Ohio State University Fact Sheet

Family and Consumer Sciences

1787 Neil Avenue, Columbus, OH 43210-1295

IRA—Individual Retirement Account

MM-03-02

Ella Mae Bard,
CFCS, Extension Agent-Family and Consumer Sciences,
Community Development and Co-Chair, Knox County, Ohio

An Individual Retirement Account—IRA—is an opportunity that enables qualifying individuals to save and invest for retirement.

IRAs—traditional and Roth—are special classifications for tax purposes. The actual investment can be stocks, bonds, certificates of deposit, or mutual funds. Arrangements are made with any stockbroker or bank. Fees vary. Before opening an IRA, read the information about each product you are considering.

For a mutual fund ask for a prospectus.

With the complexity of the IRAs and the options, few people are prepared to make all the decisions without good advice from a qualified financial advisor and/or tax preparer aware of your personal goals and risk tolerances. An IRA is only one piece in your total financial plan.

IRAs go back to the early 1980s when federal legislation created the tax deductible IRA for anyone with earned income. Significant changes in 1986 established income limits for participants in an employer-sponsored retirement plan and closed the deductible IRA for many people. Contribution limits increased as of 2002 and provisions are in place for further increases in the future. An increased limit was added for individuals age 50 and above.

The Roth IRA became available January 1, 1998. While not deductible, it offers federal income tax-free growth.

Educational IRAs were renamed as of 2002 and are called Coverdell Education Savings Accounts. For information see IRS Publication 970—Tax Benefits for Higher Education.

The specifics for each type of IRA are complex. Read carefully news reports and related information. Watch for the fine points that are easily missed or can be misleading.

• The Roth income is "Tax free!" What does that mean? It may not be what you think.
• Do you qualify?
• How much can be contributed each year and when must funds be withdrawn? Penalties are very costly for contributing too much or for waiting too long to begin withdrawals from a traditional IRA.

Factors that will determine eligibility for each type of IRA and points to be considered in the decision include:

• Type of income and amount of adjusted gross income (AGI)
• Participation in an employer-sponsored retirement plan
• Federal tax rate, current and future
• Rate of return on investment
• Other available options such as a 401(k) (especially if employer matches or contributes)
• Your age
• Number of years to retirement OR number of years to the time you will need the money
• Personal/family's long range plans
• Distribution options and penalties
• Available cash

Type of Income: Only earned income/compensation, such as salary and wages, as defined in IRS Publication 590 may be invested in either the traditional or Roth IRA. (For example, pension and investment income do not quality.)

Contribution limits for an IRA total $3,000 per year per person in 2002-2004 with an additional $500 for those 50 years of age and older. Recent changes in regulations provided for phased-in increases in the contribution limits: $4,000 in 2005 through 2007; $5,000 in 2008 with limits indexed in future years. IRA catch-up provisions will increase those limits for those 50 and older by $1,000 starting in 2006.

Minimum deposits in an IRA will vary with the financial institution and type of investment. Some businesses will set up an IRA for a monthly deposit or small initial investment.

Roth IRA

"Roth" is not a financial term. The Roth IRA is named after the sponsor of the original legislation, Sen. William V. Roth, Jr. (R-Del).

Eligibility

A person is eligible at any age with earned income.

• Joint filers whose current adjusted gross income (AGI) is less than $150,000.
  There is phase-out scale between $150,000-160,000.
  (Can not participate if your AGI is more than $160,000.)
• Single filers whose AGI is less than $95,000
  (no participation if AGI is more than $110,000);
  phase-out scale is between $95,000-$110,000.

How It Works

Contributions to a Roth IRA are NOT deductible from federal income tax.

Qualified distributions are not taxed upon withdrawal, so earnings and growth are free from FEDERAL INCOME TAX after minimum of five years. NOTE—Some states may tax this income. Also, it is not clear how the Roth interest/growth will affect the tax on Social Security receipts and calculations for alternative minimum tax.

Penalties may apply for withdrawals within the five year minimum. After five years, contributions may be taken out. It is assumed that contributions are withdrawn first.

Distributions from interest/growth before age 59¹/₂ are generally subject to a 10 percent penalty. Exceptions are withdrawals:

• for education.
• up to $10,000 for first-time home buying.
• in the event of disability or death.

Distributions need not begin at a specified age.

There is NO excise tax for excess distribution.

Estate Considerations

The Roth IRA is NOT subject to federal income tax in an estate. The effect on estate tax will depend on state and federal tax laws in effect at time of death, marital deduction, beneficiary, etc. (Talk with your attorney.)

Advantages of the Roth IRA

• Eliminates federal income tax on earnings and growth.
• Roth IRA does not have to be withdrawn starting at any age.
• Beneficiary may be able to continue income tax free status.
• Calculations prepared as examples for case studies determined that the Roth IRA provides more income during retirement than other alternatives. (Advantages decrease if tax rate is significantly less during retirement.)

The Question: To Roth or Not to Roth?

Keep up to date on changes in IRAs reported by your broker and in the news and outlined on an introduction page each year in IRS Publication 590. While future legislation may change the Roth IRA, many financial advisors continue to recommend the ROTH IRA as part of investments for long range planning.

HOWEVER, if your employer offers a 401(k) with a matching contribution in good investment options, the 401(k) may be the first choice for a retirement account. Thereafter, consider contributing additional savings into a Roth IRA, if you qualify.

The younger a person starts a savings and investment plan, the larger the fund(s) will be and potential growth is likely to be greater. The benefit of compounding is significant.

On the Internet you can learn more about the Roth IRA at http://rothira.com. This is a very informative site. Beware of archived articles that do not reflect changes to the regulations in 2001.

Traditional IRA—Deductible

Eligibility

People with earned income and NOT in an employer-sponsored retirement plan are eligible, regardless of income level. OR, people with such plans can take a FULL deduction:

• if they file jointly and their AGI in 2002 is under $54,000. (This amount increases each year reaching $80,000 in 2005.)
• single filers whose AGI is under $34,000 in 2002. (This amount increases each year getting to $50,000 in 2005.)

People with an employer-sponsored retirement plan may have a PARTIAL deduction:

• if income is between $54,000 and $64,000 in 2002. (This amount increases each year reaching $100,000 in 2005.)
• single filers whose AGI is between $34,000 and $44,000. (This amount increases each year to $60,000 in 2005.)

There is an age limit because of mandatory withdrawal.

How It Works

Contributions and earnings are not taxed until withdrawal. This is taxed as ordinary income for year of withdrawal.

Distributions before age 59¹/₂ are generally subject to a 10% penalty. Exceptions are withdrawals for:

• Education
• Medical cost above 7.5% of AGI
• Qualifying health insurance
• Up to $10,000 for first-time home purchase
• Disability or death

Distributions must begin by April 1 the year after reaching age 70¹/₂. The penalty for not starting by that time is 50% of what you were required to take out.

Estate Considerations

This type of IRA is subject to income tax for the estate or beneficiary AND it may be part of the estate for estate tax calculations. The effect on an estate will depend on state and federal tax laws in effect at time of death, marital deduction, beneficiary, etc. (Talk with your attorney.)

Advantages

• Lowers income taxes in year of contribution
• Attractive when tax bracket is lower after retirement

Traditional IRA—Non Deductible

File IRS Form 8606 each year you contribute to a non-deductible IRA.

Eligibility

Anyone under 70¹/₂ years of age with earned income.

How It Works

Contributions are after-tax earned income. Investment growth is tax-deferred until withdrawal. Distributions are ordinary income at time of withdrawal. If partially non-deductible, withdrawals are based on ratio. For example, if base is 8% of total value, 92% of withdrawal is subject to ordinary income tax.

Other rules are similar to those of deductible IRAs.

Caution

The non-deductible traditional IRA does NOT make sense if you qualify for a Roth IRA. In each case there would be no current tax savings. With the Traditional IRA, there would be income tax on earnings/growth, mandatory withdrawal, etc. Whereas the Roth IRA withdrawals would be federal income tax free.

Spousal IRA

Eligibility

A working spouse who is not covered by an employer-sponsored plan may have a deductible IRA OR a non-deductible Roth IRA even if spouse is in an employer-sponsored plan, if AGI is less than $150,000.

A non-working spouse and partner may contribute up to $6,000 to IRAs, $3,000 each, as long as the working spouse earns at least $6,000 (or amount of contributions) and meets income and other requirements. If one is 50 or older the limit is $6,500; $7,000 in 2002, if both are 50 years of age or older.

Advantages

• Establishes financial security for spouse
• Separates some resources in individual name for estate tax planning

Rollovers from qualified plan to a traditional IRA

There is no tax event for most rollovers if employer plan meets qualifying standards. However, funds should not come to you but go directly to new plan.*

Conversions from traditional IRA to a Roth IRA

Eligibility

A Traditional IRA can NOT be converted to a Roth IRA:

• If current joint AGI exceeds $100,000.
• Or if married taxpayers file separate returns.

How It Works

At conversion, tax-deferred funds and interest/growth are subject to federal income tax as ordinary income.

There are IRS limitations on the number of conversions in a given time period. Some plans may also limit transfers.

Funds should not come to you but go to your new plan in a "direct transfer."*

Considerations

• Can you pay taxes from other moneys? If not, and you are under 59¹/₂ years of age, 10% penalty is due on amount not put in new plan, as well as federal and state income tax.
• Is there a possibility of exceeding income eligibility limits later in the year? If so, there could be a penalty.
• Will you need the money within the minimum five years? If so, a penalty applies.

Sources

http://www.rothira.com

http://fairmark.com/rothira

IRS, Publication 590 http://www.irs.gov

"New Year, New Ways to Save for Retirement," Investment Intelligence, PaineWebber, January 1998.

Quinn, Jane Bryant, "The Hot New IRAs," Money Watch, Good Housekeeping, January 1998, p. 82.

"Saving for Retirement," AARP Bulletin, January 1998, Vol. 39. No. 1, pp. 10-12.

"Sweeping Tax Law Changes Present New Ways to Save for Retirement and Fund Higher Education," PaineWebber, Fall 1997.

T. Rowe Price Investment Services, Inc. "Comparing a Roth IRA with Other Options for Future Contributions." (On web page in December 1997, www.troweprice.com)

T. Rowe Price Investment Services, Inc., "Should You Convert IRA Assets into the Roth IRA?" (On web page in December 1997, www.troweprice.com)

Terms

AGI—Adjusted Gross Income (last line on front page of IRS form 1040.)

Beneficiary—individual(s) identified to inherit specific property.

CD—certificate of deposit, usually sold by banks with principal insured by FDIC.

Contribution—your deposit in a retirement plan.

Conversion—change from a traditional IRA to a Roth IRA. This is a taxable event.

Deductible—(as it applies to an IRA) adjustment to the amount of income for current year. Part of the calculation to determine AGI on IRS 1040 form.

Direct transfer—movement of retirement funds from one plan directly to another qualified plan, without owner taking possession.

Earned income—wages and salaries and other sources resulting from current work. (Does not include pension income or interest and dividends on investments.)

Growth/Income—increased value of investment from changes in market price plus earnings.

Ordinary income—the current income from various sources that are subject to standard income tax rates in effect for the tax year, such as W2 salary/wages, dividends and interest on 1099 statements.

Penalty—additional tax due when conditions of plan are not fulfilled, such as early withdrawal before age 59 or before the five-year minimum for a Roth IRA. Late withdrawal from a traditional IRA is another example of a penalty.

Rollover—transfer of funds from a plan such as a 401(k) or 403(b) to a traditional IRA. The term is also used for change from one IRA investment to another. This is a non-tax event.

Tax-deferred—not taxed in current year but will be part of income later, usually at time of withdrawal. In many cases such income is considered as "ordinary income." In that case, none of the income would be "capital gains" even if growth comes from increases in value for mutual fund or stock.

For Additional Information

Ohio Division of Securities
1-800-788-1194
www.securities.state.oh.us

U.S. Securities and Exchange Commission
450 Fifth Street NW
Washington, DC 20549
202-942-7040
www.sec.gov

Invest for Your Future
www.investing.rutgers.edu
or contact your local Extension office

Mutual Funds Education Alliance
www.mfea.com

Alliance for Investor Educator
www.investoreducation.org

Roth IRA
http://rothira.com
http://www.smartmoney.com/retirement/ira
http://www.smartmoney.com/retirement/roth

Internal Revenue Service
www.irs.gov

*When funds are moved directly from one plan to another, the entire balance may be transferred. However, if account is paid to you there is 20% withholding for federal income tax. Once you open a new account, you may qualify for an income tax refund when you file your next return, but in the meantime you will need funds to make full deposit.

Trade names, suppliers, or other private labels are used for identification. No product endorsement is implied nor is discrimination intended toward similar products or services not mentioned or listed. OSU Extension makes no warranty or guidance of any kind, expressed or implied, concerning the use of these products.

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