Most people are familiar with individual retirement arrangements, or IRAs. However, they may not be as familiar as they should be. An IRA is a powerful tool that will help you save money for your retirement, as well as shelter some of your money from taxes. Similarly, many people assume that an IRA is a specialized type of investment, perhaps a specific mutual fund or stock in which all IRA owners are invested. Not so. An IRA is strictly a type of account; it’s a category of accounts, not a specific investment. In fact, an IRA can hold stocks, bonds, real estate, annuities, or any type of investment you can think of. The types of IRAs, including the traditional and the Roth, are designed to promote retirement saving. With the introduction of the Roth IRA in 1998, retirement saving got a real boost because the Roth offers specialized tax features that no other type of retirement account does. Until recently, the annual contribution limit was $2000. This really didn’t allow the IRA accounts to show a great deal of growth over time, even with the bull market we experienced in the late 1990s. Now, Congress has agreed to increase the contribution limit, which will help those who contribute to IRAs to see a quicker increase in their savings.

Traditional IRAs

Traditional IRAs may be opened by anyone, regardless of whether the person has a retirement plan established at work. These IRAs are very common, and although they share some of the same characteristics as other IRAs and retirement accounts, they have one distinguishing  mark  about  them.  Traditional  IRAs  are  tax deductible. That is, the contribution that you make to your IRA may be deducted from your income tax, which helps you save money on an annual basis, as long as you contribute to a traditional IRA every year. Each family member may have his or her own IRA, no matter how old that person is. However, he or she must have some sort of earned income.

The only exception is that a nonworking spouse may have a traditional IRA account if the other spouse has some sort of earned income.

Special note: Those individuals who have contributed the maximum to their IRAs and are age 50 and older are allowed to “catch up” and contribute more to these accounts. See Table 14.5.

The other features of the traditional IRA are the same as for other types of IRAs. First, you may only contribute $3000 per year per person, right now. (See Table 14.5.) Second, there is a limit to the amount of money you can make per year and still be able to deduct the IRA contribution. You may still be able to make the contribution, just not deduct the amount, be it the full amount or a portion. (See Table 14.6.) Finally, all earnings and gains are accrued on a tax-deferred basis. No tax is paid on the earnings until any distributions are made.

IRA Contribution Limits

*This amount will be adjusted for inflation in $500 increments.

Once IRA distributions have begun, all the earnings and gains that the account(s) have accrued are counted as ordinary income. Your IRA will continue to have its gains accrue tax deferred as long as the account exists and has a value. As for withdrawals, any money taken out of an IRA is subject to tax. There will be a 10percent early-withdrawal penalty for distributions made to those who are younger than 591/2 years old, with a few exceptions. The IRS typically allows people to take up to $10,000 out of their IRA penalty-free as long as the money will be used for a first-time home purchase or for qualifying education purposes. There is another exception that is discussed in a subsequent section. IRA owners are required to begin taking distributions from their IRAs once they reach 701/2 years old. These are called required mini
mum distributions (RMDs). The IRS has established a formula to determine how much you should take out depending on how old you are.

Nondeductible IRAs

Nondeductible IRAs are, in essence, no different than traditional IRAs, except that you can’t take a tax deduction for your contribution. But that’s it; everything else is the same. And there is no difference in the way your account will be handled. You will just not be able to deduct whatever money you put in; all contributions are made on an after-tax basis. Nondeductible IRAs are still limited by the amount of money you may contribute. Just because you can’t deduct what you contribute doesn’t mean that you can put in whatever amount you want. The limits outlined in Table 14.5 reflect those for nondeductible IRAs, as well. The rules regarding distributions and tax treatment are the same as they are for traditional IRAs.

Rollover IRAs

Many times when a client has retired, or changed jobs, we take the money out of his or her company’s retirement plan and roll it over into an IRA. While you can roll over retirement plans and pensions into traditional IRAs, the government has established rollover IRAs in order to keep the money separate. Whether or not you utilize a rollover IRA is up to you. However, if you were to set up an SEPP program for yourself and didn’t want to use any of the money that was in your job’s retirement plan, or pension, you would want to keep that money separate. By rolling over your retirement plan money, you avoid the mandatory 20-percent tax withholding, as well as continue to enjoy tax-deferred investment growth.

Roth IRAs

Roth IRAs are the newest way to save money for retirement in an IRA. They are also the most powerful way. This is because the money that accrues in a Roth IRA is tax free. When you put money into a Roth IRA, you do so on an after-tax basis; you can’t take any type of deduction for it. However, all the interest and other gains that build up the value of your account will not generate any type of taxes. When you begin to take distributions from your account, you will pay no taxes: no taxes on the gains, and no taxes on the money that you originally put in.

Let’s consider Mike Smith. He establishes a Roth IRA for himself and puts $3000 in it. Over the years, he gradually adds to it.  Many years pass, and Mike retires and wants to take some money out of the account. He goes through his statements and finds that he has invested $18,000 total (all after tax) of his own money. The account has grown to just more than $73,000. As Mike takes money out of his Roth IRA, he won’t pay any tax on it. And as long as there is still money in the account, it will continue to grow tax free.

The Roth IRA isn’t without its drawbacks, though. First, if you have an annual adjusted gross income of at least $150,000 (married filing jointly) or $95,000 (single filers), you won’t be able to contribute the full amount to a Roth. The IRS has phased out contributions to Roth IRAs based on income levels. You won’t be able to make a contribution at all once your income hits the $160,000 (married filing jointly) or  $110,000  (single filers) level. Second, the account must have been open for at least five years, and the individual must be over the age of 591/2 when distributions are made for the tax-free provision to count. That means if you are 57 and establish a Roth IRA for yourself, you must wait until you are at least 62 before you can begin to make withdrawals. Otherwise, it’s taxable.

As for regular withdrawals, the same rules apply as for the traditional IRAs. Besides the five-year rule, the only other exception is the required minimum distribution rule. Because the money that goes into a Roth IRA is after tax, and since the money that is withdrawn from a Roth is tax free, the IRS imposes no rule as to when the money must come out of the account. So you don’t have to make any withdrawals from a Roth IRA until you are 90 if you want!

Converting to a Roth IRA

Many clients ask me about converting their traditional or rollover IRAs to Roth IRAs. They think that by converting, they will be able to take their money out of their existing IRAs tax free. However, it doesn’t work like that. To convert a traditional or rollover IRA to a Roth IRA, you will need to pay the taxes due, just as if you had taken the entire amount out of the IRA. (SEP and SIMPLE IRAs may also be converted after two years.) Plus,  if  your AGI is more than $100,000, you are ineligible to convert. (Tax payers who file as married but filing separately are always ineligible to convert.) You don’t think that the IRS will let you just convert and not pay any taxes, do you? If you think that you will benefit from the tax-free distributions, and you have the cash on hand to pay the taxes due, then converting may be a good idea. But, for most people, converting their traditional and rollover IRAs to Roth IRAs is just a poor idea, especially if you find that you have a substantial amount of money invested in IRAs.

Substantially Equal Periodic Payments

I mentioned before that there was an additional way to take distributions from your IRA prior to turning 591/2 without paying the 10-percent  early-withdrawal  penalty. The program called Substantially Equal Periodic Payments, or SEPP (not to be confused with SEP plans), will help you achieve this. The SEPP program is generally used by those individuals who have retire and have no source of income, but their retirement  funds and are younger than  591/2. Because the person has retired, he or she is not earning any income. That person will also be too young to take money out of his or her retirement accounts without penalty, or to draw social security. But, he or she has to have some sort of income, right?

Essentially, SEPP works like this. After adding up the total value of your traditional IRAs (if you have rolled over your company’s 401 (k) plan into a rollover IRA, then you may keep that separate), a computer program will calculate the monthly amount that you may take from your accounts at a fixed percent, usually between five and nine percent. Remember to keep your Roth IRAs separate. By agreeing to take the SEPP-established amount as monthly withdrawals, you agree to the terms of the program. You must not alter the payment amount for five years,  or  until  you  are 591/2 years  old,
whichever comes last.

If you do change anything about your monthly dispersements, the entire amount you have taken will be subject to the 10-percent penalty tax. By abiding by the terms, you will avoid the penalty. Of course, whatever you take will be subject to regular income taxes. Therefore, if you are 57 and wish to participate in the SEPP program, you will have to take the same amount from your accounts until the five years (60 payments) are up. Likewise, if you began taking SEPP payments at age 52, you would have to continue until you were 591/2, or for seven-and-a-half years. However, if you were to die before the 60 payments were completed, the  agreement  dies  with  you. Your  beneficiary  wouldn’t  be required to complete the SEPP program. The SEPP program is especially useful if you have rolled over your 401(k) plan from work and would like just to live off of that while your other accounts continue to grow. You can opt to have the SEPP just use the value of your rollover accounts, instead of your traditional IRA accounts.

Plus, don’t think that just because you are taking money out of your IRA, you must use it all. If you find that the monthly amount is too much income for you, and I have clients that have found that, you can always reinvest the money into a nonqualified (regular) account, where it can grow. You just can’t receive more or less than what is specified by the SEPP calculation. But by diverting some of the unnecessary money into another account, you can help continue to grow your money so that if you need it later, it will be there.

Special note: On October 3, 2002, the IRS released Revenue Ruling 2002-62 to help taxpayers preserve their retirement savings when there is an unexpected drop in the value of their retirement money. Those who began receiving fixed payments from their IRA or retirement plan under SEPP may now switch without penalty to a method of determining the amount of payments based on the value of their account as it changes from year to year.