Individual Retirement Accounts (IRAs)

Traditional IRAs and Roth IRAs

Congress established IRAs in 1974 to encourage people to save toward their retirement. Contributions may be made to traditional IRAs if the taxpayers received taxable compensation during the year and were not age 70.5 by the end of the year. Individuals who are age 50 by the end of the tax year for which the contributions are being made may make an additional catch-up contribution. Taxable compensation includes wages, salaries, commissions, tips, bonuses, or net income from self-employment; it does not include earnings and profits from property, such as rental income, interest, and dividend income, or any amount received as pension or annuity income, or as deferred compensation. Married couples are allowed to establish a special “spousal IRA” when only one spouse has earned income.

A traditional IRA is allowed whether or not the taxpayer is covered by any other retirement plan. However, if the taxpayer or spouse is covered by an employer retirement plan, contributions may not be fully deductible. Determining whether contributions made to a traditional IRA are fully or partially deductible also depends on the income and filing status of the taxpayers and whether or not they receive social security benefits. Generally, amounts in a traditional IRA (including earnings and gains) are not taxed until distributed. After taxpayers turn 701/2, mandatory minimum distributions based on life expectancy tables are required, which will be taxed as ordinary income, other than any nondeductible contribution portion.

Penalties apply to withdrawals made before reaching the age of 591/2, although exceptions can be made for withdrawals for medical expenses, qualified education expenses, and first-time home buyer expenses. Assets (money or property) can be transferred, tax-free, from other retirement programs (including traditional IRAs) to a traditional IRA. These transfers can be from one trustee to another, through rollovers, or through transfers incident to a divorce. Any excess contributions made to IRAs are subject to an excise tax.

A traditional IRA can be an individual retirement account or an annuity. It can be part of either a simplified employee pension (SEP) or an employer or employee association trust account. The trustee or custodian for a traditional account must be a bank or other entity approved by the IRS to act as a trustee or custodian. Money in these accounts cannot be used to purchase life insurance policies, and assets in the account cannot be combined with other property, except in a common trust fund or common investment fund.

As an alternative, an individual retirement annuity may be set up by purchasing an annuity contract or an endowment contract from a life insurance company. The entire interest in the contract must be nonforfeitable and it must provide that no portion can be transferred to any person other than the issuer. There must be flexible premiums so that if compensation changes, payments can also change and contributions are limited. Distributions must begin after age 701/2.

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