Ins and Outs of Individual Retirement Accounts
HE-275, Revised, July 1997
Debra Pankow, Family Economics Specialist
Judith E. Lundstrom, Account Representative, Waddell & Reed, Inc.
Individual Retirement Accounts (IRAs) are tax deferred investments that allow
individuals to save for retirement. The Economic Recovery Tax Act of 1981 enhanced the tax
incentives for individuals to save for retirement and made more individuals eligible to
participate in IRAs. The Tax Reform act of 1986 set limitations on who can take a
deduction for IRA contributions. The Act also added non-deductible IRA contributions. New
laws taking effect in January 1997 were included in the Small Business Job Protection Act
of 1996.
Who is eligible?
Anyone who earns compensation during the year can set up an IRA. Compensation is
defined by Internal Revenue Service as wages, salaries, tips, commissions, professional
fees and bonuses. Farmers and other small business owners can include their net income as
compensation as long as they are an "active" partner.
Teenagers are also eligible to set up IRAs as long as the money placed into the
accounts is equal to or less than their earned income for that year and does not exceed
$2000. Parents and grandparents may wish to give money gifts for the specific purpose of
replacing the income used to set upor add to an IRA.
Earnings and profits from property, such as rental income, interest or dividend income,
is not considered compensation (this is called `unearned' income). Neither is income
received from an investment in a limited partnership considered compensation unless that
income is in return for services provided to the partnership.
Should everyone have an IRA?
Not necessarily, but it is a good idea for those who can afford it. High demands on
income to set up a household, to save for a down payment on a house, or to invest in a
farm or business may prevent many people from being able to use an IRA to save for
retirement. But when income allows, an IRA can shelter current earnings until retirement.
Also, it is not necessary to save the maximum allowed. Even $500 a year is a start toward
retirement income security. In cases where a 401(k) or 403(b) employee-sponsored plan is
available, it might be wise to also evaluate these tax-advantaged plans.
How much can be invested in an IRA?
The yearly maximum tax deductible contribution to an IRA is $2,000 for singles, $4000
for one-earner families (with a spousal IRA, up from $2250 in 1996) and $4,000 for
families in which both spouses work. If one's total income is $2,000 or less, the entire
amount may be put in an IRA. For example, if your spouse earned $1,700 working on your
farm during the year, the total ($1,700) amount can be deposited in an IRA.
One-earner families may open a special IRA for the non-earning spouse. The working
spouse is responsible for opening the IRA. The couple must decide how to divide the money
(up to $4000) between the two accounts, but no more than $2,000 can be put in either IRA.
Consider which spouse would be eligible to withdraw earliest, without penalty, when
setting up these IRAs.
Contributions over the $2000 maximum per year per person are subject to a 6% penalty.
If a divorce or legal separation occurs, the special IRA can be maintained, subject to
certain conditions. If the special IRA was set up at least five years before the year the
divorce or separation was decreed, and if the earning spouse contributed for three out of
those five years, then a divorced or legally separated non-earning spouse can contribute
up to $1,125 a year out of alimony and incidental earnings. If the former non-earning
spouse now earns income, he or she can contribute up to $2,000 to the IRA.
How many IRAs?
There is no limit to how many IRAs you can set up, but it is recommended that you keep
the number to a manageable amount of accounts that you can easily keep track of.
What can your IRA be invested in?
You can have your IRA invest in just about anything, stocks, bonds, mutual funds, bank
accounts, and more. The important thing is to put your money in for the long term, in
something that will grow. Remember, the growth has to cover the anticipated rate of
inflation, which has averaged about 4% over the last 20 years, plus give you a return on
your investment. For a young person just starting out, perhaps the best choice is a growth
equity mutual fund since the stock market has averaged 10-12% a year. As you approach
retirement, it may be wise to transfer your IRA(s) into more conservative investments.
What about tax deductions for IRA contributions?
Starting with 1987, eligibility for tax deductions for IRA contributions varies with
your income, marital status, and whether you or your spouse participate in a qualified
retirement plan at work.
IRA contributions of up to $2,000 or 100% of the income are permitted if the individual
or married couple do not participate in a retirement plan at work.
If you and your spouse work, participate in qualified retirement plan at work, file a
joint return, and have an adjusted gross income (AGI) of $40,000 or less ($25,000 for
single taxpayer), a full 100 percent of the contribution is deductible. If your AGI is
between $40,000 and $50,000 ($25,000 and $35,000 single) the deduction is gradually phased
out. Deductions are not allowed if a couple's AGI is $50,000 ($35,000 single) or more.
Nondeductible contributions of up to $2,000 can still be made by those people not able
to take a tax deduction for their IRA contribution. Income tax is paid up front on the
contributions. Earnings on nondeductible IRA contributions are not taxed until they are
withdrawn. In the meantime, you have tax-deferred earnings on the contributions you make.
If no other tax advantaged retirement savings options are available, this may be an
excellent way to save for retirement.
How does the tax deduction work?
The tax deduction element of an IRA is quite attractive. If you meet the eligibility
rules, the amount contributed to an IRA is deducted from gross income when figuring income
taxes. For example, if you earn $20,000 annually and contribute $2,000 to your IRA, taxes
are owed only on $18,000. In addition, all the earnings on the money in the IRA is
tax-deferred.
Tax deferred means taxes are only delayed, not eliminated. Deferred taxes will need to
be paid when the money is withdrawn. Since withdrawal is usually during retirement, taxes
may be lower because of less income.
Are there withdrawal rules?
A key to understanding the rules of an IRA is the word "retirement." An IRA
is tax sheltered to encourage retirement savings. The first rule is that contributions
must remain invested until age 59�. Early withdrawal is subject to a 10% penalty on the
amount withdrawn. In addition, the amount withdrawn must be included as taxable income
that year. There may be additional penalties depending on where you have your IRA.
For example, a $10,000 withdrawal before age 59� is assessed a $1,000 penalty by the
Internal Revenue Service. Then, that $10,000 is taxed at the individual's tax rate. If the
tax rate were 25 percent, the individual withdrawing early would owe $2,500 income tax on
the $10,000, plus $1,000 in penalty, leaving a net of $6,500 after penalty and tax
payments.Withdrawals in the event of a death or serious disability are not penalized.
Rules state that withdrawals from an IRA must begin by age 70�. With the new changes,
that does not apply if the individual continues to work. An IRA must be exhausted by the
end of a normal lifetime. For example, a woman retiring at age 65 is expected to live
approximately 19 more years, to age 84. She must withdraw from her IRA at such a rate that
the funds are used by age 84. Under recent rules, life expectancy can be recalculated each
year so that IRA monies will not be outlived. Most trustees will automatically calculate
this amount and notify you.
One key change regarding the taxation of distributions included in the 1996 law
concerns the five year averaging of lump sum distributions. After 1999, the five-year
averaging income tax option on a "lump-sum' distribution will no longer exist.
However, taxpayers born before 1936 will continue to be able to elect a 10-year
averaging calculation and capital gain treatment for the pre-1974 portion of a
"lump-sum" distribution.
What about excess distributions?
During 1997, 1998 and 1999, the 15% excise tax on excess distributions from qualified
retirement plans, tax-sheltered annuities and IRAs will be suspended. The excess
distribution is the amount by which the distributions made during a calendar year exceed a
threshold dollar amount, which, indexed for inflation, was $155,000 in 1996; the dollar
limit is five times the threshold amount or $755,000 for 1996.
How does death affect an IRA?
A beneficiary is designated when an IRA is opened. At the account owner's death, the
beneficiary receives the funds, which are considered taxable income on receipt, unless the
beneficiary is your spouse. An IRA is not subject to federal estate taxes if it is paid to
the beneficiary during his or her lifetime or during a period of at least 36 months.
However, a lump sum payment to the beneficiary is included as part of the estate for
federal tax purposes.
Can an IRA be moved?
Yes, an IRA can be moved. This move is called a rollover or a transfer. The move is
called a rollover if you move money from one IRA to another IRA and if the withdrawal
check is made out to you. You can do this once every 12 months. The reinvestment must be
made by the 60th day after the day you withdraw the money from your IRA. If made after the
60th day, you will incur the 10% penalty and taxation discussed earlier.
The move is called a transfer if you make that same move, but have the check made out
to the trustee of your new IRA. The money is `transferred' to the new IRA for you. You may
make transfers as often as you wish.
A rollover or transfer is necessary to change investment instruments, such as to move
from a bank's certificate of deposit (CD) to a mutual fund company. Most financial
professionals will recommend a transfer because of the simplicity there will be less
paperwork at tax time. A rollover or transfer may involve a fee or penalty imposed by the
institution. For instance, early withdrawal from a bank CD may involve a penalty equal to
six month's interest.
How do you set up an IRA?
Setting up an IRA is easy. You will need to deal with an IRA custodian who has been
qualified with the Treasury Department. A custodian can be a bank, a brokerage house, a
mutual fund company, or an insurance company. Whichever one you choose, you can always
change later and move your funds somewhere else. Be prepared to fill out an application,
designate a beneficiary and make a deposit. For any tax year, you can set one up anytime
until April 15 of the following year.
Where do you set up an IRA?
IRAs are offered by banks, credit unions, savings and loan associations, insurance
companies, mutual funds companies and investment brokers. You will need to shop around to
find the best one for you. Compare interest rates and compounding periods, early
withdrawal penalties, fees, risks, maturity periods, personal management required and
other features you consider important.
Consider the costs involved in establishing an IRA. Federal regulation requires your
IRA be managed by a trustee. That means that the institution you choose for your
investment becomes your trustee. Usually there's a trustee fee (a flat amount or a percent
of your fund) charged for safeguarding your money.
Here are some of the options private financial institutions are offering for an IRA:
Banks, savings and loans, and credit unions
offer a variety of options on IRAs patterned after certificates of deposit (CD). Interest
rates can be fixed or variable. These rates are generally guided by the rates of U.S.
Government securities or other investments. Rates can vary several percentage points among
institutions, so shopping around will pay off. Generally, these financial institutions do
not have management fees but some have penalties for early withdrawal. Accounts in
federally chartered banks, savings and loans, and credit unions are insured up to
$100,000.
Insurance Companies offer individual
retirement annuities. Many insurance companies give investors a choice of investments and
make switching between investments very easy. Rates of return vary greatly. Usually there
is a 3% guarantee but most remain competitive and pay money market rates. Management fees
vary from a fixed fee (about $30 per year) to a percentage of funds invested. Many
insurance companies have a substantial "early" withdrawal penalty of 6 to 10%,
particularly in the early years of the policy. Money in an annuity will not be federally
insured, but state agencies that regulate insurance companies emphasize safety and
diversity in investments.
Mutual fund companies provide a
diversified portfolio of stock, bond or money market securities for an IRA investor. When
you put money in a mutual fund you are pooling your money to buy shares in securities
chosen by professional money managers. Fund families allow an investor to switch among
funds with different investment objectives, such as capital growth, income or money market
funds. Mutual funds do not guarantee a specific rate of return and depend on the fund and
the general economic climate. While there is potential for great gain, there is also a
possibility of loss. Mutual funds are either a "load" where a commission is paid
to a broker, or "no load" where there is no commission paid to a broker. Funds
may charge a management fee of 1% or less based on the value of the shares.
Mutual funds seek to achieve their investment goals through diversified investments,
but there is risk involved. Read and evaluate the prospectus. Money in a mutual fund is
not insured. Client accounts are insured up to $500,000 against loss due to failure of the
mutual fund company.
Investment brokers offer the widest
variety of IRA choices. Brokers can help the investor establish a portfolio of stocks,
bonds, mutual funds, annuities and other investments such as a limited partnership. If you
want to manage your own investments, they can help you arrange for a self-directed
individual retirement trust that will qualify as an IRA. Costs for broker fees and annual
maintenance fees will vary significantly. Investments through a brokerage firm are not
insured against loss due to normal market action. However, client accounts are insured up
to $500,000 against loss due to failure of the firm.
Final points to check
Check to see if your employer is accepting voluntary IRA contribution plans. Find out
if there is a payroll deduction plan for an IRA not related to a pension plan.
If you prefer to locate your own IRA, be sure to shop around. Use the worksheet to
compare your IRA options. Talk to the retirement specialists at various financial
institutions. Consider what you want an IRA to do for you. Assess your willingness to take
risks, your age, and your retirement income needs. Weigh the relative safety of your
investment options. Generally speaking, the closer you are to retirement the more
conservative your investment choice may be, especially if you will be depending on IRA
dollars for income.
Be sure to get the disclosure statement required by law. The trustee must give you an
explanation of all the income tax consequences of opening and maintaining an IRA. If the
rate of return on an IRA is guaranteed or can be reasonably projected, this disclosure
statement must give you a projection of program growth at the end of each of the first
five contract years and at ages 60, 65 and 70. The statement must also give start up and
management costs.
Make a point of understanding the kind of interest, or other return, that is being
offered. Ask how interest will be calculated. Interest rates and fees will vary from
institution to institution. Choose the IRA that meets your investment objectives.
The "time value" of Money
Individual A opens an IRA earning 12%, invests $2,000 a year for six years, then
stops.
Individual B spends $2,000 a year on himself for six years, then opens an IRA
earning 12% and invests $2,000 a year for the next 37 years
Look at age 65 Individual A, who only deposited $12,000, has accumulated nearly as
much money as Individual B, who deposited $74,000!
Start early - let time work for you!
The Magic of Compound Interest and an IRA
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Example A Example B
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Accumulation Accumulation
Age Payment End of Year Payment End of Year
-------------------------- -----------------------
22 $2,000 $2,240 $0 $0
23 2,000 4,749 0 0
24 2,000 7,559 0 0
25 2,000 10,706 0 0
26 2,000 14,230 0 0
27 2,000 18,178 0 0
28 0 20,358 2,000 2,240
29 0 22,803 2,000 4,749
30 0 25,539 2,000 7,559
31 0 28,603 2,000 10,706
32 0 32,006 2,000 14,230
33 0 35,880 2,000 18,178
34 0 40,186 2,000 22,599
35 0 45,008 2,000 27,551
36 0 50,409 2,000 33,097
37 0 56,458 2,000 39,309
38 0 63,233 2,000 46,266
39 0 70,821 2,000 54,058
40 0 79,320 2,000 62,785
41 0 88,838 2,000 72,559
42 0 99,499 2,000 83,507
43 0 111,438 2,000 95,767
44 0 124,811 2,000 109,499
45 0 139,788 2,000 124,879
46 0 156,563 2,000 142,105
47 0 175,351 2,000 161,397
48 0 196,393 2,000 183,005
49 0 219,960 2,000 207,206
50 0 246,355 2,000 264,668
52 0 309,028 2,000 298,668
53 0 346,111 2,000 336,748
54 0 387,644 2,000 379,398
55 0 434,161 2,000 427,166
56 0 486,261 2,000 480,663
57 0 544,612 2,000 540,585
58 0 609,966 2,000 607,695
59 0 683,162 2,000 682,859
60 0 765,141 2,000 767,042
61 0 856,958 2,000 861,327
62 0 959,793 2,000 966,926
63 0 1,074,968 2,000 1,085,197
64 0 1,203,964 2,000 1,217,661
65 0 1,348,440 0 1,363,780
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Additional questions for any investment:
- Do you have the knowledge, skill and time to manage your own investments?
- Would you rather pay an advisor to manage your investments?
- How much risk are you willing to assume?
- What will be the inflation rate?
- What if interest rates rise? Or fall?
- What other sources of retirement income do you have?
- When do you plan to retire?
HE-275 Update -- March 1998
Taxpayer Relief Act of 1997
Implications for IRAs
You can count on more paperwork, more time in education and understanding! The new tax
law brings more than 1,000 changes to tax code, many breaks narrowly targeted and phased
in over a period of years. Many details are not yet clear. IRS publication 553 will be
available in January 1998 and should explain the implications of the new laws.
There are now more options for IRAs, and many more taxpayers should be eligible for
some sort of an IRA. There is, however, a maximum contribution of $2000 per person to all
individual's IRAs per year, with the exception of the Education IRA, where contributions
can be made on top of an individual's $2000 maximum IRA contribution.
Deductible IRAs
The income levels for full deduction have gone up (to $30,000 for single taxpayers in
1998, rising to $50,000 in 2005 and to $60,000 in 2007; to $50,000 for joint filers, up to
$80,000 by 2005, and to $100,000 in 2007).
If one spouse is covered under a qualified plan at work, but the other is not, the
first spouse will be able to deduct an IRA contribution up to $2000 a year as long as the
family Adjusted Gross Income is under $150,000.
Roth IRA - The "New" IRA
This IRA is called back-loaded because the tax breaks come later on. Contributions are
not deductible, but contributions can be withdrawn penalty and tax free after five years
and after age 59� or up to $10,000 for first-time home-buyers.
Early withdrawals will suffer a 10% penalty and tax. Couples with AGI up to $150,000
and singles to $95,000, regardless of whether or not they have retirement plans, can
contribute up to $2000 each (phases out at $110,000 for singles and $160,000 for couples).
The Roth IRA is best for people who have company plans and have maxed them out, and
whose tax brackets won't drop after retirement. Withdrawals are tax and penalty free if
the owner becomes disabled or dies. Unlike a regular IRA, there is no forced withdrawal at
age 70�.
Education IRA
Couples with AGI up to $150,000, single to $95,000, can contribute up to $500 for each
child under age 18. These nondeductible annual contributions grow on a tax-free basis and
can be used tax and penalty free for college before the child is 30. The account may be
transferred to another child if the original beneficiary does not need the funds.
Annual contributions can come on top of the total of $2000 for all other IRAs per
person. In addition, several people could start funds for the same child, although all
contributions for one child in any one year cannot exceed $500. A family cannot
participate in a pre-paid tuition plan during the same year it participates in an
Education IRA.
Families must choose between tax-free withdrawals from an Education IRA, the new HOPE
Scholarship Credit, or the Lifetime Learning Credit (described below). Only one education
benefit may be claimed for a student in any given calendar year. It is unclear how an
Education IRA will affect financial aid eligibility.
The HOPE Scholarship is a tax credit of up to $1500 on the first $2000 of college
tuition and fees during the freshman and sophomore years of college. Eligibility is
affected by earnings levels.
Lifetime Learning Credit is a credit of up to 20 percent of the first $5000 of tuition
and fees for those students who have completed the first two years of college. This credit
is increased to 20 percent of the first $10,000 after December 31, 2002. Eligibility for
this credit is also affected by earnings levels.
The 1997 Tax Law also gives an interest deduction of up to $1000 in 1998, $1500 in
1999, $2000 in 2000, and $2500 in 2001 on qualified education loans. Deductions are
allowed on the first 60 months that interest payments are required and is effective for
interest due and paid on or after January 1, 1998.
HE-275, Revised, July 1997
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