Traditional Individual Retirement Accounts (IRAs)
A traditional Individual Retirement Account (IRA), otherwise known as an ordinary IRA or a regular IRA, is a retirement plan where the taxpayer can deduct annual contributions. Earnings grow tax-free. However, both contributions and earnings are tax-deferred, not tax-free, so when the taxpayer does receive distributions, both contributions and the earnings are subject to the marginal tax rate that is applicable at the time of the distribution. Furthermore, so that the government can get its money eventually, the taxpayer must start receiving distributions soon after reaching age 70½.
An IRA account is generally set up at a financial institution that is approved by the IRS to serve as custodian for the account. An IRA can also be part of a simplified employee pension (SEP), which is subject to the same withdrawal and tax rules as the traditional IRA, or an association trust account provided by employers for employees. The IRA trustee (aka issuer, sponsor) must give the taxpayer a disclosure statement, either 7 days before the IRA account is opened or the trustee must provide 7 days for the taxpayer to cancel the account, after which, the trustee will return all the money contributed. The closure statement must state in plain language when and how the IRA can be revoked and the name, address, and telephone number of the person who is to receive the cancellation notice.
A Brief History of the Traditional IRA
- Introduced in 1974, with a maximum annual contribution of $1,500 and only available to workers without an employer-sponsored retirement plan.
- In 1981, anyone younger than 70½ could contribute and the maximum annual contribution increased to $2,000.
- The Tax Reform Act of 1986 phased out eligibility for higher-income taxpayers who were also covered by an employer plan.
- Roth IRAs were introduced in 1997: contributions were not deductible but earnings and qualified withdrawals were tax-free.
Allowable investments include certificates of deposit, mutual funds, and certain limited partnerships.
Self-directed IRAs are accounts that allow the taxpayer to take an active role in managing the account. However, only some financial institutions allow a self-directed IRA. The IRS model form is Form 5305, Traditional Individual Retirement Trust Account and the model custodial account agreement is Form 5305-A, Traditional Individual Retirement Custodial Account.
However, any investment in collectibles, such as artworks, antiques, gems, rugs, metals, guns, stamps, and certain coins, will be treated as a distribution for which the taxpayer will have to pay tax. However, certain coins are exempt from this treatment, including state issued coins and certain US issued coins minted of gold, silver, and platinum. An IRA trustee can hold gold, silver, platinum, or palladium bullion if the metal meets commodity market standards; if the bullion is held by a company rather than the IRA trustee, then the investment is considered a deemed distribution.
Losses from an IRA are not deductible unless the taxpayer fails to recover his nondeductible contributions after receiving the total amount in all IRA accounts.
Individual Retirement Annuity
A taxpayer can also open an individual retirement annuity provided by a life insurance company, so no trustee or custodian is involved. Since an IRA cannot be used as collateral for a loan, the annuity cannot contain loan provisions. However, only the taxpayer or her designated beneficiaries can receive any benefits from the annuity. Additional requirements include:
- the entire interest must be nonforfeitable;
- no portion of the contract can be transferred to anyone else other than the issuer;
- the annuity or endowment contract must provide that contributions cannot be any greater than the lower of the taxpayer's compensation or the statutory contribution limits;
- refunded premiums must be used to pay future premiums or to buy more benefits by the following calendar year-end;
- distributions must start by April 1 of the year following the year in which the taxpayer reaches age 70½.
Contributions Limited by Statutory Limits, Compensation, and Modified Adjusted Gross Income (MAGI)
In addition to statutory contribution limits, contributions are limited by compensation earned by the taxpayer and may also be limited or eliminated for high income taxpayers. Furthermore, only people younger than 70½ at year-end can make contributions for that year.
Compensation is earnings from work. It does not include investment income, inherited income, pensions and annuities, deferred compensation, passive partnership income, nor any compensation — except for nontaxable combat pay — that is not taxed, such as foreign earned income and housing costs. It does, however, include taxable alimony and separate maintenance payments. Self-employment income also qualifies as compensation, but it is reduced by the self-employment tax deduction and by any deductible contributions made on behalf of the taxpayer to his retirement plans.
|Year||Age < 50||Age ≥ 50|
The statutory limit applies to the total of all contributions to all IRA accounts within any given year, regardless of whether the contribution is deductible. The contribution limit is also reduced by any contributions to a §501(c)(18) plan.
A spouse can also contribute to a separate IRA plan for a nonworking spouse if they file a joint return. If both spouses receive compensation and satisfy the age requirement, then each can have a separate IRA, with separate compensation limits for both, even in community property states. For joint filers, the spousal IRA limit is the lesser of double the statutory limit or the total compensation that is includable in the gross income of both spouses minus the other spouse's IRA contribution to a traditional IRA plus any nondeductible contribution made on behalf of the spouse with the greater compensation plus any contributions made on behalf of the other spouse to a Roth IRA. But if a couple divorces or legally separates before the year-end, then any contributions made on behalf of the other spouse are not deductible by the contributing spouse. If a spouse works for the taxpayer, then the taxpayer can set up an IRA account for the spouse but only if the employee-spouse performs actual services and receives wages.
There are also income limits, starting in 2013, that are lower than for Roth IRAs. However, there are no income limits for tax year 2012 for taxpayers or their spouses who are not covered by an employer plan. A taxpayer may not be able to make contributions or the contribution limits may be reduced if modified adjusted gross income (MAGI) is greater than certain amounts:
|Married filing jointly or separately or qualifying widower.||$189,000||$199,000||$186,000||$196,000||$184,000||$194,000||$183,000||$193,000||$181,000||$191,000|
Taxpayers Covered by an Employer Retirement Plan
There are different MAGI limits for deducting contributions for those taxpayers or their spouses who are covered by an employer retirement plan:
|Married filing jointly or qualifying widower||$101,000||$121,000||$99,000||$119,000||$98,000||$118,000||$98,000||$118,000||$96,000||$116,000|
|Joint filing with 1 nonparticipating spouse||$189,000||$199,000||$186,000||$196,000||$184,000||$194,000||$183,000||$193,000||$181,000||$191,000|
|Married filing separately||0||$10,000||0||$10,000||0||$10,000||0||$10,000||0||$10,000|
|All others, including married filing separately |
for spouses who did not live together
at any time during the tax year.
- Note that these limits apply if the taxpayer is eligible for an employer plan, even if the taxpayer chooses not to participate in the plan.
- Likewise, a nonparticipating spouse must be ineligible for the other spouse's employer's plan for these limits to apply.
Note that if only 1 spouse participates in an employer plan, then that spouse is limited by the joint filing status, but the nonparticipating spouse can still contribute to an IRA if the joint income is less than the MAGI limits for a joint filing with 1 nonparticipating spouse. So if, in 2013, Jim and Amy report $150,000 on their joint return, while Jim participates in a plan but Amy does not, then Jim can make no contributions, while Amy's contribution is limited only by the statutory limit, even if Amy makes $125,000 and Jim made only $25,000.
However, taxpayers that are limited by the MAGI limitation can still make nondeductible contributions to a traditional IRA that will grow tax-free until it is withdrawn. Withdrawal of the nondeductible contributions is also tax-free, but the portion attributed to earnings will be subject to tax. However, if allowed, the taxpayer should contribute to a Roth IRA, since both contributions and earnings are tax-free when withdrawn.
If the employee is an active plan participant, then Form W-2, Wage and Tax Statement will show this in Box 13, the retirement plan box. If a self-employed individual has a Keogh plan or SEP, then the taxpayer is treated as being an active participant in regards to the phaseout rules. For the active participant rules to apply, the taxpayer only must participate at any time during the year even if she has forfeitable benefits.
If the taxpayer's income is greater than the phaseout limit, then the taxpayer cannot make deductible contributions to an IRA. With regard to IRAs, MAGI = AGI – IRA conversions or rollovers + the following deductions and exclusions:
- non-taxable Social Security or Railroad Retirement Benefits
- student loan interest deduction,
- tuition and fees deduction,
- exclusion of qualified bond interest, reported on Form 8815,
- foreign earned income exclusion,
- foreign housing exclusion or deduction,
- domestic production activities deduction,
- exclusion of employer-provided adoption benefits, reported on Form 8839, Qualified Adoption Expenses.
Any taxable Social Security benefits received by the taxpayer increases MAGI by the amount of the taxable benefits. If no part of the social security benefits is taxable, then it is not factored in for determining contribution limits.
Active Participants in an Employer's Retirement Plan
Active participant status for taxpayers with a 401(k), profit sharing, stock bonus, or money purchase pension plan are treated as active participants if any contributions were made or allocated to the account for the plan year that ends within the taxpayer's tax year. So it is possible to be considered an active participant even if the employer made no contribution during the tax year to the employee's plan. Active participant status is not affected by whether the taxpayer has a vested right to receive the benefits from the account.
Taxpayers with defined-benefit pension plans are considered active participants if they are eligible to participate, even if the taxpayer does not actually participate. For defined contribution plans, the taxpayer will be considered an active participant if:
- the taxpayer makes elective deferrals to the plan;
- the employer contributes to the account; or
- forfeitures are allocated to the account.
Calculating the Contribution Limit for Spouses with MAGI over the Phaseout Threshold
Steps to calculate the deductible limit for taxpayers with MAGI over the phaseout threshold:
- Excess MAGI = MAGI – Applicable Phaseout Threshold.
- Multiply Excess MAGI by applicable factor:
- If married filing jointly or a qualifying widower and
- younger than 50:
- MAGI Reduction = Excess MAGI × 25%;
- 50 or older:
- MAGI Reduction = Excess MAGI × 30%;
- younger than 50:
- all others:
- younger than 50:
- MAGI Reduction = Excess MAGI × 50%
- 50 or older:
- MAGI Reduction = Excess MAGI × 60%.
- younger than 50:
- If married filing jointly or a qualifying widower and
- Tentative MAGI Contribution Limit = Statutory Contribution Limit – MAGI Reduction.
- If the result is not a multiple of $10, then round up to the next highest multiple of $10. If under $200, then the deductible limit is $200.
Example 1: Taxpayer is single and under age 50 and an active participant in an employer retirement plan.
|49-year-old Single Taxpayer Who is an Active Participant in an Employer's Retirement Plan, MAGI||$58,512|
|Phaseout Threshold for Single Taxpayer||$56,000|
|Excess MAGI||$2,512||= MAGI – Phaseout Threshold|
|MAGI Reduction||$1,256||= Excess MAGI × 50%|
|Reduced Contribution Limit||$3,744||= Statutory Contribution Limit – MAGI Reduction|
|If Last Number of Reduced Contribution Limit is Not 0, Round Up to the Next Highest Multiple of $10||$3,750|
Example 2: Both spouses are under age 50 and file a joint return. Both are active plan participants.
|Contribution Limit for each Spouse||$5,000|
|Husband and Wife MAGI||$95,000||So this couple had other income to add to their AGI, which is why it is more than $88,000.|
|Phaseout Threshold for Married Couples Filing Jointly||$90,000|
|Excess MAGI||$5,000||= MAGI – Phaseout Threshold|
|MAGI Reduction||$1,250||= Excess MAGI × 25%=|
|Reduced Contribution Limit||$3,750||= Statutory Contribution Limit – MAGI Reduction|
|If Last Number of Reduced Contribution Limit is Not 0, Round Up to the Next Highest Multiple of $10||$3,750||Applies to both spouses separately.|
Example 3: Same facts as Example 2 but only 1 spouse was an active participant. The same deduction limit applies to the active participant. However, the nonparticipating spouse is subject to a $178,000 threshold for nonparticipant spouses, so that spouse is subject only to the statutory contribution limits.
The IRA trustee reports contributions on Form 5498, IRA Contribution Information, both to the IRS and to the taxpayer. A taxpayer making a contribution between January 1 and the date in which the previous year's tax return is due, not including extensions, should designate which year for which the contribution is being made; otherwise, the trustee will assume that the contributions are for the current year and will report that to the IRS accordingly. A tax return can also be filed before actually making the contribution, but then the contribution must be made by the due date of the return. There is no requirement that contributions be made every year, even if the taxpayer is able to do so. A taxpayer can set up different IRA accounts and put differing amounts in different accounts, both traditional and Roth IRAs, but the contribution limits apply to all accounts.
Generally, administrative fees that are billed separately by the trustee of an IRA account are not deductible as contributions. Brokerage commissions, however, are deductible as part of the contribution.
The self-employed may make contributions based on self-employment earnings, after netting profits and losses among all the businesses, and deducting Keogh or SEP retirement plan contributions plus the self-employment tax deduction, equal to ½ of the self-employment tax. Profits and losses from multiple businesses owned by the same taxpayer must be netted to determine whether the taxpayer may make a contribution. If losses exceed profits, then no contribution is allowed. However, if the taxpayer also works as an employee and receives wages, then IRA contributions will be limited by the wages even if the taxpayer suffers self-employment losses greater than the wages.
Taxable alimony must be subject to a written agreement under a decree of divorce or legal separation; otherwise, the alimony payments cannot be used as a basis for determining IRA contribution limits.
A taxpayer who is older than 70½ can make a contribution for a younger spouse who has not yet reached the age limit.
A taxpayer who is called to active duty for more than 179 days or indefinitely, and received distributions from his IRA during the active duty period, may repay the distribution within the 2-year period beginning on the day after active duty, regardless of any other regular IRA contributions made during the year. However, the repayment amount is not deductible, since the original contribution has already been deducted. The qualified reservist repayment is reported as a nondeductible IRA contribution on Form 8606.
There is a 6% tax penalty on excess contributions that is cumulative, in that it is applied for each year for which the excess contributions are still present by year-end. Taxable earnings will be reported on Form 1099-R. If the excess contributions are withdrawn after the due date but before the 6-month extension period, then the penalty can be avoided if the related earnings are reported on an amended return, explaining the withdrawals. If any excess contributions were not withdrawn for a new tax year, then the excess amount can be re-characterized as a contribution for the new tax year as long as the contribution limits have not been exceeded.
Over-the-MAGI-limit taxpayers can still make contributions to a traditional IRA, but the contributions are nondeductible. Nondeductible contributions add to the tax basis of the IRA account and are reported on Form 8606, Nondeductible IRAs. Nondeductible contributions are not taxable when they are distributed, unless the contributions were not reported on Form 8606.
There are 2 tax penalties in regard to Form 8606, Nondeductible IRAs. There is a $100 penalty for each overstatement of nondeductible contributions in any given year. There is also a $50 penalty for the failure to file a required Form 8606. Both penalties can be avoided if there was a reasonable cause for the overstatement or failure.
Tax-Free Rollovers and Direct Transfers to Traditional IRAs
Rollovers and direct transfers allow a taxpayer to transfer funds to an IRA account tax-free from an employment or self-employment retirement plan, a §403(b) plan, or a government §457 plan or from a Roth or another traditional IRA account.
A rollover occurs when a taxpayer receives a distribution from a retirement account and contributes the money to an IRA. For the rollover to be tax-free, the contribution must occur within a 60 day period after receiving the distribution.
If a distribution is received and not rolled over into a new account, then the amount not rolled over is treated as a taxable distribution for the year in which the distribution was received, even if the 60 day period expires in the next tax year. If the taxpayer is younger than 59½, then a 10% tax penalty for an early distribution may apply.
Taxpayers can take advantage of the 60 day rule by borrowing money from an IRA account. If it is paid back within the 60 day period, then it's not treated as taxable income.
If there are problems completing the rollover within the 60 day period, then the IRS may allow more time if the rollover cannot be completed because of events beyond the taxpayer's control, such as a natural disaster, insolvency of the financial institutions, or illness. The deadline may also be extended if the money in the account is frozen because the financial institution is insolvent or bankrupt. If an account is frozen because of insolvency, then the 60 day period is extended until the funds become available; thereafter, the rollover must be completed within 10 days. If a distribution is used to buy or build a qualifying 1st home, but the deal falls through, then the deadline may be extended to 120 days. The IRS will automatically extend the 60 day period to one year if the taxpayer deposited rollover funds with the financial institution within the 60 day period, properly followed its rollover procedures, but, because of the institutional error, the account was not established in time. In other cases, the taxpayer must request a private letter ruling from the IRS, explaining the failure to meet the 60 day deadline. Generally, the IRS will consider the length of delay and whether the taxpayer cashed a check for the distribution.
A rollover from any given account can only be done once a year; otherwise, it must be reported as taxable income. However, if the taxpayer has more than one IRA account, then each account can be rolled over within the same 1-year period that started with the 1st rollover.
An exception to the 1-year waiting period applies to a subsequent distribution made from an insolvent financial institution, where the Federal Deposit Insurance Corporation is acting as receiver, who distributes the money to the taxpayer because it is unable to find a buyer for the distressed institution.
A direct transfer occurs when money or property is transferred directly from one retirement account to an IRA through a transfer between financial institutions or between accounts managed by the same custodian. Direct transfers, unlike rollovers, are not subject to the 1 year limitation.
To effect a direct transfer, the receiving IRA custodian will send forms to the taxpayer to fill out and return. Thereafter, the forms are forwarded to the IRA custodian holding the account to be transferred.
A direct transfer does not have to be reported on a tax return, but a rollover must be reported — the total distribution should be reported, then the taxable amount is entered as 0. A rollover that must be reported as income may also be subject to the 10% tax penalty.
Starting in 2018, under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, a conversion from a traditional IRA, SEP, SIMPLE, 401(k), or 403(b) accounts to a Roth account cannot be recharacterized back to a traditional IRA.
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