IRAs

This booklet provides an overview of the various types of IRAs and how you might use them to build financial freedom. It is not intended to give specific tax advice. You should consult your tax professional regarding your own individual situation. Depending upon your circumstances, you might elect to set up any of the following five Individual Retirement Arrangements:

Traditional IRAs are funded with tax-deductible contributions. Contributions will be deducted yearly and will not be taxed on the money invested—or the gains on that money—until you withdraw the funds, usually at retirement. Non-deductible contributions are also permitted. If you withdraw funds before age 59½, a 10 percent tax penalty may apply. Withdrawals will be taxed as ordinary income.

Roth IRA contributions are made with after-tax dollars, meaning you cannot deduct them from taxable income. Withdrawals are generally free of income tax, provided you withdraw IRA funds after you are age 59½ and meet certain other conditions.

Spousal IRA contributions can be made for a spouse who does not work.

Education IRA contributions made with after-tax dollars will grow tax-free in an education savings account for an under-18 beneficiary.

IRA-Based Retirement Plans. In addition to IRA plans that an individual might set up, some employers may have established IRA-based retirement plans for employees. Employer contributions to these plans enhance retirement savings at no cost to the employee. IRA-based retirement plans offered by some employers include the Simplified Employee Pension plan (SEP-IRA) and the Savings Incentive Match Plan for Employees (SIMPLE IRA).

A Traditional IRA allows you to contribute up to $5,000 annually in 2009. If your income is less than this maximum, you may contribute up to the full amount of your earned income. The annual contribution has periodic cost-of-living increases. Note that the IRS has made provisions for people over 50 years of age to “catch up” by increasing their annual contribution.* See "Catch-Up" Contributions below.

Are My Contributions Tax-Deductible?

Your contributions to a Traditional IRA are fully tax deductible regardless of your income provided that neither you nor your spouse also participate in a qualified employer retirement plan (e.g., a 401(k) plan). If you participate in another retirement plan, your income level will be the determining factor.

If you are not an active participant in a qualified retirement plan, but your spouse is, you will be able to deduct your Traditional IRA contribution as long as your jointly filed Adjusted Gross Income (AGI) in 2009 is less than $166,000. If your AGI is greater than $166,000, but less than $176,000, your deduction is reduced. If your AGI is $176,000 or more, you cannot take a deduction for a contribution to a Traditional IRA.

If you are an active participant in a qualified retirement plan, file as a single and your 2009 AGI is $55,000 or less you can take a full deduction. If your AGI is more than $55,000, but less than $65,000, you can take a partial deduction. If your AGI is more than $65,000 there is no deduction for a contribution to a Traditional IRA. Even if you cannot deduct them, you can still make contributions to a Traditional IRA.

Withdrawals from a Traditional IRA

Withdrawals, sometimes called distributions, from Traditional IRAs are generally subject to ordinary income tax. If you make withdrawals prior to age 59½, however, you may be subject to an additional 10 percent early withdrawal penalty. The 10 percent penalty may not apply if you:

• Die or are disabled
• Incur deductible medical expenses
• Are unemployed and use withdrawals to pay for health insurance premiums
• Make withdrawals to cover qualifying higher education expenses
• Use up to $10,000 for a qualifying first-time home purchase

Also, check with your tax advisor for other exemptions that might apply to your specific situation.

Withdrawals (distributions) from these IRAs are taxed as ordinary income. You must begin taking withdrawals no later than April 1 of the year following the year in which you turn 70½. Withdrawal rates must meet yearly Minimum Required Distribution (MRD) amounts. If you do not begin withdrawals at that time, you may incur serious tax liabilities. See your tax professional for further information on calculating your MRD.

You can change your beneficiary at any time. Additionally, upon your death, your spouse can roll over your IRA and treat it as if it were his or her own IRA, thus allowing your spouse to take distributions and pay taxes over time. Non-spouse beneficiaries cannot treat your IRA as their own but they can generally take distributions over their life expectancy

Because contributions to a Roth IRA are made with after-tax dollars, withdrawals from a Roth IRA are generally free of income tax. You can contribute to a Roth IRA as long as your earned income is below max income limitations. Like a Traditional IRA, you are permitted to contribute up to $5,000 annually to a Roth IRA in 2009, plus catch-up contributions. If you earn less than this amount, you may contribute 100 percent of your earned income. You should note that if you contribute to both a Roth IRA and a Traditional IRA, your total contributions are not permitted to exceed the permitted amount.

Your annual Roth IRA contribution may be limited if your income exceeds certain amounts. If you file a joint return, you may make the full contribution provided your Adjusted Gross Income (AGI) is below $166,000 in 2009. If you file singly, the limit is $105,000 in 2009. For incomes at or above this limit, the allowable contribution phases out gradually. Check with your tax professional to see if you are eligible to contribute to a Roth IRA.

Traditional IRAs have mandatory withdrawal starting April 1 of the year after you turn age 70½ (except for 2009 tax year), but Roth IRAs have no minimum distribution requirements during life. Generally, Roth contributions can be withdrawn income tax free. You may incur a 10 percent penalty on earnings if you withdraw your contribution from a Roth IRA within the first five years after establishing a Roth IRA. Assuming you meet the five-year test, the requirements for penalty-free withdrawals from a Roth IRA are essentially the same as those for making withdrawals from a Traditional IRA, that is, there will generally not be a penalty if you die, are disabled, if you are older than age 59½, or for a qualified first-time home purchase (up to $10,000).

Conversion from Traditional to Roth

Because funds withdrawn from a Roth IRA are not usually taxed, depending on your situation, you may elect to convert all or part of a Traditional IRA to a Roth IRA. You may convert your Traditional IRA if you are single or if you are married and file a joint return. The conversion is permitted only when your AGI is less than $100,000 in the year of conversion. The converted amount (excluding non-deductible contributions) is included in your income for the year of the Roth IRA conversion. Legislation enacted in 2006 will allow you to convert your Traditional IRA to a Roth IRA in 2010, regardless of your income level, and pay the tax over two years.

The decision to convert an existing Traditional IRA to a Roth IRA is an individual one. The amount converted from a Traditional IRA will be taxed as ordinary income. You must weigh several factors, including your current tax rate, what your tax rate may be in retirement, and your income now and in the future. You also need to consider whether or not you are able to pay the increased tax burden in the year you make the conversion. Consult with your financial advisor to determine if converting your Traditional IRA to a Roth IRA is right for you.

If you file a joint return and your spouse does not work, you can fund a Traditional or Roth IRA for your spouse. To be eligible to fund a Spousal IRA, the following requirements must be met:

• The couple must be married
• One spouse must have compensation or earned income
• A federal tax return must be filed
• An IRA must be established for the non-compensated spouse
• The recipient of the Spousal IRA must be under age 70½
• For a Roth IRA, Adjusted Gross Income is less than $176,000

If you meet the eligibility rules, the spousal contribution is the same as for a Traditional IRA, up to $5,000 annually in 2009. The spousal contribution is made to the non-compensated spouse’s IRA while the compensated spouse follows the regular IRA rules for his or her own contribution to a separate IRA. The Traditional IRA contribution may be fully tax deductible if you and your spouse are not active in an employer-sponsored plan or if covered, your joint Adjusted Gross Income is below $89,000 (for 2009). As with a Traditional IRA, your maximum deductible amount will be phased out when your joint income exceeds these amounts.

For each beneficiary under the age of 18, you can contribute up to $2,000 a year to an Education IRA (also known as a Coverdell Education Savings Account). You may make tax-free withdrawals from the Education IRA to pay for qualified elementary, secondary, and college expenses. You will not be penalized, and the distributions will not be taxed, if the withdrawal is used for tuition, fees, books, or room and board.

As with a Roth IRA, your contributions are made with after-tax dollars and you will not receive a tax deduction. You can contribute for each beneficiary until they turn 18. If you file jointly, the $2,000 limit is phased out when your income exceeds $190,000. If you file singly, it is phased out starting at $95,000.

Distributions that are not used for qualified educational expenses are subject to ordinary income tax on the earnings portion and an additional 10 percent penalty may apply. Any balance remaining in an Education Savings Account must be distributed within 30 days after the beneficiary reaches age 30 or dies. No distribution is required if the Education Savings Account is transferred to a surviving spouse or other family member under the age of 30 due to the death of the beneficiary.

SEP-IRA

A Simplified Employee Pension plan (SEP-IRA) is a plan that allows an employer to make contributions toward an employee’s retirement (or his or her own, if self-employed). Used mostly by sole proprietorships or small businesses, SEPs generally allow employers to contribute a maximum of 25 percent of an employee’s compensation, or $49,000 in 2009, whichever is less. If you are self-employed, the maximum contribution is based on net profit from the business, not gross income. SEP-IRAs are subject to most of the Traditional IRA rules and regulations (e.g., investment and distribution rules).

Money contributed to an employee's SEP-IRA belongs to the employee as soon as it is contributed. Employees are, within limits, able to exclude the entire SEP contribution from current income. Employers are not, however, required to make minimum contributions, so an employee cannot be sure of the amount an employer will contribute from year to year. If the employee leaves the company, all SEP contributions can be taken with the employee.

SIMPLE IRA

A SIMPLE IRA (Savings Incentive Match Plan for Employees) is a retirement plan maintained by an employer with no more than 100 employees who earned at least $5,000 for the preceding calendar year. The SIMPLE IRA permits you to make contributions under a qualified salary-reduction agreement. Your employer must match your contribution with a minimum of one percent and a maximum of three percent of your annual compensation. If you are an eligible employee, you may contribute up to $11,500 in 2009.

For example, if you make $25,000 a year and decide to contribute five percent of your earnings ($1,250) through salary reduction, and your employer makes a matching contribution of three percent ($750), the total contribution to your SIMPLE IRA would be $2,000. If you are 50 or older in 2009, you may make an additional “catch-up” contribution. See “Catch-Up” Contributions below.

SIMPLE IRA plans are taxed the same as Traditional IRAs; generally, contributions are not taxable until withdrawn. As with all forms of IRAs, tax penalties may be imposed if you withdraw funds from a SIMPLE IRA before you are age 591⁄2, including a 25 percent penalty if withdrawals are made during the first two years of funding. There are also restrictions on what type of account you can roll a SIMPLE IRA into during the first two years of funding.

When you retire or change jobs, you may be faced with the decision about what to do with your qualified retirement plan assets. A number of options may be available to you, including rolling over the distribution to a Traditional IRA, or leaving the assets with your former employer, if permitted. By moving eligible rollover distribution assets to an IRA (or other qualified plan), or leaving the assets with your former employer, your money can continue to grow tax-deferred until you begin withdrawing it, when it will be taxed as ordinary income.

If you do not roll the assets over, and decide to take the funds as a lump sum, there are some disadvantages to this option to consider, including:

• Mandatory 20 percent tax withholding
• Possible 10 percent premature distribution penalty if you are under age 59½
• Ordinary income taxes due currently on the taxable portion of the entire distribution.

Your distribution assets can be rolled into a newly opened IRA or one that you already own. You may also be able to roll the assets to a new employer's plan. See a tax professional, financial advisor, or benefits specialist for more information on rollover IRAs and other qualified plan distribution options.

The IRS has made provisions for individuals over 50 years of age to make catch-up contributions to their Traditional, Roth, Spousal, or SIMPLE IRA plans. For example, as shown in the following table, if you are age 50 or over and contribute the maximum of $5,000 to your Roth IRA in 2009, you may also contribute an additional $1,000 as catch-up, bringing your total 2009 contribution to $6,000.

The laws about Individual Retirement Arrangements are meant to encourage individuals to save. By becoming more familiar with IRA rules, you’ll be better able to make the right IRA choices for yourself. The sooner you do, the larger your IRA is likely to grow, and you’ll be on your way to building financial freedom. If you think an IRA might be a good retirement vehicle for you, consult a tax professional or financial advisor for information relevant to your specific situation.

References

IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out
by Twila Slesnick & John C. Shuttle
Published by Nolo, 8th Edition . . . . . . . . . $34.99 (Paper)
ISBN: 1-413-30696-9

Retire Secure!: Pay Taxes Later—The Key to Making Your Money Last as Long as You Do
by James Lange
Published by Wiley . . . . . . . . . $24.95 (Hardcover)
ISBN: 0-470-04354-7

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IRS Publications

#590, Individual Retirement Arrangements
http://www.irs.gov/pub/irs-pdf/p590.pdf

FAQs regarding IRAs
http://www.irs.gov/retirement/article/0,,id=111413,00.html

FAQs regarding SIMPLE IRA Plans
http://www.irs.gov/retirement/article/0,,id=111420,00.html