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Individual Retirement Accounts and Annuities
You have asked for general information about the law of individual retirement accounts and individual retirement annuities (both referred to herein as "IRAs"). Many of the rules discussed below reflect changes in the law made by the Economic Growth and Tax Relief Reconciliation Act of 2001.
Within limits, you may deduct the amount of your annual contributions to an IRA. The deduction is not an itemized deduction. Because it reduces gross income, the deduction is useful even if you cannot itemize.
You may open or contribute to an IRA even after the end of your taxable year (which is generally the calendar year) but still take a deduction on your tax return for that year for any contributions you actually make on or before April 15. For example, in computing your taxes early in the year you may find you will owe the government additional money. You may be able to use savings or other funds to place up to the maximum dollar amount limit in an IRA by April 15, thereby generating a deduction for use on the tax return in lowering taxable income, which reduces or even eliminates your taxes. Further, the deduction can be taken on a return even before the actual IRA contribution is made, so long as it is actually made on or before April 15.
The maximum amount that can be contributed to an IRA and deducted on your income tax return is the lesser of your compensation or $3,000 for 2002 through 2004; $4,000 for 2005 through 2007; and $5,000 for 2008 and thereafter. The $5,000 amount will be indexed for inflation in increments of $500 for years beginning after 2008. Individuals who have who have attained age 50 may make additional catch-up IRA contributions. The otherwise maximum contribution limit for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005 and by $1,000 for 2006 and thereafter. Thus, the deductible limits for such individuals are $3,500 for 2002 through 2004; $4,500 for 2005; $5,000 for 2006 and 2007; and $6,000 for 2008 and thereafter (subject to inflation adjustments).
A steady program of annual contributions can cause the value of an account or annuity to rise dramatically due to the generally tax-free accumulation of earnings allowed by the Internal Revenue Code. (Investments sometimes generate unrelated business taxable income, however.) Although investment earnings are eventually taxed when withdrawn, the present value concept produces a substantial economic advantage by deferring payment of taxes on earnings for as much as 30 or 40 years. Further, you may be in a lower tax bracket when the contributions and earnings are withdrawn and taxed. Mandatory distribution rules similar to the rules that require mandatory distributions from qualified plans after reaching age 70 1/2 apply to regular IRAs.
It is not necessary for you to make contributions to an IRA each year. For example, you may decide not to make contributions for some years due to personal financial considerations. Even if you make no contributions for a year, the amounts already held in the IRA can remain invested. Contributions can be resumed any time in the future until you reach age 70 1/2, when no further contributions are allowed.
A primary tax planning pitfall is the cutback or elimination of deductions for IRA contributions if you are an "active participant" under your employer's retirement plan. A single dollar in contributions on your behalf under an employer's plan may result in loss of your ability to deduct any IRA contributions for the year. This result is usually unavoidable, unless your employer's plan is a defined contribution plan which offers employees the opportunity to opt out of participation in the plan. In that case the advantage of "free" contributions under the plan must be weighed against the value of the ability to make fully deductible IRA contributions. If you are a participant in a plan offering salary reduction elections (a cash or deferred arrangement, a salary reduction SEP arrangement, or a salary reduction tax-sheltered annuity program), thought should be given as to whether the making of salary reduction contributions is worth the loss of fully deductible IRA contributions. Although a certain amount of income from salary can be so deferred, thereby avoiding income tax on the amount, a single dollar of such deferrals will result in active participant status. In general, one would not want to make salary reduction deferrals unless the employer also makes nonelective contributions, or unless your salary reduction amounts exceed the annual IRA maximum contribution amount.
Your employer should be able to tell you whether you are an active participant in its retirement plan. In general, if your employer's plan is a defined benefit plan and you are eligible to participate (according to the plan's eligibility rules), you will be an active participant (even if no benefits are actually accrued by you for the year). If your employer's plan is a profit-sharing plan and your account receives a share of employer contributions or forfeitures, you will be an active participant. (In some years employers do not make contributions under profit-sharing plans, and in such years you may avoid active participant status if no forfeitures are allocated to your account. Forfeitures are caused when other employees leave employment and forfeit part or all of their benefits under the plan, which are shared among the remaining employees' accounts.) Each year your employer is responsible for informing you of your active participant status by checking the appropriate box on your annual Form W-2.
Even if you are an active participant, you still may be able to make a fully deductible contribution. You will suffer no deduction cutback if your adjusted gross income ("AGI") is below certain levels. For individuals who are single or who are married filing separately and do not live with their spouse at any time during the year, this limit is $34,000 in 2002; $40,000 in 2003; $45,000 in 2004; and $50,000 in 2005 and thereafter. For married individuals filing a joint return, this limit is $54,000 in 2002; $60,000 in 2003; $65,000 in 2004; $70,000 in 2005; $75,000 in 2006; and $80,000 in 2007 and thereafter. However, if you are married filing separately from your spouse and you live with your spouse at any time during the year, the cutback is particularly severe.
For AGI above those amounts, the cutback for active participants is on a sliding scale resulting in a complete elimination of the deduction when the AGI is $10,000 over those amounts ($20,000 for a joint return after 2006). For example, in 2002, an unmarried taxpayer loses all of his deduction if his AGI reaches $44,000. The sliding scale is a simple straight-line type of cutback; if you are single and, in 2002, your AGI is $39,000 which is halfway between $34,000 (when there is no cutback) and $44,000 (when all of the deduction is eliminated), you would be entitled to half of the maximum $3,000 deduction for individuals who do not reach age 50 that year. An individual is not considered an active participant in an employer-sponsored retirement plan merely because the individual's spouse is an active participant. Thus, a non-active participant, whose spouse is an active participant, can make deductible IRA contributions. However, these deductible IRA contributions are phased-out for taxpayers with AGI between $150,000 and $160,000.
Adjusted gross income is your gross income from all sources, but some non-itemized deductions are subtracted, including certain trade or business deductions, alimony payments and deductions taken by self-employed individuals for contributions to qualified plans. You would not have to subtract itemized deductions or the deductions for personal exemptions.
To the extent your deductible limit has been cut back or eliminated, you usually can "top up" your IRA to the full amount by designating the remainder as nondeductible contributions. You must file a special form with your tax return for the year to make this designation (Form 8606).
Because nondeductible contributions are made using "after-tax" dollars (by definition, you can take no deduction for them in computing your taxes), withdrawals of nondeductible contributions from an IRA are tax-free. Unfortunately, the Internal Revenue Code provides that they cannot be distributed first. Instead, any distribution would be partially a tax-free return of nondeductible contributions and the remainder (likely to be the majority) will be attributable to deductible contributions and earnings (including earnings on the nondeductible contributions), which are fully taxable to you. Because the portion attributable to a return of nondeductible contributions is not taxable, it does not draw the usual 10% additional tax for distributions before age 59 1/2, but investment earnings would. Still, the opportunity to make nondeductible contributions means an individual who is willing to save until age 59 1/2 has the ability to place savings in a tax-sheltered account or annuity where the funds will grow faster than if they had been invested in an instrument producing taxable earnings.
Effective for distributions occurring after December 31, 2001, distributions from an IRA generally can be rolled over into a qualified plan, §403(b) annuity, or §457 plan. However, qualified plans, §403(b) annuities and §457 plans are not required to accept rollovers. Also, employee after-tax contributions may be rolled over into a traditional IRA.
First-Time Homebuyers
An individual may withdraw up to $10,000 (during the individual's lifetime) from his or her IRA for expenses of purchasing a home for the first time without incurring the 10% early withdrawal penalty. The withdrawal must be used within 120 days to pay costs (such as any reasonable settlement, financing or other closing costs) of acquiring, constructing, or reconstructing a principal residence of a first-time homebuyer. The 10% additional income tax on early withdrawals applies to any amount not so used. If the 120-day rule cannot be satisfied due to a delay or cancellation of the acquisition or construction of the residence, the taxpayer may recontribute the amount withdrawn to an IRA before the end of the 120-day period without incurring adverse tax consequences.
The first-time homebuyer must not have had an ownership interest in a principal residence during the two-year period ending on the date of acquisition of the principal residence. The acquisition date is the date on which the individual enters a binding contract to acquire the principal residence or begins construction or reconstruction of that principal residence. The individual's spouse also must satisfy the ownership interest requirement as of the date the contract is entered into or construction commences.
Nonrefundable Credit for IRA Contributions
Effective for taxable years beginning after December 31, 2001 and before January 1, 2007, there is a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a traditional or Roth IRA. The maximum annual contribution eligible for the credit is $2,000.
The credit rate depends on the taxpayer's AGI. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable to single taxpayers apply to married taxpayers filing separate returns. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution.
The credit rates based on AGI are as follows.
Head of
Joint Filers Households All Other Filers Credit Rate
$0 - $30,000 $0 - $22,500 $0 - $15,000 50 percent
$30,000 - $22,500 - $15,000 - 20 percent
$32,500 $24,375 $16,250
$32,500 - $24,375 - $16,250 - 10 percent
$50,000 $37,500 $25,000
Over $50,000 Over $37,500 Over $25,000 0 percent
Deemed IRAs under Employer Plans
For taxable years beginning after December 31, 2002, if a qualified plan, a §403(a) or §403(b) annuity plan, or a governmental §457 plan permits employees to make voluntary employee contributions to a separate account or annuity that (1) is established under the plan, and (2) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the Internal Revenue Code. For example, the reporting requirements applicable to IRAs apply. Under this provision, the deemed IRA and contributions thereto are not subject to the Internal Revenue Code rules pertaining to the eligible retirement plan. In addition, the deemed IRA and contributions thereto are not taken into account in applying such rules to any other contributions under the plan. The deemed IRA and contributions to it are subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan; however, they are not subject to the ERISA reporting and disclosure, participation, vesting, funding, and enforcement requirements applicable to the underlying plan.
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Roth Individual Retirement Accounts
You are permitted under the tax code to make non-deductible contributions to a Roth IRA. The primary tax benefit of a Roth IRA is that "qualified" distributions are tax free if certain requirements (discussed below) are met. As with regular IRAs, the earnings in a Roth IRA build up tax free. Two types of contributions can be made to Roth IRAs: regular contributions and qualified rollover contributions. A traditional IRA may be converted into a Roth IRA and the tax on the previously untaxed contributions and earnings to the traditional IRA is paid in the year of conversion. Unlike traditional IRAs, contributions can be made to Roth IRAs even after age 70 1/2, and the mandatory distribution rules do not apply to Roth IRAs.
The maximum amount that can be contributed to a Roth IRA is the lesser of your compensation or $3,000 for 2002 through 2004; $4,000 for 2005 through 2007; and $5,000 for 2008 and thereafter. The $5,000 amount will be indexed for inflation in increments of $500 for years beginning after 2008. Individuals who have who have attained age 50 may make additional catch-up contributions. The otherwise maximum contribution limit for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005 and by $1,000 for 2006 and thereafter. Thus, the Roth IRA contribution limits for such individuals are $3,500 for 2002 through 2004; $4,500 for 2005; $5,000 for 2006 and 2007; and $6,000 for 2008 and thereafter (subject to inflation adjustments). The dollar limit is reduced for any contributions made to regular IRAs, but not to simplified employee pensions (SEPs) or saving incentive match plans for employees (SIMPLE IRAs). If you cannot (or do not) make contributions to a deductible IRA or a Roth IRA, you may contribute to a nondeductible IRA. However, in no case can contributions to all of your regular IRAs and Roth IRAs for a taxable year exceed the above annual contribution limits.
The Roth IRA contribution limit (determined without taking into account deductions for regular IRA contributions) is phased out for taxpayers with a modified adjusted gross income ("AGI") of between $95,000 and $110,000 for single taxpayers; between $150,000 and $160,000 for married taxpayers filing joint returns; and between $0 and $10,000 for married taxpayers filing separate returns.
Excess contributions and earnings on contributions must be removed before you file your federal income tax return for the contribution year. Excess contributions that are not taken out of a Roth IRA are subject to a 6% excise tax. However, Treasury regulations permit a taxpayer to remove IRA contributions, including Roth IRA conversions, for which the taxpayer was not eligible because of the income limits mentioned above. Also, you may re-characterize all or part of an IRA contribution. You may re-characterize contributions by transferring the assets and their earnings to other IRAs. For example, if your income exceeds the AGI limit, you are unqualified to make to a contribution. If you mistakenly make the contribution anyway, you can re-characterize it by transferring it in a trustee-to-trustee transfer from the trustee of the first IRA to the trustee of the second IRA. In order for the re-characterization to be effective, the transfer must be made on or before the due date (including extensions) for filing your federal income tax return for the taxable year for which the contribution was made to the first IRA. Contributions that cannot be re-characterized include rollover contributions from a pension plan or §401(k) plan.
Although contributions to Roth IRAs are not deductible, you can receive "qualifying distributions" from Roth IRAs tax free: (1) after age 59 1/2; (2) on account of death or disability; or (3) for qualified first-time home buyer expenses. In order for a distribution to be tax free, your Roth IRA must exist for at least five tax years. Generally, if a distribution is not a "qualified distribution," you will be taxed on the earnings attributable to your contributions to the Roth IRA. Non-qualifying distributions are included in income and subject to a 10% early distribution tax unless an exception applies.
The entire amount in your Roth IRA must be distributed within five years of your death unless this amount is distributed over the life expectancy of a designated beneficiary beginning before the end of the calendar year following the year of your death.
Taxpayers with an adjusted gross income of less than $100,000 (and, if married, who file a joint return) are eligible to roll over or convert a traditional IRA into a Roth IRA. However, this transaction is treated as a taxable distribution, which means taxes are owed on deductible amounts contributed to the traditional IRA that are attributable to the contribution. Rolled over amounts are not counted toward the annual contribution limit. Taxpayers who have funded their IRAs with contributions that were not tax deductible are in the best position to roll over an existing IRA into a Roth. The tax liability may be too large for taxpayers that funded IRAs with deductible contributions to justify the transfer.
First-Time Homebuyers
An individual may withdraw up to $10,000 (during the individual's lifetime) from a Roth IRA for expenses of purchasing a home for the first time without incurring the 10% early withdrawal penalty. The withdrawal must be used within 120 days to pay costs (such as any reasonable settlement, financing or other closing costs) of acquiring, constructing, or reconstructing a principal residence of a first-time homebuyer. The 10% additional income tax on early withdrawals applies to any amount not so used. If the 120-day rule cannot be satisfied due to a delay or cancellation of the acquisition or construction of the residence, the taxpayer may recontribute the amount withdrawn to an IRA before the end of the 120-day period without incurring adverse tax consequences.
The first-time homebuyer must not have had an ownership interest in a principal residence during the two-year period ending on the date of acquisition of the principal residence. The acquisition date is the date on which the individual enters a binding contract to acquire the principal residence or begins construction or reconstruction of that principal residence. The individual's spouse also must satisfy the ownership interest requirement as of the date the contract is entered into or construction commences.
Nonrefundable Credit for IRA Contributions
Effective for taxable years beginning after December 31, 2001 and before January 1, 2007, there is a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a traditional or Roth IRA. The maximum annual contribution eligible for the credit is $2,000.
The credit rate depends on the taxpayer's AGI. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable to single taxpayers apply to married taxpayers filing separate returns. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution.
The credit rates based on AGI are as follows.
Head of
Joint Filers Households All Other Filers Credit Rate
$0 - $30,000 $0 - $22,500 $0 - $15,000 50 percent
$30,000 - $22,500 - $15,000 - 20 percent
$32,500 $24,375 $16,250
$32,500 - $24,375 - $16,250 - 10 percent
$50,000 $37,500 $25,000
Over $50,000 Over $37,500 Over $25,000 0 percent
Deemed IRAs under Employer Plans
For taxable years beginning after December 31, 2002, if a qualified plan, a §403(a) or §403(b) annuity plan, or a governmental §457 plan permits employees to make voluntary employee contributions to a separate account or annuity that (1) is established under the plan, and (2) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the Internal Revenue Code. For example, the reporting requirements applicable to IRAs apply. Under this provision, the deemed IRA and contributions thereto are not subject to the Internal Revenue Code rules pertaining to the eligible retirement plan. In addition, the deemed IRA and contributions thereto are not taken into account in applying such rules to any other contributions under the plan. The deemed IRA and contributions to it are subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan; however, they are not subject to the ERISA reporting and disclosure, participation, vesting, funding, and enforcement requirements applicable to the underlying plan.
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