An
Individual Retirement Arrangement (or
IRA) is a retirement plan account that provides some
tax advantageTax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. The most obvious examples are Retirement plans, but investments in many state or municipal bonds can also be exempt from certain taxes...
s for
retirementRetirement is the point where a person stops employment completely . A person may also semi-retire by reducing work hours...
savings in the
United StatesThe United States of America is a federal constitutional republic comprising fifty states and a federal district...
.
Types
There are number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include:
- Roth IRA
A Roth IRA is an Individual Retirement Account allowed under the tax law of the United States. Named for its chief legislative sponsor, the late Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs.-Overview:...
- contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William Roth.
- Traditional IRA
Established by the Tax Reform Act of 1986, . A Traditional IRA is an individual retirement account in the United States...
- contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a "deductible IRA" or a "non-deductible IRA."
- SEP IRA
A Simplified Employee Pension Individual Retirement Account is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration...
- a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name.
- SIMPLE IRA
A SIMPLE IRA is a type of tax-advantaged employer-provided retirement plan in the United States that allows employees to set aside money and invest it to grow for later use. Specifically, it is a type of Individual Retirement Account that is set up to be an employer-provided plan...
- a simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k)In the United States of America, a 401 plan allows a worker to save for retirement and have the savings invested while deferring current income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wages paid directly, or "deferred," into his...
plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.
- Self-Directed IRA
A Self-Directed Individual Retirement Account is an IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. IRS regulations require that either a qualified trustee, or custodian hold the IRA assets on behalf of the IRA owner...
- a self-directed IRA that permits the account holder to make investments on behalf of the retirement plan.
There are two other subtypes of IRA, named Rollover IRA and Conduit IRA, that are viewed as obsolete under current tax law (their functions have been subsumed by the Traditional IRA) by some; but this tax law is set to expire unless extended. However, some individuals still maintain these accounts in order to keep track of the source of these assets. One key reason is that some qualified plans will accept rollovers from IRAs only if they are conduit/rollover IRAs.
What was formerly known as an Educational IRA is now called a
Coverdell Education Savings AccountA Coverdell Education Savings Account , is a tax-advantaged investment account in the United States designed to encourage savings to cover future education expenses A Coverdell Education Savings Account (also known as an Education Savings Account, a Coverdell ESA, a Coverdell Account, or just an...
.
Starting with the
Economic Growth and Tax Relief Reconciliation Act of 2001The Economic Growth and Tax Relief Reconciliation Act of 2001 , was a sweeping piece of tax legislation in the United States. It is commonly known by its abbreviation EGTRRA, often pronounced "egg-tra" or "egg-terra", and sometimes also known simply as the 2001 act...
(EGTRRA), many of the restrictions of what type of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into were significantly relaxed. Additional acts have further relaxed similar restrictions. Essentially most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA. An example of an exception is a non-governmental
457 planThe 457 plan is a type of non-qualified tax advantaged deferred-compensation retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis...
which cannot be rolled into anything but another non-governmental 457 plan.
The tax treatment of the above types of IRAs except for Roth IRAs are substantially similar, particularly for rules regarding distributions. SEP IRAs and SIMPLE IRAs also have additional rules similar to those for qualified plans governing how contributions can and must be made and what employees are qualified to participate.
Funding
- An IRA can only be funded with cash or cash equivalents. Attempting to transfer any other type of asset into the IRA is a prohibited transaction and disqualifies the fund from its beneficial tax treatment.
- Rollovers, transfers, and conversions between IRAs and other retirement accounts can include any asset.
- The maximum for an IRA contribution in years 2006 and 2007 is 100% of earned income or $4,000, whichever is less, for an individual under the age of 50. Individuals aged 50 and older can contribute up to 100% of earned income or $5,000 whichever is less. For 2008 and 2009, the limit is $5,000.
- This limit is for Roth IRAs, traditional IRAs, or some combination of the two. You cannot put more than $5,000 into your Roth and traditional IRA combined ($6,000 for individuals aged 50 or more).
- For example, if you are 45 and put $3,500 into your traditional IRA this year so far, you can either put $1,500 more into your traditional IRA or $1,500 in your Roth IRA. There may be an additional administrative step needed so that the trustee which holds the IRA proceeds actually retitles or transfers the $3,500 Traditional proceeds into the Roth category for their internal bookkeeping to survive an IRS audit.
Valid investments
Once money is inside an IRA, the IRA owner can direct the custodian to use the cash to purchase most types of
securitiesA security is a fungible, negotiable instrument representing financial value. Securities are broadly categorized into debt securities ; equity securities, e.g., common stocks; and derivative contracts, such as forwards, futures, options and swaps. The company or other entity issuing the security...
, and some non security financial instruments. Some assets cannot be held in an IRA such as collectibles (e.g. art, baseball cards, and rare coins) and
life insuranceLife insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured individual's or individuals' death or other event, such as terminal illness or critical illness. In return, the policy owner...
. Some assets are allowed, subject to certain restrictions by custodians themselves. For example an IRA cannot own real estate if the IRA owner receives or provides any immediate gain from/to this real estate investment, for instance as his personal residence or as a property manager who takes personal compensation for this service or adds capital value to the property. The IRS specifically states that custodians may impose their own policies above the rules imposed by the IRS. It should also be noted that custodians cannot provide advice.
Most IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds, and do not permit
real estateReal estate is a legal term that encompasses land along with anything permanently affixed to the land, such as buildings, specifically property that is fixed in location.
"Real estate" The American Heritage Dictionary of the English Language, Fourth Edition. Houghton Mifflin...
in an IRA unless it is held indirectly via a security such as a
real estate investment trustA Real Estate Investment Trust or REIT is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable, into the hands of the investors...
(REIT). However, self-directed IRA custodians/administrators can allow real estate and other non-traditional assets. They typically charge fees based on asset values. There are certain special restrictions on real estate held in an IRA (the IRA owner cannot benefit from the property in any way, i.e. they cannot use it). Self Directed IRA's allowing non security investments are more complicated and to properly set up may require additional expertise and experience that not all CPAs, attorneys, or other advisors would have.
While certain types of investments are prohibited in an IRA, real estate is not one of them. As a result, real estate owned by an IRA can generate rental income and gain on a sale which escapes immediate taxation. However, the IRA does not get (or, need) the related deductions (e.g., depreciation, mortgage interest,property taxes, etc.).
An IRA may borrow money but any such loan must not be personally guaranteed by the owner of the IRA, and also the loan must be secured solely by assets in the IRA (in other words, a non-recourse loan). Also, the owner of the IRA may not pledge the IRA as security against a debt.
Distribution of funds
Although funds can be distributed from an IRA at any time, there are limited circumstances when money can be distributed or withdrawn from the account without penalties. Unless an exception applies, money can typically be withdrawn penalty free as taxable income from an IRA once the account owner reaches age 59 and a half. Also, non-Roth account owners must begin taking distributions of at least the calculated minimum amounts by April 1st of the year after reaching age 70 and a half. If the minimum distribution is not taken the penalty is 50% of the amount that should have been taken. The amount that must be taken is calculated based on a factor taken from the appropriate IRS table and is based on the life expectancy of the account owner and possibly their spouse as beneficiary if applicable. At the death of the account owner distributions must continue and if there is a designated beneficiary, distributions can be based on the life expectancy of the beneficiary.
There are several exceptions to the rule that penalties apply to distributions before age 59½.
Each exception has detailed rules that must be followed to be exempt from penalties. The exceptions include:
- The portion of unreimbursed medical expenses that are more than 7.5% of adjusted gross income.
- Distributions that are not more than the cost of medical insurance while unemployed
- Disability (defined as not being able to engage in any substantial gainful activity)
- Amounts distributed to beneficiaries of a deceased IRA owner.
- Distributions in the form of an annuity, see Substantially equal periodic payments
- Distributions that are not more than the qualified higher education expenses of the owner or their children or grandchildren
- Distributions to buy, build, or rebuild a first home. ($10,000 lifetime maximum)
- Distribution due to an IRS levy of the plan.
There are a number of other important details that govern different situations. For Roth IRA's with only contributed funds the
basisBasis , as used in United States tax law, is the original cost of property, adjusted for factors such as depreciation. When property is sold, the taxpayer pays/ taxes on a capital gain/ that equals the amount realized on the sale minus the sold property's basis.The taxpayer deserves a tax-free...
can be withdrawn before age 59½ without penalty (or tax) on a
first in first outFIFO is an acronym for First In, First Out, an abstraction in ways of organizing and manipulation of data relative to time and prioritization...
basis, and a penalty would apply only on any growth (the taxable amount) that was taken out before 59½ where an exception didn't apply. Amounts converted from a traditional to a Roth IRA must stay in the account for a minimum of 5 years to avoid having a penalty on withdrawal of basis unless one of the above exceptions applies.
If the contribution to the IRA was nondeductible or the IRA owner chose not to claim a deduction for the contribution, distributions of those nondeductible amounts are tax and penalty free.
Bankruptcy status
In the case of
Rousey v. Jacoway, the United States Supreme Court ruled unanimously on April 4, 2005 that under section 522(d)(10)(E) of the United States Bankruptcy Code , a debtor in
bankruptcyBankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor in an effort to recoup a portion of what they are owed or initiate a restructuring...
can exempt his or her IRA from the bankruptcy estate. The Court indicated that because rights to withdrawals are based on age, IRAs should receive the same protection as other retirement plans. Thirty-four states already had laws effectively allowing an individual to exempt an IRA in bankruptcy, but the Supreme Court decision allows federal protection for IRAs. The
Bankruptcy Abuse Prevention and Consumer Protection ActThe Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 , was a law enacting several significant changes to the U.S. Bankruptcy Code. It was passed by the 109th United States Congress on April 14, 2005 and signed into law by President George W. Bush on April 20, 2005. Most provisions...
of 2005 gave further protection to IRAs. Up to $1,000,000 of IRA assets can be exempt from a bankruptcy estate; this now includes both Traditional and Roth IRAs. The 2005 Act also increased the FDIC insurance limit for IRA deposits at banks.
Protection from Creditors
Many states have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. For example, IRAs are protected up to $500,000 in Nevada from Writs of Execution. However, this type of protection does not usually exist in the case of divorce, failure to pay taxes, deeds of trust, and fraud. Assets in the IRA must have been deposited before a lawsuit exists to receive this protection.
Borrowing
It is a prohibited transaction for the IRA owner to borrow money from the IRA. Such a transaction disqualifies the IRA from special tax treatment. An IRA may incur debt or borrow money secured by its assets but the IRA owner may not guarantee or secure the loan personally. Income from debt-financed property in an IRA may generate unrelated business taxable income in the IRA.
The rules regarding IRA rollovers and transfers allow the IRA owner to perform an "indirect rollover" to another IRA. This can be used to temporarily "borrow" money from the IRA, once in a twelve month period. The money must be placed in another IRA account within 60 days, or the transaction will be deemed an early withdrawal (subject to the appropriate withdrawal taxes and penalties) and may not be replaced.
Double taxation
Double taxationDouble taxation is the imposition of two or more taxes on the same income , asset , or financial transaction . It refers to two distinct situations:...
still occurs within these tax sheltered investment accounts. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the
Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital.
See also
- 401(k)
In the United States of America, a 401 plan allows a worker to save for retirement and have the savings invested while deferring current income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wages paid directly, or "deferred," into his...
- Roth 401(k)
The Roth 401 is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401 plan. As of January 1, 2006 U.S...
- Internal Revenue Service
The Internal Revenue Service is the United States federal government agency that collects taxes and enforces the internal revenue laws. It is an agency within the U.S. Department of the Treasury and is responsible for interpretation and application of Federal tax law. The official U.S...
- 401(k) versus IRA comparison matrix
- Self-Directed IRA
A Self-Directed Individual Retirement Account is an IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. IRS regulations require that either a qualified trustee, or custodian hold the IRA assets on behalf of the IRA owner...
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