Money/Finance - IRA Basics
IRA Basics
Beneficiaries
Rollover Funds
Distribution
Surviving Spouse Beneficiaries
IRA Penalties
Roth IRA
IRA Basics
IRAs (Individual Retirement Arrangements) were originally included in the Employee Retirement Income Security Act (ERISA) as a way to encourage retirement savings for workers not covered by an ERISA pension. Through the years, the rules have been relaxed so that almost anyone under the age of 70½ who has earned income can contribute up to $2,000 to an IRA. Not everyone gets an income tax deduction for this contribution, however.
If you or your spouse were covered by an employer retirement plan, then there are special rules to reduce or eliminate the deduction.
Deductible or nondeductible contributions also matter in doing your income taxes when you start to withdraw your IRA savings. Contributions that were deductible when made will be included in your gross income at the time of the withdrawal. Nondeductible contributions have already been taxed, so they are not taxed again. The IRS leaves it up to you to track what portion of your IRA balance is deductible and what portion comes from nondeductible contributions.
There are three advantages that come from putting savings into an IRA instead of your savings account at the bank. The amount put into the IRA account can be a deduction against your current year's federal income taxes. The interest that you earn on this contribution is not taxable until it is withdrawn; you do not have to report the interest earned on your IRA as income, the way you do interest earned on your savings account. Finally, taxes are paid on these funds when you begin to withdraw the money and since you are withdrawing the funds in your retirement years, when your taxable income is much lower, there is little or no tax.
One of the IRS rules is that an IRA contribution cannot be made after the worker’s death. This is one incentive for putting the annual amount in the IRA account early in the tax year, if you can afford it.
IRA accounts can be kept in all sorts of financial institutions: banks, savings and loans, credit unions or in brokerage houses or insurance companies. One consideration when choosing between these institutions is how the different organizations invest your money for you. Banks usually set the IRA up as an account or certificate of deposit, while insurance companies are more likely to set the IRA up as an annuity. In a brokerage house, you can "self-direct" the funds and manage your own investments. IRA funds held by a brokerage house or insurance company, are not federally insured through FDIC or NCUA, as are IRA funds held by financial institutions.
Beneficiaries
When you open an IRA, you are given the opportunity to name a primary and maybe a contingent (second choice) beneficiary. The IRA beneficiary is the person or entity that will receive your IRA at your death should there still be any money in it. If you are married, your beneficiary can be your spouse, but this is not required. A trust or estate could be your beneficiary. You have the right to change your beneficiary if you fill out the required paperwork. If your spouse is not your beneficiary, who you pick can have an impact on the amount that must be paid out annually when you turn 70½.
Rollover Funds
You may hear about rolling over funds to and from IRAs. Rolling over money into an IRA is the way you can move money from one IRA account to another without having tax consequences. Money from other IRAs or from other types of pensions can be rolled into an IRA, and won’t be considered a withdrawal from the old account. The benefit of this action is that you avoid the early withdrawal penalties (see below). Transfers due to divorce are another exception to the normal tax penalties for taking money out of an IRA. If the money is given to the other spouse as a part of the divorce property settlement, the withdrawal is not taxable or penalized. In most rollovers, to take advantage of the tax exemptions, the funds need to be placed in a new IRA within 60 days. It’s crucial that you never "touch" the funds -- the exchange must be from institution to institution.
Distribution
There are two significant age anniversaries in connection with IRAs: ages 59½ and 70½. Before age 59½, withdrawals from your IRA may be penalized at 10% as early withdrawals. However, under some circumstances, there is no penalty. Exceptions to the early distribution penalty are:
- Unreimbursed medical expenses exceeding 7.5% of your adjusted gross income,
- The distributions are not more than the cost of your medical insurance, if you are unemployed,
- You are disabled,
- You are the beneficiary of a deceased IRA owner,
- You are receiving distributions in the form of an annuity,
- The distributions are not more than your qualified higher education expenses,
- The distributions are used to buy, build, or rebuild a first home,
- The distribution is due to an IRS levy of the qualified plan.
Although it is commonly believed that funds cannot be withdrawn from an IRA before age 59½ except in the above circumstances, section 72t of the Internal Revenue Code clearly states that individuals can remove money from an IRA prior to age 59½ without penalty. Section 72t provides that you can start a program to withdraw funds on a regular basis; you will have to pay taxes on any amounts withdrawn. To qualify under this code section all you need to do is establish a withdrawal program, approved by the IRS, that is based on your life expectancy and then continue the program for at least five years or until you are 59½, whichever is greater. After age 59½ you can make adjustments to the plan to increase, decrease, or even eliminate withdrawals. You should seek the advice of a tax professional if you are going to consider using this plan of withdrawal.
At age 59½, you may begin to withdraw money from your IRA without penalty. When you take money out of your IRA, it is included in your gross income in that tax year. At age 70½, you must begin a plan of distributing the IRA balance, if you haven’t already. If you don't withdraw enough per year, a new penalty, for "excess accumulations" will be charged. The penalty is 50% of what should have been withdrawn.
Your options for withdrawing funds from your IRA at 70½ are:
- to withdraw the entire amount,
- to set an amount to withdraw each year calculated on your life expectancy and the amount in your IRA,
- to set the annual distribution calculated on the joint life expectancy of you and your beneficiary, or
- to set an annual distribution for a number of years, no more than either your life expectancy or your joint life expectancy with your beneficiary.
Whichever method you pick, it is final. Determining which option to choose can get complicated and you will probably need some help from a professional. Publication 590, Individual Retirement Arrangements, is available without charge from the IRS.
Under recent changes to IRS Rules, the calculation for required minimum distributions (RMDs) have been simplified. The new regulations allow all IRA owners and retirement plan participants to calculate their RMD using a life expectancy table that assumes the individual’s beneficiary is ten years younger than they are, regardless of how old their named beneficiary actually is. This rule applies even when there is no named beneficiary at all. The effect of the changes is to allow the withdrawal of smaller amounts -- the lower the withdrawal, the lower your tax bill and the more money you have accumulating on a tax-deferred basis. The institution where your IRA is deposited will have all the life expectancy tables used under the different formulas. They may be a source of assistance to you in working out the details of your distribution.
If you have more than one IRA set up, you can make the minimum withdrawal for all the IRAs out of one account. To do this, you need to sign papers for the other IRA accounts, verifying that you are withdrawing the required amount elsewhere.
If in one year you withdraw more than the minimum amount out of the account, this no longer counts as a credit for next year’s withdrawal. Next year, you have to take the entire annual minimum out. This IRS change results in the IRA being depleted sooner than calculated under your life expectancy.
Rules for Surviving Spouse Beneficiaries
If you are a beneficiary on an IRA and the owner dies, you will receive the money in the IRA. There are some rules on how this is done, depending on the deceased owner's age, and whether you are the surviving spouse.
As the surviving spouse beneficiary, you can transfer or roll over all of the funds into your own IRA, if a required distribution is not required for the year. (It would be required if your spouse was at least 70½ years old.) Otherwise, all the funds except the minimum withdrawal for the year could be rolled over to your own IRA.
If you do not want to treat this IRA as your own IRA, you can take it as a "death distribution." Any non-spouse beneficiary must take the IRA balance as a death distribution. This means a pay out of the balance on a formula figured according to the age of the deceased IRA owner. If the deceased owner is at least age 70½, the pay out continues on the payment amount set when both the owner and the beneficiary were alive.
If the IRA owner died before the required first distribution, then a beneficiary can choose to receive the IRA balance under the five year rule -- where you get to make withdrawals at any time and in any amount, but all of your share of the IRA must be withdrawn by December 31, of the year that is the fifth anniversary of the IRA owner’s death. The second option available is to take distribution payments based on your life expectancy, beginning no later than December 31 of the year following the IRA owner's death. If you want to use this option as a spouse, the start of withdrawals doesn’t need to begin until December 31 of the year your spouse would have turned 70½.
If a trust or estate is the IRA beneficiary, payments can be made under the five year rule described above.
IRA Penalties
If you don't follow all the rules on how and when to move money out of an IRA, you will owe the IRS some penalties.
- If you withdraw money before age 59½, there is a 10% penalty tax in addition to the income tax assessed on the amount withdrawn. You pay this penalty when you file your federal income taxes for the year. In addition, be aware that if the IRA funds are held in a certificate of deposit and you are also cashing the CD in early, there is an early withdrawal penalty for the certificate of deposit as well. As stated previously in this section, there are exceptions to the penalty for withdrawals before age 59½.
- You also must pay a penalty if you make a contribution in excess of the annual limit. This penalty is 6% of the excess.
- Since you cannot keep funds in an IRA indefinitely, at age 70½ you must begin taking minimum distributions. If a distribution is less than the minimum, you may have to pay a 50% excise tax for that year on the amount not distributed as required.
Roth IRA
In addition to the traditional IRA, the Roth IRA was created in 1997. Sometimes called the "ultimate tax shelter," the Roth IRA is the opposite of a regular IRA. With a regular IRA, you get a tax deduction when you put money in, and pay income tax on what you take out, while with a Roth IRA there’s no deduction at the beginning, but withdrawals are tax-free. Some of the important advantages of a Roth IRA are:
- You can make contributions to the Roth IRA even if you’re a participant in a qualified plan such as 401(k) and even if you’re over age 70½, neither of which are allowed with a traditional IRA.
- With a traditional IRA you must begin making withdrawals by age 70½ in certain minimum amounts, but with a Roth you can take out as little as you want as late as you want. This allows more tax-free growth while you’re alive.
- If your IRA is going to be passed on to your heirs, your estate tax will be lower if it’s a Roth IRA because by paying the income tax in the beginning, you reduce the size of your estate.
- You can withdraw your contributions from a Roth IRA at any time without payment of tax or a penalty -- withdrawals of earnings are subject to restrictions during the first five years.
There are special rules covering conversion of your regular IRA to a Roth IRA. When you make the conversion you will have to include the amount in the IRA as income for that year on your tax return. While it is possible to use funds from the IRA to pay the tax, this is not recommended; if you don’t have other funds with which to pay the tax, conversion to the Roth IRA is probably not worth doing. You can’t make the conversion if your income is above $100,000 a year, or if you are married and file your tax return separately.
In some circumstances conversion can make sense even if you’re already retired. Since funds in a Roth IRA do not need to be withdrawn, more can be passed to an heir, which could allow for substantial tax-free growth.
