Individual Retirement Accounts (IRAs) offer tax advantages for long-term retirement planning. There are 2 types of individual retirement accounts (IRAs) -- traditional IRAs and Roth IRAs. Earnings in these accounts can accumulate either tax-deferred or tax-free. In addition, traditional IRA contributions can be tax-deductible.
The traditional IRA is available to anyone under age 70 1/2 who receives compensation. Compensation considered for IRA purposes includes:
Wages, salaries, and tips
Sales commissions
Professional fees
Bonuses
Self-employment income
Military compensation while serving in a combat zone tax-exclusion area
Alimony
Income that is not included as compensation for IRA purposes includes:
Profit from the sale of stocks or other property
Rental income
Pension or annuity income
Deferred compensation
For 2010, the maximum annual contribution is the smaller of $5,000 or 100% of your compensation.
If you earn $2,000, then your maximum IRA contribution for the year is $2,000. For taxpayers age 50 or older, the IRA contribution limit is $1,000 more because it’s considered a "catch-up" contribution. This means that the limit is $6,000 in 2010 for those age 50 or older.
There is no minimum age to participate in an IRA. If your 15-year-old child has compensation from a part-time job, your child can contribute up to the annual limit ($5,000 in 2010) to an IRA. A one-time $5,000 investment at age 15 would grow to more than $35,533 by age 65, assuming an average 4% annual yield.
You must begin withdrawing from your traditional IRA by April 1 of the year following the year in which you reach age 70 1/2. Starting with the year that you attain age 70 1/2, you can no longer contribute to your traditional IRA account.
There’s an exception to the annual contribution limit for married couples when one spouse doesn’t receive compensation. You can open an account for a nonworking spouse and contribute up to $5,000 to each account in 2010. For taxpayers age 50 or older, that limit is $6000. In addition, you can continue contributing to a nonworking spouse’s account after you reach age 70 1/2 as long as your spouse is under age 70 1/2. However, you’ll need to file a joint return with your spouse to be eligible for a spousal IRA.
Excess contributions are subject to a 6% penalty tax.
Example: Because you expect to earn more than $4,000 in 2009, you deposit $4,000 in your IRA. However, your earnings for the year total just $1,200, which means that you can contribute no more than $1,200 to your IRA. This means that the extra $2,800 ($4,000 - $1,200) is subject to the 6% penalty, or $168 in additional tax.
The penalty applies each year until the excess is either withdrawn or used as a future year’s contribution. If you qualify for a $4,000 contribution in 2010, depositing just $1,200 bring your (2010) contribution up to $4,000 ($1,200 + $2,800). You can deduct the $4,000 in (2010).
If you withdraw the excess amount plus any related earnings before the extended due date (generally October 15th) for filing your tax return for the year involved then you won’t be subject to the penalty on the excess contribution. However, the earnings will be taxed and they will also be subject to the 10% early-withdrawal penalty in the year for which the contribution was made.
The last day to make your IRA contribution each year is the day that your tax return is originally due for the year, usually April 15. If you mail your IRA contribution, the deadline is met if it’s postmarked by the original due date for filing Form 1040 (without extensions).
If you’re an active participant in your company’s pension plan and your income is too high to allow you to deduct your traditional IRA contributions, you may be eligible to contribute to a Roth IRA instead. Although the ability to contribute to a Roth IRA also has income limitations, most people don't exceed them. If your income exceeds the limits to contribute to a Roth IRA, you can still contribute to a traditional IRA. This is called a nondeductible IRA. Even though the contribution won't give you a tax deduction, it's still a long-term investment in a tax-deferred retirement savings plan.
If you contributed to a nondeductible IRA in the past, you must keep track of your basis in the account. Basis is generally the total amount of nondeductible IRA contributions that you have made, plus basis from after-tax amounts in qualified retirement plans you have rolled over to your traditional IRA accounts. You need to track your basis so that you don't pay tax on the money again when you withdraw it. Form 8606 must be filed for any tax year in which a nondeductible IRA contribution is made, and the Form also can be used to help you track your total IRA basis. If you have a traditional IRA with basis from nondeductible contributions or rollovers, you'll need to calculate the taxable portion of any withdrawals.
IRS Publication 590 has worksheets to help you determine the taxable portion of your IRA withdrawals when you receive both taxable and nontaxable distributions. You will also use Form 8606 to report the taxable and nontaxable portions of the distributions.
There are 2 tests that determine how much of your IRA contributions are deductible: the active participant test and the income test.
Are you an "active participant" in a company retirement plan? If you’re eligible to participate in any of the following types of plans, the law considers you an active participant whether or not your benefits are vested:
Qualified Pension Plan
Profit-sharing plan
Stock Bonus Plan
Qualified annuity plan
Retirement plan for state and federal employees, including civil service and the Federal Employees Retirement System
Tax-sheltered annuity (403(b) plan)
Defined benefit plans work a little differently when determining active participation.
If you’re eligible for a company defined benefit plan (e.g., a pension plan) during any part of the year, then you’re considered covered for the entire year. For a defined benefit plan that you are eligible to participate in, you’re considered to be an active participant even if you decline to participate in the plan, you made no contributions, or didn’t perform even the minimum number of hours of service to be accrue benefits for the year. The Form W-2 that you receive from your employer should indicate whether or not you’re an active participant in an employer-sponsored plan.
If you are, the “Retirement Plan” box should be checked. A much higher income limit applies to spousal IRAs than traditional IRAs, so you might be able to deduct the spousal contribution even if you’re denied the deduction for your own contribution.
If neither you nor your spouse were active participants in a company plan, you can deduct your IRA contributions regardless of how high your income is.
If you’re covered by a company plan, a second test determines how much of your IRA contribution you can deduct. If you’re an active participant in a company plan, the traditional IRA deduction begins to phase out when your modified adjusted gross income (MAGI) reaches $55,000 on a single return ($89,000 for those filing a joint return) and is phased out completely when your income exceeds $66,000 on a single return ($109,000 for those filing a joint return). The phaseout range is increased to $167,000 - $177,000 for married taxpayers where only one spouse is covered by a retirement plan at work.
If your MAGI is equal to or less than the lower phase-out amount, you can deduct your full IRA contribution even if you're an active participant in a company plan. For these purposes, MAGI is your adjusted gross income with the following items added back:
Traditional IRA deduction
Student loan interest deduction
Tuition and fees deduction
Foreign earned income exclusion
Foreign housing exclusion or deduction
Excluded savings bond interest
Excluded employer-provided adoption benefits
Domestic production activities deduction
If you and your spouse file separate returns, the phase-out range is $0 to $10,000. This means that you can’t claim the IRA deduction if MAGI exceeds $10,000. If you’re married but you didn’t live with your spouse during the year; however, you’re considered single for the purposes of IRA deduction limitation.
Example: If you file a joint 2010 return and your MAGI is $1,000 over the lower phase-out amount of $89,000, your maximum annual deduction is reduced to one-half (or $2,500) of the maximum allowable amount ($5,000). You can contribute up to $5,000, but you can deduct no more than $2,500. If both you and your spouse make IRA contributions, each of you can deduct up to $2,500.
Roth IRAs are subject to the same rules as traditional IRAs with the following exceptions:
A Roth IRA must be designated as a Roth IRA when the account is originally established.
Earnings in a Roth account can be tax-free rather than simply tax-deferred meaning you can't deduct contributions to a Roth IRA, but the withdrawals that you make during retirement can be tax-free as long as they are qualified distributions.
You can withdraw contributions at any time without tax or penalty.
You can continue to make contributions after you reach age 70 1 / 2 as long as you receive compensation.
You don't have to begin taking withdrawals at age 70 1 / 2.
The balance in your account when you die goes to your heirs tax-free after the account has been open for at least 5 years.
The maximum amount of the contribution to all IRAs cannot exceed the lesser of your taxable compensation for the year or $5,000 ($6,000 if you’re over age 50 and making catch-up contributions). However, when determining the maximum amount that can be contributed to a Roth IRA for a year, you must combine the contributions made to all IRAs (both traditional and Roth). This means that the taxpayer's contribution limit is the lesser of:
The maximum allowable contribution for the tax year minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs, or
The taxpayer's taxable compensation minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.
If you contribute more than allowed to your Roth IRA you will be subject to the same 6% excise tax on the excess contribution that you’re subject to when you over contribute to a traditional IRA.
Although higher-income taxpayers who actively participate in company retirement plans can’t deduct contributions to traditional IRAs, they can contribute to save (on a tax-deferred basis) for retirement. This isn’t the case for Roth IRAs.
The amount that you can contribute to a Roth IRA begins to phase out when your MAGI is reaches $105,000 on a single return ($167,000 on a joint return) and is phased out completely when your income exceeds $120,000 on a single return ($176,000 on a joint return). If you and your spouse file separate returns and made over $10,000, you can’t contribute to a Roth IRA unless you didn’t live together during the year.
Example: If you file a joint 2010 return and your MAGI is $168,000, which is $1,000 over the lower phase-out amount, your maximum contribution is reduced to $4,000. When MAGI exceeds the maximum allowable amount ($176,000 in 2010), you can’t contribute to a Roth IRA at all.
Note that these phase-out levels apply even if you’re not covered by a company pension plan.
Before 2010 no conversion was allowed if your modified adjusted gross income was ($100,000) or more or you were filing using married filing separately filing status. However, the the $100,000 income limit and rule prohibiting conversion when using married filing separate status have been removed for tax years after 2009.
If you decide to convert your traditional IRA to a Roth IRA, you generally have to pay tax on the amount rolled over. However, for tax year 2010 only the income from the conversion will be reported in 2 installments in 2011 and 2012 unless the taxpayer elects out of the 2 year installment treatment. Any nondeductible contributions that you made to a traditional IRA that you rolled over or converted to a Roth IRA are tax-free.
Example: Your traditional IRA is valued at $100,000, and includes only deductible contributions and tax-deferred earnings. If you convert this IRA to a Roth IRA, you'll need to report the $100,000 as income and pay the tax on it.
How do you choose between a traditional IRA and a Roth IRA? If you're an active participant in an employer-sponsored retirement plan and you can't deduct your traditional IRA contributions because your income is too high, the Roth IRA can be a great retirement savings plan. What if you can deduct your traditional IRA contributions?
In the past, the assumption was that all retirees would need less income to maintain their lifestyles, which would put them in a lower tax bracket. However, that thinking has changed. It's now likely that you'll need to maintain your current income level when you retire. If you choose to contribute to a Roth IRA, your taxable income may be lower in retirement. If you contribute to a traditional IRA though, your taxable income may increase in retirement.
For help in making your choice, use the H&R Block IRA Advisor in the Retirement Planning section of the interview.
You can invest your IRA contribution in a variety of investment options. How you invest the money can make a significant difference in your retirement assets.
The investment options include: interest-bearing deposit accounts (such as certificates of deposit, savings accounts, money market accounts), money market mutual funds, mutual funds, stocks, corporate bonds, zero-coupon bonds, junk bonds, mutual funds, annuity contracts, certain gold or silver coins issued by federal and state governments, and gold, silver, platinum, or palladium bullion or coins that meet certain standards.
Where you invest your money depends upon your age and how much risk you are willing to take. Someone who has many years before retirement may want to choose more risky investments to take advantage of higher potential earnings. Additionally, there’s more time to make up for any losses incurred. On the other hand, someone nearing retirement may want to choose investments with guaranteed yields.
It’s important to note that you generally can’t deduct losses in an IRA. The only exception is if you cash in all your IRAs of the same type (i.e., Roth or traditional) and you end up with less money than you invested through nondeductible contributions.
Whether you contribute to a traditional IRA or a Roth IRA and regardless of where your choose to invest your money, you must contribute through a trustee or custodian approved by the IRS. However, you can maintain complete control over the investments in your account even though you can’t be the trustee of your own IRA.
You can contribute to your IRA:
At a bank, savings and loan, or credit union, where your investment is likely to be held in certificates of deposit or money-market accounts.
At a mutual fund company where your retirement money may be professionally managed in a portfolio of stocks or bonds, or in a money-market fund.
At an insurance company where your money may be invested in fixed or variable annuities.
At a brokerage firm with a self-directed account that offers the utmost in flexibility. These IRAs allow you to choose the exact stocks, bonds, mutual funds, and other investments that you want in your IRA. To invest in gold or silver coins, real estate investment trusts, and limited partnerships, you must have a self-directed account.
Some IRA accounts have annual fees, while others have no fees. The fees imposed on traditional IRAs are considered a miscellaneous itemized expense. These expenses can be deducted only if your total miscellaneous deductions exceed 2% of your adjusted gross income. The fee has to be paid directly to you rather than automatically deducted from your IRA.
You can have many IRA accounts. You can contribute to a single traditional IRA account over the years, open a different account each year, or divide each year’s contribution among several accounts. If you want, you can put some of your money into a traditional IRA and the rest into a Roth IRA. It’s important to remember, though, that your total contributions for the year can’t exceed the maximum allowable limit of $5,000 in 2010 ($6,000 for those over age 50). Also, paying multiple trustee fees and bookkeeping tasks make having too many accounts more challenging.
You aren't restricted to the same investment account from the time you first contribute to your IRA until you retire. You can move your money around to take advantage of changes in the market or your investment philosophy. However, there are certain rules that need to be followed. Some investments, such as CDs and annuities, may have early-withdrawal penalties that are assessed by the financial institution (not the IRS).
For more information, see IRS Publication 590, Individual Retirement Arrangements.