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IRA-Based Plans
An IRA is essentially a “no fuss, no muss” situation.
The IRA-based plans range from one with little employer involvement to ones that the employer establishes and funds.
Individual Retirement Accounts
An IRA is the most basic sort of retirement arrangement. People tend to think of an IRA as something that just individuals do (hence the “I” in IRA). But an employer can help its employees to set up and fund their IRAs. With an IRA, what the employee gets at retirement depends on the funding of their IRA and the earnings (or income) on those funds.
There are four types of IRA-based plans:
Payroll Deduction IRA
Under a Payroll Deduction IRA, an employee establishes an IRA (either a Traditional IRA or a Roth IRA) with a financial institution. The employee then authorizes a payroll deduction for the IRA with the remainder of the employee’s pay distributed to the employee as before.
Traditional IRA – A traditional IRA is a personal savings plan that gives you tax advantages for saving for retirement. Contributions to a traditional IRA may be tax deductible – either in whole or in part. Also, the earnings on the amounts in your IRA are not taxed until they are distributed. The portion of the contributions that was tax deductible also does not get taxed until distributed. A traditional IRA can be established at many different financial institutions, including banks, insurance companies and brokerage firms.
Roth IRA – A Roth IRA is also a personal savings plan but operates somewhat in reverse compared to a traditional IRA. For instance, contributions to a Roth IRA are not tax deductible while contributions to a traditional IRA may be deductible. However, while distributions (including earnings) from a traditional IRA may be included in income, the distributions (including earnings) from a Roth IRA are not included in income. For both IRA types – traditional and Roth – earnings that remain in the account are not taxed. A Roth IRA can be established at the same types of financial institutions as a traditional IRA.
SARSEP
A SARSEP - the Salary Reduction Simplified Employee Pension Plan - is a SEP set up before 1997 that includes a salary reduction arrangement. Because this is a simplified plan, the administrative costs should be lower than for other more complex plans. Instead of establishing a separate retirement plan, in a SARSEP, employers make contributions to their own Individual Retirement Account (IRA) and the IRAs of their employees, subject to certain percentages of pay and dollar limits.
SEP
A SEP is a Simplified Employee Pension plan. A SEP provides employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Contributions are made directly to an IRA set up for each employee (a SEP-IRA).
SIMPLE IRA Plan
A SIMPLE IRA plan is a Savings Incentive Match Plan for Employees. It gives small employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an IRA set up for each employee (a SIMPLE-IRA).
Q. How does an IRA work?
A. You invest money in an IRA, up to the amounts allowable under the tax law. These investments are termed "contributions." In many instances an income tax deduction is available for the tax year for which the funds are contributed. The contributions, as well as the earnings and gains from these contributions, accumulate tax-free until you withdraw the money from the account. You therefore enjoy the ability to generate additional earnings, unreduced by taxes on these earnings, each year the funds remain within the IRA.
The withdrawals of the funds from the IRA are termed "distributions." Distributions are subject to income taxation, generally in the year in which you receive them. (Remember that in most cases you received an income tax deduction when you contributed the money to the IRA.) As with most things involving the government, the rules for distributions are more complicated than they need to be.
Since the original purpose of the IRA is to assist you in providing for your own retirement, there is a disincentive for withdrawing your IRA funds prior to an assumed retirement age of 59 1/2. This disincentive takes the form of a tax "penalty" in the amount of 10 % of the distributions received by you prior to age 59 1/2, unless certain exceptions apply. Given the complexity of this issue alone, professional advice should be obtained whenever significant amounts of distributions are needed prior to age 59 1/2. The fact is that many times the penalty can be avoided with proper planning. Obviously these distributions, whether before age 59 1/2 or later, are subject to income taxation upon receipt. Once you are age 59 1/2 this penalty, termed a "Premature Distribution" penalty, is no longer applicable.
On the flip side of the government not wanting you to withdraw your money at too young an age, it also has rules to prevent you from not withdrawing the money soon enough. (This is done in order that the government can tax it.) You usually need to begin taking money from your IRA no later than April 1 of the calendar year following the date you attained age 70 1/2. The rules established by the government regarding these Required Minimum Distributions, their timing, the amounts, the recalculations, and the effect various beneficiary designations have on them, are among the most complex of the Internal Revenue Code. The penalty is 50 % of the shortfall between what you should have withdrawn and the amounts you actually withdrew by the proper date. This punitive penalty is matched only by the civil fraud penalty in severity. The necessary calculations are therefore not something that most individuals should attempt on their own.
Q. What are the different types of IRA’s?
A. There are five different types of IRA’s:
1. TRADITIONAL IRA
You can contribute up to $2,000 per year into an IRA. The amount of this contribution that is deductible on your income tax return depends on your Adjusted Gross Income (AGI) and whether you are covered under an employer sponsored qualified retirement plan. Thus, depending on your filing status (Single, Joint, etc), and your AGI, your contributions may range from fully deductible to totally non-deductible. So even though you are eligible to contribute to your IRA, you may be in a position where none of these contributions are in fact deductible.
2. EDUCATION IRA
You can put away up to $500 per year into an education IRA, the money grows tax-free and has preferential tax treatment upon distribution to the beneficiary who uses it for authorized education expenses. These plans are not very common in that they are very restrictive on who can make contributions to them, the amount of total contributions allowable each year, and the limitations on what exact education expenses qualify. Your financial planner should be able to assist you in evaluating what savings plan you should undertake to prepare for higher education costs, as well as in reviewing many of the tax-sheltered savings plans now sponsored by the various states, even for benefits of non-state residents.
3. SEP IRA - Simplified Employee Pension
This is an employer established and funded Simplified IRA, where the employer can put up to 15% of your compensation into a special IRA account. Sole proprietors may establish these plans for their own benefit. They are sometimes used instead of Keogh retirement plans because they have fewer administrative and tax filing requirements.
4. SIMPLE IRA
This is a rather new creation, but rapidly becoming more popular. It’s another employer sponsored and administered retirement plan. The attractive features of this plan includes not only the ability for the employer to establish and fund a retirement plan for the benefit of him/herself and his/her employees, but it also permits employees to contribute up to 100 %, but no more than $6,500 per year, into an IRA. Separate rules relative to required employer contributions and premature distributions apply.
5. ROTH IRA
Contributions are NOT deductible when the funds are contributed, but the Roth IRA earnings accumulate tax-free and remain tax-free upon distribution. To be eligible to contribute, your Adjusted Gross Income must be under $95,000 for singles and $150,000 for married couples, as of December 2000. You cannot withdraw your funds within the first 5 years after the establishment of the Roth without a penalty. Given that this 5-year testing period can successfully be addressed by proper tax planning, the establishment and at least partial funding of a Roth IRA account should be on the discussion list of the financial advisor of every taxpayer who qualifies to open such a plan
Q. Are there any changes affecting Required Minimum Distributions (RMD)s in the Internal Revenue Service’s April 17, 2002 release of the finalized regulations for IRAs?
A. The IRS first released its proposed regulations for IRAs and other qualified plans in January 2001. The final rules, released April 17, 2002, and effective as of January 1, 2003, generally keep last year's simplifications and add some new elements, incorporating many suggestions that were made after the proposed regulations were released. (However, the section dealing with annuity payments has been substantially changed and was issued as a temporary regulation, giving taxpayers a chance to offer additional feedback.) The final rules make it easier for taxpayers to calculate their required minimum distribution (RMD), and, in general, reduce the resulting amount. This means that people can stretch out their payments - and enjoy the tax shelter - for a longer period of time. The final rules also address a number of aspects related to the designated beneficiary, but here we'll focus on the new rules for RMD calculations.
According to the Federal Register, IRA owners must begin taking an annual RMD from their account on "April 1 of the calendar year following the calendar year in which the [taxpayer] attains age 70 1/2, even if the [person] has not retired" (Vol. 67, No. 74, p. 18988). Taxpayers determine their RMD by dividing their account balance by the appropriate distribution period. The good news is that the distribution period is now based on one uniform table, with an identical distribution period for almost all taxpayers of the same age. The table is based on the combined life expectancy of the individual and a hypothetical beneficiary who is ten years younger. If the sole beneficiary is a spouse who is more than ten years younger, it is possible to use another calculation, instead of the uniform table, which extends the distribution period. Moreover, the new rules include updated life expectancy figures that reflect projected mortality improvement through 2003. The end result is that most taxpayers can use a longer distribution period with a lower annual RMD.
After the individual's death, the RMD is generally calculated using the beneficiary's remaining life expectancy (based on the beneficiary's age in the year after the individual's death, which is reduced by one for each following year). If there is no designated beneficiary, the RMD is based on the individual's life expectancy in the year of death (and reduced by one for each following year).
In the past, RMD calculations were criticized for using too many variables that could change in the individual's life during any given year. This would complicate the calculations by creating different parameters for different times of the year and by making many people unsure how to determine the RMD accurately. In response, the final rules include some additional simplifications. For example, a person's marital status is determined on January 1, regardless of whether divorce or a spouse's death occurs later that year. If the beneficiary changes, due to a spouse's death, any changes in the life expectancy calculations will not come into play until the following year. Also, the account balance of an IRA or other qualified plan is now determined by the balance on the preceding December 31; any contributions or distributions made after that date are disregarded, when computing the RMD for the following year. For example, if on December 31, your IRA balance is $50,000, and you add $2,000 on Jan. 1 of the following year, your RMD calculation is based on the $50,000, not $52,000.
Taxpayers will also be getting additional help in calculating their RMD. The new rules specify that, beginning in 2003, banks, brokers, and other IRA trustees must report the RMD amount to IRA owners or calculate it for them upon request. The trustees are not required to report the RMD to the IRS, but, beginning in 2004, they will have to identify to the IRS each IRA for which an RMD is required. So taxpayers will also have to be extra careful to not miss any required distributions, since the IRS will have a complete report on which IRAs to check.
According to IRS News Release IR 2002-50, dated April 16, 2002, taxpayers have several options for the 2002 tax year regulations. They may use the final 2002 regulations, the 2001 version of the proposed regulations, or the original 1987 version of the proposed regulations.
With all of these options to consider and the complexity of the rules themselves (not withstanding their supposed "simplification"), we highly recommend consulting a qualified tax professional before you need to take any required distributions, and continuing to consult with them on at least an annual basis, as your situation changes and modifications to the rules are released.
Uniform Table - from Federal Register April 17, 2002 (Volume 67, Number 74, p.19012)
Q. Where can I find a copy of the Uniform Lifetime Table published with the final regulations for IRAs in April 2002?
A. Right here. The following table and introduction is taken from the Federal Register: April 17, 2002 (Vol. 67, No. 74, p. 19012)
[Table for]...the applicable distribution period for an individual account for purposes of determining required minimum distributions during an employee's lifetime under section 401(a)(9)[.]
The following table, referred to as the Uniform Lifetime Table, is used for determining the distribution period for lifetime distributions to an employee in situations in which the employee's spouse is either not the sole designated beneficiary or is the sole designated beneficiary but is not more than 10 years younger than the employee.
401K Tips To Consider:
A retirement plan makes good sense and can attract and reward key employees. The benefits and tax advantages of
supplementing Social Security with a qualified retirement plan are significant. A qualified plan is one meeting
Internal Revenue Service (IRS) specifications. Currently, such contributions are tax deductible and earnings accumulate
on a tax-deferred basis. A small California-based company, Target Laboratories (www.targetlab.com) is giving its
employees these significant tax benefits. In addition, benefits earned are not part of the participant's taxable income.
Uniform Lifetime Table
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Age of Distribution
Distribution
Period
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70 ............................... 27.4
71 ............................... 26.5
72 ............................... 25.6
73 ............................... 24.7
74 ............................... 23.8
75 ............................... 22.9
76 ............................... 22.0
77 ............................... 21.2
78 ............................... 20.3
79 ............................... 19.5
80 ............................... 18.7
81 ............................... 17.9
82 ............................... 17.1
83 ............................... 16.3
84 ............................... 15.5
85 ............................... 14.8
86 ............................... 14.1
87 ............................... 13.4
88 ............................... 12.7
89 ............................... 12.0
90 ............................... 11.4
91 ............................... 10.8
92 ............................... 10.2
93 ............................... 9.6
94 ............................... 9.1
95 ............................... 8.6
96 ............................... 8.1
97 ............................... 7.6
98 ............................... 7.1
99 ............................... 6.7
100 ............................... 6.3
101 ............................... 5.9
102 ............................... 5.5
103 ............................... 5.2
104 ............................... 4.9
105 ............................... 4.5
106 ............................... 4.2
107 ............................... 3.9
108 ............................... 3.7
109 ............................... 3.4
110 ............................... 3.1
111 ............................... 2.9
112 ............................... 2.6
113 ............................... 2.4
114 ............................... 2.1
115+ ............................... 1.9
Q. What are the new contribution limits for IRAs, 401(k)s, and other retirement plans?
A. The Economic Growth and Tax Relief Reconciliation Act of 2001 enacted a number of changes to the rules regarding IRAs, 401(k)s, 403(b)s, and other retirement plans. One of the areas affected are contribution limits. However, it is important to remember that a number of the changes are being phased in between 2002 and 2010. Also, the Act does not apply to tax years after 2010. It will be up to Congress to renew or change the law; they may even do so well before 2010.
Traditional and Roth IRAs
Contribution limits for Traditional and Roth IRAs will rise from $2000 to $5,000 between 2002 and 2008. After 2008, the limit may be adjusted annually for inflation.
Tax Year Limit
2002-2004 $3,000
2005-2006 $4,000
2008 $5,000
2009-2010 Indexed to Inflation
401(k), 403(b), and 457 Plans
These limits are on pretax contributions to certain employer- sponsored retirement plans. Remember that employers have the option of imposing lower limits than the government maximums, which will rise to $15,000 by 2006.
Tax Year Limit
2002 $11,000
2003 $12,000
2004 $13,000
2005 $14,000
2006 $15,000
2007-2010 Indexed to Inflation
Catch-Up Contributions
"Catch-up" contributions are for people aged 50 and over, in order to balance out the advantages of increased contributions for younger individuals. To be eligible for a catch-up contribution, an individual must first make the maximum regular contribution to his or her IRA or employer-sponsored plan.
Tax Year Catch-Up Contribution
2002-2005 $500
2006-2010 $1000
Catch-up contributions to Traditional IRAs may be tax deductible if the taxpayer meets certain income restrictions.
SIMPLE
A SIMPLE plan is a retirement planning vehicle for small business owners and employees. There is a catch-up contribution available for SIMPLE plans that will be gradually increased to $2,500 by 2006, and then indexed to inflation for 2007 through 2010.
Tax Year Limit
2002 $7,000
2003 $8,000
2004 $9,000
2005 $10,000
2006 Indexed to inflation
There are many other changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, the nuances of which may affect your eligibility for various tax benefits. For instance, the tax-deductible portion of the contribution limits may be reduced depending upon your income. The advice of a qualified professional should always be sought before implementing any tax or financial planning strategy
Q. How much of my IRA contribution is tax-deductible?
A. It depends. First, this does not apply to Roth IRAs; they have different rules. But, for a Traditional IRA, it depends mostly on the amount of taxable compensation you earned in that tax year and whether or not you, or your spouse if married, are an active participant in a qualified plan (click highlighted words for explanation of these terms). Assuming you, or you and your spouse jointly, earned more in taxable compensation than the maximum deductible amount for your IRA contributions, and neither of you are active participants in a qualified plan, you should be eligible to deduct the full amount of your contribution up to the maximum deductible amount.
If you or your spouse is an active participant in a qualified or employer-sponsored plan, then the amount of your contribution that is tax-deductible can be reduced depending on your AGI (adjusted gross income). For example, in 2002, single taxpayers’ deduction starts being reduced at $34,000 AGI, and no part of their contribution is deductible if their AGI is more than $44,000. For jointly filing married couples, the reduction is based on their combined AGI. For 2002, the reduction for them begins at $54,000 AGI, and no part of their contribution is deductible if they earn more than a combined AGI of $64,000.
Q. I am leaving a company and taking my 401K proceeds. How much time do I have to deposit them in an IRA before they are taxed as income?
A. You have 60 days to roll over your distribution if the money was given to you. The best way to do this is to have the company administrator write a check to the IRA ROLLOVER account directly, this makes sure that nothing is withheld in taxes, and is much cleaner. Keep in mind that you can do only one rollover per year, but there is no limit on the number of trustee-to-trustee transfers in a year
Q. What are educational IRAs and how do they relate to many of the state plans that are being offered?
A. Educational IRA’s allow you to put away $500 per year per child. The contributor cannot have an income over $100,000 AGI. If the money is used for authorized college expenses, the proceeds can be taken out tax-free. Some of the state education plans are better because you can put in more money. Issues to consider include: what happens if your child does not go to a college in that state, the possibility of a partial or full scholarship, the possibility that the child will defer going to college for a period of years, that they may attend a non-qualified technical school, or establish a dot.com business in your garage after dropping out of Harvard. Some of the older State plans only work well if your child attends a state college in the state where the plan was established, and are quite inflexible under any other set of circumstances. Many of the newer State plans now favorably address a number of potential alternative circumstances to immediate, in-State college attendance after high school. Your financial planner can assist you in identifying the advantages and disadvantages of the various State plans throughout the country.
Q. What happens if I contribute too much to my IRA?
A. Typically you need to withdraw some or all of the money from the plan, or reallocate it to next year’s contribution. Taxpayers have until the due date for filing the tax return, not including extensions, (generally April 15) to withdraw the excess contributions plus any income generated by the excess contributions. Failure to properly withdraw the excess contributions results in a penalty of 6 % per year, or fraction thereof, based on the amount of the excess contributions. In some circumstances, the withdrawal may be accomplished by reallocating the excess contribution to the following tax year. Consult your financial advisor for more details on the proper procedures.
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and www.run-it-yourself401k.com.
Q. What are the implications for my estate if I leave my investments in my IRA?
A. IRA accounts can be rolled over to a spouse with no immediate income taxation to the decedent, the estate, nor to the spousal beneficiary. If there is no surviving spouse, or when the surviving spouse dies still owning the IRA assets, typically the IRA is highly taxed. Combined income and estate federal tax rates of 65 %, and more, are not uncommon in such situations. State taxes add to this tax burden. First, the IRA is taxed as part of your federal gross estate, whether the named beneficiary of the IRA is the estate, or any non-spousal beneficiary. In addition, the IRA is taxed again as ordinary income to the ultimate beneficiary as distributions are received. Of course, the IRS has rules forcing these beneficiaries to take taxable distributions within a certain time frame beginning with their inheritance of the IRA. Given the unique opportunities available for minimizing both the Estate and Income taxes otherwise due upon the death and subsequent distribution of an individual's IRA, as well as the devastating results of a failure to properly plan and document your intentions, a review session with a qualified financial professional can resolve this matter in your favor.
Q. What type of investment can be used as an IRA?
A. Almost all investments are technically eligible for inclusion in an IRA account, (see ineligible investment assets for a discussion of unauthorized investments), but some are more appropriate than others from a financial investment and/or tax perspective. Most authorized IRA custodians will advise you of any restrictions they place on your access to various investments. You may find that in order to participate in selected investment areas, you need to open IRA accounts with specialized IRA custodians who cater to that industry.
Q. What are the benefits of making a conversion from a traditional IRA to a Roth IRA?
A. Assuming you are eligible to convert, the benefits of making a conversion from a traditional IRA to a Roth IRA include:
Contributions can be made to your Roth IRA after you reach age 70 ½, whereas you cannot make additional contributions to a traditional IRA after attaining age 70 ½.
You can leave amounts in your Roth IRA as long as you live. In other words, unlike the traditional IRA, there is no minimum distribution requirement for amounts in a Roth IRA account.
Qualified Distributions from a Roth IRA are not subject to taxation or penalties, after the plan has been open for at least 5 years.
Q. What is the disadvantage of making a conversion from a traditional IRA to a Roth IRA?
A. The key disadvantage of making a conversion from a traditional IRA to a Roth IRA is:
The amount being converted from a traditional IRA into a Roth IRA is subject to inclusion in your taxable gross income, and thus increases your taxable income and tax, in the year of conversion. You therefore may have a significant tax bill to pay with little or no funds available from the conversion.
There is no penalty imposed on the conversion as long as the full amount of the distribution from the traditional IRA is converted into the Roth IRA. Otherwise, the premature penalty of 10 % of the amounts not converted into the Roth account may apply.
Q. How do I donate an IRA to charity or give as a gift?
A. The best way is to name the charity as the beneficiary of your IRA upon your death. This helps avoid the heavy tax burden when you take money out while still alive. If you withdraw money prior to age 59.5 and donate the money to a charity you will still have a 10% early withdrawal penalty, so if you plan to give them ongoing income, it is better to wait until you are older than age 59.5.
Q. What is an IRA Rollover or Conversion? When do I need to do this?
A. A rollover is when you move a qualified plan or another IRA into a rollover IRA. You can only do one (1) rollover every twelve months. You can do as many trustee-to-trustee transfers as you want per year. A trustee- to-trustee transfer is where your current plan sends the money or assets to another rollover plan. You should have a competent advisor help you with this type of transaction.RRP
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