IRAs offer tax advantages for long-term retirement planning. The 2 most common types of IRAs are traditional IRAs and Roth IRAs. Earnings in these accounts can accumulate either tax-deferred or tax-free. Also, you can deduct traditional IRA contributions.
The traditional IRA is available to anyone under age 70 1 / 2 who receives taxable compensation. This compensation includes:
Wages, salaries, and tips
Military compensation while serving in a combat zone tax-exclusion area
Alimony or separate maintenance payments included in gross income
Income not included as compensation for IRA purposes includes:
Profit from the sale of stocks or other property
Pension or annuity income
For 2012, the maximum annual contribution is the smaller of $5,000 or 100% of your compensation. If you earn $2,000, then your maximum IRA contribution for the year is $2,000.
If you're age 50 or older, you can contribute $1,000 more to your IRA since it's considered a catch-up contribution. So, the limit is $6,000 in 2012 for those age 50 or older.
There is no minimum age to participate in an IRA. If your teen-age child has compensation from a part-time job, your child can contribute to an IRA up to the annual limit - $5,000 in 2012. A 1-time $5,000 investment at age 15 would grow to more than $35,533 by age 65. This assumes an average 4% annual yield.
You must begin withdrawing from your traditional IRA by April 1 of the year after the year when you reach age 70 1 / 2. Also, you can no longer contribute to your traditional IRA account beginning in the year you reach 70 1 / 2.
If you’re married and 1 spouse doesn't receive compensation, you can open an IRA account for the nonworking spouse. You can contribute up to $5,000 to each of your accounts in 2012. For those age 50 or older, that limit is $6,000 .
You can also continue contributing to a nonworking spouse's account after you reach age 70 1 / 2. This is true as long as your spouse is under age 70 1 / 2.
You must file as married filing jointly to qualify for a spousal IRA.
Contributing Too Much
If you make excess IRA contributions, you're subject to a 6% penalty tax.
Ex: Since Jake expects to earn more than $4,000 in 2011, he deposits $4,000 in his IRA. However, his earnings for the year total only $1,200. So, he can’t contribute more than $1,200 to his IRA. The extra $2,800 ($4,000 - $1,200) he contributed is subject to the 6% penalty, or $168 in additional tax.
The penalty applies each year until the excess is either withdrawn or used as a future year's contribution. Ex: If Jake qualifies for a $4,000 contribution in 2012. So, depositing $1,200 would bring his 2012 contribution up to $4,000 ($1,200 + $2,800). He can deduct the $4,000 in 2012.
If you withdraw the excess amount plus any related earnings before the extended due date (usually October 15), both of these apply:
You won't be subject to the penalty on the excess contribution.
You’ll pay tax on the earnings.
Due Date for IRA Contributions
The last day to make your IRA contribution each year is the day your return is originally due for the year. This is usually April 15. If you mail your IRA contribution, you’ll meet the deadline if it's postmarked by the original due date for filing Form 1040. This doesn't apply to the extension due date.
If your income is too high to deduct contributions to a traditional IRA, you might qualify for a Roth IRA. This might apply if you're covered by your company's retirement plan. However, contributions to a Roth IRA aren’t tax deductible.
If your income is too high to contribute to a Roth IRA, you can still contribute to a traditional IRA. This is called a nondeductible IRA. You won’t get a tax deduction for your contributions. However, you’ll still have a long-term investment in a tax-deferred retirement savings plan.
If you’ve contributed to a nondeductible IRA, you must keep track of your basis in the account. By doing so, you won't pay tax on the money again when you withdraw it.
Basis is usually the combination of both of these:
Total amount of nondeductible IRA contributions you've made
Basis from after-tax amounts in qualified retirement plans you've rolled over to your traditional IRA accounts
You must file Form 8606 for any tax year you made a nondeductible IRA contribution. You can also use Form 8606 to help you track your total IRA basis. You might have a traditional IRA with basis from nondeductible contributions or rollovers. If so, you'll need to calculate the taxable portion of any withdrawals.
You might receive both taxable and nontaxable distributions. If so, use IRS Publication 590 worksheets to help you determine the taxable portion of your IRA withdrawals. You’ll report the taxable and nontaxable portions of the distributions on Form 8606.
Limited IRA Deductions
These 2 tests determine how much of your IRA contributions are deductible:
Active participant test
Active Participant Test
You’re an active participant in a company retirement plan if you put funds in a defined-contribution plan account. This is true even if your benefits weren’t vested. Any of these types of defined contribution plans qualify you as an active participant:
Qualified pension plan
Simplified employee pension (SEP) plan
Qualified annuity plan
Retirement plan for state and federal employees, including civil service and the Federal Employees Retirement System
Tax-sheltered annuity (403(b) plan)
Active participation is different for defined benefit plans. If you're eligible for a company defined benefit plan during any part of the year, you're considered covered for the entire year. A company defined benefit plan includes pension plans.
For a defined benefit plan you qualify for, you're considered to be an active participant even if you:
Decline to participate in the plan
Made no contributions
Didn't perform the minimum number of hours of service allowed to receive benefits for the year
The Form W-2 your employer sends you should show if you're an active participant in an employer-sponsored plan. If you’re an active participant, the “Retirement Plan” box should be checked.
It might be that neither you nor your spouse were active participants in a company plan. If so, you can deduct your IRA contributions regardless of how high your income is.
IRA Income Test
If you're covered by a company plan, a second test determines how much of your IRA contribution you can deduct. If you're an active participant in a company plan, the traditional IRA deduction:
Begins to phase out when your modified adjusted gross income (AGI) reaches $58,000 - $92,000 if married filing jointly
Is phased out completely when your income is more than $68,000 - $112,000 if married filing jointly. The phase-out range increases to $173,000 - $183,000 for married couples who have only 1 spouse covered by a workplace retirement plan.
If your modified AGI is equal to or less than the lower phase-out amount, you can deduct your full IRA contribution. This is true even if you're an active participant in a company plan. For these purposes, your modified AGI is your adjusted gross income with these items added back:
Traditional IRA deduction
Student-loan interest deduction
Tuition and fees deduction
Foreign earned-income exclusion
Foreign-housing exclusion or deduction
Excluded U.S. Savings Bond interest
Excluded employer-provided adoption benefits
Domestic production activities deduction
If you and your spouse file separate returns, the phase-out range is $0 to $10,000 . So, you can't claim the IRA deduction if your modified AGI is more than $10,000 . If you're married but you didn't live with your spouse during the year, you're considered unmarried for purposes of the IRA deduction limitation.
Ex: You file a joint 2012 return. Your modified AGI is $10,000 more than the lower phase-out amount of $92,000 . Your maximum annual deduction is $2,500 - half of the maximum allowable amount ($5,000 ). You can contribute up to $5,000 . However, you can deduct no more than $2,500 . Each of you can deduct up to $2,500 if both of these apply:
Both you and your spouse make IRA contributions.
You both are covered by a retirement plan at work.
Roth IRAs are subject to the same rules as traditional IRAs with these exceptions:
You must designate the account as a Roth IRA when you originally establish the account.
Earnings in a Roth account can be tax-free rather than tax-deferred. So, you can't deduct contributions to a Roth IRA. However, the withdrawals you make during retirement can be tax-free if they're qualified distributions.
You can withdraw contributions at any time without tax or penalty.
You can continue to make contributions after you reach age 70 1 / 2 as long as you receive compensation.
You don't have to begin taking withdrawals at age 70 1 / 2.
The balance in your account when you die goes to your heirs tax-free after the account has been open for at least 5 years.
The maximum amount you can contribute to all IRAs must be the lesser of your taxable compensation for the year or $5,000 . The amount increases to $6,000 if both of these apply:
You're age 50 or older.
You're making catch-up contributions.
However, to figure the maximum amount you can contribute to a Roth IRA for a year, you must combine the contributions made to all IRAs. This includes both traditional and Roth IRAs. So, your contribution limit is the lesser of:
Your maximum allowable contribution minus all IRA contributions for the year except Roth IRAs. The contributions also don’t include employer contributions under a SEP or SIMPLE IRA plan.
Your taxable compensation minus all IRA contributions for the year except Roth IRAs. The contributions also don’t include employer contributions under a SEP or SIMPLE IRA plan.
If you contribute more than allowed to your Roth IRA, you’ll be subject to a 6% excise tax on the excess contribution.
Who Can Contribute to a Roth IRA?
Higher-income people who actively participate in company retirement plans can't deduct traditional IRA contributions. However, they can still contribute to save on a tax-deferred basis for retirement. This doesn’t apply to Roth IRA contributions.
The amount you can contribute to a Roth IRA:
Begins to phase out when your modified AGI reaches $110,000 - $173,000 if married filing jointly
Is phased out completely when your income is more than $125,000 - $183,000 if married filing jointly
These phase-out levels apply even if you're not covered by a company pension plan.
Married couples filing separate returns can't make Roth IRA contributions if both of these apply:
You made more than $10,000 .
You lived together at any time during the year.
Ex: Your maximum Roth IRA contribution will be $4,500 if:
You file a joint 2012 return.
Your modified AGI is $170,000 -- $1,000 more than the lower phase-out amount.
When modified AGI is more than the maximum allowable amount -- $183,000 in 2012 -- you can't contribute to a Roth IRA.
Converting Your Traditional IRA to a Roth IRA
Before 2010, you couldn’t make a conversion if either of these applied:
Your modified AGI was $100,000 or more.
You filed as married filing separately.
However, the government removed the income-limit and filing-status requirements.
If you convert your traditional IRA to a Roth IRA, you usually must pay tax on the amount rolled over. However, for 2010, you must report the conversion income you received in 2 installments in 2011 and 2012 -- unless you opted out of the 2-year installment treatment and reported the entire conversion amount on your 2010 tax return. If you made a Roth conversion in 2010, you must report 1 / 2 of the amount on your 2011 return by filing Form 8606.
Ex: Your traditional IRA is valued at $100,000, and it includes only deductible contributions and tax-deferred earnings. If you converted this IRA to a Roth IRA in 2010, include the amount in income in 2011 and 2012 in equal installments of $50,000 unless you paid tax on the full $100,000 by including it in your 2010 income.
Nondeductible contributions you made to a traditional IRA are tax-free if you either:
Rolled over the IRA
Converted to a Roth IRA
Choosing Your Trustee
You must contribute to your IRA through a trustee or custodian the IRS approves. However, you’ll always have complete control over the investments in your IRA account.
You can contribute to your IRA at an IRS-approved:
Bank, savings and loan, or insured credit union where your investment is likely to be held in:
Certificates of deposit
Mutual-fund company where your retirement money might be professionally managed in a:
Portfolio of stocks or bonds
Insurance company where your money might be invested in fixed or variable annuities
Brokerage firm with a self-directed account that offers flexibility. These IRAs allow you to choose the exact types of investments you want in your IRA. You must have a self-directed account to invest in:
Gold or silver coins
Real estate investment trusts
Some IRA accounts have annual fees, while others have no fees. Traditional IRA fees are a miscellaneous itemized deduction if they are both:
Not automatically deducted from your account
You can deduct these expenses only if your total miscellaneous deductions are more than 2% of your adjusted gross income (AGI).
You can have many IRA accounts. You can:
Contribute to a single traditional IRA or Roth IRA account each year
Open a different account each year
Divide each year's contribution among several accounts
Divide your contribution between a traditional IRA and a Roth IRA
However, by having more than 1 account, you might also pay multiple trustee and bookkeeping fees.
No matter how many accounts you have, your total annual contributions can't be more than the maximum allowable limit of $5,000 in 2012. The maximum is $6,000 for those age 50 or older.
Moving Your Money Around
You don’t have to keep your IRAs in the same accounts from your contribution date to your retirement date. You can move your money around to take advantage of changes in the market or in your investment philosophy.
However, you must follow certain rules. Some financial institutions might impose early withdrawal penalties on investments, like CDs and annuities, from their institutions. They can do this even though you roll over the investments. If you do a direct rollover, you won’t pay an IRS penalty, though.