribution limit of $2,000, which had not changed through decades of inflation. Starting with contributions for 2002, the amount increases to $3,000, then to $4,000 in 2005 and $5,000 in 2008. These higher limits will make Roth IRAs the primary (but not exclusive) retirement savings program for many people, instead of Keoghs, SEPs or employers’ 401k plans.
Traditional IRAs can be converted to Roth IRAs (or their contents rolled over from a traditional IRA to a Roth). The value of the traditional IRA on the date of the conversion becomes taxable, though. You may remember that in 1998 (the first year of Roth IRAs), there was a one-time tax break on these conversions, letting you spread the income over four years. Not everyone took advantage of that one-time window. Some couldn’t because of income limitations. Others looked at the amount involved and didn’t think they could come up with the cash to pay the taxes.
Anyone who still has money in a traditional IRA should take another look at the idea of switching to a Roth now. Was the value of your IRA flattened by the stock market decline? That means the taxable income from a conversion will be a whole lot less. Make lemonade by converting now, and as the market recovers it will be tax-free. The conversion doesn’t need to be all or nothing. If you want to spread the income between two years, you can convert half now, and half in January.
Section 529 College Savings Plans.
Years ago, several states began offering prepaid tuition plans at state universities: Pay us this many dollars now, and that will pay your child’s tuition at the state university when he or she is old enough. This was a pretty good idea, but only if you were the sort of family where everyone has gone to the same state university for generations. If you might move to another state, or discover that your kid was better suited to Harvard or the local community college than to the state university, it wasn’t very appealing.
More recently, some people (who apparently have nothing better to do with their time than figure out novel interpretations of the Internal Revenue Code) found a way to exploit this. As long as a state government ran the program, and the parents had no control over how the money was invested, the money could go to tuition at any institution of higher learning. And thus Section 529 plans were born. A parent (or grandparent or even a family friend) could put money away, let it compound tax-free, and pay tax on the earnings only when withdrawn.
Most states now have them. But two things made many investors hesitant. First, the taxability of earnings. Second, and more worrisome, was the limitation on investment control. Investment strategy was set when the plan was established and could not be changed if market conditions (or the kid’s plans) changed.
Beginning January 1, 2002, Section 529 plans start to work like Roth IRAs: Distributions from Section 529 plans are tax-free if they are used for tuition. If the child doesn’t go to college, the earnings are taxable when withdrawn, but they may not have to be taken out. You can change the beneficiary of the plan to a younger (and perhaps more scholarly) sibling or nephew or cousin or neighbor’s child or whatever.
Investments become significantly more flexible, too, at the first of next year. You can change the investment strategy of a Section 529 plan once a year, or when there is a change in beneficiary. You still don’t have infinite control, since you must choose from a limited range of investment programs offered by the plan, but it’s no worse than many 401k plans were a few years ago.
Most states do not actually run these plans themselves, but have investment management companies do so under contract. The Illinois program (which you may have received some mailings on) is called Bright Star, and is run by Salomon Smith Barney. Many other states work with TIAA-CREF, which has traditionally handled retirement plans for universities and nonprofit organizations.
If you are considering investing in a Section 529 plan, you are not limited to the plan from the state you live in. Most states—not surprisingly, almost all of those states which use outside investment firms—allow nonresidents to invest as well. Each of them has different rules and limitations, and some do allow special breaks for in-state investors, so gather your information carefully before you make a decision.
Are there money or
tax questions you would like to see discussed in this column? Let me know,
at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or 773/525-1778 (888/525-1778
outside the Chicago area).
Greg
Mermel is a certified public accountant whose clients in the arts range
from individual performers to major theatre companies and suppliers. He
also sometimes produces theatre.