A Guide to Individual Retirement Accounts

[TeenieTina]

This will be a thread on Individual Retirement Accounts.

Individual Retirement Arrangements (IRA)

Table of Contents
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I. WHAT IS AN INDIVIDUAL RETIREMENT ACCOUNT (IRA)?

II. WHO IS ELIGIBLE FOR THESE PLANS?

III. WHAT ARE THE KEY TERMS I NEED TO KNOW?

IV. ARE THERE CONTRIBUTION LIMITS?

V. ARE THERE ANY PENALTIES FOR EARLY WITHDRAWALS?

VI. HOW WOULD IT AFFECT MY TAXES?

VII. WHAT ARE THE REGULATIONS REGARDING INHERITED IRAs?

VIII. HOW ABOUT BANKRUPTCY?

IX. WHEN IS A GOOD TIME TO SET UP AN IRA?

X. HOW DO I SET UP AN INDIVIDUAL RETIREMENT ACCOUNT?

XI. CAN I CONVERT FROM A TRADITIONAL IRA TO A Roth IRA?
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SECTION I. WHAT IS AN INDIVIDUAL RETIREMENT ACCOUNT (IRA)?
An individual retirement arrangement (IRA) is a self-provided retirement plan account that provides tax advantages for retirement savings in the United States. Some people may choose to invest, gamble, or rely on their business to save for retirement. However, these types of investment/savings vehicles require you to invest with post-tax income. Once you reap the earnings or capital gains of these investments, you get taxed again on those earnings/gains. With an Individual Retirement Account, unless you make a nonqualified distribution, you will only be taxed once during this savings process, either before you deposit or after you withdraw your savings. This makes IRAs more attractive savings vehicles.

There are actually ten types of IRAs, but this article will be focusing on the more common IRAs: the traditional IRA, Roth IRA, SEP IRA, and the SIMPLE IRA.

• The Traditional IRA is an individually established plan that allows contributions to be made with pre-tax income. Once contributions are made to the account, the money within the account may be used towards different investment options, such as stocks, bonds, and mutual funds and allowed to grow. The traditional IRA offers tax-deferred savings; the portion of your income you put into the account is not taxed, but your withdrawals will be taxed when you withdraw it years later. Any growth within the account is taxed, however, and withdrawals from this account are also taxed. The Traditional IRA can either be an individual retirement account or an individual retirement annuity.
• In the United States, an individual retirement account is one of two types of the traditional IRA. It is a trust or custodial account set up for the benefit of you and your beneficiaries. Contributions must be made in cash, and money in your account cannot be used to purchase a life insurance policy.
• An individual retirement annuity is one of two types of the traditional IRA. It is a retirement account in which contributions are made in the form of premium payments on a Fixed Dollar Annuity or Variable Dollar Annuity or both.
• The Roth IRA is an individually established plan that allows contributions to be made with after-tax income. Once contributions are made to the account, the money within the account may be used towards different investment options, such as stocks, bonds, and mutual funds and allowed to grow. Any growth within the account and qualified distributions from the account are not taxed, making this IRA option very attractive to those who qualify. However, you will be charged a penalty if you make a nonqualified distribution. Unlike a traditional IRA, you cannot deduct contributions.
• The Simplified Employee Pension (SEP) IRA is a simplified method for employers to contribute up to 25% or $46,000 of employee’s compensation to employees’ retirement pensions. The SEP IRA is basically a traditional IRA account that is either labeled as a SEP IRA or as a traditional IRA that accepts SEP contributions. Thus, the SEP IRA is subject to the same tax and withdrawal rules as the traditional IRA. However, with a SEP IRA, the contribution limit is much higher. The size of the contributions made to your account depends on the amount your employer would like to contribute to your account. You and your employer establish this account, but only your employer contributes to this retirement fund. Funds within the account may be used towards the investment option(s) of your choice.
• The SIMPLE IRA, Savings Incentive Match Plan for Employees IRA, is a retirement plan that allows the employer to deduct a certain percentage or dollar amount of your salary each period to contribute to a retirement account. One notable aspect of this retirement plan is the ability of the employer to match any contributions that an employee makes to the SIMPLE account. Your employer may match up to $10,500 per year, and for those ages 50 and over, $13,000 per year. The SIMPLE IRA plan is subject to the same withdrawal rules as the traditional IRA: early withdrawals are taxed. Earnings within the account are also taxed.
• A Spousal IRA is either a traditional or Roth IRA funded by a married taxpayer in the name of his or her spouse who has less than $2,000 in annual compensation. The couple must file a joint tax return in the year of the contribution. The working spouse may contribute up to $2,000 per year to the Spousal IRA and up to $2,000 per year to his or her own IRA. A couple, then, may contribute up to $4,000 per year as long as neither IRA receives more than $2,000.
• A Rollover (Conduit) IRA is a traditional IRA set up by an individual to receive a distribution from a qualified retirement plan. Distributions transferred to a rollover IRA are not subject to any contribution limits. The distribution may also be eligible for transfer into a qualified retirement plan available through a new employer.
• An Inherited IRA is either a traditional or a Roth IRA acquired by the non-spousal beneficiary of a deceased IRA owner. Special rules apply to an inherited IRA. A tax deduction is not allowed for contributions to this IRA, a rollover to or from another IRA owned by the heir is not permitted, and the proceeds must be distributed and taxed within a specific period as established by the Internal Revenue Code.
• An Education IRA (EIRA) is an IRA established to provide funds for a beneficiary to use for higher education purposes. There is no tax deduction allowed for the contribution, but all deposits and earnings may be withdrawn free of tax and penalties if used to pay for the costs of higher education. Beginning in 2002, EIRA proceeds may also be used free of tax and penalty to pay for the qualified expenses of a kindergarten through 12th grade education in public, private, and/or religious schools. EIRA contributions are limited to a maximum of $500 per year, but that's in addition to the $2K limit on any other IRA. Beginning in 2002, allowable EIRA contributions increase to $2,000 per year.

SECTION II. WHO IS ELIGIBLE FOR THESE PLANS?
If you qualify for an IRA, you have the opportunity to combine the powers of compound interest and tax savings to save up for retirement.


Traditional IRA

• To qualify for a traditional IRA account, there is no minimum age; the participant must be under 70 ½ years of age and must have income from wages, salary, tips, commission, alimony, or self-employment to contribute to the account.

• Types of money that cannot be contributed are pensions, earnings and profits from property rental income, dividends, loans, and interest on money.
• There is no income limit for this retirement plan, and you can have a traditional IRA whether or not you are covered by another retirement plan.
• If you would like to open a joint account with your spouse, your spouse must also have some form of compensation. However, you and your spouse may each have an IRA account, even if one of you is not employed.

Roth IRA

• Unlike the traditional IRA, the Roth IRA has an income limit for its participants.
• Single filers must have an annual income below $116,000. If you’re single and your AGI is below $101,000, you are eligible for a full Roth contribution. If you’re single and your AGI is between $101,000 and $116,000, you can put a gradually declining portion of your contribution into a Roth and the rest into a traditional IRA (partial Roth).
• As of 2008, joint filers qualify for a full Roth if income is under $159,000. Joint filers with income between $159,000 and $169,000 qualify for a partial Roth. Over $169,000 and you don’t qualify for a Roth. Single married filers must earn below $10,000 per year.
• Like the traditional IRA, you must have a form of compensation that would qualify as contribution for the IRA. Pensions, earnings and profits from property rental income, dividends, loans, and interest on money are not considered compensation.
• There is no age limit to opening this plan, and no forced withdrawal at any age.

Simple IRA

• To qualify for a traditional IRA account, there is no minimum age; the participant must be under 70 ½ years of age and must have income from wages, salary, tips, commission, alimony, or self-employment to contribute to the account.
• Types of money that cannot be contributed are pensions, earnings and profits from property rental income, dividends, loans, and interest on money.
• There is no income limit for this retirement plan.
• If you would like to open a joint account with your spouse, your spouse must also have some form of compensation.

Simplified Employee Pension (SEP) IRA

• To qualify for the SEP IRA, you must be at least 21 years of age, must have worked for your employer for at least 3 out of the last 5 years, and must have received at least $500 in compensation from the employer for the tax year.
• Your employer may establish a SEP IRA for an employee who is entitled to contribution if the employee is unable or unwilling to establish the SEP IRA.
• Your employer exclude employees with retirement benefits covered by a union contract and employees that are nonresident aliens that received no earned income from sources in the U.S.

SECTION III. WHAT ARE THE KEY TERMS I NEED TO KNOW?


You shouldn’t put your hard-earned money into something unless you understand the terms involved. Here are important terms you will have to know before you open an IRA:

• Pre-tax income – Income before tax deductions
• Post-tax income – Income after tax deductions
• Compensation – What you earn from working such as wages, salaries, commissions, self-employment income, alimony and separate maintenance, and nontaxable combat pay. Compensation does not include earnings and profits from property, pension and annuity income, deferred compensation received, income from a partnership for which you do not provide services that are a material income-producing factor, and any amounts you exclude from income.
• Capital Gains – Profit that results from the sale or exchange of a capital asset over its purchase price
• Early withdrawal – Removal of funds from an investment account before the maturity date, usually when the account owner reaches 59 ½ years of age, which may or may not come with penalty, depending on what type of IRA you have.
• "Qualified" distribution from a Roth IRA is a withdrawal that meets one or more of the following:

1. Made after the taxpayer attains age 59 ½
2. Made to a beneficiary after the taxpayer's death
3. Made because the taxpayer is disabled
4. Made by a first-time homebuyer to acquire a principal residence

• Annuity – a deferred investment contract that, upon "annuitization," will make regular payments to a person (the "annuitant") over a period of years. In our case, annuity contracts provide income during retirement.
• Fixed Dollar Annuity – Annuity that guarantees that a specific sum of money will be paid in the future, usually as a monthly income, to an annuitant.
• Variable Dollar Annuity – Annuity in which premium payments are used to purchase accumulation units. The value of a unit is determined by the value of portfolio stocks in which the insurance company invests the premiums. The accumulation units are converted to a monthly fixed number of units when benefits are paid to the annuitant.
• Modified AGI – Adjusted gross income as shown on your return.
• Phase-out range – This term pertains to Roth IRAs. For a Roth IRA, if your AGI is below $101,000, you qualify for a full Roth. If your income is between $101,000 and $116,000, you fall into a “phase-out range,” meaning you don’t qualify for a full Roth, but you can put a gradually declining portion of your contribution into a Roth.

SECTION IV. ARE THERE CONTRIBUTION LIMITS?

Yes, there are annual contribution limits and forced withdrawals:


Traditional IRA

1. The traditional IRA allows you to contribute up to $5000 a year (in 2008) if you are under the age of 50. If you are age 50 or above, you may contribute up to $6000 a year. This amount may be higher if you had a 401k plan under an employer that went bankrupt earlier in the year.
2. Contributions are with pre-tax compensation, and growth within the account is subject to taxation.
3. You may not contribute more than your gross annual income. For example, if you earned $3000 in one year, you may only contribute up to $3000 to your traditional IRA account.
4. Starting at age 70 ½, the owner of the account is forced to make withdrawals from the account. If you do not make a withdrawal when required to, the IRS may confiscate half the amount of that withdrawal.

Roth IRA

1. Contributions are made with after-tax income.
2. Growth within the Roth IRA and withdrawals from the account are not taxed.
3. The Roth IRA allows you to contribute up to $5000 a year (in 2008) if you are under the age of 50. If you are age 50 or above, you may contribute up to $6000 a year. This amount may be higher if you had a 401k plan under an employer that went bankrupt earlier in the year.
4. Contributions are with pre-tax compensation, and growth within the account is subject to taxation.
5. You may not contribute more than your gross annual income. For example, if you earned $3000 in one year, you may only contribute up to $3000 to your Roth IRA account.

Simple IRA

1. You may contribute up to $10,500 to your SIMPLE IRA. For those ages 50 and over, the limit is $13,000.
2. Contributions from your employer cannot exceed 3% of your compensation. Your employer can choose to reduce this percentage to a percentage no lower than 1%. This reduction cannot last for more than 2 years out of the last 5 years of the period of the plan. The employee must be notified of this decision during the 60-day period before the employee enters a new salary reduction arrangement.
3. Your employer has the option of making a non-elective contribution. Non-elective contributions are those made on behalf of all SIMPLE-eligible employees that do not match any specific contribution. The employer must notify employees that this election was made, and the contribution is limited to 2%.

Simplified Employee Pension (SEP) IRA

1. The SEP IRA allows the employer to contribute up to 25% or $45,000, whichever comes first, of the employee’s compensation to the employee’s retirement fund. Only the employer contributes, not the employee.
2. You or your employer may choose the financial institution as the trustee/custodian.
3. The SEP IRA can be set up for those who are self-employed, even if the employer is under another business’ retirement plan. However, the contribution limit in this case would be 18.587%.

SECTION V. ARE THERE ANY PENALTIES FOR EARLY WITHDRAWALS?



Traditional IRA – Withdrawals from the account are taxed like income and early withdrawals are subject to an additional penalty of 10%. There are eight exceptions for withdrawals. Nonqualified distributions will not be penalized if they

1. Occur because of the IRA owner's disability.
2. Occur because of the IRA owner's death.
3. Are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
4. Are used to pay for medical expenses that exceed 7.5% of adjusted gross income (AGI).
5. Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
6. Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
7. Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.
8. Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.

Roth IRA – There are a few exceptions for nonqualified distributions from a Roth IRA. Barring these exceptions, withdrawals before the owner has reached 59 ½ years of age or before the money has been in the account at least five years will be taxed and the earnings will incur a 10% penalty. Nonqualified distributions that will not be penalized if they

1. Occur because of the IRA owner's disability (review IRS Code Section 72(m)(7) and IRS Publication 590 for more information).
2. Occur because of the IRA owner's death.
3. Are a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner.
4. Are used to pay for medical expenses that exceed 7 1/2% of adjusted gross income (AGI).
5. Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than 12 weeks.
6. Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10,000).
7. Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members.
8. Are used to pay back taxes because of an Internal Revenue Service levy placed against the IRA.

Simple IRA – Withdrawals from the account are subject to taxation, and early withdrawals (withdrawals before you reach age 59) are subject to a 25% tax.

Simplified Employee Pension (SEP) IRA – Withdrawals are subject to taxation and are subject to the same withdrawal rules as the traditional IRA. There is a penalty for early withdrawal (withdrawals before you reach age 59).


SECTION VI. HOW WOULD IT AFFECT MY TAXES?


Traditional IRA

• You can deduct all or your IRA contribution if you’re single and your AGI is below $53,000. If your income is between $53,000 and $63,000, you can deduct a gradually decreasing portion of your contribution. You cannot deduct anything is your AGI is over $63,000.
• If you fall within the twenty-five percent marginal tax bracket, and contribute $4000, you may receive a $1000 deduction from your tax liabilities.
• If you were a participant in your employer's pension/profit sharing plan, your traditional IRA contributions would not be fully deductible. If you were not in your employer's pension/profit sharing plan, your contributions would be fully deductible.
• Withdrawals from the account are taxed like income and early withdrawals are subject to an additional penalty of 10%. There are exceptions for withdrawals used toward education, medicals costs above 7.5% of your gross annual income, first home purchases, health insurance, disability, and death.

Roth IRA – Contributions are made with after-tax income. Growth within the Roth IRA and withdrawals from the account are not taxed. Contributions are not tax-deductible.
Simple IRA – Growth within the account is subject to taxation. Withdrawals from the account are also subject to taxation, and early withdrawals (withdrawals before you reach age 59) are subject to a 25% tax.


Simplified Employee Pension (SEP) IRA

1. Contributions do not have to be made every year. Contributions are not taxable and not included in gross income
2. Growth within the account is taxed like income. Withdrawals are subject to taxation and are subject to the same withdrawal rules as the traditional IRA. There is a penalty for early withdrawal (withdrawals before you reach age 59).

SECTION VII. WHAT ARE THE REGULATIONS REGARDING INHERITED IRAs?

• For a traditional IRA, the value of the IRA will be included in your estate. However, the traditional IRA earnings will also be taxed as income to your beneficiaries. This could cause a very large combined estate/income tax to be assessed against your traditional IRA.
• With a Roth IRA, you are able to build up the value of the IRA free from all income taxes for the benefit of your heirs. And while estate taxes may have to be paid on the value of the Roth IRA upon your death, no part of the Roth IRA will be subject to income tax to your beneficiaries.
• If the beneficiary of your Roth IRA is your spouse, he/she can treat the Roth IRA as his/her own.
• If the beneficiary of your Roth IRA is someone other than your spouse, Roth IRA distributions need to be made

1. By the end of the year containing the fifth anniversary of the account owner's death; or
2. Over the life expectancy of the beneficiary, starting no later than Dec. 31 of the year following the year that the account owner died.

SECTION VIII. HOW ABOUT BANKRUPTCY?

• Under Rousey v. Jacoway, the United States Supreme Court ruled that a debtor can exempt his/her IRA in bankruptcy. Up to $1,000,000 of IRA assets can be exempt from a bankruptcy estate, including Traditional and Roth IRAs.
• IRA assets are also protected from lawsuit seizures. However, they may be not protected in cases of divorce, failure to pay taxes, deeds of trust, and fraud. Assets must be deposited into an IRA before a lawsuit exists to receive protection.

SECTION IX. WHEN IS A GOOD TIME TO SET UP AN IRA?

Which IRA you should invest in is up to you to decide based on the following facts:

Traditional IRA – Since the traditional IRA would lower your income by the amount contributed and would defer taxes, it would be ideal for those who would like to lower their income to pay less tax. For example, someone who is earning $166,000 per year before taxes and falls in the 33% tax bracket would want to open an IRA account to able to deduct $5000 from his income to have an annual income of $161,000 to fall into the 28% tax bracket.

Roth IRA – The Roth IRA plan is ideal for those who have incomes below the limit to qualify for the plan. Those with incomes below the limit would pay less taxes so it would be more advantageous for them to pay less taxes now, contribute money to the Roth IRA, and allow it to grow tax free. The Roth IRA is ideal for students and low to upper middle income earners.

Simple IRA – This account is ideal for those who want an employer-sponsored account that gives more leverage to the individual in deciding how much to contribution each month. For those working for a company with 100 employees or less, the SIMPLE IRA is a great option to take advantage of because it has a higher contribution limit than other IRAs.

Simplified Employee Pension (SEP) IRA – This plan is a great option for those who are self-employed because it allows you to establish your own retirement plan and at the same time have another retirement plan under another company.
This plan is best for those with high incomes because the plan allows contributions of up to $45,000, or 25% of the employee’s income. With a higher income, this 25% would be higher and closer to the $45,000 limit.



SECTION X. HOW DO I SET UP AN INDIVIDUAL RETIREMENT ACCOUNT?
An IRA is easy to set up—just fill out a simple application at the financial institution you choose. IRAs are self-directed; you decide how to invest the money, and you're also responsible for putting in only the amount you're entitled to each year. You must also report your annual contribution to the IRS, on your basic return if it's deductible and on Form 8606 if it's not. You may contribute a lump sum, or spread out your contribution over 15 months.

Traditional IRA – The traditional IRA can be set up anytime at a bank, financial institution, mutual fund, or life insurance company. Traditional IRAs are regulated by the IRS, and when establishing one you must arrange a contract between you and your trustee/custodian.

Roth IRA – The Roth IRA can be set up anytime at a bank, financial institution, mutual fund, or life insurance company. Roth IRAs are regulated by the IRS, and when establishing one you must arrange a contract between you and your trustee/custodian.
Simple IRA – You and your employer must sign a contract stating what percentage or set dollar amount of your compensation will be contributed to your account and your employer must match the amount contributed. If your employer chooses the trustee/custodian, you must use Form 5305-SIMPLE. If you are to choose the trustee/custodian, you must use Form 5304-SIMPLE. You must also sign a contract between you and your trustee (Form 5305-S) or custodian (Form 5305-SA).
oSIMPLE IRAs must be set up between January 1 and October 1 (if your sponsor did not previously set up a SIMPLE plan) and on January 1 (if your sponsor did previously set up a SIMPLE plan).

Simplified Employee Pension (SEP) IRA – You must establish a traditional IRA to which your employer will make SEP contributions. Some financial institutions require that your traditional IRA account be labeled as a SEP IRA, and others will allow your employer to make SEP contributions to an account labeled as a traditional IRA.
oThe employee and employer must sign a formal agreement using the Internal Revenue Service (IRS) model SEP using Form 5305-SEP, Simplified Employee Pension - Individual Retirement Accounts Contribution Agreement, or a prototype. Prototypes are offered by banks, insurance companies, and other financial institutions.



SECTION XI. CAN I CONVERT FROM A TRADITIONAL IRA TO A Roth IRA?

• Many people consider the Roth IRA more attractive than the traditional IRA. However, some already have a traditional IRA when they realize this. Is it possible to convert from a traditional IRA to a Roth IRA? Yes, it is possible, but the “rollover” must be qualified: you must wait 60 days after opening your traditional IRA before you may convert. For more information, see IRS Publication 590.
• In addition, your adjusted gross income (AGI) cannot exceed $100,000—this goes for single filers as well as for joint filers and head-of-household filers. Funds transferred from a traditional IRA to a Roth IRA that weren’t taxed will be taxed at your normal tax rate.
• In addition, because a conversion is a “qualified” distribution, you would not be charged the 10% penalty that is charged to nonqualified distributions. However, you would be charged a penalty is you remove funds from the Roth IRA early.

[Calamari]

Very informative guide!

[Madmark]

Another thing to consider when choosing between the Traditional vs Roth is the Saver’s Credit.

"Lower income workers" get a credit on their income tax based on their contribution to a retirement savings plan.

You can find more details here: http://www.irs.gov/newsroom/article/...172969,00.html

[pwsolutions]

thanks for posting such a informative article.

[Avidsaver]

Very nice guide. You should definitely have some form of retirement goal set at all time because you will want to take it easy when you are no longer capable of working.