IRA’s Defined

Marie Adams, Attorney

This article will continue my series on financial planning products. This time I am focusing on IRAs, or Individual Retirement Accounts.

An IRA is a vehicle in which to keep various types of investments, such as cash, mutual funds, stocks, or bonds. Think of it like a greenhouse where you plant all of your investments. This greenhouse protects your investments from taxes while they are growing. There are four types of IRAs: Traditional, Roth, Simplified Employee Pension (SEP), and Savings Incentive Match Plan (SIMPLE). Next I’ll describe the basic features of each type of IRA.

Traditional IRA
A Traditional IRA allows individuals to contribute money tax-deductible, and investments compound tax-deferred. This means that your money goes into this IRA, and you will get back the taxes when you file your tax return, making this a great vehicle to save for retirement. Anyone can contribute the annual maximum, $5,500 for 2013 ($6,500 if he or she is over age 50) as long as he or she earns income and is under age 70 ½. There are other rules as to whether the contribution is tax deductible or not. These rules are listed below. The downside is that money cannot be withdrawn without penalty until the owner is age 59 ½. If you need the money prior to turning age 59 ½, you will pay income taxes, along with a 10% penalty for withdrawing it, unless it is for one of the qualifying exceptions. If the withdrawal is a qualified exception, you will still be assessed income tax, but the penalty will be waived. On the contrary, at age 70 ½, the owner must take minimum required distributions from his or her Traditional IRA. The amount he or she is required to withdraw is calculated based on the amount you have in the account and the individual’s life expectancy according to tables published by the IRS.

IRA Contribution Tax Deductible?

• If you do not have access to a retirement plan at work, your contributions are fully tax deductible.
• If you have access to a retirement plan at work, like a 401k plan, you must have an adjusted gross income (AGI) of less than $59,000 ($95,000 for a married couple filing jointly) for your contributions to be fully tax deductible.
• If you have a retirement plan at work and your AGI is more than $69,000 ($115,000 for a married couple filing jointly), the deduction is phased out completely.

Roth IRA
A Roth IRA has tax advantages too, but they are different than the Traditional IRA. Instead of the contributions being tax deductible on the front-end, contributions to a Roth IRA go into the account after taxes. Any contribution put into a Roth IRA has already been taxed. Since taxes have already been paid, the investments can grow without ever being taxed again. When withdrawals are made from a Roth IRA, all of the earnings come out tax-free. Below are some additional differences between the Roth IRA and the Traditional IRA.

• There is no age limit for contributions. Anyone can contribute at any age.
• An individual can take their contributions out at any time after the account is aged 5 years, without penalty. There is a penalty for taking out earnings before age 59 ½, unless it is for one of the qualifying exceptions.
• There is no requirement to start taking withdrawals at a certain age. An individual can leave their money in a Roth IRA for as long as they please.

Like the rules for Traditional IRAs, the contribution limitations for Roth IRAs are based on AGI. You can contribute the annual maximum to a Roth IRA, $5,500 for 2013 (or $6,500 for people over age 50), if your AGI is less than $112,000 ($178,000 for married filing jointly. Your contribution amount is completely phased out when your AGI reaches $127,000 ($188,000 for married filing jointly). See IRS Publication 590 for a worksheet to calculate reduced contributions.

Unlike Traditional IRAs, there is also no required age at which you need to start taking withdrawals. If you need your money, you can take your contributions out after the account has been established for 5 years, penalty free. You will incur a 10% penalty if you take out your investment earnings prior to age 59 ½, unless the reason is a qualifying exception. Qualifying exceptions include the following: (1) qualified college expenses for you, your spouse, your kids or your grandkids, (2) medical expenses greater than 7.5% of your AGI, (3) first-time home purchase up to $10,000, (4) total and permanent disability.

SEP IRA
SEP stands for Simplified Employee Pension and is a type of IRA designed for small business owners or self-employed individuals. Any employer with one or more employees can open a SEP IRA account, and only the employer makes contributions to a SEP IRA. The contributions are tax deductible to the company, but they go into a Traditional IRA held in the employee’s name. Like the Traditional IRA, the contributions and earnings are taxed at the time of withdrawal. SEP IRAs also follow the same distribution and rollover rules as Traditional IRAs. An important difference between the Traditional IRA and the SEP IRA is the higher contribution amounts. Employers can contribute up to 25% of the employee’s compensation or $51,000, whichever is less. Generally, all employees must be included in the SEP plan if they meet all of the requirements. The most restrictive requirements that an employer can put in a plan are the following: age 21, worked for the company for a minimum of 3 of the last 5 years, and received at least $550 in compensation from the company for the year. A company can have less restrictive requirements for their plan.

SIMPLE IRA
SIMPLE stands for Savings Incentive Match Plan for Employees, and it too is designed for small business owners or self-employed individuals. This type of IRA functions similarly to a 401(k) plan, in that it encourages employees to contribute to their retirement savings. A SIMPLE IRA allows employees to contribute up to the maximum annual amount, $12,000 in 2013 ($14,500 for employees over 50), tax-deductible. Like the Traditional IRA, the employee’s investments then grow tax-deferred, which mean they are not taxed until they are withdrawn at retirement. The employer is required to either match the employees’ contributions up to 3% of their salaries or contribute a flat 2% of the employees’ salaries, whether the employees choose to contribute or not.

An employer must have no more than 100 employees to set up a SIMPLE IRA, and each employee must have earned at least $5,000 in the previous calendar year. Also the employer cannot offer any other type of retirement plan in addition to the SIMPLE IRA.

The higher contribution limits and the simplicity of administering SIMPLE IRAs make them an attractive option for both employees and employers.