An IRA (individual retirement arrangement) is a federally sanctioned personal savings plan designed to save money for retirement. Within certain limits, contributions to an IRA are tax deductible. Interest, dividends and capital gains earned inside an IRA, are allowed to compound tax free. IRA deposits and accumulations must be paid out during retirement and such distributions are taxed at ordinary income. However, an IRA does offer considerable flexibility, as to the amount and timing of the distributions.
Anyone receiving compensation, who is not age 70 ½ or older, can set up an IRA. You can have an IRA even if your are covered under an employer sponsored pension, profit sharing or a 401k plan. However, if you are a participant in any of these types of plans, your contributions to an IRA may be limited. Because an IRA is an individual account,
it can not be held in joint name, but it can have one or more named beneficiaries.
IRAs can take the form of an Individual Retirement Account or an Individual Retirement Annuity. An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document, which must show that the account meets all of the qualifying requirements. Banks, savings associations, credit unions, mutual fund sponsors and stock brokerage firms are common sources of IRAs.
Except for rollovers (transfers from a qualified account or between IRAs) , IRA contributions must be in cash and the account holder must have a non forfeitable right to the balance at all times. Assets in the account cannot be combined with other property, except in a common trust fund or common investment fund and the money in the account cannot be used to purchase life insurance.
An Individual Retirement Annuity is an annuity contract or an endowment contract from a life insurance company. It must meet a number of requirements that are similar in nature to the restrictions on an Individual Retirement Account. Despite their variations in legal structure, it makes little practical difference whether a saver chooses an individual account or an individual annuity. However, the annuity does offer built-in protections against outliving your retirement nest egg, which are not provided in by an account.
As a general rule an individual can contribute and deduct a maximum of $4,000 a year to an IRA ($5,000 if they are age 50 or older). An IRA can not be held jointly, but contributions can be made to a spousal IRA. This means that the total combined contributions that can be made for the year to your IRA and your spouse's IRA can be as much as $8,000 ($9,000 if only one of you is age 50 or older or $10,000 if both of you are age 50 or older).
The allowable contributions are limited by income, joint income and participation in other qualified plans. If you, your spouse, or both of you are covered by a qualified retirement plan, your IRA deduction may be reduced or eliminated, depending on the amount of your Modified Adjusted Gross Income and your filing status. Individual retirement accounts and annuities are intended as long term retirement accumulations. Premature distributions before age 59 ½ are subject to a 10% penalty tax in addition to the income tax due, there are of course exceptions for certain specified emergencies.
IRA distributions after age 59 ½ are taxed as normal income at the tax rates in effect in the year of the distribution. After age 70 ½, an IRA is subject to minimum distributions, often called force-outs. RMDs (Required Minimum Distributions) that are not made in accordance with the IRS guidelines expose the IRA assets to a massive penalty tax. In other words, if you don’t distribute it, you loose it. The Required Minimum Distribution is based on an estimate of your life expectancy as computed using tables published by the IRS and increases each year after age 70 1/2.
For tax year 2007, individuals covered by a retirement plan at their place of employment, have their IRA deductions phased out if they fall within certain income brackets as measured by their AGI (adjusted gross Income)
IRA & Roth IRA Phase Out Income Limits
Less than $10,000 if married & filing separately
More than $52,000, but less than $62,000 for single or head of household filers
More than $83,000, but less than $103,000 for joint returns or qualifying widow(er).
Because annuities
are retirement vehicles, they have been granted special tax advantages. Interest income earned inside an annuity avoids all current tax liability. Taxes are only due when the funds are actually used for retirement or withdrawn for some other purpose. (see 2nd Half of the Story)
In 2007, if you are not covered by a retirement plan at work, but your spouse is a participant in an employer sponsored qualified plan, your deduction for contributions to a traditional IRA may be reduced (phased out). If you either, lived with your spouse or file a joint return, and your spouse is a covered employee, your deduction is phased out if your adjusted gross income (AGI) is more than $156,000 but less than $166,000. If your AGI is $166,000 or more, you cannot take a deduction for contributions to a traditional IRA.
Roth IRA
A Roth IRA is similar to a traditional IRA, except its contributions are not tax deductible. In general, it shares many of the the same limitations and regulations as traditional IRA. Contributions to a Roth IRA must be integrated with those of a traditional IRA. There is only one IRA contribution allowance. Individual tax payers can choose to allocate it entirely to a traditional IRA, entirely to a Roth IRA, or any combination of the two. Spousal Roth IRA’s also work much like traditional spousal IRA’s.
Earnings accumulations inside a Roth IRA compound tax free, but unlike a traditional IRA, distributions from a Roth IRA received tax free. Premature Roth IRA distributions are subject to the same 10% penalty tax, but distributions meeting the following requirements are exempted:
Medical expenses in excess of 7.5% of AGI
Disability
Qualified higher education expenses
First home buyer costs
Beneficiary distributions in event of death
Lifetime income
Qualified distributions to military reservists
Please see IRS regulations for the exact details of the above exemption to the 10% penalty tax. (Link provide below).
Unlike a traditional IRA, contributions to a Roth IRA are not limited by age and can continue for the lifetime of the taxpayer. Also, there are no force-outs for a Roth IRA. Accumulations can continue until the death of the tax payer.
Both IRAs and Roth IRAs have special rules for transfer at death. See
Inherited IRAs
For an comparison of the performance of an IRA and a Roth IRA in a retirement situation, see
Second Half of the Story
For more detailed information on both traditional and Roth IRAs, please see IRS Publication 590 or follow this link to the IRS web site
http://www.irs.gov/publications/p590/
