Powered by

Individual Retirement Accounts (IRAs)

Individual Retirement Accounts are tax-deferred plans that a participant establishes with a bank, mutual fund, or brokerage; periodic contributions can be invested in different types of securities such as stocks, bonds, etc. The preferential tax treatment applies to all dividends, interest, and capital gains until the age of retirement, which is 59 1/2.

Annual contributions are tax-deductible if certain IRS requirements are met. A participant can only contribute to an IRA if there is no 401(k) plan or other employer-sponsored retirement plan. Contributions are dependent on a participant's annual gross income (AGI), but in general, there is a limit of $3,000 a year for single participants and $6,000 for married couples. Single participants will be eligible for the deduction if they earned less than $50,000 and married participants will be eligible if their joint income was less than $70,000. Contributions can be made for a particular year until April 15 of the following year.

If the money is taken out before the retirement age of 59 1/2 , there is a penalty of 10% in addition to the applicable ordinary income taxes. There are some exceptions to this rule; purchase of a first home up to $10,000, certain higher education expenses, medical expenses above 7.5% of the participant's AGI, health insurance premiums during unemployment, or permanent disability. A participant is able to roll over a distribution to another IRA or withdraw funds using a special schedule of early payments made over the participant's life expectancy. Distributions are required to start once the participant reaches age 70 1/2.

In the case of married couples, a surviving spouse can take over the deceased spouse's IRA and continue the tax deferral. All other beneficiaries have to take the distributions from an Inherited IRA, distributions which are subject to taxation. There are a couple of options on the distributions:

• Lump Sum
  Following the five-year rule, a beneficiary may take the amount in the IRA without penalty no later than December 31 of the fifth year after the IRA owner died. The beneficiary can keep what is left of the money after paying ordinary income taxes.
• Little-by-little
  IRA distributions paid over the beneficiary's life expectancy; the annual distributions are subject to taxation. This option must be selected no later than December 31 of the year following the IRA owner's death. If the money is not withdrawn then the five-year rule will apply.

The tax implications of IRAs can be broken down into the following categories:

• Taxing of deductible and non-deductible contributions
  Withdrawals are taxed if the original contribution was deductible in the first place. If the contributions were not deductible, then the withdrawals will not be taxed.

• Taxes on Excess Contributions
  There are limits on annual contributions but a participant may elect to make additional contributions. Those will be taxed at 6% if the money is not removed from the account before the tax filing deadline. To avoid the penalty, the excess money and earnings can be removed from the account prior to the filing date, although the earnings are taxable for that year.

• Rollovers
  It is possible to move the funds from another IRA or a qualified retirement plan such as a 401(k) within 60 days. This will allow for the funds to keep their tax-deferred status while the funds are moved into another 401(k) plan.

• Premature withdrawals
  Withdrawals usually start at the age of 59 1/2; otherwise, there is a 10% penalty. However, there are some exceptions to this rule. Penalty-free withdrawals can be made before the retirement age if the participant qualifies. The qualifications include:

  • Withdrawal by the beneficiary in case of owner's death or disability.
  • Withdrawals taken in equal periods determined by the participant's life expectancy or the joint life expectancy of the participant and the beneficiary.
  • Withdrawals used to pay for medical expenses that excel 7 1/2% of your AGI.
  • Withdrawals used to pay for medical insurance if the owner has received unemployment for more than 12 weeks.
  • Withdrawals used to pay for the first home, subject to a $10,000 limit.
  • Withdrawals used to pay for higher education expenses.

  All of these withdrawals are subject to ordinary income taxes but there is no additional penalty for this premature distribution.

  There are three methods for premature withdrawals:

  • Life Expectancy Method
    There are IRS tables that determine life expectancy of the owner or the joint life expectancies of the owner and a beneficiary. The withdrawal amount is calculated by dividing the balance at the beginning of the year by the factor found in the IRS life expectancy tables. For each year that passes by, the life expectancy factor is reduced by one.

  • Amortization Method
    The life expectancy is determined using the IRS tables mentioned above. The annual withdrawal amount is determined by applying an assumed earnings rate over the life expectancy. Generally, the rate must be within 120% of the applicable federal long-term rate. Once the rate is determined, the withdrawal remains fixed each year.

  • Annuity Factor Method
    Similar to the second method, but the withdrawal amounts are calculated using a different set of life expectancy tables than those used by the life insurance agency, which is the UP-1984 Mortality Table.

  Regardless of which method is used, the process must continue for a minimum of five years or until age 591/2.

• Traditional IRA
  The term used to define the regular IRA to participants under age 70 1/2. Annual contributions have a limit of $3,000 minus the participant's deductible IRA contributions. Earnings on the account are tax deferred until withdrawal, which must begin at age 70 1/2. Distributions are taxed at that time; if the distributions are not taken at that age, there is a 50% penalty on the amount not taken. After the age of 70 1/2, contributions can be made to the IRA; the limit of $2,000 is phased out if the participant's AGI falls below a specified level.

• Roth IRA
  Roth IRAs are similar to traditional IRAs, except that contributions come from after-tax earnings and are not taxed when withdrawn. After holding the Roth IRA account for a minimum of five years and reaching the age of 59 1/2, all withdrawals are tax-free, with the exception of gains.In order to qualify, participants filing jointly must have an adjusted gross income below $160,000 and single participants below $110,000 (note: these numbers change from year to year). Roth IRA's are described in detail in the next section.

• Individual Retirement Annuity
  A traditional or a Roth IRA established with a life insurance company through the purchase of a special annuity contract.

• Group IRA or Employer and Employee Association Trust Account
  A traditional IRA established by an employer for employees.

• Simplified Employee Pension (SEP-IRA)
  A traditional IRA established by an employer for employees. Employer contributions can be up to $40,000 or 25% of an employee's annual compensation.

Continued on Page 2 >