CHAPTER 16 INDIVIDUAL RETIREMENT ACCOUNTS

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1 CHAPTER 16 INDIVIDUAL RETIREMENT ACCOUNTS Introduction Through the enactment of the Employee Retirement Income Security Act of 1974 (ERISA), Congress established individual retirement accounts (IRAs) to provide workers who did not have employment-based pensions an opportunity to save for retirement on a tax-deferred basis. U.S. tax law has subsequently substantially changed the eligibility and deduction rules for IRAs. The Economic Recovery Tax Act of 1981 (ERTA) extended the availability of IRAs to all workers, including those with pension coverage. The Tax Reform Act of 1986 (TRA 86) retained tax-deductible IRAs for those families in which neither spouse was covered by an employment-based pension but restricted the tax deduction among those with pension coverage to families with incomes below specified levels. In addition, TRA 86 added two new categories of IRA contributions: nondeductible contributions, which accumulate tax free until distributed, and partially deductible contributions, which are deductible up to a maximum amount less than the maximum otherwise allowable. While TRA 86 made IRAs less advantageous for some individuals, many individuals may contribute the maximum amount on a tax-deductible basis. Roth IRAs were created by the Taxpayer Relief Act of 1997 as a new type of IRA that modifies the incidence of taxation. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 increased the contribution limits for IRAs significantly, and added the option of catch-up contributions for those age 50 or older. The Pension Protection Act (PPA) of 2006 made the increased contribution limits from EGTRRA permanent. For all individuals, IRAs remain a tax-effective way to save for retirement. However, like any other financial arrangement, IRAs require careful planning and monitoring. This chapter offers an introduction to IRA eligibility rules, contribution limits, distributions, and taxation. 1 1 The Small Business Job Protection Act of 1996 allows employers with 100 or fewer employees to set up a savings incentive match plan for employees (SIMPLE) IRA. Details of this new pension plan for small employers are provided in the chapter on SEPs and SIMPLEs. This chapter refers solely to IRAs other than those used in SIMPLE or simplified employer pension (SEP) plans. 155

2 Eligibility IRAs may be established under one or more of the following circumstances: Individuals 2 who are not active participants in an employment-based retirement plan Regardless of income level, any part-time or full-time worker who is younger than age 70½ and not an active participant in an employment-based plan may establish and contribute to a personal IRA. The Internal Revenue Service (IRS) defines active participant as a person who is covered by a retirement plan, i.e., an employer or union has a retirement plan under which money is added to the individual s account or the individual is eligible to earn retirement credits. An individual is considered an active participant for a given year even if he or she is not yet vested in a retirement benefit. In certain plans, the individual may be considered an active participant even if he or she was only with the employer for part of the year. IRA investors must have earned income. The maximum dollar amount applicable to IRA contributions is $5,000 in In 2010 and going forward, the contributions will be indexed to inflation in $500 increments. An individual who has attained age 50 by the close of the taxable year may make an additional catch-up IRA contribution of $1,000. Individuals who are active participants in an employment-based plan and whose modified adjusted gross income (MAGI 3 ) does not exceed $55,000 (single taxpayers) or $89,000 (married taxpayers filing jointly) in These values are indexed to inflation thereafter These taxpayers may make a fully deductible IRA contribution. Again, contributions can only be made from earned income. In 2009, individuals who are active participants in an employmentbased plan and whose MAGI falls between $55,000 and $65,000 (single taxpayers) and between $89,000 and $109,000 (married taxpayers filing jointly) These taxpayers may make a fully deductible IRA contribution of less than the maximum dollar amount and a nondeductible IRA contribution for the balance, as follows. The maximum deductible 2 Special rules apply to families with two wage earners. For more detail, see the discussion of maximum deductible contributions in the following section on contribution limits. 3 Modified adjusted gross income is the adjusted gross income calculated on the federal income tax forms modified to include IRA deductions, student loan interest deductions, tuition and fees deductions, domestic production activities deductions, foreign earned income exclusions, foreign housing exclusions or deductions, exclusions of qualified savings bond interest shown on Form 8815 and of interest from Series EE and I U.S. Savings Bonds issued after 1989, and exclusions of employer-provided adoption benefits shown on Form Fundamentals of Employee Benefit Programs

3 contribution is reduced by $1 for each $5 of income between the MAGI limits. For example, a single taxpayer with MAGI of $60,000 could make a $2,500 deductible IRA contribution and a $2,500 nondeductible contribution. Under a special rule, the deductible amount is not reduced below $200 if a taxpayer is eligible to make any deductible contributions. Again, contributions can only be made from earned income. In 2009, individuals who are active participants in an employment-based plan and whose AGI is at least $65,000 (single taxpayers) or at least $109,000 (married taxpayers filing jointly) These taxpayers may only make nondeductible IRA contributions of up to the maximum dollar amount; earnings on the nondeductible contribution are tax deferred until distributed to the IRA holder. Again, contributions can only be made from earned income. Individuals who are eligible for IRAs established as rollover vehicles for lump-sum distributions from employment-based pension plans or other IRAs A worker who receives a distribution from his or her employment-based retirement plan, an IRA, or a Keogh can generally place the distribution in a rollover IRA without tax penalty or current taxation (see section on rollovers). Contribution Limits Maximum Deductible Contributions As stated earlier, IRA contributions may not exceed $5,000 per year in 2009 (excluding catch-up contributions for those age 50 or older). The amount that is tax deductible varies according to a worker s income tax filing status, MAGI, and pension coverage status. Single workers may contribute up to $5,000 or 100 percent of earned income (whichever is lower) per year if they are not active participants in an employment-based plan or if they are covered and have MAGI of not more than $55,000. For those with MAGI between $55,000 and $65,000, the deductible amount is prorated (see section on eligibility). Two-Earner Couples Where a husband and wife both have earned income, each may contribute up to $5,000 or 100 percent of earned income (whichever is lower) per year. This means that a two-earner couple may then make a combined annual deductible contribution of up to $10,000, excluding catch-up. If a husband and wife file a joint tax return and either spouse is covered by an employment-based plan, both are restricted in their eligibility to make deductible IRA contributions under the rules that apply to their combined MAGI. If a joint return is filed, the spouse who is not covered by a plan at work may make a full deduction if the modified adjusted gross income is $166,000 or less and no deduction if the modified adjusted gross income is $176,000 or more. 157

4 Partial deductions may be taken for modified adjusted gross incomes between those levels. If the couple files separately, then the limits are reduced to zero and $10,000, respectively. If a married individual files a separate tax return, the spouse s active participation does not affect the individual s eligibility to make deductible IRA contributions. But if a married individual files separately, the phase-out of the $5,000 deduction begins with $0 of MAGI and ends at $10,000. For example, if a married person is an active participant, has $3,000 of income, and files a separate return, the maximum allowable IRA deduction would be $2,800 (i.e., 0.40 x ($10,000 $3,000)). If the same individual had AGI of $10,000 or more, no deductible IRA contribution would be allowed. One-Earner Couples The Small Business Job Protection Act of 1996 increased the amount that an individual may contribute to joint IRAs for the individual and the nonworking spouse. The new limit equals the maximum combined IRA contributions allowable if both spouses work, which remains unchanged. Employment-Based IRAs An employer may contribute to an IRA that has been set up by the employee or may set up an IRA for employees. The employee s interest must be nonforfeitable, and separate records showing the employee s contributions and the employer s contributions must be maintained. Although regular IRA contribution limits apply, the employer is also permitted to pay reasonable administrative expenses associated with the IRA. Employers may also offer employees IRAs through payroll deduction arrangements. Automatic deductions from employees earnings would be deposited in IRAs that are set up by the company. Some employers permit employees to select among a variety of investment options. This arrangement should not be confused with employment-based retirement plans called simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLEs), in which an employer establishes an IRA for each employee and makes contributions on his or her behalf. SEPs and SIMPLEs have different contribution limits from regular IRAs and are subject to some of the same rules as other qualified retirement plans (for further discussion of these plans, see chapter on SEPs and SIMPLEs). Roth IRAs The Roth IRA is an individual retirement account subject to all the rules of regular IRAs, with certain exceptions. Contributions are nondeductible 158 Fundamentals of Employee Benefit Programs

5 and qualified distributions are tax free. Furthermore, contributions can be made to a Roth IRA after the individual reaches age 70½ and can be left there for as long as the individual lives. In 2009, an individual can contribute to a Roth IRA if he or she has taxable compensation and modified AGI less than $176,000 for individuals married filing jointly or qualifying widow(er)s; $120,000 for a single head of household, or married couples filing separately and not living with one s spouse for any time during the year; and $10,000 for those married filing separately and living with their spouse at any time during the year. Contributions can be made to a spousal Roth IRA under the same provisions as those for a regular IRA. Distributions are generally considered qualified if they are from contributions held at least five years and the individual is age 59½ or older. Regular contributions can be withdrawn without penalty, but other additions to the account have to be held for the five-year waiting period. The exceptions to the penalty are the same as those for traditional IRAs. 4 Distributions Minimum annual IRA distributions must begin by April 1 of the calendar year following the calendar year in which the individual reaches age 70½, otherwise a penalty tax is imposed for insufficient distributions. Rollovers A rollover is a tax-free distribution of assets from one retirement plan to another. Rollover contributions are not deductible. Rollovers may be made from the following plans to a traditional IRA: A traditional IRA. An employer s qualified retirement plan for its employees. A deferred compensation plan of a state or local government (Sec. 457 plan). A tax-sheltered annuity plan (Sec. 403(b) plan). Rollovers may also be made from a traditional IRA to a qualified plan. 5 The part of the distribution that may be rolled over is the part that would otherwise be taxable. Qualified plans are not required to accept such rollovers. Rollover contributions must generally be made by the 60th day after the day the distribution is received from the traditional IRA or the employer s plan. Rollover From One IRA to Another Generally, if a tax-free rollover of any part of a distribution is made from a traditional IRA, there is a one-year 4 For further information, see Internal Revenue Service Publication 590, Individual Retirement Arrangements. 5 These plans include the Federal Thrift Savings Fund (for federal employees), deferred compensation plans of state or local governments (Sec. 457 plans), and tax-sheltered annuity plans (Sec. 403(b) plans). 159

6 waiting period before a tax-free rollover may be made from the same IRA. If only a portion of the assets withdrawn from a traditional IRA is rolled over, the remainder will generally be taxable (except for the part that is a return of nondeductible contributions) and may be subject to the 10 percent additional tax on early distributions. Amounts that must be distributed during a particular year under the required distribution rule are not eligible for rollover treatment. Rollover From an Employer s Plan Into an IRA A participant can roll over into a traditional IRA all or part of an eligible rollover distribution received from: An employer s qualified pension, profit-sharing, or stock bonus plan. An anuity plan. A deferred compensation plan of a state or local government (Sec. 457 plan). A tax-sheltered annuity plan (Sec. 403(b) plan). An eligible rollover distribution is any distribution of all or part of the balance to the participant s credit in a qualified retirement plan except the following: A required minimum distribution. A hardship distribution. Any of a series of substantially equal periodic distributions paid at least once a year over: The participant s lifetime or life expectancy. The lifetimes or life expectancies of the participant and his or her beneficiary. A period of 10 years or more. Corrective distributions of excess contributions or excess deferrals and any income allocable to the excess, or of excess annual additions and any allocable gains. A loan treated as a distribution because it does not satisfy certain requirements either when made or later unless the participant s accrued benefits are reduced to repay the loan. Dividends on employer securities. The cost of life insurance coverage. Generally, a distribution to the plan participant s beneficiary. A rollover into a traditional IRA may include both amounts that would be taxable and amounts that would not be taxable if they were distributed 160 Fundamentals of Employee Benefit Programs

7 to the participant but not rolled over. To the extent the distribution is rolled over into a traditional IRA, it is not includable in income. Generally, if an eligible rollover distribution is paid directly to the participant, the payer must withhold 20 percent of it. This can be avoided by choosing a direct rollover option. 6 Employers qualified plans are required to give participants the option to have any part of an eligible rollover distribution paid directly to a traditional IRA (unless the distributions are expected to total less than $200 for the year). Taxation IRA taxation rules reflect the basic purpose of an IRA (i.e., to provide retirement income). Use of IRA savings for purposes other than retirement income, therefore, is discouraged through tax penalties. In general, penalty taxes will not apply to IRA distributions that begin no earlier than age 59½ and no later than April 1 of the calendar year following the calendar year in which the individual attains age 70½. Certain distributions can begin prior to age 59½ without penalty. Distributions are considered income in the year received and are subject to applicable marginal income tax rates. See chapter on retirement plans for more detail. The exceptions for the tax penalty for distributions prior to age 59½ include: Being disabled. Being the beneficiary of a deceased IRA owner. The distribution is to be used to pay certain qualified first-time homebuyer amounts. The distributions are part of a series of substantially equal payments. Having significant unreimbursed medical expenses. Paying medical insurance premiums after losing a job. The distributions are not more than qualified higher education expenses. The distribution is due to an IRS levy on the qualified plan. The distribution is a qualified reservist distribution. 6 The payer does not have to withhold from an eligible rollover distribution paid to the participant if either of the following apply: The distribution and all previous eligible rollover distributions received during the tax year from the same plan total less than $200. The distribution consists solely of employer securities, plus cash of $200 or less in lieu of fractional shares. 161

8 Bibliography Bickley, Mary C., and William H. Rabel. Individual Retirement Arrangements (IRAs), Simplified Employee Pensions (SEPs), Savings Incentive Match Plans for Employees (SIMPLE Plans), and HR-10 (Keogh) Plans. In Jerry S. Rosenbloom, ed., The Handbook of Employee Benefits: Design, Funding and Administration. Sixth edition. New York: McGraw-Hill, BISYS Retirement Services. IRA Fact Book edition. Brainerd, MN: BISYS Retirement Services, Copeland, Craig. Ownership of Individual Retirement Accounts and 401(k)- Type Plans. EBRI Notes, Vol. 29, No. 5 (Employee Benefit Research Institute, May 2008).. IRA Assets and Contributions, EBRI Notes, no. 9 (Employee Benefit Research Institute, September 2008). Employee Benefit Research Institute. EBRI Databook on Employee Benefits. Online at Fleisher, Martin, and Jo Ann Lippe. Individual Retirement Account Answer Book. Fifteenth edition. New York: Aspen Publishers, Internal Revenue Service. Publication 590. Individual Account Arrangements. (2007). Lesser, Gary S., et al. Roth IRA Answer Book. Fifth edition. New York: Aspen Publishers, Fundamentals of Employee Benefit Programs

9 Additional Information American Benefits Council 1501 M Street, NW, Suite 600 Washington, DC (202) International Foundation of Employee Benefit Plans W. Bluemound Road Brookfield, WI (262) U.S. Department of the Treasury Internal Revenue Service 1111 Constitution Avenue, NW Washington, DC (800) (Tax Forms and Publications) (800) (Taxpayer Assistance and Information 163