An Individual Retirement Account (IRA) is a personal savings account which allows taxpayers in the United States to set aside money for retirement, while offering tax advantages. The umbrella term for the concept is legally Individual Retirement Arrangement. The IRA can either be an annuity (typically deferred) or a trust set up that meets specific criteria the Internal Revenue Service (IRS) has defined. This trust and funding by financial instruments makes it an account, and thus the term Individual Retirement Account is the most common name by which IRAs are known.
Congress established IRAs in 1974 to encourage people to save toward their retirement. Contributions may be made to traditional IRAs if the taxpayers received taxable compensation during the year and were not age 70.5 by the end of the year. Individuals who are age 50 by the end of the tax year for which the contributions are being made may make an additional catch-up contribution. Taxable compensation includes wages, salaries, commissions, tips, bonuses, or net income from self-employment; it does not include earnings and profits from property, such as rental income, interest, and dividend income, or any amount received as pension or annuity income, or as deferred compensation. Married couples are allowed to establish a special “spousal IRA” when only one spouse has earned income.
A traditional IRA is allowed whether or not the taxpayer is covered by any other retirement plan. However, if the taxpayer or spouse is covered by an employer retirement plan, contributions may not be fully deductible. Determining whether contributions made to a traditional IRA are fully or partially deductible also depends on the income and filing status of the taxpayers and whether or not they receive social security benefits. Generally, amounts in a traditional IRA (including earnings and gains) are not taxed until distributed. After taxpayers turn 70½, mandatory minimum distributions based on life expectancy tables are required, which will be taxed as ordinary income, other than any nondeductible contribution portion.
Penalties apply to withdrawals made before reaching the age of 59½, although exceptions can be made for withdrawals for medical expenses, qualified education expenses, and first-time home buyer expenses. Assets (money or property) can be transferred, tax-free, from other retirement programs (including traditional IRAs) to a traditional IRA. These transfers can be from one trustee to another, through rollovers, or through transfers incident to a divorce. Any excess contributions made to IRAs are subject to an excise tax.
A traditional IRA can be an individual retirement account or an annuity. It can be part of either a simplified employee pension (SEP) or an employer or employee association trust account. The trustee or custodian for a traditional account must be a bank or other entity approved by the IRS to act as a trustee or custodian. Money in these accounts cannot be used to purchase life insurance policies, and assets in the account cannot be combined with other property, except in a common trust fund or common investment fund.
As an alternative, an individual retirement annuity may be set up by purchasing an annuity contract or an endowment contract from a life insurance company. The entire interest in the contract must be nonforfeitable and it must provide that no portion can be transferred to any person other than the issuer. There must be flexible premiums so that if compensation changes, payments can also change and contributions are limited. Distributions must begin after age 70½.
The Taxpayer Relief Act of 1997 established Roth IRAs, championed in Congress by Senator William Roth of Delaware. There are no age limits on when Roth IRAs can be set up and contributions made. Unlike contributions to a traditional IRA, no part of a contribution to a Roth IRA is deductible. The benefit of a Roth IRA is that income earned by the Roth IRA is not taxable to the owner (or the owner’s beneficiary) when withdrawn if certain requirements are met. The maximum amount that can be contributed to a Roth IRA is the same as the maximum amount that can be contributed to a traditional IRA. However, if an individual makes a contribution to a traditional IRA, the amount that can be contributed to a Roth for any tax year is reduced by that amount contributed to the traditional IRA. Distributions are never mandatory, regardless of age, and any distributions taken from a Roth IRA are not taxed as long as certain criteria are met.
Amounts can be converted from a traditional IRA into a Roth IRA if, for the tax year of the withdrawal from the traditional IRA, the modified adjusted gross income for Roth IRA purposes does not exceed a specified amount. All or part of the assets from a traditional IRA can be withdrawn and reinvested in a Roth IRA, which are then called conversion contributions. Income distributions from a traditional IRA that would have been included in income had they not been converted into a Roth IRA must be included in gross income at the time of conversion.
An SEP is a written arrangement that allows small businesses that do not have any other type of retirement plan to make deductible contributions to a traditional IRA (an SEP-IRA). Generally, distributions from SEP-IRAs are subject to the withdrawal and tax rules that apply to traditional IRAs. An SEP-IRA is based only on employer contributions, and vesting is immediate. Any employee who is at least 21 years old, has been employed for 3 of the 5 preceding years, and has earned a minimum compensation of $450 in the current year is eligible to participate. There are three formulas that may be used to allocate contributions to an SEP-IRA: a flat dollar amount, a specified percentage of eligible compensation, or a Social Security integration formula. SEP-IRAs are easy to set up and maintain compared with other retirement plans, and no annual tax returns are required. The employer contribution is optional, which eliminates the problem of required contributions in years when cash flow is a problem.
A Savings Incentive Match Plan for Employees (SIMPLE) IRA is a tax-favored retirement plan that certain small employers (including self-employed individuals) can set up for the benefit of their employees. Employees may choose to reduce their compensation by a certain percentage each pay period and have their employers contribute the salary reductions to a SIMPLE IRA on their behalf, up to a specified maximum amount each year. The employer is then required to match up to 3% of employee pay or make a 2% nonelective contribution. SIMPLE IRAs require little documentation and no annual tax filings. Employer and employee contributions are both vested immediately. Although it is possible to reduce the contribution percentage in designated years, these may not be reduced to zero.
Employee Retirement Income Security Act of 1974 (ERISA); Pensions
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