Individual Retirement Plans
Taxation of IRA Distributions
Funds withdrawn from a traditional IRA are subject to ordinary income tax if they were not taxed before. In other words, any previously deducted contributions and any untaxed fund earnings are taxed when they are received. Any contributions that were not deducted will not be taxed again when taken. If an IRA owner dies before the funds in his or her account have been fully paid out, they will be paid (and taxed) to the beneficiary. Likewise, the value of any funds remaining in a deceased's IRA account is included in the value of the deceased's estate for estate tax purposes.
RA Rollovers and Conversions
As they're building their retirement resources over the years, individuals' needs and circumstances change. Tax laws allow people to move their retirement savings from one qualified account to another without being taxed or penalized.
Roth IRAs
Introduced in 1997, Roth IRAs provide for "back-end" tax benefits. This means that contributions to a Roth account are paid with after-tax dollars and cannot be deducted. But the earnings on those contributions, when withdrawn, are entirely tax free, provided the withdrawal meets the requirements for a qualified distribution. Roth IRAs are an attractive alternative to traditional IRAs. This is especially true for those who cannot deduct contributions because they are covered by an employer plan.
How to Effect Rollovers
People can roll over funds in one of two ways: 1. The participant can choose to receive the funds personally and then deposit them into the rollover account. 2. The participant can specify that the funds be transferred directly from the trustee of the existing plan to the trustee of the rollover IRA. A participant has 60 days to complete a rollover IRA transaction after receiving funds for transfer. If the funds are not deposited within 60 days, they are subject to tax and a potential tax penalty.
Quiz
Question 1 If a Roth IRA owner takes a withdrawal at age 50 to pay for a grandchild's education after having owned the account for three years, then: The entire withdrawal is subject to income tax. -The earnings portion of the withdrawal is subject to income tax and a 10 percent penalty tax. The entire withdrawal is subject to income tax and a 10 percent penalty tax. None of the withdrawal is subject to tax. If a withdrawal is taken from a Roth IRA before the five-year waiting period ends, the earnings portion of the withdrawal is taxed. If the withdrawal is taken before the owner reaches age 59 1/2, the earnings portion is also subject to a 10 percent penalty tax. The owner's basis in the IRA (his or her contributions) is not subject to tax. Question 2 A husband and wife, ages 49 and 51, jointly earn $175,000 a year. They each participate in a 401(k) plan at work, and each owns a traditional individual IRA. Which of the following statements is correct? -Any contributions they make to their traditional IRAs will not be tax deductible. They are not eligible to contribute to a traditional IRA this year because their income is too high. They are also eligible to contribute to a Roth IRA. Only part of their IRA contributions will be tax deductible. The husband and wife are not eligible to contribute to a Roth IRA because their income exceeds the adjusted gross income limits. Question 3 Which of the following will happen if a traditional IRA owner dies before all of the funds in his or her account have been paid out? -The funds will be paid and taxed to the beneficiary. The funds will be excluded from the deceased owner's estate for estate tax purposes. The owner forfeits the balance. The funds will be paid to the beneficiary but taxed to the owner's estate. If a traditional IRA owner dies before the funds in his or her account have been fully paid out, they will be paid and taxed to the beneficiary. Question 4 Anne turned 70 this year on March 15. By what date does she have to begin taking distributions from her retirement plan? October 1 this year -April 1 next year April 1 this year October 1 next year Anne is required to take her first minimum distribution by April 1 of the year following the year in which she turned age 70 1/2. Because Anne did not turn 70 1/2 until later in the current year, she can delay taking her first distribution until April 1 next year. Question 1 If a person receives funds directly from a qualified pension plan and intends to roll them over to an IRA, within how many days must the rollover be completed? 75 days 90 days 30 days -60 days If a person receives funds directly from a qualified plan and plans to transfer them to an IRA rollover account, he or she has 60 days to complete the rollover transaction. If the funds are not deposited within 60 days, they are subject to income tax and a penalty tax. Question 2 Jenna, age 40, works full time and earns $175,000 a year while her husband, Rick, age 42, currently does not work. Which of the following statements is correct? -Jenna can contribute the maximum contribution amount to a traditional IRA for both herself and for Rick. Jenna can set up and contribute to a traditional IRA for herself; she can contribute a lesser amount to a traditional IRA for Rick. Jenna can set up and contribute to a traditional IRA only for herself. Jenna cannot contribute to a traditional IRA because her adjusted gross income is too high. People who are eligible to establish traditional IRAs for themselves can also set up separate IRAs for a non-working spouse. Eligible people can contribute up to the annual amount allowed to each account. In this case, Jenna can contribute up to the maximum limit to an IRA set up in her name. She can also contribute up to the maximum limit to an IRA set up in Rick's name. Question 3 Paul reached age 70 1/2 this year and has a Roth IRA worth $100,000. Which of the following statements best describes his distribution options? Paul will have to pay a 50 percent penalty tax if he does not take the full amount of the required minimum distribution. -Paul is not required to take any distributions from his Roth IRA. Paul must take his first required minimum distribution by April 1 of the year following the year he turns 70 1/2. If Paul waits to take a distribution until next year, he must take two distributions. Unlike traditional IRAs, Roth IRA owners are not required to take distributions once they reach age 70 1/2. As a result, a Roth IRA can remain intact and can be passed to the owner's beneficiary when the owner dies, if desired. Question 4 Jason, age 27, is single, works for a small computer company, and earns $125,000 a year. Because the company does not have any retirement plan for its employees, Jason set up and contributed to a traditional IRA this year. Which of the following statements is correct? Jason can deduct part of his IRA contribution this year. Jason cannot take a deduction for his IRA contribution because he is not covered by a qualified employer plan. Jason cannot take a deduction for his IRA contribution because his adjusted gross income is too high. -Jason can deduct the full amount that he contributes to his traditional IRA. Because Jason is not covered by a qualified employer plan, he can deduct the full amount that he contributes to a traditional IRA.
Roth IRA Eligibility
Roth IRAs are more limited than traditional IRAs in one respect. Roth IRAs are limited to those whose adjusted gross incomes (AGIs) are below $133,000 for single filers (2017) and $196,000 (2017) for joint filers. (Traditional IRAs are available to anyone under 70½ with earned income.) The following chart shows how this applies: +chart give
Roth IRA Contribution Limits
The contribution limits to a Roth IRA are the same as those for a traditional IRA. In 2018, for example, the maximum contribution that a person can make to a Roth is $5,500. For those age 50 and older, an additional $1,000 can be contributed. A person can maintain both a Roth IRA and a traditional IRA and can make contributions to both in any given year. However, the maximum amount that a person can contribute to both combined is limited to the overall contribution limit. For example, 42-year-old Sarah contributes $2,500 to her Roth IRA in 2018. Because the maximum IRA contribution limit for that year is $5,500, Sarah can contribute no more than $3,000 to her traditional IRA.
Rollovers
When a distribution is received from a qualified plan, it is normally taxed. However, in a rollover IRA, those amounts avoid current taxation and can continue to build tax-deferred for later access. Rollover IRAs are common today as people move from job to job. For example, 52-year-old Brent has been working for and participating in InTech's 401(k) plan. Brent decides to take a job with one of InTech's competitors. He has $100,000 in a 401(k) plan with InTech. Rather than have that amount distributed (and taxed) to him or leave it with InTech, Brent opens a rollover IRA. He transfers the $100,000 funds to that new account. The funds in the rollover account will continue to build tax-deferred for later access. As another example, Leonard, at the age of 62, decides to take early retirement. He does not currently need the funds that have grown in his 401(k). So, he rolls them over into an IRA at his local bank. As in our other examples, these funds will continue to grow tax-deferred in the IRA. Funds can also be rolled over from one IRA to another IRA. There are no limits on amounts that can be transferred. However, after the rollover account is opened and the rollover funds are transferred, the rules that apply to IRAs then apply to the rollover account.
Traditional IRAs
IRAs were established in 1974 with the passage of the Employee Retirement Income Security Act (ERISA). At first, IRAs were reserved for working people who were not covered by a qualified employer plan. The principal and earnings in IRA accounts would grow tax-deferred, taxed only when withdrawn. In 1981, IRA eligibility was extended to all wage earners regardless of whether they were covered by an employer plan. The annual contribution limit was raised to $2,000, with an additional $250 for nonworking spouses. In 1986, the Tax Reform Act (TRA '86) phased out the deductibility of IRA contributions for higher wage earners who are covered by a qualified employer plan. The main changes TRA '86 made are still in place today, but additional changes to IRAs have since been made. What has not changed over the years is that earnings on a traditional IRA enjoy tax-deferred accumulation until withdrawn. At that point, withdrawals are fully taxed
Roth Conversions
Tax laws permit converting traditional IRAs into Roth IRAs (called a Roth conversion) if certain conditions are met. Anyone can convert a traditional IRA to a Roth IRA. However, income taxes must be paid on the traditional IRA when the account is converted. Whether a person can contribute to a Roth IRA depends on the person's adjusted gross income. Suppose, for example, that Frank wants to convert his $200,000 traditional IRA to a Roth IRA. The $200,000 represents fully deductible (never taxed) contributions and earnings. So, Frank must pay taxes on the $200,000 when he converts the account to a Roth. From that point on, however, the converted account builds tax free. As long as Frank holds the account for five years and is older than 59½, any distribution he takes from the Roth will be tax free. Anyone can convert a traditional IRA to a Roth IRA. Income taxes are due when the conversion occurs. But from that point on, the funds will be available for tax-free withdrawal.
Traditional IRA Distributions
The IRS imposes penalties for early withdrawals from a traditional IRA. On the other hand, traditional IRAs cannot be used to endlessly shelter income from taxes. At a certain point, traditional IRA owners must begin taking distributions from their plans. When distributed, traditional IRA funds are taxed. -Premature IRA Distributions Withdrawals from a traditional IRA before the age of 59½ are subject not only to regular income taxation but also to a 10 percent tax penalty. For example, if Frances took a distribution from her IRA at the age of 55, she would owe income tax on the distribution plus a 10 percent penalty. The penalty is applied to the amount of distribution that is subject to tax. Distributions taken from a traditional IRA for any of the following reasons, though taxable, are exempt from the 10 percent penalty: --The IRA owner dies or becomes disabled. --The IRA owner has medical expenses that exceed 10 percent of his or her adjusted gross income (7.5 percent of AGI if the owner is at least 65 years old). --The distributions are used to buy a first-time home. --The distributions are used to pay for qualifying higher education expenses. --The distributions are used to pay for health insurance premiums while unemployed. --The IRA owner takes them as substantially equal payments over his or her life. -Required IRA Distributions Beginning no later than April 1 of the year following the year they turn age 70½, owners of traditional IRAs must begin taking required minimum distributions (RMDs) from their IRAs. These distributions must also be taken yearly in no less than minimum amounts prescribed by the tax laws. Failure to take an RMD results in one of the stiffest penalties the IRS imposes. This penalty is 50 percent of the difference between the amount that was taken and the amount that should have been taken.
Roth IRA Withdrawals
The main benefit to a Roth IRA is that no income tax is due when withdrawals are taken from the account in a qualified distribution. This means that interest and earnings grow in the account tax free and are tax free when taken. However, to receive this tax-free treatment, the distribution must be a qualified distribution. To be deemed a qualified distribution, two requirements must be met: 1. The account must be held for a minimum of five years. 2. The distribution must occur --after the owner has reached age 59½, or --when the account owner dies, or --when the account owner becomes disabled, or --when the distribution is used to buy a first-time home (limited to a lifetime maximum of $10,000). If the withdrawal meets these requirements, then no portion is taxable. But, if a withdrawal is taken before the five-year waiting period ends, then the earnings portion of the withdrawal is taxed. If the withdrawal is taken before the owner's age 59½, the earnings portion is subject to a 10 percent tax penalty. (Like a pre-59½ distribution from a traditional IRA, the pre-59½ distribution from a Roth is exempted from the 10 percent penalty if certain conditions are met.) The amount of a withdrawal that represents contributions is not taxed. This is because such contributions were not deducted when they were made. Unlike a traditional IRA that requires distributions to begin by an owner's age 70½, a Roth IRA does not require mandatory distributions. The funds can stay in the account for as long as the owner desires and can even be passed on to beneficiaries and heirs.
Traditional IRA Participation
Today, anyone who is younger than 70½ and earns income can set up and contribute to an IRA through just about any financial institution. There are a few restrictions on the types of financial instruments that can be used to fund the IRA. Certificates of deposit, securities, annuities, and some forms of real estate are allowed to fund IRAs. Life insurance and collectibles (such as artwork, stamps, rare books, or antiques) are not permitted as IRA funding vehicles. People can contribute any amount they want to a traditional IRA, up to specified limits. These limits are either a specified dollar amount or 100 percent of earned income, whichever is less. The specified dollar amount is subject to change. In 2018, the IRA contribution limit is $5,500. Those 50 or older can make additional "catch-up" contributions of up to $1,000. As a result, a 50-year-old can contribute a maximum of $6,500 to his or her IRA in 2018. (Catch-up contribution limits are subject to change yearly for inflation.) Those who are eligible to set up IRAs for themselves can also set up separate IRAs for a non-working spouse. Eligible people can contribute up to the annual amount allowed to both accounts. For example, in 2018, Jeremy can contribute up to $5,500 to an IRA set up in his name. He can also contribute up to $5,500 to an IRA set up in his wife's name, even if she is not working. (If Jeremy is 50 or older, an additional $1,000 can be contributed to his account. If his wife is 50 or older, an additional $1,000 can be contributed to her account.)
Traditional IRA Deductions
Whether an IRA contribution can be deducted from the worker's taxes depends on whether the IRA owner is covered by an employer-sponsored retirement plan and what the IRA owner's income level is if covered under an employer-sponsored retirement plan. If a person is not covered by an employer plan, he or she can fully deduct the amount contributed to an IRA. This is true no matter what the level of income. Married couples who both work and have no employer-sponsored plan coverage can each contribute and deduct up to the maximum contribution each year. Those who are covered by an employer-sponsored plan can contribute up to the maximum IRA limit but the amount deductible is phased out based on income level (see chart for 2018 limits). -Filing Status Full Deduction Allowed Partial Deduction Allowed No Deduction Allowed --Single, with adjusted gross income (AGI) of: $63,000 or less More than $63,000 but less than $73,000 $73,000 or more --Joint, with adjusted gross income (AGI) of: $101,000 or less More than $101,000 but less than $121,000 $121,000 or more Be careful not to confuse the ability to make IRA contributions with the ability to deduct those contributions. Again, anyone who is younger than 70½ with earned income can contribute to a traditional IRA. Whether the contributions can be deducted depends on whether the IRA owner is covered by an employer plan and, if covered, the level of his or her adjusted gross income. A person can make nondeductible contributions to an IRA. In these cases, the contributions, when later withdrawn, are not taxed. This is because they were not deducted when contributed. Earnings, however, are always taxed when withdrawn.
Key Points
-Earnings on a traditional IRA enjoy tax-deferred accumulation until withdrawn. At that point, withdrawals are fully taxed. -Life insurance and collectibles (such as artwork, stamps, rare books, or antiques) are not permitted as IRA funding vehicles. -Those who are eligible to set up IRAs for themselves can also set up separate IRAs for a non-working spouse. Eligible people can contribute up to the annual amount allowed to both accounts. -If a person is not covered by an employer plan, he or she can fully deduct the amount he/she contributes to his or her IRA. -Beginning no later than April 1 of the year following the year they turn age 70½, owners of traditional IRAs must begin taking required minimum distributions (RMDs) from their IRAs. -Contributions to a Roth account are paid with after-tax dollars and cannot be deducted. But the earnings on those contributions, when withdrawn, are entirely tax free. -A person can maintain both a Roth IRA and a traditional IRA and can make contributions to both in any given year. -The main benefit to a Roth IRA is that no income tax is due when withdrawals are taken from the account in a qualified distribution. -A participant has 60 days to complete a rollover IRA transaction after receiving funds for transfer. -Anyone can convert a traditional IRA to a Roth IRA. However, income taxes must be paid on the traditional IRA when the account is converted.
