Individual Retirement Accounts (IRAs) function as personal tax-qualified retirement savings plans. Anyone who works, whether as an employee or self-employed, can set aside up to $2,000 in an IRA for the 2001 tax year, and the earnings on these investments grow, tax-deferred, until the eventual date of distribution. Moreover, certain individuals are permitted to deduct all or part of their contributions to the IRA. As of 1998, certain individuals can also set up "Roth IRAs," to which contributions are not deductible, but from which withdrawals at retirement won't be taxed.
IRAs are set up as trusts or custodial accounts for the exclusive benefit or an individual and his or her beneficiaries. You can set up an IRA simply by choosing a bank, mutual fund, brokerage house or other financial institution to act as trustee or custodian. The institution will give you the necessary forms to complete. A lesser-known alternative is to purchase an individual retirement annuity contract from a life insurance company. An individual cannot be his own trustee.
You must begin taking distributions from an IRA no later than April 1st of the year following the year in which you reach age 70 1/2, or the year in which you retire, whichever is later. There's an exception to this rule for Roth IRAs, which carry no mandatory distribution requirements.
Amount. The most that you can contribute in any year to an IRA is the smaller of $2,000 or an amount equal to the compensation includible in income for the year. The same limit applies even if the individual has more than one IRA, or more than one type of IRA. When both a husband and wife have compensation, the limit applies separately to each, so that as much as $4,000 can be contributed.
Beginning in 2002, IRA contribution limits will increase significantly due to the Economic Growth and Tax Relief Reconciliation Act of 2001. Those 50 years old and above will also be allowed to make additional catch-up contributions to an IRA to help them save more for retirement. The table below summarizes the future contribution increases.
|IRA Contribution Limit Increases
|Additional Catch-Up Amount
|indexed for inflation
|indexed for inflation
Earned income requirement. The contribution must be from compensation, which means wages, salaries, commissions and other sources of earned income. It does not include deferred compensation, retirement payments or portfolio income such as interest or dividends.
Nonworking spouses. The Small Business Job Protection Act of 1996 changed the amount that may be contributed to an IRA on behalf of a nonworking spouse from $250 to a maximum of $2,000. Separate accounts must be used for each spouse. The couple must file a joint tax return to claim the deduction, and the combined compensation of both spouses must be at least equal to the amount contributed to both spouses' IRAs.
Timing. An IRA can be established and a contribution made after year-end. It must be made no later than the due date for filing the income tax return for that year, not including extensions. This generally means that you have until April 15th of the following year to make the contribution and deduct it on your tax return. You don't have to contribute the full amount allowed every year. You may skip a year or even several years. You may resume making contributions in a later year, but you cannot "catch up" for years no contribution was made.
Excess contributions. If you contribute more than the allowable amount, a 6 percent excise tax penalty will be assessed. This penalty is due for the year of the excess contribution and for each year thereafter until corrected.
Disallowed contributions. No contributions may be made to an inherited IRA; in a form other than cash; or during or after the year in which the individual reaches age 70 1/2. For Roth IRAs, however, there is no upper age limit on when contributions can be made.
Deductible IRAs. Everyone is eligible to establish and maintain an IRA, but whether the contributions into the IRA will be deductible depends on the individual's (or, if married, the couple's) income level and whether or not the individual is covered by another pension plan at work.
If neither the individual nor spouse is covered under another retirement plan, they may take full advantage of the tax deduction for the amount contributed, regardless of their income level.
If the individual making the contribution is covered under another retirement plan, the amount of the contribution eligible for deduction is determined by the filing status and adjusted gross income of the couple, as shown on the Form 1040 Income Tax Return. The following table is in effect for 2001.
|Figuring Your Maximum IRA Deduction
|If you file a single return and compensation is no higher than:
|If you file a joint return and compensation is no higher than:
|Maximum deduction is lesser of 100% of compensation or
These dollar amounts will increase in the future. For both single and joint returns, the phaseout will increase by $1,000 in 2002, and then $5,000 per year for the next three years. Ultimately, the phaseout range in 2007 for joint returns will be $80,000 to $100,000, and the range for singles will be $50,000 to $60,000.
As of 1998, if the individual making the contribution is not covered by another retirement plan at work, but his or her spouse is covered by such a plan, the non-covered individual may make deductible contributions to an IRA. The phase-out range for such contributions is $150,000 to $160,000.
Roth IRAs. As of 1998, some taxpayers can set up an IRA that is backloaded: that is, the contributions are not deductible, but the withdrawals from the account, including all the buildup in value over the years, are tax-free as long as certain conditions are met. The conditions are that the withdrawals are made five years or more after the account was opened, and after you attain age 591/2 or have become disabled. Joint filers with income under $150,000 can make full contributions to Roth IRAs; for those with income between $150,000 and $160,000, the contribution amount is phased down, until it is phased out completely at $160,000. For singles, the phase-out range is between $95,000 and $110,000.
You may be able to convert a "regular" IRA to a Roth IRA, if your adjusted gross income is under $100,000 (single or joint). The catch is that you must pay current income tax on the entire amount that you convert. If the conversion took place in 1998, the IRS allows you (but does not require you) to spread the tax on the conversion over four years. The converted amount must remain in the account for five years; if it is withdrawn prematurely a 10 percent penalty will apply and any tax due on the conversion that has not already been paid (for instance, if it was to have been spread forward for four years) will become due in the year of the withdrawal.
Nondeductible contributions. To the extent that you can't meet the requirements for deductible IRAs or Roth IRAs, you may still make a nondeductible contribution to an IRA. However, your total annual contributions to any type of retirement IRA may not exceed $2,000. Just be sure that you don't mix deductible and nondeductible contributions (or Roth IRAs, or converted Roth IRAs) in the same account. The earnings on nondeductible contributions will still accumulate on a tax-deferred basis, and when you make withdrawals from your account, you'll be able to receive your original contributions (but not the additional buildup in value over the years) tax-free. To report nondeductible contributions, you must file Form 8606 with your tax return.
Transfers and rollovers. The shifting of funds from one IRA trustee/custodian directly to another trustee/custodian is called a transfer. It is not considered a rollover because nothing was paid over to you. A transfer is tax-free and there are no waiting periods between transfers.
A rollover, in contrast, is a tax-free distribution to you of assets from one retirement plan that you then contribute to a different retirement plan. Under certain circumstances, you may either roll over assets withdrawn from one IRA into another, or roll over a distribution from a qualified retirement plan into an IRA. If the distribution from a qualified plan is made directly to you, the payer must withhold 20 percent of it for taxes. You can avoid the withholding by having the payer transfer the funds directly to the trustee/custodian of your IRA.
A rollover must be made within 60 days of receipt of the distribution. You cannot deduct the rollover contribution, but you must report it on your tax return. Rollovers not completed within 60 days are treated as taxable distributions. On top of the regular income tax, you may also have to pay a 10 percent excise tax penalty on the premature distribution and another 15 percent excise tax penalty on an excess distribution.
A rollover from one IRA to another enables you to change your investment strategy and enhance your rate of return. This type of rollover may be made only once a year. This rule applies separately to each IRA owned. If property other than cash is received, that same property must be rolled over. Except for an IRA received by a surviving spouse, an inherited IRA cannot be rolled over into, or receive a rollover from, another IRA.
Withdrawals/distributions from an IRA. There are rules limiting the withdrawal and use of your IRA assets. Violation of the rules generally results in taxation of the withdrawn amount, plus a penalty equal to 10 percent of the withdrawal. Generally, you violate the rules if you withdraw assets from your IRA before you reach the age of 59 1/2. However, there are special exceptions that allow you to take distributions from a regular (non-Roth) IRA if the amounts are used to pay medical expenses in excess of 7.5 percent of adjusted gross income or if the distributions are used by certain unemployed, formerly unemployed, or self-employed individuals to pay health insurance premiums. Beginning in 1998, you can take a penalty-free withdrawal from any type of IRA to purchase your first home.
For IRAs that are not Roth IRAs, you can also take penalty-free withdrawals before age 591/2 to pay certain education expenses for yourself or your dependents, or if you set up a schedule to take "substantially equal" periodic payments for the rest of your life. You must begin withdrawing the balance from any IRA that is not a Roth IRA by April 1st of the year following the year in which you reach age 70 1/2 or the year in which you retire.
A withdrawal from your IRA, net of the portion representing return of any
nondeductible contributions, is includible in your ordinary income.