Chapter 5: traditional IRA.
A traditional IRA (which stands for either individual retirement account or individual retirement annuity) is a type of retirement savings arrangement under which IRA contributions, up to certain limits, and investment earnings are tax-deferred. That is, interest earned and gains received inside the traditional IRA are free of federal income tax until withdrawn from the IRA.
Traditional IRAs are primarily plans of individual savings, rather than employee benefits. However, their features should be understood. They fit into an employee's plan of retirement savings and, therefore, they influence the form of employer retirement plans to some degree.
Employers can sponsor traditional IRAs for employees, as a limited alternative to an employer-sponsored qualified retirement plan. Employers who have a qualified plan can also sponsor a "deemed IRA" as part of the qualified plan to provide an alternative form of retirement savings for employees. Employer-sponsored IRAs and deemed IRAs are discussed later in this chapter. An arrangement similar to the employer-sponsored IRA which allows greater annual employer contributions is the SEP (simplified employee pension) discussed in Chapter 24. SIMPLE IRA plans involve employee salary reduction contributions and employer matching or nonelective contributions that are contributed to an IRA. SIMPLE plans are discussed in Chapter 23.
See also the chapter on the Roth IRA. The Roth IRA provides benefits comparable to those from a traditional IRA. Detailed comparisons between the two are covered in Chapter 6.
WHEN IS IT INDICATED?
1. When there is a need to shelter current compensation or earned income from taxation.
2. When it is desirable to defer taxes on investment income.
3. When long-term accumulation, especially for retirement purposes, is an important objective.
4. When a supplement or alternative to a qualified pension or profit sharing plan is needed.
1. Eligible individuals may contribute up to the maximum annual contribution amount (see below) to a traditional IRA (and up to the maximum annual contribution amount for a spouse if a traditional spousal IRA is available) and possibly deduct this amount from their current taxable income.
2. Investment income earned on the assets held in a traditional IRA is not taxed until it is withdrawn from the account. This deferral applies no matter what the nature of the investment income. It may be in the form of interest, dividends, rents, capital gain, or any other form of income. Such income will generally be taxed only when it is withdrawn from the account and received as ordinary income.
1. The traditional IRA deduction is limited to the maximum contribution amount each year (and up to the maximum contribution amount for a spouse if a traditional spousal IRA is available), with phaseout of the deduction if modified adjusted gross income exceeds certain limits and the individual or spouse is an active participant in a tax-favored employer retirement plan, as discussed below.
2. Traditional IRA withdrawals are subject to the 10% penalty on early withdrawals applicable to all tax-favored retirement plans.
3. Traditional IRAs cannot be established once an individual reaches age 701/2 (except in the case of rollover IRAs) and withdrawals from the account are required by April 1 of the year after the year in which the individual reaches age 701/2. For additional information on required distributions, see Chapter 8.
1. There is no required minimum contribution to an IRA. An individual can put aside relatively small amounts each year and still see them grow into a considerable sum for retirement. Also, a contribution does not have to be made every year. It is possible to skip a year or any number of years without jeopardizing the tax-deferred status of the account. However, failure to make contributions reduces the value of the account for tax-shelter purposes and limits the amount of earnings that will build up on a tax-free basis.
2. Deduction Limits. The maximum annual deductible IRA contribution for an individual is the lesser of (a) the maximum annual contribution amount or (b) the individual's earned income1 The maximum annual contribution amount is $5,000 in 2009. For individuals who have attained age 50 before the close of the tax year, an additional catchup contribution amount of $1,000 is available.
3. Earned Income. The income must be produced from personal services which would include wages, salaries, professional fees, sales commissions, tips, and bonuses. Unearned income such as dividends, interest, or rent cannot be used in determining the amount of the IRA contribution.
4. Spousal IRAs. An additional contribution can be made for a spouse in certain cases. The provision works like this: if individual Pat's spouse Chris is not working or receives lesser includable compensation for the year than Pat, the couple may contribute up to $5,000 in 2009 to an IRA for Chris, for a total contribution for the couple of up to $10,000. More technically, assuming the "active participant" restrictions below do not apply, the maximum allowable deductible contribution for Chris is the lesser of (1) $5,000 or (2) 100% of Chris's includable compensation, plus 100% of Pat's includable compensation minus the amount of the deduction taken by Pat for IRA contributions for the year. In order to contribute to a traditional spousal IRA, the couple must file a joint return. (2)
If both spouses have earned income, each can have a traditional IRA. The deduction limit for each spouse with earned income is the maximum annual contribution amount/100% limit. However, traditional IRA contribution limits are combined with Roth IRAs. The maximum annual contribution amount is reduced for each dollar contributed by the same taxpayer to a Roth IRA.
5. Married couples with two incomes should each establish a separate IRA account. Contributions are based on each separate income and each contribution is a separate tax deduction. This is true even though a couple may live in a community property state.
6. Active Participant Restrictions. Income limitations are imposed on the deductibility of traditional IRA contributions for those persons who are "active participants" in an employer retirement plan that is tax-favored-including a qualified retirement plan, simplified employee pension (SEP), Section 403(b) tax deferred annuity plan, or SIMPLE IRA. (3)
A person is an active participant in an employer's retirement plan for a given year if the participant actually receives an employer contribution or accrues a benefit under an employer's defined benefit plan for any part of that year. A person is an active participant in a defined contribution-type plan if any contribution or forfeiture is allocated to his account during the year.
For example, in a qualified profit sharing plan it is possible for an employer to omit making a plan contribution in a given year. For such a year, an employee is generally not considered an active plan participant even though covered under the plan, so long as there was no contribution made (or forfeiture allocated) to the employee's account under the plan.
But in rare cases (e.g., where an employee is covered by a plan but receives no contribution because the employee worked insufficient hours during the plan year), an employee may be an active participant even if the employee receives no contribution. (4)
Note, however, that an employee is considered an active participant if a contribution is made for the employee by the employer but the employee is not vested in the amount in his account. If the employee stays long enough to become vested, the employee will acquire full rights to that amount, so the employee is considered an active participant for the year in which the contribution was made.
If an otherwise eligible person actively participates in the employer plan, the available traditional IRA deduction is reduced below the maximum annual contribution amount if the AGI of the taxpayer is within the phaseout ranges indicated below, with the deduction eliminated entirely if the AGI is above the upper limit of the phaseout range.
If only one spouse is an active participant, the non-active participant spouse filing a joint return may receive a full IRA deduction if joint income is less than $166,000. The non-participant spouse may receive a partial deduction if joint income is between $166,000 and $176,000.
The reduction in the maximum annual contribution amount in the phaseout AGI region is proportional to the amount by which the AGI exceeds the lower limit. For example, suppose that in 2009 a single taxpayer's AGI is $57,000 and he is an active participant under age 50. The taxpayer is $2,000 into the phaseout region of $10,000, so his annual traditional IRA deduction is reduced by $2,000/$10,000 or 20%. This is a reduction of $1,000 (20% of $5,000), so the maximum IRA deduction is $4,000 ($5,000 less $1,000).
There is a $200 "floor" under the reduction formula. That is, as long as the taxpayer is below the IRA Active Participant AGI phaseout ranges for 2009
AGI cutoff level, at least $200 can be contributed and deducted. For example, if the taxpayer in the preceding example had an AGI of $64,900, he could contribute and deduct up to $200.
For example, suppose Chris and Pat, age 35 and 35, are married and file jointly. Both are working and Chris, but not Pat, actively participates in an employer-sponsored qualified plan. Chris earns $100,000 and Pat earns $50,000 in 2009. Pat may contribute and deduct up to $5,000 to an IRA. Chris may not make any deductible contributions to an IRA. However, if Chris and Pat together earned $176,000 or more in 2009, neither one could make a deductible IRA contribution since this "no spousal attribution of active participation" rule would be fully phased out at their joint AGI level of $176,000. If joint AGI was between $166,000 and $176,000, Pat's deduction limit would be reduced ratably below $5,000.
If neither the individual nor the spouse is an active participant in a qualified retirement plan, simplified employee pension (SEP), Section 403(b) annuity plan, or SIMPLE IRA, they may contribute up to the maximum annual contribution deduction limit, as set out above, and deduct the full amount of the contribution regardless of the level of AGI.
Example: Minnie (age 35) and Bill (age 40), a married couple, each earn $75,000 annually. Neither is an active participant in any qualified plan, SEP, Section 403(b) plan, or SIMPLE IRA. For 2009, Minnie and Bill can each contribute and deduct up to $5,000 to their own IRA plan (a total of $10,000 for both).
Example: Mabel earns $75,000 annually. Her husband, Alf, has no earned income (although he has investment income over $100,000 annually). Neither spouse is over 49 or an active participant in a tax-favored plan. For 2009, Mabel can contribute and deduct up to $5,000 to an IRA for herself and up to $5,000 to an IRA for her spouse (for a total of $10,000) provided they file a joint return.
7. Nondeductible IRAs. An individual or married couple can also make nondeductible traditional IRA contributions, within limits.5 The limit is the same regardless of income level; it is the excess of the maximum annual contribution amount over the amount deductible. If the individual or couple make no deductible contributions, they can therefore contribute up to the maximum annual contribution limit in the case of an individual, and up to an additional maximum annual contribution amount in accordance with the spousal IRA rules set out above, on a nondeductible basis. Nondeductible contributions will be free of tax when they are distributed, but income earned on such contributions will be taxed. If nondeductible contributions are made to a traditional IRA, amounts withdrawn will be treated as partly tax free and partly taxable. Because nondeductible IRA contributions impose additional accounting problems, and provide generally no better result than simply investing in tax-free or tax-deferred non-IRA investments, most advisers do not recommend them.
For a discussion of nondeductible Roth IRAs, see Chapter 6.
8. Time Limits. Eligible persons may establish an IRA account and claim the appropriate tax deduction any time prior to the due date of their tax return, without extensions, even if the taxpayer actually receives an extension of the filing date.6 For most individuals or married couples the contribution cutoff date is April 15th. However, since earnings on an IRA account accumulate tax-free, taxpayers may want to make contributions as early as possible in the tax year. The advantage of making an IRA contribution at the beginning of the year can be seen in the following table which assumes $5,000 annual contributions and a rate of return of five percent.
Years Beginning End Advantage of of Year of Year of Early Growth January December 31 Contributions 5 $ 29,010 $ 27,628 $ 1,381 10 66,034 62,889 3,144 15 113,287 107,893 5,395 20 173,596 165,330 8,266 25 250,567 238,635 11,932 30 348,804 332,194 16,610 35 474,182 451,602 22,580 40 634,199 603,999 30,200 45 838,426 798,501 39,925
The advantage of early contributions continues as the contribution limits increase; of course, the accumulations would be even greater the larger the contributions to the traditional IRA.
9. Saver's Credit. Certain lower-income taxpayers may claim a temporary, nonrefundable credit for "qualified retirement savings contributions."7 "Qualified retirement savings contributions" include elective deferrals to SIMPLE IRAs, as well as other elective deferrals and contributions to Roth or traditional IRAs. (However, the total is reduced by certain distributions received by the taxpayer or his spouse during the prior two taxable years and the current taxable year for which the credit is claimed, including the period up to the due date (plus extensions) for filing the federal income tax return for the current taxable year.) Only the first $2,000 of annual deferrals is eligible for the credit.
The credit is allowed against the sum of the regular tax and the alternative minimum tax (minus certain other credits) and is allowed in addition to any other deduction or exclusion that would otherwise apply. In addition, to be eligible, the taxpayer must be at least 18 as of the end of the tax year and must not be claimed as a dependent by someone else or be a full-time student.
The amount of the credit is limited to an "applicable percentage" of IRA contributions and elective deferrals up to $2,000. The "applicable percentages" are as follows for 2009:
ADJUSTED GROSS INCOME Joint return Head of a household Over Not over Over Not over 0 $33,000 0 $24,750 33,000 36,000 24,750 27,000 36,000 55,500 27,000 41,625 55,500 41,625 All other cases Applicable Over Not over percentage 0 $16,500 50% 16,500 18,000 20% 18,000 27,750 10% 27,750 0%
Example: Joe and Jennifer have an adjusted gross income of $35,000 on a joint return for 2009 and they each contribute $3,000 to a traditional IRA. Neither participates in an employer-provided retirement plan and neither has received any distributions. Not only can Joe and Jennifer each deduct their $3,000 contributions, they each can also claim a tax credit of $400 (20% x $2,000) ($800 collectively) on their federal income tax return.
10. If more than the maximum allowable amount is contributed in any year, a 6% excise tax will be imposed on the excess contribution. However, the 6% tax can be avoided by withdrawing the excess contribution and earnings prior to the filing date for the federal income tax return (normally April 15). If the excess contribution plus earnings is not withdrawn by the tax return filing date, the 6% excise tax will be imposed in each succeeding year until the excess is eliminated. (8)
1. IRA contributions are not locked into any one particular investment. First, the IRA participant may select more than one organization that sponsors IRA programs, as long as the total of all investments made each year is within the maximum annual contribution limit. For example, part of the contribution could be placed in a savings account and the remainder in a mutual fund plan. Second, at any time the IRA participant may request an IRA sponsor to transfer IRA assets directly from one sponsoring organization to another; not all IRA sponsors will agree to do this, however. Alternatively, assets may be taken out of an IRA and reinvested with another IRA sponsor within 60 days without any tax consequences. However, the IRA participant is allowed to make this type of transaction from an IRA-a "rollover"-only once every 12 months. (9)
2. IRA funds can be invested in any type of asset, with three specific limitations:
(a) An IRA cannot be invested in a "collectible" as defined in IRC Section 408(m). A collectible is any work of art, rug, antique, metal or gem, stamp, coin, alcoholic beverage, or any other item designated as a collectible by the IRS. The IRA can, however, invest in certain state or federally-issued coins. (10)
(b) IRAs cannot be invested in life insurance contracts. (11)
(c) Since IRAs cannot make loans to an IRA participant, (12) the participant's note is in effect another type of property the IRA cannot invest in. That is, an IRA owner cannot lend IRA funds to himself or to a related person or business. IRAs can, however, make loans to individuals or companies that are not "disqualified persons" under the prohibited transaction rules,' if the underlying IRA documents permit. For example, Letter Ruling 8723082 states that an IRA owner could make loans from the IRA to an unrelated company that was in the business of owning and managing shopping centers.
1. An IRA owner cannot borrow from his IRA. Loans from IRAs to the IRA owner or a related party are prohibited transactions subject to penalty.
2. An IRA owner can use the 60-day IRA rollover provision to, in effect, make a 60-day interest free loan from an IRA. (13) The owner simply takes the money out, uses it during the 60-day period, and then deposits it in the same or another IRA on or before the 60th day after withdrawal. (14) This type of transaction may be helpful as part of a "swing loan" when selling one residence and buying another, or for similar financial needs.
Distribution and Rollover Rules
1. An IRA account belongs to the participant and the participant is free to take the money out at any time, in any amount, or leave it in indefinitely. However, the tax penalty provisions described below impose significant penalties that effectively require money to be left in until age 59 1/2 (with some exceptions to the 10% early withdrawal penalty) and also require distributions to begin after age 70 1/2 on a joint-life annuity basis or faster.
If IRA assets are a significant part of the participant's savings, planning for distributions to minimize taxes can be extremely important. The rules (unfortunately very complex) for distributions are discussed in Chapter 8.
2. A participant's spouse need not consent to an IRA distribution under federal law. The federal consent requirements enacted under the Retirement Equity Act of 1984 apply to qualified plans but not to IRAs. Spousal consent may be required when a qualified plan distribution is rolled over to an IRA, but distributions thereafter can be made without spousal consent. This underscores the importance of making careful long-range retirement and estate plans for both spouses when a significant qualified plan distribution is rolled over to an IRA. Notwithstanding the absence of federal consent requirements, however, a spouse's property rights in an IRA account are a matter of state law, and may differ depending on whether the state is a common law or community property jurisdiction.
3. Generally, the entire amount of an IRA distribution including principal and earnings is ordinary income in the year of receipt. However, if nondeductible contributions have been made to the account, they are recovered tax-free. If money is withdrawn periodically in installments or an annuity, only the amount received each year is taxable. If nondeductible contributions have been made, a portion of each payment is received tax-free.
4. The government penalizes certain early withdrawals from IRAs. The early distribution penalty is 10% of the taxable amount withdrawn from the IRA. (15) Therefore, IRA contributions should be made from funds that can be left in the account until one of the "non-penalty" events listed below occurs.
For IRAs, the early distribution penalty (discussed further in Chapter 8) does not apply to:
* distributions made on or after attainment of age 59 1/2,
* distributions made to the IRA participant's beneficiary or estate on or after the participant's death,
* distributions attributable to the participant's disability,
* distributions that are part of a series of substantially equal periodic payments made at least annually over the life or life expectancy of the participant, or the participant and a designated beneficiary,
* distributions for medical care (in excess of the 7.5% of itemized deduction "floor" for such expenses),
* distributions to unemployed individuals for health insurance premiums under certain conditions,
* distributions for higher education costs (tuition, fees, books, supplies and equipment) for the taxpayer, spouse, child, or grandchild, and
* distributions to pay acquisition costs of a first home for the participant, spouse, child, grandchild, or ancestor of the participant or spouse, up to a $10,000 lifetime maximum.
The exception for periodic payments provides some flexibility and can be very favorable in some cases. For example, suppose Ira Participant decides at age 52 to take some money out of his IRA. Ira can do so without penalty, as long as the amount taken out annually is substantially what the annual payment would be under a life annuity (or joint life annuity) purchased with his IRA account balance. No actual annuity purchase is required. (16) Then, when Ira reaches age 59 1/2, he can withdraw all the rest of the money in his IRA account. Ira doesn't have to continue the annuity payments since he is now relying on a different penalty exception, the exception for payments after age 59 1/2.
However, if the series of payments is changed before the participant reaches age 59 1/2 or, if after age 59 1/2, within five years of the date of the first payment, the tax that would have been imposed, but for the periodic exception, is imposed with interest in the year the change occurs. In the example above, if Ira Participant had begun receiving payments under the periodic payment exception when he was 57, he would have to continue the annuity payments for at least five years to avoid the penalty. (17)
5. Distributions must begin by April 1 of the year after the year in which age 701/2 is reached. (18) The minimum distribution requirements are discussed in Chapter 8.
6. An IRA can be used to receive a "rollover" of certain distributions of benefits from employer-sponsored retirement plans. The distribution must be directly transferred or rolled over to the rollover IRA within 60 days after it is received. (19) IRA rollovers are usually straightforward, but there are some complicated rules in special situations. These are discussed further in Chapter 8.
7. When an IRA owner dies, a somewhat complex pattern of tax rules applies. Planners need to understand the tax treatment of this common situation in order to prevent unnecessary tax penalties for their clients. These rules are generally designed to prevent IRA distributions from being "stretched out" unduly to increase tax deferral. See Chapter 9 for a detailed discussion.
Employer Sponsored IRAs
1. Employer-sponsored IRA. An employer (or a labor union) can sponsor IRAs for its employees as an alternative to a pension plan. There is no requirement of nondiscrimination in coverage. The IRAs can be made available to any employee or a discriminatory group of employees. Contributions to the IRA can be made either as additional compensation from the employer or as a salary reduction elected by the employee. If the employer contributes extra compensation, it is taxable to the employee, but the employee may be eligible for the IRA deduction. The maximum annual contribution limit for an employer-sponsored IRA is the same as for traditional individual IRAs. Employers may establish payroll deduction IRA plans for employees under Department of Labor guidelines without the arrangement becoming subject to the employee benefit provisions and restrictions of ERISA. (20)
2. Deemed IRA. An employer that has a qualified plan, Section 403(b) tax sheltered annuity, or eligible Section 457 governmental plan may allow employees to make voluntary contributions to an account or annuity set up under the plan that meets the rules for traditional IRAs. (21) Such deemed IRAs will not be subject to the IRC rules governing the employer plan but will be subject to the exclusive benefit and fiduciary rules of ERISA (to the extent they apply to the employer plan).
3. SEP IRA. An arrangement similar to the employer-sponsored IRA is the simplified employee pension (SEP) discussed in Chapter 24. SEPs allow greater annual employer contributions; however, SEPs require nondiscriminatory coverage of employees. See Chapter 24.
4. SIMPLE IRA. This arrangement involves employee salary reduction contributions and employer matching or nonelective contributions that are contributed to an IRA. See Chapter 23.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. Most banks, savings and loans, insurance companies, and brokerage firms actively market IRAs, and can provide brochures describing their IRA plans. These firms will indicate the types of investments available as well as any charges that may be applied to such accounts.
2. IRS Publication 590, Individual Retirement Arrangements (IRAs), is available without charge from the IRS or the U.S. Government Printing Office.
QUESTIONS AND ANSWERS
Question--How are IRAs treated for state tax law purposes?
Answer--State tax laws vary, and not every state accords IRAs the same favorable tax treatment as does federal law. Three issues can arise:
1. Is the IRA contribution deductible for state (or local) income tax purposes?
2. Are IRA withdrawals taxable under state income tax law?
3. If an IRA owner takes a deduction for an IRA contribution in State A and then moves to State B, does the owner owe income tax to State A when making an IRA withdrawal? Some states apparently took the position that taxes were due in that situation. However, Title 4 United States Code Section 114, enacted by Congress in 1996, prohibits a state from imposing taxes on certain retirement income (including IRA withdrawals) of individuals who are not residents or legally domiciled in that state.
Question--If a participant's spouse is the beneficiary of the participant's IRA, is the amount eligible for the marital deduction for federal estate tax purposes?
Answer--In general, amounts transferred to a spouse at death are eligible for the marital deduction. There is no problem with this if the spouse receives the IRA directly. However, if a trust for the spouse's benefit receives the IRA assets, the trust must qualify as a qualified terminable interest property (QTIP) trust in order to be eligible for the marital deduction.
In Revenue Ruling 2000-2, (22) the IRS indicated the requirements that must be met for an IRA beneficiary trust to qualify as a QTIP trust. Generally, income must be distributable currently to the spousal beneficiary.
(1.) IRC Secs. 219(a), 219(b).
(2.) IRC Sec. 219(c).
(3.) IRC Sec. 219(g).
(4.) Colombell v. Comm., TC Summ. Op 2006-184.
(5.) IRC Sec. 408(o).
(6.) IRC Sec. 219(f)(3).
(7.) IRC Sec. 25B.
(8.) IRC Secs. 4973, 408(d)(4).
(9.) Prop. Reg. [section]1.408-4(b). But see footnote 15.
(10.) IRC Sec. 408(m)(3).
(11.) IRC Sec. 408(a)(3).
(12.) It is a prohibited transaction under IRC Section 4975(c)(1)(B).
(13.) Let. Rul. 9010008.
(14.) Note, however, that there may be tax consequences with more than one rollover. In Martin v. Comm., TC Memo 1992-331, a taxpayer made "rollovers" from two separate IRAs within one 12-month period. The Tax Court characterized the second transaction as a distribution taxable under IRC Section 408(d)(1), noting only that IRC Section 408(d)(3)(B) states that the rollover exemption can only be used once during any one year period.
(15.) IRC Sec. 72(t).
(16.) Rules for calculating the annual annuity payment are provided by the IRS in IRS Notice 89-25, 1989-1 CB 662, Question 12. Three methods of calculating payments are listed with approval: (1) use of the minimum distribution rules of Section 401(a)(9); (2) amortizing the account balance over single or joint life expectancies of owner and beneficiary; (3) using an annuity factor using a "reasonable" interest rate and mortality table. See also IRS Publication 590.
(17.) IRC Sec. 72(t)(4).
(18.) IRC Secs. 408(a)(6), 408(b)(3), 401(a)(9). Required minimum distributions are waived for 2009; see Chapter 8.
(19.) IRC Sec. 408(d)(3)(A)(ii).
(20.) IB 99-1, 64 Fed. Reg. 32999 (6-18-99).
(21.) IRC Sec. 408(q).
(22.) 2000-3 IRB 305.
IRA Active Participant AGI phaseout ranges for 2009 Single Married Married filing filing jointly separately 55,000-65,000 89,000-109,000 0-10,000
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|Publication:||Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.|
|Date:||Jan 1, 2009|
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