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Encyclopedia > Individual Retirement Account
Taxation in the United States

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An Individual Retirement Arrangement (or IRA) is a retirement plan account that provides some tax advantages for retirement savings in the United States. A retirement plan is an arrangement to provide people with an income, or pension, during retirement, when they are no longer earning a steady income from employment. ... Tax advantage refers to the economic bonus which applies to certain accounts or investments that are, by statute, tax-reduced, tax-deferred, or tax-free. ... Retirement is the point where a person stops employment completely. ...

Contents

Legal basis

The individual retirement account and related vehicles (see Definitions) were created by amendments to the Internal Revenue Code of 1954 (as amended) made by the Employee Retirement Income Security Act of 1974 (ERISA), which enacted (among other things) Internal Revenue Code sections 219 (26 U.S.C. § 219) and 408 (26 U.S.C. § 408) relating to IRAs. The Internal Revenue Code (or IRC) (more formally, the Internal Revenue Code of 1986, as amended) is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax (see Income tax in the United States), payroll taxes, gift taxes, estate taxes... The Employee Retirement Income Security Act of 1974 (ERISA) (Pub. ... The Internal Revenue Code (or IRC) (more formally, the Internal Revenue Code of 1986, as amended) is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax (see Income tax in the United States), payroll taxes, gift taxes, estate taxes... The Internal Revenue Code (or IRC) (more formally, the Internal Revenue Code of 1986, as amended) is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax (see Income tax in the United States), payroll taxes, gift taxes, estate taxes...


Types

There are a number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include:

  • Roth IRA - contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William Roth.
  • Traditional IRA - contributions are often tax-deductible (often simplified as "money is deposited before tax" or "contributions are made with pre-tax assets"), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted).
  • SEP IRA - a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name, instead of to a pension fund account in the company's name.
  • SIMPLE IRA - a simplified employee pension plan that allows both employer and employee contributions, similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.
  • Self-Directed IRA - a self-directed IRA that permits the account holder to make investments on behalf of the retirement plan.

There are two other subtypes of IRA, named Rollover IRA and Conduit IRA, that are viewed as obsolete under current tax law (their functions have been subsumed by the Traditional IRA) by some; but this tax law is set to expire unless extended. However, some individuals still maintain these accounts in order to keep track of the source of these assets. One key reason is that some qualified plans will accept rollovers from IRAs only if they are conduit/rollover IRAs. A Roth IRA is an Individual Retirement Account (IRA) allowed under the tax law of the United States. ... William Victor Roth, Jr. ... A traditional IRA is an individual retirement account (IRA) in the United States. ... A Simplified Employee Pension Individual Retirement Account is a variation of the Individual Retirement Account used in the United States. ... A SIMPLE IRA is a type of employer provided retirement plan in the United States. ... The 401(k) plan is a type of employer-sponsored defined contribution retirement plan under section 401(k) of the Internal Revenue Code () in the United States, and some other countries. ... A Self-Directed Individual Retirement Account is an IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. ...


What was formerly known as an Educational IRA is now called a Coverdell Education Savings Account. A Coverdell Education Savings Account (also known as an Education Savings Account, a Coverdell ESA, a Coverdell Account, or just an ESA and formerly known as an Education IRA), is a tax-advantaged investment account in the United States designed to encourage savings to cover future college education expenses. ...


Starting with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), many of the restrictions of what type of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into were significantly relaxed. Additional acts have further relaxed similar restrictions. Essentially most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA. An example of an exception is a non-governmental 457 plan which cannot be rolled into anything but another non-governmental 457 plan. The Economic Growth and Tax Relief Reconciliation Act of 2001 was a sweeping piece of tax legislation in the United States. ... The 457 plan is a type of tax advantaged defined contribution retirement plan that is available for governmental and certain non governmental employers in the United States. ...


The tax treatment of the above types of IRAs except for Roth IRAs are substantially similar, particularly for rules regarding distributions. SEP IRAs and SIMPLE IRAs also have additional rules similar to those for qualified plans governing how contributions can and must be made and what employees are qualified to participate.


Funding

  • An IRA can only be funded with cash or cash equivalents. Attempting to transfer any other type of asset into the IRA is a prohibited transaction and disqualifies the fund from its beneficial tax treatment.
  • Rollovers, transfers, and conversions between IRAs and other retirement accounts can include any asset.
  • The maximum for an IRA contribution in years 2006 and 2007 is 100% of earned income or $4,000, whichever is less, for an individual under the age of 50. Individuals aged 50 and older can contribute up to 100% of earned income or $5,000 whichever is less. For 2008, the limits are $5,000 and $6,000 respectively.
  • This limit is for Roth IRAs, traditional IRAs, or some combination of the two. You cannot put more than $5,000 into your Roth and traditional IRA combined ($6,000 for individuals aged 50 or more).
For example, if you are 45 and put $3,500 into your traditional IRA this year so far, you can either put $1,500 more into your traditional IRA or $1,500 in your Roth IRA. There may be an additional administrative step needed so that the trustee which holds the IRA proceeds actually retitles or transfers the $3,500 Traditional proceeds into the Roth category for their internal bookkeeping to survive an IRS audit.

Valid investments

Once money is inside an IRA, the IRA owner can direct the custodian to use the cash to purchase most types of securities, and some non security financial instruments. Some assets cannot be held in an IRA such as collectibles (e.g. art, baseball cards, and rare coins) and life insurance. Some assets are allowed, subject to certain restrictions by custodians themselves. For example an IRA cannot own real estate if the IRA owner has any involvement with that real estate, for instance as his personal residence or as a property manager (or if a relative fills one of these roles). The IRS specifically states that custodians may impose their own policies above the rules imposed by the IRS.[1] It should also be noted that custodians cannot provide advice. For security (collateral), the legal right given to a creditor by a borrower, see security interest A security is a fungible, negotiable instrument representing financial value. ... Life insurance or life assurance is a contract between the policy owner and the insurer, where the insurer agrees to pay a sum of money upon the occurrence of the insured individuals or individuals death. ...


Most IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds, and do not permit real estate in an IRA unless it is held indirectly via a security such as a real estate investment trust (REIT). However, self-directed IRA custodians/administrators can allow real estate and other non-traditional assets. They typically charge fees based on asset values. There are certain special restrictions on real estate held in an IRA (the IRA owner cannot benefit from the property in any way, i.e. they cannot use it). Self Directed IRA's allowing non security investments are more complicated and to properly set up may require additional expertise and experience that not all CPAs, attorneys, or other advisors would have. Real estate is a legal term that encompasses land along with anything permanently affixed to the land, such as buildings. ... // A Real Estate Investment Trust or REIT (rēt, rhymes with treat) is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. ...


An IRA may borrow money but any such loan must not be personally guaranteed by the owner of the IRA, and also the loan must be secured solely by assets in the IRA (in other words, a non-recourse loan). Also, the owner of the IRA may not pledge the IRA as security against a debt.


Distribution of funds

Although funds can be distributed from an IRA at any time, there are limited circumstances when money can be distributed, or withdrawn from the account, without penalties. Unless an exception applies, money can typically be withdrawn penalty free as taxable income from an IRA once the account owner reaches age 59 and a half. Also, non-Roth account owners must begin taking distributions of at least the calculated minimum amounts by April 1st of the year after reaching age 70 and a half. If the minimum distribution is not taken the penalty is 50% of the amount that should have been taken. The amount that must be taken is calculated based on a factor taken from the appropriate IRS table and is based on the life expectancy of the account owner and possibly their spouse as beneficiary if applicable. At the death of the account owner distributions must continue and if there is a designated beneficiary, distributions can be based on the life expectancy of the beneficiary.


There are several exceptions to the rule that penalties apply to distributions before age 59½. Each exception has detailed rules that must be followed to be exempt from penalties. The exceptions include:[2]

  • The portion of unreimbursed medical expenses that are more than 7.5% of adjusted gross income.
  • Distributions that are not more than the cost of medical insurance while unemployed
  • Disability (defined as not being able to engage in any substantial gainful activity)
  • Amounts distributed to beneficiaries of a deceased IRA owner.
  • Distributions in the form of an annuity, see Substantially equal periodic payments
  • Distributions that are not more than the qualified higher education expenses of the owner or their children or grandchildren
  • Distributions to buy, build, or rebuild a first home. ($10,000 lifetime maximum)
  • Distribution due to an IRS levy of the plan.

There are a number of other important details that govern different situations. For Roth IRA's with only contributed funds the basis can be withdrawn before age 59½ without penalty (or tax) on a first in first out basis, and a penalty would apply only on any growth (the taxable amount) that was taken out before 59½ where an exception didn't apply. Amounts converted from a traditional to a Roth IRA must stay in the account for a minimum of 5 years to avoid having a penalty on withdrawal of basis unless one of the above exceptions applies. Substantially equal periodic payments (SEPP) are one of the exceptions in the United States IRS Code that allows receiving payments without penalty from a retirement plan or deferred annuity before the usual 59 1/2 age restriction under certain circumstances. ... Cost basis, or basis as used in United States tax law, is the original cost of property adjusted for factors such as depreciation. ... This article is about FIFOs in computing and electronic design. ...


If the contribution to the IRA was nondeductible or the IRA owner chose not to claim a deduction for the contribution, distributions of those nondeductible amounts are tax and penalty free.


Bankruptcy status

In the case of Rousey v. Jacoway, the United States Supreme Court ruled unanimously on April 4, 2005 that under section 522(d)(10)(E) of the United States Bankruptcy Code (11 U.S.C. § 522(d)(10)(E)), a debtor in bankruptcy can exempt his or her IRA from the bankruptcy estate.[3] The Court indicated that because rights to withdrawals are based on age, IRAs should receive the same protection as other retirement plans. Thirty-four states already had laws effectively allowing an individual to exempt an IRA in bankruptcy, but the Supreme Court decision allows federal protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 gave further protection to IRAs. Up to $1,000,000 of IRA assets can be exempt from a bankruptcy estate; this now includes both Traditional and Roth IRAs. The 2005 Act also increased the FDIC insurance limit for IRA deposits at banks. The Supreme Court Building, Washington, D.C. The Supreme Court Building, Washington, D.C., (large image) The Supreme Court of the United States, located in Washington, D.C., is the highest court (see supreme court) in the United States; that is, it has ultimate judicial authority within the United States... is the 94th day of the year (95th in leap years) in the Gregorian calendar. ... Year 2005 (MMV) was a common year starting on Saturday (link displays full calendar) of the Gregorian calendar. ... Bankruptcy in the United States is a matter placed under Federal jurisdiction by the United States Constitution (in Article 1, Section 8, Clause 4), which allows Congress to enact uniform Laws on the subject of Bankruptcies throughout the United States. The provision, however, is not self-executing and is implemented... Title 11 of the United States Code outlines the role of Bankruptcy in the United States Code. ... Notice of closure stuck on the door of a computer store the day after its parent company, Granville Technology Group Ltd, declared bankruptcy (strictly, put into administration—see text) in the United Kingdom. ... The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. ... The Federal Deposit Insurance Corporation (FDIC) was created by the Glass-Steagall Act of 1933. ...


Protection from Creditors

Many states have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. For example, IRAs are protected up to $500,000 in Nevada from Writs of Execution. However, this type of protection does not usually exist in the case of divorce, failure to pay taxes, deeds of trust, and fraud. Assets in the IRA must be deposited before a lawsuit exists to receive this protection.


Borrowing

It is a prohibited transaction for the IRA owner to borrow money from the IRA. Such a transaction disqualifies the IRA from special tax treatment. An IRA may incur debt or borrow money secured by its assets but the IRA owner may not guarantee or secure the loan personally. Income from debt-financed property in an IRA may generate unrelated business taxable income in the IRA.


The rules regarding IRA rollovers and transfers allow the IRA owner to perform an "indirect rollover" to another IRA. This can be used to temporarily "borrow" money from the IRA, once per year. The money must be placed in another IRA account within 60 days, or the transaction will be deemed an early withdrawal (subject to the appropriate withdrawal taxes and penalties) and may not be replaced.


Double taxation

Double taxation still occurs within these tax sheltered investment accounts. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital. Double taxation is a situation in which two or more taxes may need to be paid for the same asset, financial transaction and/or income and arises due to overlap between different countries tax laws and jurisdictions. ... A dividend is the distribution of profits to a companys shareholders. ...


See also

The 401(k) plan is a type of employer-sponsored defined contribution retirement plan under section 401(k) of the Internal Revenue Code () in the United States, and some other countries. ... The Roth 401(k) is a type of retirement savings plan. ... Seal of the Internal Revenue Service Tax rates around the world Tax revenue as % of GDP Part of the Taxation series        IRS redirects here. ... This does not adequately cite its references or sources. ...

Notes

  1. ^ Retirement Plans FAQs regarding IRAs. Internal Revenue Service. Retrieved on 2006-12-21.
  2. ^ Publication 590 (2005), Individual Retirement Arrangements (IRAs)
  3. ^ Rousey Et Ux. v. Jacoway. Supreme Court Of The United States (2005-10). Retrieved on 2006-12-21.

Year 2006 (MMVI) was a common year starting on Sunday of the Gregorian calendar. ... is the 355th day of the year (356th in leap years) in the Gregorian calendar. ... Year 2006 (MMVI) was a common year starting on Sunday of the Gregorian calendar. ... is the 355th day of the year (356th in leap years) in the Gregorian calendar. ...

References

  • (April 5, 2005). Court shields IRAs from bankruptcy seizure. The Seattle Times
  • IRS Publication 590 (2005), Individual Retirement Arrangements (IRAs)

External links

  • IRA Online Resource Guide. IRS.gov
  • Retirement Plans FAQs regarding IRAs. IRS.gov

  Results from FactBites:
 
IRA FAQs - TD AMERITRADE (3339 words)
Individuals who attain the age of 50 before the close of the taxable year may contribute an amount in excess of the basic annual IRA contribution limit as follows: 2006 and beyond $1,000.
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