Subject: Retirement Plans - Traditional IRA

Last-Revised: 9 Feb 2008
Contributed-By: Chris Lott (contact me), Dave Dodson, David Hinds (dhinds at hyper.stanford.edu), Rich Carreiro (rlcarr at animato.arlington.ma.us), L. Williams (taxhelp at hawaiicpa.com), John Schussler (jeschuss at erols.com), John Lourenco (decals at autodecals.com)

This article describes the provisions of the US tax code for traditional IRAs as of mid 2001, including the changes made by the Economic Recovery and Tax Relief Reconciliation Act of 2001. Also see the articles elsewhere in the FAQ for information about Roth IRA and Education IRA accounts.

An individual retirement arrangement (IRA) allows a person, whether covered by an employer-sponsored pension plan or not, to save money for use in retirement while deferring taxes on the account's earnings. Stated differently, a traditional IRA converts investment income (interest, dividends, and capital gains) into ordinary income. Taxes are assessed at time of withdrawal.

Funds in an IRA may be invested in a broad variety of vehicles such as stocks, mutual funds, and bonds. Because an IRA must be administered by some trustee, most people are limited to the investment choices offered by that trustee. For example, an IRA at a bank at one time pretty much was limited to CDs from that bank. Similarly, if you open an IRA account with a mutual-fund company, that account is probably restricted to owning funds run by that company. Certain investments are not allowed in an IRA, however; for example, options trading is restricted and you cannot go short.

IRA contributions are limited, and the limits are quite low in comparison to arrangements that permit employee contributions such as a 401(k) (see the article elsewhere in the FAQ for extensive information about those accounts). For tax year 2007, an individual may contribute the lesser of US$4,000 or the amount of wage income from US sources to his or her IRA account(s). In other words, an individual may have both a traditional and a Roth IRA, but can only contribute $4,000 total to those accounts, divided up any way he or she pleases. Catch-up provisions apply to those 50 and older; they can contribute an extra $1000. The limit rises for tax year 2008 to $5,000 but the catch-up provision stays the same.

There is one notable exception that was introduced in 1997, namely a provision for a spousal IRA. Under this provision, married couples with only one wage earner may each contribute the full amount to their respective IRA accounts. Note that total contributions are still limited to the couple's total gross income, so each spouse cannot contribute the limit if together they earned less than twice that.

Annual IRA contributions can be made between January 1 of that year and April 15 of the following year. Because of the extra three and a half months, if you send in a contribution to your IRA custodian between January and April, be sure to indicate the year of the contribution so the appropriate information gets sent to the IRS.

Many people can deduct their IRA contributions from their gross income. Eligibility for this deduction is determined by the person's modified adjusted gross income (MAGI), the person's filing status on their 1040(-A, -EZ) form, and whether the person is eligible to participate in an employer-sponsored pension plan or contributory plan such as a 401(k). To compute MAGI, you include your federally taxable wages (i.e., salary after any 401(k) contributions), investment income, business income, etc., then subtract your adjustments (not to be confused with deductions) other than the proposed IRA deduction. In essence, the MAGI is the last line on the front side of a Form 1040 with no IRA deductions.

Anyhow, if your filing status is single, head of household, or equivalent, the income test has limits that are lower when compared to filing status married filing jointly (MFJ). These income tests are expressed as ranges. Briefly, if your MAGI is below the lower number, you can deduct everything. If your MAGI falls within the range, you can deduct some portion of your IRA contribution. And if your MAGI is above the upper number, you cannot deduct any portion. (No longer does coverage of one spouse by an employer-maintained retirement plan influence the other's eligibility.) The income ranges for 2007 look something like this:

• Not covered by a pension plan: fully deductible.
• Covered by a pension plan:
  • MAGI less than 32k (MFJ 52k): fully deductible
  • MAGI in the range 32-42k (MFJ 52-62k): partially deductible
  • MAGI greater than 42k (MFJ 62k): not deductible

If your filing status is "Married Filing Separately" (MFS), then the income restriction is much tighter. If your filing status is MFS and both spouses have a MAGI of $10,000 or more, then neither spouse can deduct an IRA contribution.

It's important to understand what it means to be "covered" by a pension plan. If you are eligible for a defined benefit plan, that's enough; you are considered covered. If you are eligible to participate in a defined contribution plan, then either you or your employer must have contributed some money to the account before you are considered covered. IRS Notice 87-16 gives all the gory details about who is considered covered by a pension plan.

Here's an excerpt from Fidelity's IRA disclosure statement concerning retirement plans.

An "employer-maintained retirement plan" includes any of the following types of retirement plans:

• a qualified pension, profit-sharing, or stock bonus plan established in accordance with Section 401(a) or 401(k) of the Code.
• a Simplified Employee Pension Plan (SEP) (Section 408(k) of the Code).
• a deferred compensation plan maintained by a governmental unit or agency.
• tax sheltered annuities and custodial accounts (Section 403(b) and 403(b)(7) of the Code).
• a qualified annuity plan under Section 403(a) of the Code.

You are an active participant in an employer-maintained retirement plan even if you do not have a vested right to any benefits under your employer's plan. Whether you are an "active participant" depends on the type of plan maintained by your employer. Generally, you are considered an active participant in a defined contribution plan if an employer contribution or forfeiture was credited to your account under the plan during the year. You are considered an active participant in a defined benefit plan if you are eligible to participate in the plan, even though you elect not to participate. You are also treated as an active participant for a year during which you make a voluntary or mandatory contribution to any type of plan, even though your employer makes no contribution to the plan.

If you can't deduct your contribution, think about making a full contribution to a Roth IRA (see the article elsewhere in this FAQ for more information). The power of untaxed, compound interest should not be underestimated. But if you insist on making a non-deductible contribution into a traditional IRA in any calendar year, you must file IRS form 8606 with your return for that year.

For tax purposes, each person has exactly one (1) regular IRA. It may be composed of as many, or as few, separate accounts as you wish. There are basically only four justifiable reasons for having more than one regular IRA account:

1. Legitimate investment purposes such as diversification.
2. Estate planning purposes.
3. Preserving roll-over status. If you have rolled a former employer's 401K money into an IRA and you wish to retain the right to re-roll that money into a new employer's 401k, plan (if allowed by that new plan), then you must keep that money in a separate account.
4. Added flexibility when making penalty-free early withdrawals from your IRA via the "substantially equal payments" method, since there are IRS private letter rulings (which, admittedly, are only binding on the addressees) that strongly hint the IRS takes the position that for this purpose, you can make the calculation on an account-by-account basis. See your tax professional if you think this applies to you.

Here's an example. Let's say that you go so far as to have IRA accounts with 2 different companies and alternate years as follows:

• Odd years: contribute the maximum deductible amount to fund A and deduct it all.
• Even years: contribute $2000 to fund B and deduct none of it. (Yes, you are allowed to decline taking an IRA deduction you are eligible for. You just need to include the actual amount of contributions you made - the amount you're deducting on Form 8606.)

Total IRA = $12,000 + $18,000 = $30,000
Total NDC = $0 + $6,000 = $6,000
Ratio = $6,000 / $30,000 = 1/5
Amount transferred = $18,000
NDC transferred = 1/5 of $18,000 = $3,600.

Unfortunately, you can't just say "All of my nondeductible contributions are in fund B" (even though it's demonstable that this must be so) and pay taxes on $18,000 - $6,000 = $12,000. You have to go through the above math and pay taxes on $18,000 - $3,600 = $14,400.

So, once you make a non-deductible contribution, you're committed to doing the paperwork when you take any money out of the IRA. On the upside, the tax "problem" never gets any more complicated. You don't have to keep track of where different contributions came from: all you need to do is keep track of your basis, the sum of all your non-deductible contributions. This number is on the most recent Form 8606 that you've filed (the form serves as a cumulative record, perhaps once of the more taxpayer-friendly forms from the IRS).

Occasionally the question crops up as to exactly why people cannot go short (see the article elsewhere in the FAQ explaining short sales) in an IRA account. The restriction comes from the combination of the following three facts. First, the law governing IRAs says that if any part of an IRA is used as collateral, the entire IRA is considered distributed and thus subject to income tax and penalties. Second, the rules imposed by the Federal Reserve Board et al. say that short sales have to take place in a margin account. Third and finally, margin accounts require that you pledge the account as collateral. So if you try to turn an IRA into a margin account, you'll void the IRA; but without a margin account, you can't sell short.

Withdrawals can be made from a traditional IRA account at any time, but a 10% penalty is imposed by the IRS on withdrawals made before the magic age of 59 1/2. Note that taxes are always imposed on those portions of withdrawals that can be attributed to deductible contributions. Withdrawals from an IRA must begin by age 70 1/2. There are also various provisions for excess contributions and other problems.

The following exceptions define cases when withdrawals can be made subject to no penalty:

• The owner of the IRA becomes disabled or dies.
• A withdrawal program is set up as a series of "substantially equal periodic payments" (known as SEP) that are taken over the owner's life expectancy. Part of the deal with SEP is that the person also must continue to take that amount for a period of 5 years before he or she is allowed to change it.
• The funds are used to pay unreimbursed medical expenses that exceed 7.5% of the owner's adjusted gross income.
• The funds are used to pay medical insurance premiums provided the owner of the IRA has received unemployment for more than 12 weeks.
• The funds are used to pay for qualified higher-education expenses.
• The funds are used to pay for a first-time home purchase, subject to a lifetime maximum of 10,000. Note that a husband and wife can both take distributions from their IRAs for a total of 20k to apply to a first-time home purchase (lots of strings attached, read IRS publication 590 carefully).

When an IRA account holder dies, the account becomes the property of the named beneficiary, and is subject to various minimum distribution rules.

The IRS issued new regulations in April 2002 for minimum distributions from traditional IRAs. The rules (which are retroactive to 1 April 2001) simplify the old, complex rules and reduce the minimum distribution amounts for many people. First, IRA trustees are required to report minimum required distributions to the IRS each year (to make certain Uncle Sam gets his share). Second, account holders can name beneficiaries at practically any time -- even after the death of the account holder. Third, major changes were made to the calculation of required minimum distributions. According to the 2002 rules, the IRA owner is required (as before) to begin minimum distributions at age 70 and 1/2, or suffer tax penalties. However, these distributions are calculated based on one of three new tables:

1. Single Life Table: This (depressingly) is used after the owner dies.
2. Joint and Last Survivor Table: Used when the named beneficiary is a spouse younger than the owner by at least 10 years (lucky them).
3. Uniform Lifetime Table: Used in nearly all other cases (i.e., when the named beneficiary is close in age to the owner).

The traditional IRA permits a distribution to be treated as a rollover. This means that you can withdraw money from an IRA account with no tax effect as long as you redeposit it (into any of your IRA accounts, not necessarily the one you took the money from) within 60 days of the withdrawal. Any monies not redeposited are considered a distribution, subject to income tax and the penalty tax if applicable. You are permitted one rollover every 12 months per IRA account.

Order IRS Publication 590 for complete information. You can also get a PDF version of Pub 590 from the IRS web site: http://www.irs.ustreas.gov/

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