What is an IRA?
An IRA is an INDIVIDUAL RETIREMENT ACCOUNT. An IRA is a personal savings plan that provides income tax advantages to individuals saving money for retirement purposes.
How does an IRA work?You invest money in an IRA, up to the amounts allowable under the tax law. These investments are termed "contributions." In many instances an income tax deduction is available for the tax year for which the funds are contributed. The contributions, as well as the earnings and gains from these contributions, accumulate tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes on these earnings, each year the funds remain within the IRA.
The withdrawals of the funds from the IRA are termed "distributions." Distributions are subject to income taxation, generally in the year in which you receive them. (Remember that in most cases you received an income tax deduction when you contributed the money to the IRA.) As with most things involving the government, the rules for distributions are more complicated than they need to be.
Since the original purpose of the IRA is to assist you in providing for your own retirement, there is a disincentive for withdrawing your IRA funds prior to an assumed retirement age of 59½. This disincentive takes the form of a tax "penalty" in the amount of 10 % of the distributions received by you prior to age 59½, unless certain exceptions apply. Given the complexity of this issue alone, professional advice should be obtained whenever significant amounts of distributions are needed prior to age 59½. The fact is that many times the penalty can be avoided with proper planning. Obviously these distributions, whether before age 59½ or later, are subject to income taxation upon receipt. Once you are age 59½ this penalty, termed a "Premature Distribution" penalty, is no longer applicable.
On the flip side of the government not wanting you to withdraw your money at too young an age, it also has rules to prevent you from not withdrawing the money soon enough. (This is done in order that the government can tax it.) You usually need to begin taking money from your IRA no later than April 1 of the calendar year following the date you attained age 70½. The rules established by the government regarding these Required Minimum Distributions, their timing, the amounts, the recalculations, and the effect various beneficiary designations have on them, are among the most complex of the Internal Revenue Code. The penalty is 50% of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date. This punitive penalty is matched only by the civil fraud penalty in severity. The necessary calculations are therefore not something that most individuals should attempt on their own.
What are the different types of IRA's?
There are five different types of IRA’s:
- Traditional IRA
You can contribute up to $2,000 per year into an IRA. The amount of this contribution that is deductible on your income tax return depends on your Adjusted Gross Income (AGI) and whether you are covered under an employer sponsored qualified retirement plan. Thus, depending on your filing status (Single, Joint, etc), and your AGI, your contributions may range from fully deductible to totally non-deductible. So even though you are eligible to contribute to your IRA, you may be in a position where none of these contributions are in fact deductible.
- Education IRA
You can put away up to $500 per year into an education IRA, the money grows tax-free and has preferential tax treatment upon distribution to the beneficiary who uses it for authorized education expenses. These plans are not very common in that they are very restrictive on who can make contributions to them, the amount of total contributions allowable each year, and the limitations on what exact education expenses qualify. Your financial planner should be able to assist you in evaluating what savings plan you should undertake to prepare for higher education costs, as well as in reviewing many of the tax-sheltered savings plans now sponsored by the various states, even for benefits of non-state residents.
- SEP IRA - Simplified Employee Pension
This is an employer established and funded Simplified IRA, where the employer can put up to 15% of your compensation into a special IRA account. Sole proprietors may establish these plans for their own benefit. They are sometimes used instead of Keogh retirement plans because they have fewer administrative and tax filing requirements.
- Simple IRA
This is a rather new creation, but rapidly becoming more popular. It’s another employer sponsored and administered retirement plan. The attractive features of this plan includes not only the ability for the employer to establish and fund a retirement plan for the benefit of him/herself and his/her employees, but it also permits employees to contribute up to 100 %, but no more than $6,500 per year, into an IRA. Separate rules relative to required employer contributions and premature distributions apply.
- Roth IRA
Contributions are NOT deductible when the funds are contributed, but the Roth IRA earnings accumulate tax-free and remain tax-free upon distribution. To be eligible to contribute, your Adjusted Gross Income must be under $95,000 for singles and $150,000 for married couples, as of December 2000. You cannot withdraw your funds within the first 5 years after the establishment of the Roth without a penalty. Given that this 5-year testing period can successfully be addressed by proper tax planning, the establishment and at least partial funding of a Roth IRA account should be on the discussion list of the financial advisor of every taxpayer who qualifies to open such a plan.
Who is Eligible to open an IRA?
Any individual can open and make contributions to a traditional IRA, as long as you, or your spouse (if you file a joint return), received taxable earned compensation during the year and you were not 70 ½ years old by the end of the year.
How much of my IRA contribution is tax-deductible?
It depends. First, this does not apply to Roth IRAs; they have different rules. But, for a Traditional IRA, it depends mostly on the amount of taxable compensation you earned in that tax year and whether or not you, or your spouse if married, are an active participant in a qualified plan (click highlighted words for explanation of these terms). Assuming you, or you and your spouse jointly, earned more in taxable compensation than the maximum deductible amount for your IRA contributions, and neither of you are active participants in a qualified plan, you should be eligible to deduct the full amount of your contribution up to the maximum deductible amount.
If you or your spouse is an active participant in a qualified or employer-sponsored plan, then the amount of your contribution that is tax-deductible can be reduced depending on your AGI (adjusted gross income). For example, in 2002, single taxpayers’ deduction starts being reduced at $34,000 AGI, and no part of their contribution is deductible if their AGI is more than $44,000. For jointly filing married couples, the reduction is based on their combined AGI. For 2002, the reduction for them begins at $54,000 AGI, and no part of their contribution is deductible if they earn more than a combined AGI of $64,000.
I am leaving a company and taking my 401K proceeds. How much time do I have to deposit them in an IRA before they are taxed as income?
You have 60 days to roll over your distribution if the money was given to you. The best way to do this is to have the company administrator write a check to the IRA ROLLOVER account directly, this makes sure that nothing is withheld in taxes, and is much cleaner. Keep in mind that you can do only one rollover per year, but there is no limit on the number of trustee-to-trustee transfers in a year.
Can I have multiple IRA accounts at different institutions?
Yes.
What is the fee structure associated with IRA's?
Each plan is different; the best way to evaluate which plan is best for you is to see what services are provided by each plan.
I have an IRA and a regular brokerage account. Can I sell the stock in my regular brokerage account and then immediately buy it in my IRA?
You cannot mix a non-IRA account and an IRA account without creating tax problems. This would be considered self-dealing and would not be allowed.
What are educational IRAs and how do they relate to many of the state plans that are being offered?
Educational IRA’s allow you to put away $500 per year per child. The contributor cannot have an income over $100,000 AGI. If the money is used for authorized college expenses, the proceeds can be taken out tax-free. Some of the state education plans are better because you can put in more money. Issues to consider include: what happens if your child does not go to a college in that state, the possibility of a partial or full scholarship, the possibility that the child will defer going to college for a period of years, that they may attend a non-qualified technical school, or establish a dot.com business in your garage after dropping out of Harvard. Some of the older state plans only work well if your child attends a state college in the state where the plan was established, and are quite inflexible under any other set of circumstances. Many of the newer state plans now favorably address a number of potential alternative circumstances to immediate, in-state college attendance after high school. Your financial planner can assist you in identifying the advantages and disadvantages of the various state plans throughout the country.
What happens if I contribute too much to my IRA?
Typically you need to withdraw some or all of the money from the plan, or reallocate it to next year’s contribution. Taxpayers have until the due date for filing the tax return, not including extensions, (generally April 15) to withdraw the excess contributions plus any income generated by the excess contributions. Failure to properly withdraw the excess contributions results in a penalty of 6 % per year, or fraction thereof, based on the amount of the excess contributions. In some circumstances, the withdrawal may be accomplished by reallocating the excess contribution to the following tax year. Consult your financial advisor for more details on the proper procedures.
What are the implications for my estate if I leave my investments in my IRA?
IRA accounts can be rolled over to a spouse with no immediate income taxation to the decedent, the estate, nor to the spousal beneficiary. If there is no surviving spouse, or when the surviving spouse dies still owning the IRA assets, typically the IRA is highly taxed. Combined income and estate federal tax rates of 65 %, and more, are not uncommon in such situations. State taxes add to this tax burden. First, the IRA is taxed as part of your federal gross estate, whether the named beneficiary of the IRA is the estate, or any non-spousal beneficiary. In addition, the IRA is taxed again as ordinary income to the ultimate beneficiary as distributions are received. Of course, the IRS has rules forcing these beneficiaries to take taxable distributions within a certain time frame beginning with their inheritance of the IRA. Given the unique opportunities available for minimizing both the Estate and Income taxes otherwise due upon the death and subsequent distribution of an individual's IRA, as well as the devastating results of a failure to properly plan and document your intentions, a review session with a qualified financial professional can resolve this matter in your favor.
What type of investment can be used as an IRA?
Almost all investments are technically eligible for inclusion in an IRA account, (see ineligible investment assets for a discussion of unauthorized investments), but some are more appropriate than others from a financial investment and/or tax perspective. Most authorized IRA custodians will advise you of any restrictions they place on your access to various investments. You may find that in order to participate in selected investment areas, you need to open IRA accounts with specialized IRA custodians who cater to that industry.
What are the benefits of making a conversion from a traditional IRA to a Roth IRA?
Assuming you are eligible to convert, the benefits of making a conversion from a traditional IRA to a Roth IRA include:
- Contributions can be made to your Roth IRA after you reach age 70 ½, whereas you cannot make additional contributions to a traditional IRA after attaining age 70 ½.
- You can leave amounts in your Roth IRA as long as you live. In other words, unlike the traditional IRA, there is no minimum distribution requirement for amounts in a Roth IRA account.
- Qualified Distributions from a Roth IRA are not subject to taxation or penalties, after the plan has been open for at least 5 years.
What is the disadvantage of making a conversion from a traditional IRA to a Roth IRA?
The key disadvantage of making a conversion from a traditional IRA to a Roth IRA is:
The amount being converted from a traditional IRA into a Roth IRA is subject to inclusion in your taxable gross income, and thus increases your taxable income and tax, in the year of conversion. You therefore may have a significant tax bill to pay with little or no funds available from the conversion.
There is no penalty imposed on the conversion as long as the full amount of the distribution from the traditional IRA is converted into the Roth IRA. Otherwise, the premature penalty of 10 % of the amounts not converted into the Roth account may apply.
How do I decide which IRA is right for me?
It depends on your taxable income, and your age and family status. The best way is to meet with a financial advisor, to help you determine which type of strategy will work best for you.
How do I open/sign-up for an IRA?
Only certain organizations can open an Individual Retirement Account for you. They are called trustees or custodians. The IRS may approve certain financial institutions, mutual funds, stock brokerage firms, or insurance companies to act as a trustee or custodian for IRAs. You may also choose to open your IRA through a bank, a savings and loan association, or a federally insured credit union. It takes a written document to open your IRA and it must be done in the United States.
How do I donate an IRA to charity or give as a gift? The best way is to name the charity as the beneficiary of your IRA upon your death. This helps avoid the heavy tax burden when you take money out while still alive. If you withdraw money prior to age 59½ and donate the money to a charity you will still have a 10% early withdrawal penalty, so if you plan to give them ongoing income, it is better to wait until you are older than age 59½.
What is an IRA Rollover or Conversion? When do I need to do this? A rollover is when you move a qualified plan or another IRA into a rollover IRA. You can only do one (1) rollover every twelve months. You can do as many trustee-to-trustee transfers as you want per year. A trustee- to-trustee transfer is where your current plan sends the money or assets to another rollover plan. You should have a competent advisor help you with this type of transaction.
Can I borrow funds from my IRA? NEVER.
Back to Personal Banking - IRAs
