Blog / Post

IRA's and You

Dec 5, 2012

The other day, two different people called and asked us about IRA matters within a matter of minutes. Following the adage, “one complaint heard means 20 unheard,” this indicated to us that there may be some demand for information regarding IRA’s. Therefore, we will give you a little background and instruction as to how to handle different scenarios.

In 1973, the only money available for your retirement were contributions to company or government pension plans, your social security benefits, or whatever money you managed to stash away in a bank or king-sized mattress (or wall, garden, shoe box, etc). There was really no other way for people to save money, let alone get a tax benefit while doing it.

That changed in 1974. In an effort to get people to save for their futures (wonder if they were already worried about Social Security not being there!), the Employee Retirement Income Security Act (ERISA) created this thing called an Individual Retirement Account (IRA). It was basically the current “traditional” IRA that you know: contribute up to a certain amount>>those contributions are exempt from taxes>>when you pull the money out in your ripe old age of retirement, the distributions get taxed at whatever your ordinary tax rates are at that time (unless you withdraw funds before turning 59 ½, which costs you 10% extra)>>you don’t have to take money out until you hit the age of 70>>you live happily ever after.

Initially, these IRA’s were available to those folks who were not covered under any pension plans, which of course, made those who could not get these feel as if they were being treated unfairly, and they lobbied to get in on those tax savings. In 1981, the rules were changed to allow everyone, regardless of pension plan participation, to open up IRA’s (and what a time to invest that was—back then, even your run-of-the-mill savings accounts used to pay anywhere between 10%-15% interest!!! Yes, you read correctly, the same account that now insults you with its 0.25% payout). The consensus in government was that lower income workers would all jump on this retirement train and ensure themselves of having a nice comfy retirement.

If only…to paraphrase the saying, “the rich get taxed more and the poor gets taxed less.” The lower income employees that were the original targets did not board the train, but those in the higher tax brackets did. I mean, with income tax brackets as high as 50% back then, who wouldn’t take advantage, right? In fact there was too much advantage, and just a few years later in 1986, strict income restrictions were placed on IRA’s for people who were already covered by other plans.

People again were disenchanted, lobbied some more, and eventually, Delaware senator William Roth spearheaded the Taxpayer Relief Act of 1997, from which the Roth IRA sprouted. The Roth IRA was a favorite because, although you didn’t deduct the contributions from your taxable income, you got to pull all the money out tax-free after it had presumably grown considerably in the 20-30 years invested. The timing was right, as the 1990’s were experiencing a tremendous boom in the stock market and those Roth accounts grew fast. Currently, though, with stock markets down, the Roth IRA isn’t as awesome as it once was since it’s not growing as much. The traditional IRA may become favored again, especially as our tax brackets increase.

These retirement accounts really haven’t changed much since they were created. For 2012, provided you fall within the limits placed by IRS (discussed below) you can put up to $5,000 into your Roth or Traditional IRA’s ($6,000 if you’re over 50). Married Filing Jointly (MFJ) couples simply double those limits (even if only one of them works). For 2013, the limits are set to increase by $500.

Please note that IRS has a sentence right after the contribution amounts that reads, “or your taxable compensation for the year,” whichever is smaller. Whether Single (S), Head of Household (HOH), Qualifying Widower (QW), Married Filing Separate (MFS) or MFJ, you can not contribute more than what is shown on the tax return as being taxable for the year. This limit, however, does not apply for rollovers or qualified reservist repayments.

The contribution deadline is the due date of that year’s tax return, NOT INCLUDING the extension date. Typically, this means the last day to fund your IRA is April 15th. Beware that if you make a contribution between Jan1 - Apr15, you’ll want to tell the sponsor (bank, investment co—whoever maintains your IRA) which year you’ve designated for that payment.

Keep in mind that you can only contribute if you have compensation for the year (this includes sources like nontaxable combat pay and taxable alimony). See below for limits. If you have no income, you can not contribute to an IRA account.

Both types of IRA’s have early withdrawal penalties of 10% if you take non-qualified distributions before turning 59 ½, without a proper excuse. IRA’s are meant to be retirement savings vehicles, not your personal emergency fund. Therefore, the reasons that get you out of the 10% early withdrawal penalty are only:

• Distributions made to your beneficiary or estate on or after your death.
• Distributions made because you are totally and permanently disabled.
• Distributions made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary. If these distributions are from a qualified plan other than an IRA, you must separate from service with this employer before the payments begin for this exception to apply.
• Distributions that are equal to or less than your deductible medical expenses under section 213, that is, the amount of your medical expenses that is more than 7.5% of your adjusted gross income. You do not have to itemize to meet this exception. For more information on medical expenses, refer to Topic 502 here:
• Distributions made due to an IRS levy of the plan under section 6331.
• Distributions to qualified reservists. Generally, these are distributions made to individuals called to active duty after September 11, 2001 and on or after December 31, 2007.
• Distributions made to buy, build, or rebuild a first home (one-time $10,000 exemption).
• Distributions made to pay certain higher education costs.

By the way, you can only use these reasons if you’ve owned the IRA five or more tax years. Any distributions taken prior to the 5 year ownership rule are deemed automatically to be non-qualified. Also keep in mind the fact that these reasons only get you out of the 10% early withdrawal penalty, but not the income tax that will be due on the amount you received (mostly on Traditional distributions, but even Roth ones may be taxable sometimes).

If you ever need to pull money out of your IRA, before you’re 59 ½, and you don’t meet the criteria above, remember to thank us for putting this paragraph in this blog. A little-known fact about IRA’s is that you can take money out of them and not pay tax on the money. “Why, that’s heresy!” you say. Of course, THERE IS A BIG IFF (“if and only if”): you have to deposit the money back within 60 calendar days—including weekends and holidays—or else they’ll get you with the 10% penalty and the income tax on top of that! But hey, in the case of an emergency, it’s good to know that option is available to you. If you have more than one type of IRA, make sure you put the money back into the correct type (Roth to Roth, Traditional to Traditional).

Another fee you can get caught with is a 6% excise tax on excess contributions. This special excise tax takes effect if your contributions for the year exceed the established limits ($5K/$6K). That 6% tax will be due each and every year that the excess stays in your IRA account. If you don’t want to pay the 6%, you have until the due date of your return, INCLUDING extensions, to pull the excess—and its earnings—out without being penalized.

Although similar, the two types of IRA’s are also different from each other. If you choose a Roth IRA, for example, you will be able to fund that IRA every April 15th until the day you die. Even if you make it to 150 yrs old! Not so with a Traditional IRA. With the Traditional, you can not contribute to it once you reach age 70 ½.

With a Traditional IRA, you are required to take a Required Minimum Distribution (RMD) by April 1st of the year following the year in which you reach age 70 ½ . This RMD is based on life expectancy tables and if it is not taken as IRS mandates, they’ll tax you 50% on the difference between the RMD amount you should’ve taken and the amount you actually took. With the Roth, you never have to take a distribution. However, depending on when you die, your beneficiaries may have to take the money out within the first year after your death, any time during the 5 years following your death, their life expectancy, or what your life expectancy was at the time of your death. If these rules are not followed, the same 50% RMD penalties as the Traditional will apply.

Finally, as mentioned above, there are income, age, and participation limits in place for these plans. For 2012, these limits are as follow:

A. 2012 Traditional IRA Contribution and Deduction Limits – If You ARE Covered by a Retirement Plan at Work

If Your Filing Status Is.....And Your Modified AGI Is…….Then You Can Take...
S or HOH………$58,000 or less……..a full deduction up to the amount of your contribution limit.
“ “ “……….more than $58,000 but less than $68,000…….. a partial deduction.
“ “ “……….$68,000 or more……no deduction.
MFJ or QW……….$92,000 or less………..a full deduction up to the amount of your contribution limit. “ “ “……….more than $92,000 but less than $112,000……a partial deduction.
“ “ “……….$112,000 or more………no deduction.
MFS…………less than $10,000……..a partial deduction.
“ “ “……….$10,000 or more………no deduction.
If you MFS and did not live with your spouse at any time during the year, your IRA deduction is determined under the "single" filing status.

B. 2012 Traditional IRA Contribution and Deduction Limits – If You ARE NOT Covered by a Retirement Plan at Work

If Your Filing Status Is.....And Your Modified AGI Is…….Then You Can Take...
S, MFJ, HOH, QW or MFS (spouse not covered at work)..………any amount……..a full deduction up to the contribution limit
MFJ with a spouse covered at work……….$173,000 or less………..a full deduction up to the contribution limit.
“ “ “……….more than $173,000 but less than $183,000……a partial deduction.
“ “ “……….$183,000 or more………no deduction.
MFJ with a spouse covered at work…………less than $10,000……..a partial deduction.
“ “ “……….$10,000 or more………no deduction.
If you MFS and did not live with your spouse at any time during the year, your IRA deduction is determined under the "single" filing status.

C. 2012 Roth IRA Contribution Limits

If Your Filing Status Is.....And Your Modified AGI Is…….Then...
S, HOH or MFS not living with spouse during the year………less than $110,000…… can contribute the full amount.
“ “ “………….more than $110,000 but less than $125,000……..the amount of contribution is reduced.
“ “ “…..…….$125,000 or more……no contribution allowed.
MFJ or QW……….$173,000 or less……… can contribute the full amount. “ “ “……….more than $173,000 but less than $183,000……the amount of contribution is reduced.
“ “ “……….$179,000 or more………no contribution allowed.
MFS who lived with spouse at any time of year…………$0.00 (Zero)…….you can contribute the full amount.
“ “ “……….$10,000 or less………the amount of the contribution is reduced.
“ “ “……….more than $10,000………no contribution allowed.

Keep in mind that the Traditional IRA limits above are for the calculation of your IRA deduction. If your MAGI falls outside the range, you can still make what they call a “nondeductible contribution.” This contribution also maxes at the lesser of $5K/$6K or your taxable income. However, you can take that amount out once you retire without having to pay tax on it, since you’d just be pulling your principal out of it, and the return of your principal is not subject to any tax.

Of course you should; especially if you have no plan coverage at work. An IRA is money that will be there for you for when you get old. It’s not a “what if” instrument, like term-life insurance, for example, where, “if you don’t use it, you lose it.” This money is going to be there either for you, or your heirs. You don’t have to be a millionaire to get one. A quick internet search finds that the minimum deposit needed to open an account is around $1000-$2500. If you don’t have that up-front amount, I saw at least one place where the $1000 deposit requirement gets waived if you set up an automatic $100 monthly transfer going into the account. You can certainly do it.

In the case of a Traditional, you get the immediate tax benefit. If you’re in a high tax bracket (25%-35%), a $12,000 contribution by a MFJ couple over 50 turns into a $4200 tax savings right away. The wisdom on the Traditional is that you get your tax benefit now, and pay the tax later, when you’re retired, and presumably in a much lower tax bracket than your current one.

Or you can choose the Roth, and when you retire, take the distributions out tax-free! The Roth is especially great for younger people (be honest with yourself, here) who can watch that account grow and grow over 35-45-55 years (since no RMD) and then pull all the principal and earnings without worrying about having to pay any taxes on it.

No one can predict the future. Imagine the irony if, at 18 years old, you chose a Roth and then died at 59. All that time, the government got the best of you because you chose to sacrifice the tax savings of a Traditional, hoping to be able to live until 85-90 without having to pay any taxes on those future Roth distributions.

Or imagine how you saved on taxes by choosing to fund a Traditional all those years, only to find that now that you’re ready to take a distribution, the income tax brackets have increased to the mid-to-high 40 percent range (remember the 50% tax brackets?). Or what if for some reason or another, you’re still working at age 70 ½ and you have to start taking RMD’s, which get added to your regular earnings, potentially pushing you into even higher tax brackets?

We may not know what’s ahead in our futures. However, we do know that if we’re not disciplined enough to save for our retirement, we’ll be in worse shape than if we had. In the 90’s, it was said that your investment would double in value every 7-9 years. Now that market growth and interest are down, it may be more like every 18-25 years. However, no matter what amount of time passes, you can’t double zero dollars. Plan for your retirement. We do not deal with retirement plans but could recommend a few brokers. Call us if you need a recommendation. We want what’s best for you.

Category: Taxes