What Is an IRA?
An Individual Retirement Account or Annuity (IRA) allows workers and their spouses to set aside funds for retirement on a tax-deferred basis. Once heralded as the little guy’s tax shelter, the popularity of these arrangements (and the revenue loss to the government) prompted the federal government to restrict considerably those who could deduct their IRA contributions.
Anyone with earned income (and certain spouses of workers) can open an IRA and accumulate tax-deferred earnings. However, the only workers eligible to take a full IRA federal income tax deduction without regard to their Adjusted Gross Income (AGI) level are those who are not active participants in:
- a qualified employer plan,
- a Keogh plan,
- a 403(b) plan, or
- certain other designated retirement plans.
Owners cannot transfer or assign their IRAs. Distributions from the IRA must be made to the IRA owner or a named beneficiary.
In 1998, the Traditional IRA just described was supplemented by an alternative individual retirement account known as a “Roth IRA.” Contributions to a Roth IRA by eligible individuals are nondeductible, but earnings grow income tax free and distributions are also income tax free if certain requirements (discussed later) are met.
“Education IRAs” have been officially renamed “Coverdell education savings accounts,” and are discussed elsewhere in this service. Click here if you wish to jump to that discussion. Thus, there are two types of IRAs—the Traditional IRA and the Roth IRA.
The Purpose of IRAs
The purpose of IRAs is threefold. First, IRAs provide retirement benefits to workers and spouses who may not be covered by another plan. Second, the tax-deferral of IRA earnings and the tax deduction for contributions—if available—give the IRA owner an opportunity to conserve dollars that would otherwise be lost to current taxes. And third, the IRA owner has more dollars at work than if the IRA was depleted by annual taxes on investment earnings.
Individual Retirement Accounts
Individual retirement accounts are the most popular IRA arrangement. These accounts are established with an individual retirement account document which takes the form of a trust or custodial account. The trustee or custodian of one of these accounts must be a bank, a federally insured credit union, a savings and loan association, or a person or organization that receives IRS permission to act as trustee or custodian.
Individual Retirement Annuities
Individual retirement annuities are similar to individual retirement accounts except that some unique rules apply to accommodate the special features inherent in annuity contracts.
First, IRA annuities may not require fixed premiums. Annual fees can be charged, and level premiums for supplementary benefits, such as waiver of premium in the case of disability, are allowed. If interest paid exceeds the guaranteed rate, a refund of premium is allowed; however, these premiums must be used to pay future premiums or buy additional benefits in a timely manner.
A life insurance policy may not be used to fund an IRA.
The IRS has liberalized the rules with respect to self-directed investments held in an IRA annuity. Effective for all tax years, the ability of the annuity contract holder to direct the investment of premiums into publicly traded securities will not result in the holder being currently taxed on earnings [Rev. Proc. 99-44, 1999-2 CB 598]. The purpose was to put annuity investments on a more level playing field with custodial accounts offered by banks, brokerage houses, and mutual funds.
Contributions to Traditional IRAs
Anyone under age 70½ who receives compensation—salary, self-employment income, commissions or alimony—or is married to someone who receives compensation and files jointly is eligible to make a contribution to an IRA.
Eligible individuals may make IRA contributions up until the due date for filing the federal income tax return. For example, an individual could make an IRA contribution on April 15, 2013 that would be effective for tax year 2012. Note the time for making an IRA contribution cannot be extended past this filing date by asking for an extension.
Annual contributions to a Traditional IRA, a Roth IRA, or a combination of the two are limited to the lesser of 100% of earned income or a dollar amount that changes periodically. For IRA purposes, compensation includes earnings from wages, salaries, commissions, tips, professional fees, bonuses and any other earnings a taxpayer receives for providing personal services, along with taxable alimony and separate-maintenance payments. In addition, nontaxable combat pay and military differential pay are wages for IRA purposes. Military differential payments are payments an employer makes to employees who have been called to active duty for a period of more than 30 days. Compensation does NOT include income derived from investments, retirement income, disability payments, or nonqualified deferred compensation. Taxpayers may contribute less than the full deductible amount.
Taxpayers who have reached at least age 50 by December 31 of a year are permitted to make additional “catch-up” contributions to IRAs. The limits are summarized in the following schedule:
|Contribution Limit||Contribution Limit|
|Year||Under Age 50||Age 50 and Over|
Beginning in 2009, the annual limits on IRA contributions and catch-ups were inflation-indexed.
The 100%-of-earned-income limitation on IRA contributions has not changed. Thus, a person who has only investment income may not contribute to an IRA.
A working spouse may set up and contribute to an IRA for a non-working (or part-time) spouse, based on the earnings of the working spouse. The non-working spouse’s IRA is often called a “spousal IRA.” The spousal IRA deduction is $5,500 in 2013 when one spouse has compensation or earnings of less than $5,500 for the year ($6,500 for age 50 and over). However, the combined annual IRA contributions of both spouses cannot exceed their combined compensation for the year.
The annual limit on spousal IRA contributions rises with the general increase in IRA contribution limits.
Contributions that exceed the allowable limits may be refunded without penalty within a limited period of time—generally before the tax return for the year is required to be filed, including extensions. If the excess remains in the IRA beyond this grace period, it is subject to a 6% annual excise tax until withdrawn. The interest attributable to excess contributions may also avoid the 6% penalty if refunded before the tax filing due date. This interest is taxable, and, if the taxpayer is under age 59½, is subject to the 10% penalty for premature distributions (unless an exception applies).
Deductions for Contributions to Traditional IRAs
Contributions to traditional IRAs are fully deductible up to the current year’s contribution limit when neither the taxpayer nor his or her spouse is an active participant in an employer’s qualified retirement plan.
The IRS says an active participant is a person covered by a plan for a tax year. A person is considered covered by a defined contribution plan (money purchase pension, profit sharing, 40l(k) plans, stock bonus plans, SEPs, SIMPLE and 403(b) plans) if amounts are contributed to or allocated to the person’s account for the tax year, or if the person is eligible for the allocation (e.g., 401(k) deferral eligibility).
A person is considered covered by a defined benefit plan if the person meets the minimum age and service requirements within the tax year. The defined benefit plan active-participation rules apply even if the person declined to participate, did not make a required contribution, or did not perform the minimum service required to accrue a benefit.
When the taxpayer is an active participant in a qualified plan, the IRA deduction may be reduced or eliminated depending on marital status and modified adjusted gross income (MAGI). MAGI is AGI with certain items added back, including the IRA contribution. This is necessary because the IRA contribution is an “above the line” deduction taken in arriving at AGI.
For single taxpayers, the phaseout begins with the inflation adjusted applicable dollar amount and is fully phased out once MAGI exceeds the applicable dollar amount for that year by $10,000.
For married taxpayers filing a joint return, the phaseout begins with the inflation-adjusted applicable dollar amount and is fully phased out once MAGI exceeds the applicable dollar amount for that year by $20,000.
|Tax Year||Married Filing Joint Return||Unmarried Taxpayers|
Example: In 2012, Molly, a single taxpayer, had AGI of $55,000. She made an IRA contribution of $5,000; her deduction is $4,000, calculated as follows:
$55,000 AGI + $5,000 IRA contribution = MAGI of $60,000
$60,000 – $58,000 (the applicable dollar amount for 2012) divided by $10,000 = 20%
$5,000 x 20% = $1,000 (the reduction amount)
$5,000 – $1,000 = $4,000 (the deductible amount)
In 2012, Sarah and Ken, married taxpayers, had AGI of $95,000. They made an IRA contribution of $5,000; their deduction is $3,000, calculated as follows:
$95,000 AGI + $5,000 contribution = MAGI of $100,000
$100,000 – $92,000 (the applicable dollar amount for 2012) divided by $20,000 = 40%
$5,000 x 40% = $2,000 (the reduction amount)
$5,000 – $2,000 = $3,000 (the deductible amount)
For married taxpayers filing separately, the applicable dollar amount is $0 and the deduction phaseout is complete once modified AGI reaches $10,000.
For a married taxpayer who is not a plan participant, but whose spouse is covered by a qualified plan, the 2013 phaseout for deducting the IRA contribution begins when MAGI exceeds $178,000 on their joint return. The deduction is lost completely once MAGI reaches $188,000.
State Law Conformity Problems
States may also allow deductions for IRA contributions, often adopting the federal rules regarding eligibility and amount of contribution. Some states, however, specify a fixed dollar amount in their statutes as the maximum contribution. Thus, if a particular state has a statutory maximum of $2,000, and has not acted to conform state law to the federal contribution limit, an IRA owner could not take advantage of the higher federal contribution limit without making an excess contribution for state law purposes.
Distributions from Traditional IRAs
Distributions from an IRA—whether paid in a lump sum or installments—are taxable under the Section 72 annuity rules. Although taxpayers are free to make withdrawals whenever they want, distributions that occur before age 59½ are subject to tax penalties (unless certain exceptions apply) in addition to the regular income tax. When the IRA owner reaches age 70½, he or she must begin taking distributions in minimum annual amounts or the incur tax penalties.