By George M. Hiller, JD, LLM, MBA, CFP®
The rules and regulations pertaining to IRAs continue to grow in complexity as time goes on, even though some of the latest rules purportedly simplify IRAs and liberalize contribution limits. This update touches on some of the basic rules and regulations governing IRAs. As such, it is intended only as a general overview. Your particular facts and circumstances may very well dictate seeking professional advice from your attorney, CPA, or qualified financial planner regarding the proper handling and planning of your IRA.
It is important to note at the outset that contributions to traditional IRAs or Roth IRAs for the tax year 2003 must be made no later than April 15, 2004.
You can’t extend the deadline even if you obtain an extension for filing your tax return. If you want to fund a deductible IRA, but are short of money, a tax tip is to claim the IRA deduction on your tax return and file early, get an early tax refund and use your refund money as part of your IRA contribution.
The general IRA contribution limit for tax year 2003 is $3,000 per spouse on a joint return so long as at least $6,000 of earned income is reported on the return. For tax year 2005 the IRA contribution limit is increased to $4,000 per spouse, and then to $5,000 per spouse in tax year 2008. The limit is increased by an additional $500 for individuals age 50 or older increasing to an additional $1,000 in tax year 2006. For example, in tax year 2003, a married couple both age 50 or older can contribute up to $3,500 each to IRAs.
If neither spouse is a participant in a qualified employer retirement plan then the IRA contributions are fully deductible. If either spouse or both spouses participate in an employer retirement plan, then part or all of IRA contributions may be nondeductible depending upon complex phase out rules based on modified adjusted gross income. In general, if modified adjusted gross income is less than $60,000, then IRA contributions are fully deductible even if both spouses participate in qualified employer retirement plans. If one spouse participates in a qualified employer retirement plan and the other does not, special phase out rules may apply that can allow the non-participant spouse to make a deductible IRA contribution if modified adjusted gross income is under $150,000.
In general, distributions from a traditional IRA are fully taxable except for any basis in nondeductible IRA contributions. Also, distributions prior to age 59 ½ are subject to a 10% penalty tax in addition to the regular income tax.
There are a few exceptions to the 10% penalty tax for distributions prior to age 59 ½. Distributions will not be taxable and will not be subject to a 10% penalty tax if they are rolled back into an IRA within 60 days. Other exceptions to the 10% penalty tax for early distributions include total disability, medical costs exceeding 7.5% of your adjusted gross income, qualified higher education expenses, a distribution of $10,000 or less to a first time home buyer, or an election to receive annual payment under an annuity schedule or amortize your IRA based upon a reasonable interest rate and life expectancy tables. You should consult with a qualified advisor if you seek to utilize these exceptions to the 10% penalty tax.
Contributions to a Roth IRA are nondeductible, but distributions from a Roth IRA are tax-free provided that the Roth IRA has been maintained for at least 5 years or until age 59 1/2 whichever is longer. The tax-free treatment of Roth IRA distributions in many cases can be expected to more than compensate for the lack of an upfront tax deduction at the time of contribution.
Roth IRAs are also distinguishable from tradition IRAs in other ways. Traditional IRAs require mandatory minimum distributions to begin by April 1 of the year following the year in which the taxpayer turns age 70 ½. These mandatory distributions are usually fully taxable. Roth IRAs are not subject to minimum distribution requirements for taxpayers over age 70 ½. Also, taxpayers are prohibited from making contributions to a traditional IRA after age 70 ½, but are allowed to continue to make contributions to a Roth IRA provided they have earned income.
It should be noted that Roth IRAs are subject to certain modified adjusted gross income limitations that do not apply to traditional IRAs. In general you can only contribute to Roth IRAs if your modified adjusted gross income is below $95,000 if single and below $150,000 if married filing jointly. Traditional IRAs may be converted to Roth IRAs if your modified adjusted gross income is less than $100,000.
One of the biggest planning opportunities applicable to IRAs is the ability to take a lump sum distribution from a qualified employer retirement plan upon termination of employment or retirement and roll the lump sum over to an IRA Rollover account in a tax-free transfer. This allows the funds in the IRA to be under the control of the investor and to continue to grow tax deferred until such time as distributions are begun.
Other planning opportunities involve the ability of IRA beneficiaries of a deceased IRA owner to continue to defer recognition of taxable income for extended periods of time. In general, if the IRA beneficiary is a surviving spouse, he or she can often reregister the IRA in his or her name and allow the tax deferral on the IRA assets to continue until distributions are begun. If the IRA beneficiary is a child of the deceased IRA owner or other person, then that child or person can often elect to “stretch out” IRA distributions over his or her life expectancy. If no “stretch out” election is made the IRS will require that the IRA account be fully distributed and fully taxed within 5 years. This again is a complex area of IRA planning where it is highly advisable to consult with a competent and knowledgeable professional.
In summary, the new rules for IRAs provide new planning opportunities and many of the existing benefits of traditional IRAs and Roth IRAs continue and are in fact enhanced. Individuals and married couples will be able to benefit from significantly increased contribution limits in tax year 2003 and beyond. With the new rules has come added complexity and this means that in order to best plan for using IRAs it is often necessary to consult with an advisor who can guide you through the various rules and regulations so that you can make tax and financial planning decisions that maximize your opportunities.