Individual Retirement Accounts

INDIVIDUAL RETIREMENT ACCOUNTS

An Individual Retirement Account (IRA) provides some form of tax advantage to assets held by an individual until retirement, with certain exceptions. Despite the recent trend toward the use of the 401(k) and similar plans, the IRA is still a valuable tool for retirement planning and other goals. The types of IRAs are traditional, Roth, education, SEP, and SIMPLE; all of them use one of two forms of preferential tax treatments affecting contributions and gains. Individuals, small businesses, and the self-employed can all potentially use IRAs. The Internal Revenue Service (IRS) does not dictate the type of investment held in an IRA; investors can use stocks, bonds, mutual funds, and others (Preston). The investment choice should be determined by investment horizon, risk tolerance, and possibly investment savvy (Hanna and Chen).

The traditional IRA has been available for some time. The Roth IRA was born out of the 1997 Taxpayer Relief Act and provides a different tax advantage than other types of retirement savings vehicles, which will be discussed later. The 2001 Taxpayer Relief Act (2001 TRA) brought changes to contribution limits and will be in effect beginning in 2002. These changes will be highlighted where applicable.

Traditional IRA

The traditional IRA allows an individual to place up to $2,000 per year in an account on a tax-deferred basis. This means that the contribution is not counted as taxable income the year it is contributed and will not be taxed until it is withdrawn. This also applies to any earnings on the contributions. Each member of a married couple may have his or her own IRA and may contribute as much as $2,000 per person. The 2001 TRA has provided for increases in this amount. The contribution allowed per person increases to $3,000 between 2002 and 2004, increases again to $4,000 from 2005 to 2007, and finally reaches $5,000 for 2008 and beyond. The contribution amount will be indexed for inflation after 2008 and will increase in increments of $500. A special catch-up provision is instituted for taxpayers age fifty and over. Taxpayers who are fifty or over during 2002 may make an additional $500 contribution between 2002 and 2005 and an additional $1,000 beginning in 2006.

A qualified contribution reduces the amount of income that will be used in computing the total income tax owed because the contribution is not taxable income. The investment gains and the principal will be taxed as the distributions are taken. The actual reduction in tax liability is equal to the amount of the contribution multiplied by the marginal tax rate, the tax rate on the last dollar earned. For example, if Matt can contribute $2,000 to an IRA and he is in the 28 percent marginal tax bracket, he would save about $560 (2000 × 0.28) on his tax bill by contributing to a traditional IRA.

Households can contribute some amount to a traditional IRA as long as the taxpayer will not be seventy and one-half by the end of the year and has earned income for the year. The exception to the earned income rule is a nonworking spouse, who may contribute to an IRA provided that the couple's combined income less IRA contributions is greater than $2,000. This spousal IRA allows for a contribution to be made by one spouse on behalf of the other, who has little or no monetary compensation. The amount of the allowable contribution can be reduced or phased out as the household's modified adjusted gross income (MAGI) increases. The MAGI is the adjusted gross income plus exempt qualified interest, such as interest from a municipal bond. The rules for the phaseout are determined by whether or not the individual is participating in an employer-provided retirement plan. In the case of a married couple where one spouse is covered by such a plan and the other is not, the allowable contribution is based on each spouse's own situation. Employer-provided retirement plans include 401(k), SEP, SIMPLE, tax-sheltered annuities, and defined benefit plans.

In addition to annual contributions, three types of transfers can fund traditional IRAs. The first is a transfer from one IRA provider to another. This does not involve any direct payment or distribution to the investor, and hence there are no tax implications. A transfer from a traditional IRA or defined contribution plan to another IRA, also known as a rollover, must be declared, but if it is contributed within sixty days of the distribution, the rollover is tax-free; otherwise there will be a penalty on any distribution that was not frozen during that time. Frozen assets are those that cannot be withdrawn from the financial institution because the institution is insolvent or the state where the institution is located restricts withdrawals because of insolvency. Further, if the distribution is not a direct rollover, or is paid to the owner, 20 percent must be withheld and is taxable. Only the amount in the account that could be taxed can be rolled over. Last, the amount of an IRA transferred into another IRA because of a divorce settlement is tax-free.

Distributions from the traditional IRA can begin without penalty after the account holder reaches age fifty-nine and one-half. Withdrawals prior to that age incur a 10 percent federal tax penalty unless they meet one of the criteria determined by the IRS. One is payment of medical costs. These medical expenses must not be reimbursed and must exceed 7.5 percent of adjusted gross income (AGI). Second, withdrawals are allowed before fifty-nine and one-half when funds are needed because of recent disability. A third situation that avoids the 10 percent penalty is if a person is the beneficiary of an inherited IRA. Fourth, withdrawal of a sum not in excess of qualified higher education expenses, such as tuition and books, is permitted. An additional provision allows up to $10,000 to be withdrawn and applied toward purchasing or building a first home. Distributions from an IRA must begin by April 1 in the year after the account holder reaches seventy and one-half. If the entire amount is not withdrawn, then a schedule based on the owner's life expectancy must be followed for the distributions. Under this provision, annuity payments taken prior to fifty-nine and one-half are not penalized.

IRAs can be passed to heirs (more than one) and are included in the estate of the deceased. However, only the spouse of the decedent can take over the IRA; others cannot contribute to, roll over, or roll over assets into the IRA. Inherited IRAs must be withdrawn entirely within the first five years after the owner's death or over the life expectancy of the beneficiary. If this person is not the spouse, the serial withdrawals begin after the first year following the death of the IRA owner; a spouse can wait until the time at which the deceased would have been seventy and one-half.

Roth IRA

As part of the 1997 Taxpayer Relief Act, the Roth IRA was introduced to provide taxpayers with a unique means of saving for retirement and other goals. The principal difference between the Roth and the traditional IRAs is related to the taxation of contributions and distributions. While a deduction can be taken for contributions to a traditional IRA, there is no deduction for contributions to a Roth IRA. Instead, the earnings grow tax-exempt. This means that when money is withdrawn, there will be no taxes to pay. Therefore the key difference between Roth and traditional IRAs is that with the Roth, taxes are paid on contributions but not in retirement, and the opposite is true for the traditional IRA.

The Roth IRA may be preferable to a traditional IRA. The question one must answer to determine which one is best is at what rate the individual would like to pay taxes. While this may require making some assumptions about one's income sources in retirement, and assuming that tax laws will not change, it is still a reasonable approach to deciding which choice is best. If one expects his or her tax rate to increase in retirement, then a Roth IRA is preferable. This might be the situation for many young individuals, especially those just finishing college. If one expects it to decrease in retirement, then a traditional IRA is preferable. This may be the case for one who is making this choice later in life and is more established in his or her career.

As with a traditional IRA, individuals can place $2,000 into a Roth IRA each year ($4,000 for married couples). The increases provided by the 2001 TRA discussed for the contributions to a traditional IRA are also applicable to the Roth IRA. The rules regarding spousal Roth IRAs are the same as those for the traditional spousal IRA. The phaseout for allowable contributions for a Roth IRA is the same as that for those not participating in employer-sponsored retirement plans for the traditional IRA. Contributions to a Roth IRA can be made at any age, even beyond seventy and one-half.

Generally the rollover provisions of a Roth IRA are similar to those of a traditional IRA. In order to be eligible for a traditional-to-Roth rollover, certain conditions must be met. Failure to meet these guidelines subjects the rollover to a 6 percent federal tax for excess contributions as well as the 10 percent federal tax penalty; it also is included in ordinary income, and thus is subject to income taxes. Prior to 1999 the traditional-to-Roth rollover distribution could be taken over a four-year period, but this is not the case for new or current rollovers.

Distributions from a Roth IRA will be tax-free as long as they have been held in the IRA for five years or more and are withdrawn for appropriate reasons (the same as those for a traditional IRA). Otherwise, the early withdrawal penalty applies to the total amount withdrawn in that year. Unlike the traditional IRA, the rule requiring distributions to begin by age seventy and one-half does not apply to the Roth IRA. However, the rules regarding distributions after the owner's death are the same as those for the traditional IRA.

Education IRA

The education IRA, although similar to a Roth, has several important differences. Like the Roth, the education IRA does not provide a current tax deduction but does allow for tax-free growth of the investment principal, and has the same phaseout rules for allowable contributions. The purpose of the education IRA is to save for qualified higher education expenses for the named beneficiary. These expenses include tuition, fees, books, and room and board for students enrolled at least half-time, and as of 2002 will also include expenses for elementary and secondary schools. The contributions to this IRA must be made before the beneficiary reaches eighteen years of age and must be made in cash. The cash stipulation differs from other IRAs, for which the contributions can also be in the form of securities. Another important difference is that the contribution for an education IRA cannot exceed $500 per year per child. However, this limit increases to $2,000 after 2001. Excess contributions face the same rules as the Roth IRA, but if there are contributions made on the child's behalf to a qualified state tuition program, such as a Section 529 plan or prepaid tuition plan, then any amount contributed to the education IRA is considered excess. Excess contributions must be withdrawn by year-end or face a 10 percent penalty.

The distributions from an education IRA in any year cannot exceed the amount of qualified higher education expenses. Otherwise, the same rules apply for withdrawal and bequests that exist for traditional and Roth IRAs. The only exception is that the funds must be distributed by the time the beneficiary is thirty years old or, if the beneficiary dies, the assets must be distributed to that person's beneficiaries within thirty days from the time of death. If the person is a minor or does not have a will then state laws of intestacy will dictate the beneficiary.

SEP-IRA

The fourth type of IRA is a Simplified Employee Pension (SEP-IRA), which allows employers to make contributions on behalf of qualified employees. To qualify, an employee must be at least twenty-one years old, have worked three out of the five previous years for the employer, and earned at least $400 of compensation in the year contributions are made.

The contribution by the employer on behalf of an employee for the SEP-IRA is limited to the lesser of $30,000 or 15 percent of the employee's compensation, excluding the employer contribution to a tax-deferred account; a SEP-IRA cannot be a Roth IRA. Although employees can also contribute to this account, the same rules for contributions apply as in a traditional IRA. Further, the SEP-IRA is considered an employer-sponsored plan, and thus any contributions by the employee are subject to the same phaseout rules that govern the traditional IRA. Rules regarding distributions are the same as those for a traditional IRA.

SIMPLE IRA

The fifth type of IRA is the Savings Incentive Match Plan for Employees (SIMPLE). A SIMPLE plan allows an employee to allocate a portion of his or her income to an IRA as long as the employee received at least $5,000 in compensation in one of the previous two years and will receive at least $5,000 during the current year. Further, employees whose benefits are covered by a union, who are nonresident aliens, or who would not have been eligible if not for an acquisition, disposition, or similar activity do not need to be included in the SIMPLE plan.

The contribution is limited to $6,000 per year. As part of the 2001 TRA, the annual contribution increases to $7,000 in 2002, and will increase in $1,000 increments per year, up to $10,000 in 2005. After 2005, the contribution will be indexed to inflation and increase in $500 increments. Employers are required to contribute between 1 and 3 percent of the individual's compensation, but the amount can be only 1 percent for two of the five years following the election period. Rules regarding distributions are the same as those for a traditional IRA. A SIMPLE IRA cannot be a Roth IRA.

Who is using IRAs?

Results from the 1998 Survey of Consumer Finances (SCF) show that almost 49 percent of U.S. households have some type of retirement account, an increase of more than three percentage points over 1995 (Kennickell et al.). The SCF provides more specific data regarding ownership of IRAs (Kennickell). Additional statistics were computed using data from the 1998 SCF to determine the percentage of individuals between nineteen and ninety-five years of age using IRAs during 1997. Over 28 percent owned an IRA in 1997, and the average balance was $20,209. The proportion of those owning IRAs increases with age, then decreases for those approaching retirement. The amount invested also increases with age, then begins to decrease, which is consistent with the fact that when a person retires, he or she is receiving distributions.

The overall strategy when deciding on an IRA is determining the best time to pay taxes, which is when the marginal tax rate is lowest. Further information can be obtained from Publication 590 of the U.S. Department of the Treasury.

Michael Steven Gutter

See also Retirement Planning.

BIBLIOGRAPHY

Hanna, S., and Chen, P. "Subjective and Objective Risk Tolerance: Implications for Optimal Portfolios." Financial Counseling and Planning 8, no. 2 (1997): 17–26.

Hoffman, W. H.; Smith, J. E.; and Willis, E., eds. Individual Income Taxes: 2001 Edition. Cincinnati: South-Western College Publishing, 2001.

Kennickell, A. B. Codebook for 1998 Survey of Consumer Finances. Washington, D.C.: Federal Reserve System, 1997.

Kennickell, A. B.; Starr-McCluer, M.; and Surette, B. "Recent Changes in U.S. Family Finances: Results from the 1998 Survey of Consumer Finances." Federal Reserve Bulletin 86, no. 1 (2000): 1–29.

Preston, R. "The Dos and Don'ts of IRA Investing." Journal of Accountancy 189, no. 4 (April 2000): 45–53.

U.S. Department of the Treasury. "Individual Retirement Arrangements." Publication 590, 1999. http://www.irs.ustreas.gov/