Traditional IRAs
Course Section
A traditional IRA allows you to save money without paying taxes until you withdraw it. The money you put into the IRA can lower your taxable income and grows tax-free while it's in the IRA account.
Who Can Contribute
Anyone who earns income is eligible for an IRA. You can have an IRA and a
retirement plan at work, but you may not be able to deduct your IRA
contributions on your tax return.
In general, if you are covered by an employer plan, you can deduct the full amount you contribute to an IRA if your modified adjusted gross income is less than $50,000 ($75,000 or less if married filing joint). Deductibility phases out if your modified adjust gross income is between $50,000 and $60,000 (if single); or $75,000 and $85,000 (if married, filing jointly, and both spouses have a plan at work). If one spouse is covered by a retirement plan at work and the other is not, and your combined modified adjusted gross income is more than $150,000, the amount you can deduct may gradually decrease until it reaches zero at $160,000.
Contribution Limits
You can contribute up to $4,000 of your earned income annually. This amount is increasing (see table). You may be able to exclude that amount from your gross taxable income on your tax returns. If you're married and both you and your spouse earn income, you can both contribute to the maximum.
Catch Up if You're 50+
If you're 50 or older, you can make an additional "catch-up" contribution of $1,000 annually for a total contribution limit of $5,000.
How/When to Contribute
There are several ways to make contributions:
- You can write an annual check to your IRA for the maximum contribution.
- You can make small contributions to an IRA throughout the year.
- You can even wait until April 15 of the year following a particular tax year to make your contribution. For example, you can wait until April 15, 2006 to make IRA contributions for the 2005 tax year. Just make sure that your IRA statement credits the contribution to the proper year.
- You can't contribute any more money to your IRA after you reach age 70 1/2.
You don't have to deposit the same amount of money in your IRA each year. And, you can make contributions to more than one IRA. However, each person's total IRA contribution can't be more than the maximum contribution allowed per person for that year.
Making Investments
The IRA is not an investment itself. It's an account into which you invest
your money. You can invest the money you contribute in stocks, bonds, bank CDs,
mutual funds, and other investments, including real estate. Pick investments
that match your retirement goals.
Money Grows Tax-Free
A great feature of an IRA is that you won't pay taxes on the money earned
from investments until you withdraw the money from the account. This means that
everything you earn stays in the account to continue earning more money over
the years. The more years you leave the money in, the more your money can
accumulate and grow.
Because your money grows tax-deferred in a traditional IRA, don't invest in something that grows tax-free in a regular account, such as a municipal bond. Instead, choose investments that would be taxed if in a regular account, such as a stock mutual fund.
Loans and Withdrawals
You can't take a loan from your IRA. Any other withdrawals prior to age 59
1/2 may be subject to income taxes and a 10% IRS early withdrawal penalty, with
these exceptions:
- You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
- The distributions are not more than the cost of your medical insurance.
- You are disabled.
- You are the beneficiary of a deceased IRA owner.
- You are receiving distributions in the form of an annuity.
- The distributions are not more than your qualified higher education expenses.
- You use the distributions to buy, build, or rebuild a first home.
- The distribution is due to an IRS levy of the qualified plan.
- You must start withdrawing money from your IRA when you turn 70 1/2. You'll pay income taxes on any money you withdraw at the tax rate you have at that time.
- All withdrawals from an IRA and any other type of tax-qualified plan are considered ordinary income, not capital gains.
Taking Distributions
When you reach age 59 1/2, you can begin withdrawing money for any reason
without a tax penalty, but your earnings will still be subject to income
taxation.
Once you reach 70 1/2, you'll have to take at least a minimum withdrawal from your IRA each year. Distributions-withdrawals must begin starting April 1 the year after you turn 70 1/2. If you fail to take distributions by that time, you will be taxed at a 50% rate on the amount that should have been withdrawn. Dividends, interest and capital gain growth within an IRA are not taxable until they're withdrawn from the account. Your tax rate and other factors at that time will determine the amount of tax you owe.
How much to take. To calculate your minimum required distribution for a given tax year, divide the value of your account at the end of the previous year by the number of years in your life expectancy.
Here's an example. Let's say your Traditional IRA account is worth $60,000 on December 31, 2020. Your life expectancy was 10 years. You should have withdrawn $6,000 from your Traditional IRA account in 2021. (The $60,000 IRA divided by your 10-year life expectancy equals $6,000.) Your minimum withdrawal will change every year, as your account balance and your life expectancy change.
Changing Your Account
Here are some changes you can make:
- Switch financial institutions. You can move your account from one institution to another without a penalty, but be aware there may be sales charges.
- Convert to a Roth IRA. For some people, Roth IRAs may be better savings vehicles than traditional IRAs. You may be able to convert some or all of your IRA money into a Roth IRA. It's a two-step process. First, you must withdraw your money from the Traditional IRA and pay taxes on the withdrawn money. Then, you can use that money to open a new Roth IRA. Consult with a financial expert to make sure such a conversion is beneficial to you. Roth IRAs are described below.
- Convert between an IRA and employer plan. If your money is in an IRA and you get a job that has a good 401(k) plan, you can roll your money into that. And the reverse is also true: If you have a retirement plan at your employer and leave the company, you can transfer your retirement plan funds to a traditional IRA in order to keep earning tax-deferred money and avoid paying penalties and income taxes (but check to see whether you can keep your money in the company plan even after you leave). There's no annual contribution limit for transfers, so you can transfer all your money in one year.
- Transfer funds directly. When you transfer funds between IRAs or between a company plan and an IRA, you can request a direct transfer from one account to another.
Or, you can have the money sent directly to you. If you take the money, you have 60 days to reinvest the funds in an IRA. But if you fail to reinvest some or all of your money on time, you'll have to pay taxes on your withdrawal. You may even have to pay an early-withdrawal penalty.
Do yourself a favor. Request a direct transfer so you don't risk losing your IRA's tax-deferred status and find yourself paying penalties and taxes.
IRAs for Kids
You may want to get your children or grandchildren in the habit of saving money
as early as possible. Give them an incentive to learn how to save. Open an
account for them. The only requirement is that they have earned income equal to
or greater than the IRA contribution. That means you may be able to pay them
for work and then put it into an IRA. Consult a tax advisor.
Take Action
- To find out about contribution levels and which type of IRA may be best for you, go to http://screen.morningstar.com/ira/iracalculator.html.
- Find out minimum IRA distributions at different ages at www.bankrate.com/brm/itax/news/20010321b.asp.
This column is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.
Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.
