Over the years as a financial advisor we have discussed many financial matters with consumers. No topic seems to be as misunderstood or improperly grasped by consumers on a consistent basis than that of the topic of IRA’s.
In this discussion we will try to simplify your
understanding of IRA’s—and particularly as it relates to taxation—so that you
can make an informed and well thought out decision—if you are considering IRA’s
in your financial portfolio.
With a traditional IRA—you get a tax deduction up front in the form of a tax deduction on your personal tax return.
You would pay taxes on your distributions at "ordinary income" tax rates—whereas, with a ROTH you get no tax deduction up front, however all contributions and "qualified" distributions are tax free.
If you own—or anticipate owning a Traditional or
ROTH IRA, and you make a “non-qualified” distribution you may have to pay
federal income taxes on withdrawals—and in some cases be socked with a 10%
penalty on top of the income tax bill.
In 2011 the income cutoffs for a traditional IRA where you can get the full deduction is $56,000 and partial deduction is $65,999 if you are single.
In 2011 the income cutoffs for a ROTH IRA where you can get the full contribution is $107,000 and partial contribution is $122,000 if you are single.
In 2011 the income cutoffs for a traditional IRA where you can get the full deduction is $90,000 and partial deduction is $109,999 if you are married.
In 2011 the income cutoffs for a ROTH IRA where
you can get the full contribution is $169,000 and partial contribution is
$179,000 if you are married.
Keep in mind that the above figures represent the "income cutoff" that is based on your AGI or Adjusted Gross Income—not Total Income!
The annual contribution limit is $5,000 if you are single and have earned income ($6,000 if you are over age 50).
The annual contribution limit is $10,000 if you are married and have earned income ($12,000 if you are both over age 50).
If your earned income is less than the
contribution limit—your contribution is limited—to your earned income!
With a traditional IRA you would set it up with an IRA custodian and contribute to it in the manner that you chose to do so—for example weekly, monthly or yearly. You have up until the tax deadline of the current year—to make contributions for the previous year.
Let’s say you contribute $5,000 by the April 17th, 2012 filing deadline. If you filed your return on April 17th, 2012 you could deduct it on your 2011 tax return on line 32 of form 1040. If you were in the 35% tax bracket you could save roughly $1,750 on your taxes if you were able to utilize the full deduction.
If you had already filed your return before April 17th 2012 you could amend your 2011 return—or you could decide to make the $5,000 contribution after April 17th, 2012 and deduct the 2012 contribution on your 2012 income tax return.
The correct choice for you—would depend on your
expected contributions. To maximize your contributions—you would choose the
Taxation at Withdrawal
If you were to withdraw funds prior to age 59 ½ you would have a 10% early withdrawal penalty and the withdrawal would be taxed at your ordinary income tax rate.
If you were to withdraw funds after age 59 ½ you would “not” have a 10% early withdrawal penalty and the withdrawal would be taxed at your ordinary income tax rate.
Keep in mind that withdrawals are mandatory at
age 70 ½ with a Traditional IRA.
With a ROTH IRA you would pay your taxes on your contributions up front and then contribute to your IRA.
Your earnings would grow tax free and your “contributions” that you later decide to withdraw would be tax free—because you have already paid taxes on them. You cannot deduct your contributions on your personal income tax return.
Once you reach age 59 ½ and have contributed for at least five years you can receive your earnings—or investment gains tax free.
Withdrawals are not mandatory at age 70 ½.
Deadline to Contribute
Also keep in mind that you have until the tax deadline (April 17) to fund your IRA for 2011—and be sure that you understand that with a traditional IRA–your contributions are in pre-tax dollars (deducted on your tax return)—and your withdrawals are taxable.
You can make 2011 contributions up until the April 17th deadline and you can make 2012 contributions up until the 2012 tax filing deadline of April 15, 2013.
With a ROTH you pay your taxes upfront, however
you or those who inherit your IRA—will owe no taxes on withdrawals. Depending
on your tax bracket—the ROTH is often the best choice in the long run—for many.
If you're 59 1/2 or older and have had at least one Roth IRA that has been open for more than five years, withdrawals from any of your Roth IRAs are called qualified withdrawals.
Your qualified withdrawals would be free of any federal income tax or penalty. The “five-year period” for qualified withdrawals starts on January 1 of the first tax year for which you make a Roth contribution.
If you established your first Roth IRA on April 15, 2007—and the contribution was for the 2006 tax year, your five-year period would start on Jan. 1, 2006.
You could begin taking qualified withdrawals at any time after Jan. 1, 2011. You could also take tax-free qualified withdrawals from any—and all Roth IRAs that you own by then—as long as you're 59 ½ or older.
Let’s say you opened a second Roth account in 2009 by converting a traditional IRA, you could take tax-free qualified withdrawals from that account too—after Jan. 1, 2011—as long as you're at least 59 1/2.
What Happens if I Take withdrawals Before Age 59 ½?
If you take a ROTH distribution before age 59 ½ it would be considered a non-qualified withdrawal—unless an exception applies.
A non-qualified withdrawal or distribution may be subject to federal income tax and a 10% penalty tax.
As far as the IRS is concerned, non-qualified withdrawals come first from your annual Roth “contributions”—not your “investment gains or earnings.”
Always remember that withdrawals from your “contributions” are always tax-free and penalty-free with a ROTH IRA.
To figure out how much of your account is “qualified” you would add up your annual contributions to all Roth IRAs set up in your name (do not use any accounts in your spouse's name).
(To prove you don't owe any income tax or penalty, you'll have to fill out Part III of IRS Form 8606 (Nondeductible IRAs) and file it with your Form 1040).
If You Converted From a Traditional IRA to a ROTH IRA—Nonqualified withdrawals are deemed to come from Roth conversion contributions “after” you determine what your contributions are.
To figure out how much is non-qualified due to conversion—you would add up all conversion contributions from converting a traditional IRA or a retirement plan payout to all Roth IRAs set up in your name (again—do not use any accounts in your spouse's name).
Withdrawals from the conversion are federal-income-tax-free, but you could still get hit with a 10% penalty—unless an exception applies.
Keep in mind that age 59 1/2 is generally the required age for starting to receive IRA distributions without getting hit with the federal 10% premature withdrawal penalty tax (whether you continue to work or not), there are some circumstances under which you can receive your IRA funds even earlier without the penalty.
The 10% penalty applies unless you qualify for an exception:
Exceptions for Early Distributions from an IRA for a Traditional & ROTH IRA:
• You had a "direct rollover" to your new retirement account
• You received a lump-sum payment but rolled over the money to a qualified retirement account within 60 days
• You were permanently or totally disabled
• You were unemployed and paid for health insurance premiums
• You paid for college expenses for yourself or a dependent
• You bought a house (can be for kids or grandkids—dollar limits apply)
• You paid for medical expenses exceeding 7.5% of your adjusted gross income
• The IRS levied your retirement account to pay off tax debts.
• It has been more than five years since the
conversion contribution (the five-year period starts on Jan. 1 of the year when
the conversion contribution occurred)
Lesser Known Exceptions:
• Annuitize Your IRA—one way to take money from your traditional IRA without incurring the 10% penalty is to "annuitize" your account. The way this works is that for five years, or until you turn age 59 1/2 (whichever is longer), you take annual cash withdrawals based on your life expectancy, as predicted by the IRS.
• Withdraw Roth Contributions—the Roth IRA allows penalty and tax-free withdrawals of contributions for any reason. However, once you've taken out that money, you don't have the option of replacing it.
• Take a 60-Day Loan—you can withdraw funds from your IRA for up to 60 days tax-and penalty-free as long as you return the funds to an IRA by the end of the 60-day period. The IRS looks at this as a nontaxable rollover.
Just make sure that the funds are back in an IRA within the 60 days, otherwise it will be treated as a withdrawal that is subject to taxes and penalties if you are under age 59 1/2.
Also, if you follow this strategy, you can only
do it once within a 12-month period for the account in question.
Special Penalty-Free Withdrawal Situations:
• First-time home purchase—up to $10,000 for you, your spouse, your kids or even your grandkids.
• Qualified education expenses—for you, your spouse, your kids or even your grand-kids. Approved expenses include post-secondary education, tuition, books, supplies and, if the student is enrolled at least half-time, room and board.
• Disability—to qualify for a disability exemption, you must prove that you are incapable of working.
• Unreimbursed medical expenses—expenses must exceed 7.5% of your adjusted gross income.
• Health insurance for the unemployed—only after 12 consecutive weeks of collecting unemployment benefits.
Use caution before you dip into an IRA or any Retirement Account:
Before you start dipping into your retirement stash, you should explore other options including a standard bank loan.
If you must withdraw funds from an IRA, avoid paying taxes by withdrawing contributions from your Roth IRA first.
Be sure to tap a tax-deductible IRA last. Above
all, use these tax-sheltered accounts as a last resort. And before you raid
your retirement savings, make sure you are leaving enough to support your
Key Points to Remember:
• Traditional IRA withdrawals used for higher education are 10% penalty free but taxable at your ordinary income rate
• Funds in a ROTH that are withdrawn for higher education would be taxed on earnings only—not original contributions
• Funds in a ROTH that have been there for five or more years would be taxed on earnings only—not original contributions
• Funds in a ROTH that have been there for less than five years would be taxed on earnings only—not original contributions
• Traditional IRA withdrawals used for first-time home buying are 10% penalty free but taxable at your ordinary income rate
• ROTH IRA withdrawals used for first-time home buying are 10% penalty free and taxed on earnings—not original contribution
• ROTH IRA withdrawals used for first-time home buying are 10% penalty free and not taxed at all if funds have been there for five years or more
At this time there is a $10,000 maximum withdrawal of IRA funds for a home purchase—whether Traditional or Roth!
• Traditional IRA withdrawals used for disability or death are 10% penalty free but taxable at your ordinary income rate
• A Roth IRA used for death or disability held in account for less than five years would have no penalty but would be taxed on earnings—not original contributions
• A Roth IRA used for death or disability held in account for more than five years would have no penalty –and would have no taxes
Withdrawals when an exception does not apply:
• Traditional IRA withdrawals would have a 10% penalty—and would be taxable at your ordinary income rate
• Funds in a Roth IRA for less than 5 years would have a 10% penalty on earnings—not contributions—and would be taxed on earnings at ordinary income rates—original contributions would be non-taxable
• Funds in a Roth IRA for more than 5 years would have a 10% penalty on earnings—unless you are age 59 ½ or older—and would be taxed on earnings at ordinary income rates—unless you are age 59 ½ or older—original contributions would be non-taxable regardless of age
• Finally, any further non-qualified withdrawals from Roth accounts set up in your name (after you've tapped all your contributions) are deemed to come from earnings or investment gains.
• Non-qualified withdrawals from earnings are 100% taxable. You or your tax professional would fill out Part III of Form 8606 to calculate the taxable amount from this layer, and enter that figure on Line 15b of Form 1040.
• In addition, the 10% penalty applies, unless
you're eligible for an “exception.” If you owe the penalty tax, fill out Form
5329 and enter the penalty on line 58 of Form 1040.
What if I am age 59 ½ but I fail to meet the five-year test:
Any Roth withdrawal taken before passing the five-year mark would be considered a non-qualified withdrawal. As such, it may be subject to income tax and a 10% penalty tax.
In this case, non-qualified withdrawals are generally handled in the same order as above—first from annual contributions—then from conversion contributions—and lastly from investment gains or earnings.
Most importantly, non-qualified withdrawals from investment gains are subject to income tax, and, if you're under 59-1/2, the 10% penalty (unless you're eligible for an exception).
You or your tax professional would fill out Part III of Form 8606 to calculate the taxable amount from investment gains, and enter that figure on Line 15b of Form 1040. If you owe the penalty tax, fill out Form 5329 and enter the penalty on line 58 of Form 1040.
If you qualify for the home purchase exception: If you've passed the five-year test but you're under 59 , a special exception allows tax-free and penalty-free Roth withdrawals in order to buy a principal residence.
However, there's a lifetime $10,000 limit on this deal, and you must use the money within 120 days of the withdrawal. The home-buyer can be you or certain relatives (including kids and grand-kids). However, the buyer must not have owned a principal residence within the two-year period ending on the purchase date.
Final Thoughts on Taxation & IRA’s
While the tax rules for "Traditional" and "Roth" contributions and withdrawals may seem complicated, you (or your tax professional) will clear up much of your confusion by completing Part III of Form 8606.
In addition you will receive a 1099-R from your IRA custodian or trustee shortly after the end of any year in which you take withdrawals.
By providing this form to your tax professional—or utilizing the form yourself you can complete your taxes in an efficient manner.
As for contributions—you mainly have to keep the income cutoffs in mind if you have income that is in the income cutoff limitation ranges. Your contribution limit is easy to remember—as it will be $5,000—or $6,000 if you are age 50 or older.
The 1099-R would show the total amount of withdrawals for the preceding year—and the IRS gets a copy—so if you took any “nonqualified withdrawals”—the IRS will expect to see a Form 8606 included with your return.
With a traditional IRA—you get a deduction up front on your tax return and you pay taxes on your distributions at "ordinary income" tax rates—whereas, with a ROTH you get no deduction up front, however all "qualified" distributions are tax free.
Be sure to go to our individual retirement account page where you can find helpful ways in which you can use IRA's to reach your and your family's retirement and other goals.
For income tax preparation you can utilize the tax professional of your choice—or if your tax situation is not very complicated you can choose among—the following: