Questions about IRA


Q. What is an IRA?

A. An IRA is an INDIVIDUAL RETIREMENT ACCOUNT. An IRA is a personal savings plan that provides income tax advantages to individuals saving money for retirement purposes.


Q. How does an IRA work?

A. You invest money in an IRA, up to the amounts allowable under the tax law. These investments are termed "contributions." In many instances an income tax deduction is available for the tax year for which the funds are contributed. The contributions, as well as the earnings and gains from these contributions, accumulate tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes on these earnings, each year the funds remain within the IRA.

The withdrawals of the funds from the IRA are termed "distributions." Distributions are subject to income taxation, generally in the year in which you receive them. (Remember that in most cases you received an income tax deduction when you contributed the money to the IRA.) As with most things involving the government, the rules for distributions are more complicated than they need to be.

Since the original purpose of the IRA is to assist you in providing for your own retirement, there is a disincentive for withdrawing your IRA funds prior to an assumed retirement age of 59 1/2. This disincentive takes the form of a tax "penalty" in the amount of 10 % of the distributions received by you prior to age 59 1/2, unless certain exceptions apply. Given the complexity of this issue alone, professional advice should be obtained whenever significant amounts of distributions are needed prior to age 59 1/2. The fact is that many times the penalty can be avoided with proper planning. Obviously these distributions, whether before age 59 1/2 or later, are subject to income taxation upon receipt. Once you are age 59 1/2 this penalty, termed a "Premature Distribution" penalty, is no longer applicable.

On the flip side of the government not wanting you to withdraw your money at too young an age, it also has rules to prevent you from not withdrawing the money soon enough. (This is done in order that the government can tax it.) You usually need to begin taking money from your IRA no later than April 1 of the calendar year following the date you attained age 70 1/2. The rules established by the government regarding these Required Minimum Distributions, their timing, the amounts, the recalculations, and the effect various beneficiary designations have on them, are among the most complex of the Internal Revenue Code. The penalty is 50 % of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date. This punitive penalty is matched only by the civil fraud penalty in severity. The necessary calculations are therefore not something that most individuals should attempt on their own.


Q. What are the different types of IRA’s?

A. There are five different types of IRA’s:


    You can contribute up to $2,000 per year into an IRA. The amount of this contribution that is deductible on your income tax return depends on your Adjusted Gross Income (AGI) and whether you are covered under an employer sponsored qualified retirement plan. Thus, depending on your filing status (Single, Joint, etc), and your AGI, your contributions may range from fully deductible to totally non-deductible. So even though you are eligible to contribute to your IRA, you may be in a position where none of these contributions are in fact deductible.
    You can put away up to $500 per year into an education IRA, the money grows tax-free and has preferential tax treatment upon distribution to the beneficiary who uses it for authorized education expenses. These plans are not very common in that they are very restrictive on who can make contributions to them, the amount of total contributions allowable each year, and the limitations on what exact education expenses qualify. Your financial planner should be able to assist you in evaluating what savings plan you should undertake to prepare for higher education costs, as well as in reviewing many of the tax-sheltered savings plans now sponsored by the various states, even for benefits of non-state residents.
  3. SEP IRA - Simplified Employee Pension
    This is an employer established and funded Simplified IRA, where the employer can put up to 15% of your compensation into a special IRA account. Sole proprietors may establish these plans for their own benefit. They are sometimes used instead of Keogh retirement plans because they have fewer administrative and tax filing requirements.
    This is a rather new creation, but rapidly becoming more popular. It’s another employer sponsored and administered retirement plan. The attractive features of this plan includes not only the ability for the employer to establish and fund a retirement plan for the benefit of him/herself and his/her employees, but it also permits employees to contribute up to 100 %, but no more than $6,500 per year, into an IRA. Separate rules relative to required employer contributions and premature distributions apply.
    Contributions are NOT deductible when the funds are contributed, but the Roth IRA earnings accumulate tax-free and remain tax-free upon distribution. To be eligible to contribute, your Adjusted Gross Income must be under $95,000 for singles and $150,000 for married couples, as of December 2000. You cannot withdraw your funds within the first 5 years after the establishment of the Roth without a penalty. Given that this 5-year testing period can successfully be addressed by proper tax planning, the establishment and at least partial funding of a Roth IRA account should be on the discussion list of the financial advisor of every taxpayer who qualifies to open such a plan.


Q. Who is eligible to open an IRA?

A. Any individual can open and make contributions to a traditional IRA, as long as you, or your spouse (if you file a joint return), received taxable earned compensation during the year and you were not 70 ½ years old by the end of the year.

Q. What are the new contribution limits for IRAs, 401(k)s, and other retirement plans?

A. The Economic Growth and Tax Relief Reconciliation Act of 2001 enacted a number of changes to the rules regarding IRAs, 401(k)s, 403(b)s, and other retirement plans. One of the areas affected are contribution limits.

Traditional and Roth IRAs


Tax Year Age < 49 Age > 50
2002-2004 $3,000 $3,500
2005 $4,000 $4,500
2006-2007 $4,000 $5,000
2008-Current $5,000 $6,000

401(k), 403(b), and 457 Plans
These limits are on pretax contributions to certain employer- sponsored retirement plans. Remember that employers have the option of imposing lower limits than the government maximums.


Tax Year Age < 49 Age > 50
2005 $14,000 $18,000
2006 $15,000 $20,000
2007-2008 $15,500 $20,500
2009-2011 $16,500 $22,000
2012 $17,000 $22,500


There are many other changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, the nuances of which may affect your eligibility for various tax benefits. For instance, the tax-deductible portion of the contribution limits may be reduced depending upon your income. The advice of a qualified professional should always be sought before implementing any tax or financial planning strategy.


Q. How much of my IRA contribution is tax-deductible?

A. It depends. First, this does not apply to Roth IRAs; they have different rules. But, for a Traditional IRA, it depends mostly on the amount of taxable compensation you earned in that tax year and whether or not you, or your spouse if married, are an active participant in a qualified plan (click highlighted words for explanation of these terms). Assuming you, or you and your spouse jointly, earned more in taxable compensation than the maximum deductible amount for your IRA contributions, and neither of you are active participants in a qualified plan, you should be eligible to deduct the full amount of your contribution up to the maximum deductible amount.

If you or your spouse is an active participant in a qualified or employer-sponsored plan, then the amount of your contribution that is tax-deductible can be reduced depending on your AGI (adjusted gross income). For example, in 2002, single taxpayers’ deduction starts being reduced at $34,000 AGI, and no part of their contribution is deductible if their AGI is more than $44,000. For jointly filing married couples, the reduction is based on their combined AGI. For 2002, the reduction for them begins at $54,000 AGI, and no part of their contribution is deductible if they earn more than a combined AGI of $64,000.