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Op-Ed: What do I need to know about IRAs?

Author Rubén M. Rodríguez-Vega is a CPA and special collaborator for the Puerto Rico Society of CPAs. Author Rubén M. Rodríguez-Vega is a CPA and special collaborator for the Puerto Rico Society of CPAs.

An Individual Retirement Account is one of very few deductions that remained available in the income tax return after the approval of the new Internal Revenue Code. Consequently, the IRA is one of the few legally approved instruments that provide a tax relief when filling the income tax return. In addition, the IRA encourages the creation of a private and individual fund for the eventual retirement of the account holder.

This savings vehicle for a retirement fund becomes even more significant at times when statistics reflect that we are living longer and that we will live approximately one third of our life in the retirement period. On the other hand, having this savings culture becomes more relevant due to the uncertainty of the availability of federal Social Security funds by time we retire, and the unfortunate reality that not all employers provide a retirement plan for their employees.

The IRA account has many benefits, but the most attractive is that taxpayers can take a deduction of $1 for each $1 of contribution to the IRA account on their income tax return. The maximum amount of contribution allowed by the Puerto Rico Internal Revenue Code for taxable year 2013 (which corresponds to the income tax return that must be filed by or before April 15, 2014) is $5,000 per taxpayer. In the case of married taxpayers filling jointly, a contribution to an IRA account may be made for each spouse, even if one of them is not working or generating income. This means that the maximum contribution in this case will be $10,000.

It is important to know that any taxpayer who receives income from salary, or wages, or gains attributed to professions or occupations, and who has not reached 75 years of age, may contribute to an IRA. Also remember that under the new code, anyone who participates in an employer-sponsored retirement plan — either from a private business entity, the government, or in the case of self-employed individuals — will be able to contribute to the IRA the maximum amount allowed by the code, without limitation to the contribution that is made to their own retirement plan.

What’s the tax benefit?
Many people ask, how can I determine the tax benefit that my contribution to an IRA will represent? The tax benefit or saving that will be derived from what otherwise you would pay for income taxes, is determined based on the effective tax rate resulting upon completing your tax return and computing your income tax responsibility.

For example, if your tax responsibility results in 33 percent of net taxable income, then a contribution of $5,000 to the IRA will represent a tax saving of $1,650 (this is, $5,000 x 33 percent). Following this same example, if the taxpayer is married filling a joint tax return and decides to contribute $5,000 to their respective IRAs, then the tax saving will be of $3,300 (contribution of $10,000 x 33 percent effective tax rate).

Another benefit that the IRA provides is that the increase in the account value is deferred from the payment of taxes. This means that the income earned by way of interests or dividends paid to the account is not taxable until funds are withdrawn from the IRA, which provides an opportunity for greater growth at maturity of the account.

So, after knowing the dynamics of its tax advantages, the next question is: What type of IRA account should I open?

There are two basic types of IRAs as determined by Law: the Regular IRA (or deductible IRA) and the Roth IRA (also known as non-deductible IRA). The Regular IRA is the most commonly used since it is the vehicle that provides the tax benefit of claiming a deduction in the income tax return.

On the contrary, the contribution to a Roth IRA cannot be taken as a deduction for income tax purposes; however, the whole amount of the account, including its growth or income earned, will be exempt from payment of income tax if funds are kept in the account until taxpayer reaches retirement age (60 years).

Knowing the benefits that may be obtained from contributing to an IRA and upon determining the amount that will be contributed, the next step is to select the investment instrument in which to make the deposit. For this purpose it is extremely important to consider the investment objectives and risk tolerance of each person.

Variety of investment vehicles
Essentially, there are four types of investment vehicles for the IRA accounts — one of these alternatives available in the market is a deposit in an annuity, which is generally offered by insurance companies.

The Federal Deposit Insurance Corporation does not insure this type of investment, reason for which its guarantee depends on the safety and soundness of the insurance company issuing the instrument. However, you may receive a greater return and in some instances when the insurance company might include a guarantee to the principal amount deposited.

The second alternative is a certificate of deposit (CD type of account) with a fixed interest rate and fixed term of maturity. The FDIC insures this deposit up to a maximum of $250,000 when funds are deposited in a commercial bank that is member of the FDIC.

The third type of IRA is an investment fund, also known as mutual fund, whose yield depends on the behavior of the securities in which the Fund invests. This type of deposit is not insured by the FDIC, for which it will be subject to fluctuation and the risk of loss of principal.

The fourth alternative of IRA is a hybrid of the ones previously described. It consists of a certificate of deposit (CD type of account) usually with a 5-year maturity term, where the FDIC insures the principal up to $250,000 and the yield is subject to the behavior of a market index. Therefore, this last one provides the opportunity to participate of a potential growth of the securities market without risking its principal deposited, or as many would say, the best of both worlds.

We suggest you carefully read the disclosures of the accounts that are part of the promotional materials in order to obtain information regarding charges and fee penalties for early withdrawal of each instrument. We also suggest that you consult your financial advisor or your Certified Public Accountant to determine the most convenient type of investment instrument for contribution to your IRA.

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