Individual Retirement Arrangements

Introduction

An Individual Retirement Arrangement (IRA) is a tax-sheltered retirement fund that individual taxpayers can establish for themselves. IRAs may also be established by employers on behalf of their employees.

The two primary types of IRAs are traditional IRAs and Roth IRAs. There are a number of differences between these two types of IRAs.

The IRAs that an employer can establish for its employees include the simplified employee pension (SEP) IRA and the savings incentive match plan for employees (SIMPLE) IRA.

Certain distributions from an IRA must be reported on Line 15 of Form 1040, U.S. Individual Income Tax Return. The taxable amount of such distributions depends on the type of IRA and certain other factors.

Certain contributions to an IRA may be reported as an above-the-line deduction on Line 32 of Form 1040. However, some contributions to IRAs may not be deductible. If a taxpayer is subject to additional taxes or penalties on an IRA, those amounts generally are reported on Line 58 of Form 1040.

Traditional IRAs

A traditional IRA is any IRA that is not a Roth IRA, SIMPLE IRA, or SEP IRA. There is a maximum age limit for setting up and contributing to a traditional IRA. There are also limits on the amount that can be contributed to a traditional IRA. Contributions to a traditional IRA generally are deductible, with the amount of the deduction based on the taxpayer's income, filing status, employee retirement coverage, and receipt of social security benefits. However, in some cases, contributions made to a traditional IRA are nondeductible. Distributions from a traditional IRA generally are taxable. However, a distribution may not be fully taxable if it is partly attributable to nondeductible contributions. Early distributions from a traditional IRA may be subject to an additional tax. A taxpayer generally is required to begin receiving distributions from his traditional IRA by a certain age.

Setting Up a Traditional IRA

A taxpayer can set up an IRA and make contributions to it if:

1. the taxpayer (or spouse, if married filing jointly) received taxable compensation during the tax year; and
2. the taxpayer is not age 70 ½ by the end of the tax year ( Code Sec. 219)

Tip
If spouses both have compensation, they can each set up an IRA for themselves but they cannot both participate in the same IRA.

Compensation for this purpose includes wages, salaries, commissions, self-employment income, alimony and separate maintenance payments and nontaxable combat pay.

A taxpayer is treated as reaching age 70 ½ six months after his 70th birthday. Thus, for example, a taxpayer born on June 30, 1941 is considered to reach age 70 ½ on December 31, 2011 while a taxpayer born on July 1, 1941 is considered to reach age 70 ½ on January 1, 2012.

A taxpayer can set up a traditional IRA whether or not he is covered under another retirement plan. However, if a taxpayer (or spouse, if married filing jointly) is covered by an employer retirement plan, some or all of his IRA contributions may not be deductible.

A traditional IRA can be set up with many different types of organizations (sponsors), including a financial institution (such as a bank), a mutual fund, a stock broker, or a life insurance company. Any IRA that is set up must meet the requirements of the Internal Revenue Code.

There are a couple of vehicles that taxpayers can use to set up a traditional IRA for themselves: the individual retirement account and the individual retirement annuity. In addition, there are several vehicles that employers can use to set up for traditional IRAs for their employees: the simplified employee pension (SEP) IRA, the savings incentive match plan for employees (SIMPLE) IRA, and the employer or employee association trust account.

Individual Retirement Account
An individual retirement account is a trust or custodial account set up in the United States for the exclusive use of the taxpayer or his beneficiaries. It is created by a written document that shows that the account meets all of the following requirements:

1. the trustee or custodian must be a bank, credit union, savings and loan association, or other entity approved by the IRS;
2. the trustee or custodian generally cannot accept contributions of more than the deductible amount for the year (other than rollover contributions and employer contributions to a SEP);
3. contributions must be in cash (other than rollover contributions);
4. the taxpayer must have a nonforfeitable right to the account balance at all times; and
5. the taxpayer must start receiving distributions by April 1 of the year following the year in which the taxpayer reaches age 70 ½ ( Code Sec. 408(a)).

Individual Retirement Annuity
An individual retirement annuity is set up by purchasing an annuity contract or an endowment contract from a life insurance company. The annuity must be issued in the taxpayer's name as owner, and the only ones who can receive the benefits or payments are the taxpayer or his beneficiaries who survive him. An individual retirement annuity must meet all of the following requirements:

1. the contract must provide that the taxpayer cannot transfer any portion of it to any person other than the insurer;
2. the contract must provide that contributions cannot be more than the deductible amount for the year, and that the taxpayer must use any refunded premiums to pay for future premiums or to buy more benefits before the end of the calendar year after the year in which the taxpayer receives the refund;
3. there must be flexible premiums so that if the taxpayer's compensation changes, his payments can also change;
4. the taxpayer's entire interest in the contract must be nonforfeitable; and
5. the taxpayer must start receiving distributions by April 1 of the year following the year in which the taxpayer reaches age 70 ½ ( Code Sec. 408(b)).

Employer Or Employee Association Trust Accounts
A taxpayer's employer or employee association (such as a labor union) can set up a trust to provide IRAs for employees or members. These types of IRAs are generally subject to the tax rules that apply to traditional (Code Sec. 408(c)).

Contributions to a Traditional IRA

Contributions to a traditional IRA must be made in the form of money (cash, check, or money order). Property may not be contributed to a traditional IRA. However, rollovers to a traditional IRA may include property.

Tip
A taxpayer may not make contributions to a traditional IRA for (i) a year in which he does not have taxable compensation, or (ii) the year he reaches age 70 ½ or any later year.

There are timing rules on when a contribution to a traditional IRA must be made for the year. There are also limitations on the dollar amount of contributions that may be made to a traditional IRA for the year. There is a general dollar limitation on the amount of contributions that may be made and there are also a couple of special limitations.

These limitations are reduced by the amount of any contributions made to a Section 501(c)(18) plan (this is a pension plan created before June 25, 1959, that is funded entirely by employee contributions) (Code Sec. 219(b)(3)).

Timing Of Contributions
Contributions to a traditional IRA must be made by the due date (excluding extensions) for the filing of the taxpayer's tax return for the year ( Code Sec. 219(f)(3)). Thus, a taxpayer generally must make 2010 contributions to a traditional IRA by April 17, 2012. In other words, a taxpayer may make 2011 contributions any time from January 1, 2011 through April 17, 2012.

If a taxpayer makes a 2011 IRA contribution between January 1, 2012, and April 17, 2011, he should clearly designate that the contribution is being made for 2011, not 2012.

General Limitation On Contributions
There is a general dollar limitation on the amount of annual contributions that can be made to a traditional IRA. The contribution that a taxpayer may make to a traditional IRA for 2011 is limited to the smaller of:

1. $5,000 ($6,000 if age 50 or older); or
2. the taxpayer's taxable compensation for the year ( Code Sec. 219(b)(5); Notice 2009-94)

Example 1

Steve is a 35-year-old single taxpayer who has $25,000 of compensation in 2011. Steve's 2011 contributions to a traditional IRA are limited to $5,000.

Example 2

Assume the same facts as in Example 1, except that Steve is a full-time student and has only $4,200 of compensation in 2011. Steve's contributions to a traditional IRA for the year are limited to $4,200.

Example 3

Assume the same facts as in Example 1, except that Steve is 52 rather than 35. Steve's 2011 contributions to a traditional IRA are limited to $6,000.

This general limitation applies to the total contributions made to all traditional IRAs during the year. Moreover, it applies even if some or all of the contributions made to a traditional IRA are nondeductible.

Tip
Members of a reserve component of the military who were called to duty after September 11, 2001, were allowed to receive qualified reservist distributions from an IRA. These amounts can be repaid to an IRA even if the repayment contributions would cause total contributions to the IRA to be more than the general limitation on contributions. However, such repayment contributions cannot be made later than (i) the date two years after the reservist's active duty period ends, or (ii) August 17, 2008.

Observation
For tax years 2007 through 2009, if the taxpayer participated in a 401(k) plan and the employer that maintained the plan went into bankruptcy, the taxpayer may have been able to contribute an additional $3,000 to his traditional IRA. This increase in the amount of the limitation applied if:

1. the taxpayer was a participant in the 401(k) plan at least six months before the employer went into bankruptcy;
2. under the 401(k) plan, the employer matched at least 50 percent of the taxpayer's contributions to the plan in company stock;
3. the employer was a debtor in a bankruptcy case in an earlier year; and
4. the employer was subject to indictment or conviction based on business transactions related to the bankruptcy ( Code Sec. 219(b)(5)(C)).

If this exception applied to increase the limitation by $3,000, the additional $1,000 catch-up contribution limitation for taxpayers age 50 or older did not apply. Thus, the maximum contribution under this limitation was $8,000.

Limitation For Joint Filer With Higher Compensation Spouse
The limitation on traditional IRA contributions is different for a taxpayer who files a joint return with a spouse and has less compensation than the spouse. In that case, the contribution that a taxpayer may make to a traditional IRA is limited to the smaller of:

1. $5,000 ($6,000 if age 50 or older); or
2. the combined compensation of the taxpayer and spouse reduced by (i) the amount of any contribution by the spouse to a traditional IRA, and (ii) the amount of any contribution made on behalf of the spouse to a Roth IRA.

Thus, the total combined contributions that can be made to the traditional IRAs of the taxpayer and spouse are limited to $10,000 ($11,000 if one spouse is age 50 or older and $12,000 if both spouses are age 50 or older).

Example

During 2011, Elaine, a 24-year-old full-time student with no compensation, marries Jerry, a 32-year-old comedian with taxable compensation of $30,000. If Elaine and Jerry file a joint return for 2011, each can contribute $5,000 to a traditional IRA. Jerry's contribution limitation is equal to the smaller of $5,000 or his compensation ($30,000). Elaine's contribution limitation is equal to the smaller of $5,000 or their combined compensation less any contribution made by Jerry to a traditional IRA or a Roth IRA ($30,000 - $5,000 = $25,000).

Contributions More Than The Contribution Limitation
If a taxpayer makes contributions to a traditional IRA in excess of the contribution limitation, he can apply the excess amount to a later year. However, a 6 percent excise tax may apply to such excess contributions.