IRAs (INDIVIDUAL RETIREMENT PLANS)
INDIVIDUAL RETIREMENT ACCOUNT
TRADITIONAL INDIVIDUAL RETIREMENT ACCOUNT
The Pension Reform Act created an unprecedented opportunity for many individuals who have no tax sheltered retirement plan. With a traditional Individual Retirement Account (IRA), one may deposit funds for retirement purposes and deduct the amount invested from adjusted taxable income. The result is a deferment of the tax on the top dollars earned, plus a tax shelter on all earnings on these deposits until retirement.
The fund will grow through the “magic” of compound interest and the interest on dollars that would have been paid in taxes during the accumulation years. 100% of your earned income up to $5,000 for 2008 can be deposited annually.
The actual maximum deduction allowed to an individual for a cash contribution to a traditional IRA for a non-working spouse for a taxable year is the lesser of (1) the “deductible amount” or (2) 100% of the non-working spouse’s includable compensation, plus 100% of the working spouse’s includable compensation minus (a) the amount of any IRA deduction taken by the working spouse for the year, and (b) the amount of any contribution made to a Roth IRA by the working spouse.
Likewise, contributions to Roth IRAs for a non-working spouse reduce this limit. While a husband and wife who file jointly and are both under age 50 are permitted a maximum deduction of up to $10,000 in 2008, the deduction for each spouse is computed separately.
An active participant in an employer sponsored pension plan may not also be eligible to set up a traditional IRA and contribute under the full or restricted limits. Participants in Keogh plans, employer-sponsored simplified employee pension plans and thrift plans are also restricted as to IRA contributions under the new rules. However, the tax reform imposed restrictions and in some cases, complete elimination of deductible IRA contributions if the person is a participant in a qualified employer provided retirement plan.
The law does allow a spouse who does not actively contribute to an employee-sponsored plan to establish a traditional IRA under specified income limitations.
The deduction for contributions made to individual and spousal plans may be reduced or eliminated if the individual or the spouse is an “active participant” in a qualified Keogh pension, profit sharing, stock bonus, or annuity plan, in a simplified employee pension, in a 403(b) tax sheltered annuity, SIMPLE IRA or in a government plan.
There is no minimum dollar limit for active participant status (i.e., if an individual has only $1 allocated to his account during the year he is still an “active participant”).
The amount of the reduction is the amount that bears the same ratio to the overall limit as the taxpayers adjusted gross income in excess of an applicable limit bears to $10,000. Thus, for taxable years beginning in 2008, the IRA deduction limit is $0 for (1) individuals who are active participants and file a single or head-of-household return with AGI of $63,000 and above, (2) married individuals who are active participants and file a joint return with AGI of $105,000 and above, (3) married individuals whose spouses are active participants but they are not and file a joint return with AGI of $169,000 and above, and (4) married individuals who are active participants or their spouses are active participants and file separately with AGI of $10,000 and above.
DEDUCTIBLE INDIVIDUAL RETIREMENT ACCOUNT
Many individuals have not taken advantage of the ability to have a non-deductible IRA in the past. However, the 1997 Tax Law introduced the Roth IRA. Although contributions to a Roth IRA are not tax deductible for anyone, all or part of the money can be taken out at 59 ½ - tax free, including the growth. There are no complicated record keeping, or minimum withdrawal formulas, as required by traditional IRAs. Another advantage is that there is no requirement to start taking withdrawals at age 70 ½.
MAXIMIZING TAX DEFERMENT
If, at retirement, a current income is sufficient, the main goals may be to enjoy spending the income and to establishing a financial plan whereby capital increases are used to provide protection against runaway inflation or very high medical expenses. The new Uniform Lifetime Table published by the IRS permits a smaller withdrawal, thereby permitting a greater amount to compound and grow, free of tax. If contributions are in a Roth IRA, there are no required distributions - ever.
A person may withdraw funds in a lump sum at retirement and pay tax on the entire amount, subject to five-year averaging. However, one will probably want to take a series of payments such as an annuity guaranteed for a lifetime and perhaps that of a spouse.
With a traditional IRA, the income will be taxed after retirement when the applicable tax bracket may be lower than during working years. Roth IRA contributions are made with after-tax dollars, and those contributions then grow tax-free. The tax code does permit penalty free withdrawal from either traditional or Roth IRAs in some circumstances, such as disability, education and first time homebuyers. Other pre-59 ½ distributions are charged a 10% penalty.
INVESTING THE ACCOUNT
IRA funding may be through savings accounts, CDs, mutual funds, common investment trust and either fixed or variable annuity contracts. There are advantages to each of these options, and the specific situation might indicate a particular funding method to be more effective.
Each retirement investment vehicle offers a different investment advantage, but the annuity is the only investment that can provide lifetime payments at retirement. If the IRA is invested in bonds, savings accounts, etc., an annuity must be purchased to avoid lump sum taxation and provide lifetime income. Due to the increasing life expectancy, future annuity purchase rates may be substantially more costly than at present and will involve additional acquisition costs.
Traditional IRA funds, Roth IRA Funds, and any other deferred retirement plan funds are all includible in one's estate for estate and generation skipping transfer tax purposes. There is no deduction for the eventual income tax still due in a non-Roth plan. The government does allow for a partial miscellaneous itemized deduction for estate taxes paid when retirement plans pay out to the beneficiaries.
Source: Tax Facts 2008, National Underwriter Company
IRA Funding Alternatives
IRA Question and Answer