YOUR TAXES : PART THREE: INVESTING, SAVING, SPENDING : Do IRAs still give you a break? : Deductions limited, but earnings are tax-deferred

To contribute, or not to contribute?

That is the question that millions of individual retirement account holders must grapple with for tax year 1987. The Tax Reform Act of 1986 has sharply curtailed the deductibility of IRA contributions, eliminating a major enticement for many taxpayers.

In the wake of tax reform, participants in other tax-advantaged retirement programs, such as employer-sponsored 401(k) plans and Keogh plans for the self-employed, will also be forced to rethink their strategies.

But few areas of the new tax code have engendered as much confusion as the provisions concerning IRAs, according to tax professionals and other experts.

The first point to clear up is that contributions to IRAs for tax year 1986 remain fully deductible for all wage earners--regardless of their income level or whether they are covered by a pension plan.

Fully deductible contributions for tax year 1986 can be made until April 15, 1987. “For many taxpayers, this is a last chance that should not be missed,” said Lawrence A. Krause, head of a San Francisco financial planning firm that bears his name.

IRA contributions for tax year 1986 provide both short- and long-term benefits. In the short run, contributors get an immediate dollar-for-dollar tax deduction. In the long run, the earnings on their investments compound tax free until retirement.

Despite these powerful lures, IRAs are not for everyone. “A lot of people are made to feel guilty that they don’t put money into an IRA,” Krause notes. “If you need the money to put food on your table or to clothe the kids, skip your IRA.”

The advantages of IRA contributions are less clear cut for tax year 1987, especially for those who will lose the instant gratification of a tax deduction.

Under the new rules, workers who are not eligible for employer-sponsored retirement plans--regardless of their income level--retain the right to deduct their IRA contributions. (Employer-sponsored retirement plans are broadly defined by the Internal Revenue Service and include pension, profit-sharing and 401(k) savings plans.)

An employee is deemed to be covered by his employer’s retirement plan whether the employee is vested in that plan or not.

Workers who are covered by employer-sponsored retirement plans may also be able to deduct IRA contributions--provided their incomes are below certain thresholds.

Single taxpayers whose adjusted gross income is $25,000 or less retain the right to fully deductible IRAs, as do married couples whose adjusted gross income falls below $40,000 a year.

Above those thresholds, every $10 of additional income reduces the potential IRA deduction by $2. For example, a single person with $30,000 in adjusted gross income can make a deductible contribution of $1,000.

Since the maximum allowable contribution to an IRA is $2,000 a year, the new formula means that single people who earn more than $35,000, and couples who earn more than $50,000, lose the IRA deduction entirely if they are covered by an employee-sponsored plan. (For couples earning more than $50,000, if either spouse is covered by an employer-sponsored plan, neither spouse can deduct IRA contributions. And, as in the old tax code, one-earner couples may make deductible contributions of up to $2,250 a year if they meet the other eligibility requirements.)

The Investment Company Institute, a mutual fund trade association, estimates that 78 million of the nation’s 87 million households will remain eligible for either full or partial IRA deductions under the new rules.

What about those who are no longer eligible to deduct their IRA contributions? By and large, they are the most affluent: the very people who were most likely to invest in IRAs in the first place.

They are still permitted to put $2,000 into their IRAs every year, and they’ll still get the valuable benefit of tax-free compounding.

But is a non-deductible IRA a wise investment? Predictably, purveyors of IRAs answer that question with an emphatic yes.

“The value of tax-free compounding cannot be overstated,” said Jeremy G. Duffield, a senior vice president of the Vanguard Group of mutual funds.

Annual investments of $2,000 over 25 years would total $216,364 in a tax-deferred IRA earning 10% a year, according to Vanguard.

But if that same $2,000 annual investment were made in an identical account without the benefit of tax deferral, the total in the account at the end of 25 years would be just $139,583. The income on that amount, though, would not be taxed further.

The example assumes that the taxpayer is in the top 28% federal tax bracket. Californians who put their money in a non-tax-deferred investment would have even less to show for it at the end of 25 years because of the impact of state income taxes.

But, frets Duffield of the Vanguard Group, “the tax deferral argument is rather arcane. The IRA is becoming a much tougher sell.”

Another argument in favor of IRAs--even those that aren’t deductible--is that they enforce a certain discipline on savers.

“Although individuals may invest with retirement in mind, discipline is required to save the money for as much as 40 years without making withdrawals,” notes Lisa Swaiman, a spokeswoman for Fidelity Investments in Los Angeles.

“Most investors would think twice before paying the penalty tax that is assessed if money is withdrawn before age 59 1/2,” she added. (The penalty for early withdrawals remains 10%.)

Financial planner Krause calls regular annual contributions to an IRA--whether deductible or not--”a good habit.” At the same time, he added, “there are a number of viable alternatives to the non-deductible IRA.”

These include a range of investments on which earnings are tax-exempt, including municipal bonds and mutual funds that invest in munis, or tax-deferred, such as U.S. savings bonds and certain insurance products such as deferred annuities and single-premium life insurance.

One unabashed opponent of the non-deductible IRA is Peter I. Elinsky, a tax partner for the accounting firm of Peat, Marwick, Mitchell & Co. in Washington. Elinsky is bothered by what he calls “the Draconian approach to taxation” when funds are withdrawn from IRAs.

Instead of IRAs, he suggests certain insurance products and the so-called 401(k) plans that many employers offer. Such plans allow employees to invest pretax dollars into various savings programs and are often matched by employer contributions.

The major change in 401(k) plans brought about by tax reform reduces the maximum deductible contribution to $7,000 a year from $30,000 previously.

“The $7,000 cap will not be a big problem for rank-and-file workers,” Elinsky said. “But for the big kahunas, this is a major blow.”

One type of retirement account left unscathed by the new tax law is the Keogh account for self-employed individuals.

For defined-contribution Keogh plans, the top deduction remains $30,000 or 15% of earned income, whichever is less.

Even individuals who are covered by a company retirement plan can fund a Keogh with outside income and reap the benefits of tax-free compounding, although it may not be worth the paper work.

Qualified outside income includes free-lance income, director’s fees and payments from consulting work.