Individual Retirement Accounts (IRAs) offer tax advantages for long-term retirement planning. There are two 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 2007, the maximum annual contribution is the smaller of:
$4,000
100% of your compensation
If you earn $2,000, then your maximum IRA contribution for the year is $2,000. In 2008, the maximum annual limit will rise to $5,000. 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 $5,000 in 2007 and $6,000 in 2008 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 ($4,000 in 2007) to an IRA. A one-time $4,000 investment at age 15 would grow to more than $73,000 by age 65, assuming an average 6% annual yield.
You must begin withdrawing from your traditional IRA by April 1 of the year after 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 couples in which one spouse doesn’t receive compensation. You can open an account for a nonworking spouse and contribute up to $4,000 to each account in 2007. 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.
Excess contributions are subject to a 6% penalty tax.
Example: Because you expect to earn more than $4,000 in 2007, 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 2008, depositing just $1,200 would use the $2,800 excess contribution and avoid another 6% penalty. You can deduct the $1,200 in 2008.
If you withdraw the excess amount before you file your tax return for the year involved and you don’t deduct the IRA contribution, then you don’t have to report the withdrawal as income. Make sure to withdraw any earnings on the excess $2,800 from the account also. If you don’t withdraw the earnings and you’re under age 59 1/2, the earnings will be taxed and they will also be subject to the 10% early-withdrawal penalty.
The last day to make your IRA contribution each year is the day that your tax return is due for the year, usually April 15. If you mail your IRA contribution, the deadline is made if it’s postmarked on the due date.
If you’re an active participant in your company’s pension plan and your income is too high to deduct your traditional IRA contributions, you can contribute to a Roth IRA instead. Although the 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 the total amount of nondeductible contributions that you make. You need to do this so that you don’t pay tax on the money again when you withdraw it.
If you have a traditional IRA with nondeductible contributions, you need to calculate the taxable portion of your withdrawal. Here’s how you do it:
Find the total amount in all of your IRA accounts at the end of the tax year.
Find the total that you withdrew from your IRA accounts during the year.
Add (1) and (2).
Find your basis in your IRAs—the total of your nondeductible contributions over the years minus any nontaxable withdrawals made in previous years.
Divide (4) by (3). This is the percentage that’s tax-free for the year. The rest is taxable.
There are two tests that determine how much of your IRA contributions are deductible:
Company pension plan test
Income test
Are you an "active participant" in a company pension 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:
Pension, profit-sharing, or 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)
If you’re eligible for a company pension plan during any part of the year, then you’re considered covered for the entire year. However, if you’re in a profit-sharing plan but no contribution is made to your account for the year, then you aren’t considered covered for that year. The W-2 form that you receive from your employer should indicate whether or not you’re an active participant in a plan. If you are, box 13 (Retirement plan) will be checked.
If you’re married and either you or your spouse is covered by an employer-sponsored plan, both of you are considered covered. 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.
If you’re not an active participant in a company plan, you can continue to 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 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 $52,000 on a single return ($83,000 for those filing a joint return) and is phased out completely when your income exceeds $62,000 on a single return ($103,000 for those filing a joint return). If your MAGI is 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 before subtracting your IRA contributions. If you exclude from income any U.S. savings bonds interest used to pay college expenses, then you must also include that amount when calculating your MAGI.
A higher phase-out amount is used to calculate whether or not spousal IRA contributions are deductible by the nonworking spouse of someone who is covered by a company retirement plan. The deduction begins to phase out when your MAGI reaches $156,000 and is phased out completely when your income exceeds $166,000.
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 your 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 IRA deduction.
Example: If you file a joint 2007 return and your MAGI is $10,000 over the lower phase-out amount of $83,000, your maximum annual deduction is reduced to one-half (or $2,000) of the maximum allowable amount ($4,000). You can contribute up to $4,000, but you can deduct no more than $2,000. If both you and your spouse make IRA contributions, each of you can deduct up to $2,000.
This IRA is named after senator William Roth. You can’t deduct contributions to a Roth IRA, but the withdrawals that you make in retirement can be totally tax-free.
Roth IRAs are similar to traditional IRAs in many ways:
You must have compensation from a job to contribute to a Roth IRA.
For 2007, the maximum annual contribution is the smaller of $4,000 or 100% of your compensation. If you earn $1,200, then your maximum IRA contribution for the year is $1,200. In 2008, the maximum annual limit will rise to $5,000. 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 $5,000 in 2007 and $6,000 in 2008 for those age 50 or older.
The annual dollar limits are the total limit for all IRA accounts (traditional and Roth) that you have. The same 6% penalty for excess contributions applies to both the Roth IRA and the traditional IRA.
You can open accounts and make annual contributions until the day that your tax return is due for the year, usually April 15.
You can contribute up to $4,000 of your 2007 earnings to a spousal Roth IRA for a nonworking spouse ($5,000 if your spouse is age 50 or older by the end of the year).
Earnings grow tax-deferred inside the account.
Some rules for Roth IRAs differ from traditional IRAs:
Earnings in a Roth account can be tax-free rather than simply tax-deferred.
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 making withdrawals at age 70 1/2.
The balance in your account when you die goes to your heirs tax-free.
Although higher-income taxpayers who actively participate in company pension plans can’t deduct contributions to traditional IRAs, anyone can contribute to save tax-deferred for retirement. This isn’t the case for Roth IRAs. If your modified adjusted gross income (MAGI) exceeds $114,000 for a single return or $166,00 for a joint return, you can’t contribute to a Roth IRA.
The amount that you can contribute to a Roth IRA begins to phase out when your MAGI is reaches $99,000 on a single return ($156,000 on a joint return) and is phased out completely when your income exceeds $114,000 on a single return ($166,000 on a joint return). If you and your spouse file separate returns, you can’t contribute to a Roth IRA unless you didn’t live together during the year.
Example: If you file a joint 2007 return and your MAGI is $161,000, which is $5,000 over the lower phase-out amount, your maximum contribution is reduced to one-half (or $2,000) of the maximum allowable amount ($4,000). When your MAGI exceeds the maximum allowable amount ($4,000 in 2007), 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.
If your modified adjusted gross income is $100,000 or less, you can convert your traditional IRA to a Roth IRA so that all future earnings are tax-free. The $100,000 level applies to all returns except married filing separately. If you’re married and you file separate returns, you can’t convert your traditional IRA to a Roth IRA.
If you decide to convert your traditional IRA to a Roth IRA, you have to pay tax on the amount rolled over. However, any nondeductible contributions that you made to a traditional IRA that you rolled over 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 a company pension 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 income level when you retire. If you choose to contribute to a Roth IRA, your taxable income will be lower in retirement. If you contribute to a traditional IRA though, your taxable income will 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.
The types of options that you have for investing your IRA contributions include:
Conventional investments, such as bank accounts
Stocks
Corporate bonds, zero-coupon bonds, or junk bonds
Mutual funds
Annuity contracts
Gold and silver American Eagle coins issued by federal and state governments
Platinum coins and gold, silver, platinum, or palladium bullion
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 choose more risky investments because there’s more time to make up for any losses incurred. On the other hand, someone nearing retirement may 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 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 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:
By using H&R Block’s Easy IRA feature—just follow the interview.
At a bank, savings and loan, or credit union, where your investment is likely to be in certificates of deposit or money-market accounts.
At a mutual fund company where your retirement money will be professionally managed in a portfolio of stocks or bonds, or in a money-market fund.
At an insurance company where your money will be invested in either fixed or variable annuities. Since earnings on an annuity are already tax-deferred, it isn’t the wisest IRA choice.
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 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 $4,000 in 2007 ($5,000 for those over age 50). Also, paying multiple trustee fees and bookkeeping tasks make having too many accounts more challenging.
One reason not to contribute to an IRA is the 10% early-withdrawal penalty that you’ll incur if you withdraw money from your IRA before age 59 1/2. However, 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).
You can convert your money from a traditional IRA to a Roth IRA, but you can’t transfer money from a Roth IRA to a traditional IRA. Remember, though, that you’ll pay tax on the rollover if you do convert your traditional IRA to a Roth.
There are two ways to move money from a traditional IRA to another traditional IRA, or from one Roth IRA to another:
Direct transfer
Rollover
The direct-transfer method is the most convenient way to move the funds in your IRA accounts, and it allows you to move them as often as you want. A direct transfer involves telling the holder of your current IRA account that you want to transfer the money to a new account. The sponsor of the new account should be able to expedite the change once you’ve opened the new account. Before you begin the process, make sure to find out how long the transfer will take and whether or not you’ll be charged any setup or withdrawal fees.
A rollover involves withdrawing money from one account and personally moving the funds to a new IRA within 60 days of the date that you receive the money. If you fail to meet the 60-day deadline, you lose the rollover designation. As far as the IRS is concerned, you’ve cashed in the IRA. If a traditional IRA is involved, the full amount withdrawn is taxable (except for any nondeductible contributions that you made). If you’re under 59 1/2, you’ll also have to pay the 10% early-withdrawal penalty. If the withdrawal is from a Roth IRA, the rules to calculate the taxable amount are more complex.
If you roll over your IRA, make sure that you tell the sponsor you are leaving not to withhold any taxes. Otherwise, 10% of the amount withdrawn will be withheld and sent to the IRS, treating this transaction as a taxable distribution rather than a tax-free rollover. If this happens, you’ll need to file your tax return to get a refund for any taxes overpaid.
You can roll over an account only once every 12 months. If you have 4 separate IRAs, you can roll over each of them once a year.
Although you’re not allowed to borrow against your IRA, the rollover offers you a chance to temporarily use your IRA money. You can withdraw money from the IRA and use it for whatever you want, including a bridge loan. As long as the same amount you withdrew is put back into an IRA within 60 days, you won’t owe any tax. (You can also put the money back into the original IRA account.)
For more information, see IRS Publication 590, Individual Retirement Arrangements.