IRAs: The Purpose. Allowable Contributions

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1 IRAs: The Purpose Individual retirement accounts (IRAs) allow income earners and in certain cases, their unemployed spouses to save for retirement on a tax-deferred basis. No taxes are due until the IRA owner begins withdrawing the funds, typically at retirement (Roth withdrawals may be tax free). The IRA may be either a traditional IRA or a Roth IRA. IRA contributions and earnings accumulate in a trust or custodial account, with a bank, federally insured credit union, savings and loan association, or other organization acting as trustee. Another option is an individual retirement annuity, generally subject to the same requirements but following rules applying specifically to annuity contracts. Allowable Contributions Limits on how much may be contributed annually are the same for both traditional and Roth IRAs, or a combination of the two, and vary by age, year of contribution, and income. Maximum contributions for persons age 49 and under are $5,000 in For persons age 50 and older, the maximum is $6,000 in Contributions may not exceed 100 percent of earned income. Example: a 21-year-old with $3,500 total earnings in 2010 may only contribute up to that amount, not $5,000. An IRA owner may contribute to an IRA for a nonworking or part- time working spouse. Combined yearly IRA contributions for both spouses can t exceed their combined earnings for the year.

2 Roth IRA contributions may be limited based on Modified AGI. A traditional IRA requires owners to begin taking minimum distributions after age 70 1/2. This doesn t apply to lifetime Roth IRA distributions. The Tax Picture Traditional IRA Contributions may be tax-deductible, but Roth IRA contributions are not. The maximum deduction for traditional IRA contributions corresponds to the maximum allowable contribution. Example: the maximum deduction in 2010 for a traditional IRA is $5,000 ($6,000 for age 50 and up), or the amount of the actual contribution if smaller. A traditional IRA is subject to restrictions on who may take full advantage of the deduction. The full deduction is available for wage earners who are not active participants in other qualified retirement arrangements. Examples are employer-sponsored retirement arrangements, 401(k) and 403(b) arrangements, SEP and SIMPLE arrangements. For wage earners who are active participants in another retirement arrangement, the deductible amount is gradually phased out according to the person s filing status and Adjusted Gross Income (AGI). In 2010, the phase-out for single filers begins when the AGI reaches $56,000, and the deduction is lost completely at $66,000. For married couples filing jointly, the 2010 phaseout amounts are $89,000 and $109,000, respectively. Roth IRA contributions are not tax-deductible, but no federal income tax is due when distributions are made, provided certain requirements are met. Single filers with Adjusted Gross Incomes above $120,000 and joint filers above $176,000 may not contribute to a Roth IRA. A phase-out reducing the allowable contribution begins when a single filer s AGI is between $105,000 and $120,000, and when a joint filer s AGI is between $167,000 and $177,000.

3 If one spouse is covered by an employer-sponsored arrangement but the other is not, and their joint income is less than $167,000, the amount contributed to the non-covered spouse's IRA would be fully deductible. Participation in another qualified retirement arrangement is not relevant with a Roth IRA. If the Roth IRA owner also owns a traditional IRA, the maximum contribution limit is not permitted for each IRA, but to the total contributions to both types of IRAs. Distributions Distributions may begin from IRAs without a tax penalty when the owner reaches age 59 1/2. Earlier distributions are generally subject to a 10 percent penalty tax on the amount includible in gross income. Under certain conditions, the 10 percent penalty does not apply. Possible exceptions include distributions made when the owner dies or becomes disabled, when they are used to pay qualified higher education expenses, or for qualifying, first-time homebuyer expenses up to a $10,000 lifetime maximum. Other exceptions include substantially equal periodic payments within the terms of the law, or payments that are properly rolled over within a permitted 60-day rollover period. Traditional IRA distributions are taxed as ordinary income in the year they are made. Roth IRA contributions may be withdrawn at any time without taxation or penalty. Earnings may also be withdrawn income tax- free if the owner has reached age 59 1/2 or has died or become disabled, and the withdrawal occurs at least five years after the Roth IRA was established. If the five year requirement is met, tax-free eligibility also pertains to first-time homebuyer expenses, up to a $10,000 lifetime maximum. The Bottom Line IRAs offer effective, tax-advantaged ways to save for retirement. Choosing between a traditional IRA and a Roth IRA in specific situations involves such considerations as the individual s age, income and participation in other qualified arrangements.

4 How Do IRAs Work? The wage earner opens a trust or custodial account with a bank, a federally insured credit union, a savings and loan, or other authorized organization. Another option is to purchase an individual retirement annuity. What Is an IRA? An Individual Retirement Account (IRA) is an account used by people with earned income and in some cases, their nonworking spouses to set aside a portion of their earnings for retirement. The tax treatment of the account differs between a traditional IRA and the newer Roth IRA. With a traditional IRA, contributions may be tax-deductible, and tax is deferred on contributions and earnings until the money is withdrawn, typically at retirement. With a Roth IRA, by contrast, contributions are never tax-deductible. But unlike a traditional IRA, contributions are not taxed when withdrawn. Earnings on Roth contributions may also be withdrawn tax-free under certain circumstances. In 2010, participants in both traditional and Roth IRAs are subject to annual contribution limits of $5,000 for age 49 and under and $6,000 for age 50 and over. Contributions are limited to 100 percent of earned income if less than the dollar maximums. Contributions for nonworking spouses are also subject to certain limits. Are There Other Limitations? Under a Roth IRA, the contribution amount may be limited or phased out depending on AGI and marital status. Under a traditional IRA, participation in an employer retirement arrangement such as a pension or 401(k) may limit or phase out the deduction depending on AGI and marital status.

5 How Are IRA Distributions Taxed? Taxes on IRA distributions are directly related to the tax treatment of the contributions when they were made. Distributions from a traditional IRA are taxed as ordinary income to the extent they are attributable to tax-deferred contributions and earnings. Distributions from a Roth IRA are not taxed as long as certain requirements are met, since the contributions were made with after-tax dollars. Distributions before age 59 1/2 are subject to a 10 percent penalty tax unless certain exceptions apply. The traditional IRA owner cannot make contributions after age 70 and must begin taking minimum distributions on reaching age 70 1/2. There is no such requirement for a Roth IRA owner who, if still working, may continue contributions after that age. The Benefits: A Summary Retirement benefits for workers and spouses Tax-deductibility of contributions to traditional IRAs, subject to limits and restrictions Tax-deferred growth for both types of IRAs Tax-free withdrawals from a Roth IRA, unless it is a conversion of a traditional IRA in which case the 10% premature distribution tax may apply. No required minimum distributions from a Roth IRA during the owner s lifetime NOTE: Required Minimum Distributions for 2009 have been waived by legislation.

6 Benefits paid prior to age 59 1/2 can incur a 10 percent tax penalty unless an exception applies. Distributions must begin no later than April 1 of the year following the year when the participant reaches age 70 1/2. There s another tax penalty equal to 50 percent of the amount that should have been taken but wasn t for not taking required minimum distributions each year once the trigger date occurs. NOTE: Required Minimum Distributions for 2009 have been waived by legislation.

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