Well, you've come to the right place.
Let's take an in-depth look at the IRA--one of the most popular ways to save for retirement. This week we'll focus on traditional IRAs, next week we'll discuss what you need to know about Roth IRAs, and finally we'll examine rollover IRAs and inherited IRAs.What Is a Traditional IRA?
A traditional deductible IRA allows you to put money away on a pretax basis (that is, you don't have to pay tax on that money before you invest it) and let it grow tax-deferred over time. When you eventually take money out of a traditional IRA, you pay tax on the distribution at ordinary income-tax rates.Deductible Contributions
If you are eligible to contribute to a traditional deductible IRA, you get to take a deduction on your tax return for that contribution. To be eligible, you must meet the following requirements:
- In general, you must have earned income or alimony income in order to contribute to a traditional IRA, and you can't contribute more than you get in earned income or alimony. (Note: The exception to this rule is for spouses who are not working outside of the home. In that case, the spouse may make an IRA contribution even without income of his or her own. This is sometimes called a "spousal" IRA.)
- If you don't participate in a company retirement plan (and neither does your spouse), the amount you can deduct for your IRA contribution may still be limited by your earnings. The IRS bases its earnings limits on something called "modified AGI" (Adjusted Gross Income). IRS Publication 590, Pages 14-15, explains all the rules.
- If you do participate in a company retirement plan (such as a 401[k], 403[b], SEP, SIMPLE, etc.) and your income is too high, you may not be able to make a full deductible contribution to a traditional IRA, or you may not be able to make a deductible contribution at all. See IRS Publication 590, Pages 14-15.
- The maximum contribution is $4,000 for 2006-2007. If you are older than age 50, you can contribute another $1,000 for a total of $5,000. These extra allowances for people older than age 50 are called "catch-up contributions."
- You can make contributions to an IRA in the year the income is earned or up to the filing deadline of your tax return (April 15 in most cases), not including extensions.
- You can't be older than age 70 1/2.
Just because you can't deduct a traditional IRA contribution doesn't mean you shouldn't invest in an IRA.
Even if your income precludes you from making a deductible contribution, you can still make a nondeductible contribution of as much as $4,000 ($5,000 if you're older than age 50) to a traditional IRA in 2006 or 2007 (assuming you have that much earned income). Although you won't get a tax deduction, you will get tax-deferred growth on the earnings.
You will need to file a Form 8606 when you make nondeductible traditional IRA contributions. (There is a $50 penalty if you should have filed a Form 8606 and did not.) The form lets the IRS know that the money you contribute has already been taxed. Then later, when you take a distribution, you won't have to pay tax on your contributions. You will owe tax on any earnings when you take a distribution.
If you've made nondeductible traditional IRA contributions in the past and have not filed Form 8606, you may want to amend your prior returns and attach completed Form 8606s.
There's another reason that a nondeductible IRA contribution may be attractive: Since the Tax Increase Prevention and Reconciliation Act of 2005 was passed (in 2006), anyone, regardless of income level, will be able to convert a traditional IRA to a Roth IRA in 2010 and beyond. Short of investing in a Roth 401(k), this is one of the few ways higher-income investors can get tax diversification through different types of IRA accounts. (Traditional deductible IRAs, as we just discussed, are off-limits to higher-income savers, and Roth IRAs are out of reach for investors in even higher income brackets.)Tax Penalties
The IRS is going to get you if you try to take money out of your traditional IRA too early or too late. If you try to take a distribution before age 59 1/2, you'll have to pay a 10% early-withdrawal penalty. If you try to delay taking a distribution past age 70 1/2, you'll have to pay a 50% penalty on what you should have withdrawn but did not.
There are a few ways around the 10% early-distribution penalty. The exceptions to this rule are:
- Divorce decree
- Certain medical expenses
- Qualified higher-education expenses
- Up to $10,000 toward the purchase of a first home
- Distributions that are substantially equal periodic payments (72[t])
Here's how the 72(t) rules work: Using one of three calculation methods (see IRS Publication 590
, Page 50, for the three methods), you take distributions from your traditional IRA over the greater of
five years or until you reach age 59 1/2. For example, if you start taking distributions at age 57, you must continue until you are age 62 (five years is greater than age 59 1/2).
Revenue ruling 2002-62 allows you to make a one-time change to the calculation method used for 72(t) withdrawals. Read "IRA Relief for Retirees"
for more on this rule. This change was necessary because IRA values dropped drastically during the 2000-2002 market decline and the withdrawals were depleting the accounts too soon.Multiple Accounts
You can have as many different IRA accounts as you'd like. You just can't contribute more than $4,000 ($5,000 if you're older than age 50) in one year.
Once you begin taking required minimum distributions, you can calculate your distributions on the total IRA balance but take the money from only one (or more) IRA account.
Just because you can have multiple IRA accounts (true for traditional or Roth IRAs), that doesn't mean you should keep them all separate. You can cut down considerably on your paper inflow and the time spent managing your assets by consolidating your IRAs at a "supermarket" brokerage, where you can purchase many mutual funds from different families, individual stocks and bonds, or exchange-traded funds.
About the only reason not
to consolidate your traditional IRAs and even your rollover IRAs is if you think you may go bankrupt. New legislation this year gives unlimited bankruptcy protection to IRAs that hold old retirement plans (sometimes called "rollover" IRAs). "Contributory" IRAs (where you've made contributions over the years) are limited to $1 million in bankruptcy protection. Even if you'd contributed the maximum from the time IRAs started, you wouldn't have accumulated $1 million. So, if you're not worried about the bankruptcy implications, go ahead and consolidate your accounts.
The only other reason not
to consolidate a rollover IRA with a contributory IRA is if you think you may want to roll your rollover IRA into a new employer retirement plan. Most people I talk to don't want to do that because the IRA gives them more investment choices than they have in their 401(k) plans.Moving Money from One Traditional IRA to Another
You can do as many direct rollovers (sometimes called trustee-to-trustee transfers) as you'd like in any year. A "direct" rollover just means that the sending financial institution transmits the funds straight to the receiving financial institution. This can be done by wire transfer or by check (assuming the check is made out to the new custodian and not you).
If you're trying to roll over assets and receive a check made payable to you, you're going to have tax problems. In these cases, the issuing company must deduct 20% for taxes. You have to make up that amount if you want to do a full rollover and not get hit for an early distribution (assuming you are younger than 59 1/2). Then you have to wait until the following tax filing to get your 20% back. Needless to say, it pays to be careful so you can avoid all of this red tape.
The other problem with receiving a check made payable to you is that you are limited to doing this type of rollover only once a year and you have 60 days to get it deposited in the new IRA account. If you miss the 60-day deadline, it's all taxable immediately. That's one deadline you don't want to mess with.Traditional IRA Distributions
When you withdraw your money from a traditional IRA, distributions are taxable at ordinary income-tax rates. (If you have a nondeductible IRA, you've made your contributions with aftertax money and your withdrawals will only be taxable on the investment earnings.)
At age 70 1/2, you are required to take minimum distributions from traditional IRAs. For more on RMDs, click here
.IRA Contribution Credits on Your Tax Return
Since 2002 you can take a credit
of up to $1,000 ($2,000 if filing jointly) on your tax return for IRA contributions. The credit reduces tax you would owe dollar-for-dollar. This is separate from your $4,000 deduction
. See IRS Publication 590
for more details on eligibility for this credit. Download IRS Form 8880
to see how much credit you are eligible for.Coming Up
Next week, we'll move on to Roth IRAs, and later I'll write more on rollover IRAs and inherited IRAs.A version of this article appeared in the July 2005 issue ofMorningstar Practical Finance