As fewer companies provide employee pension plans and concerns grow about the long-term future of Social Security, one thing is clear: the responsibility for accumulating assets for a comfortable retirement lies increasingly with the individual. IRAs represent an important component of personal retirement planning.
An Individual Retirement Account (IRA) is an individual savings plan that you establish and to which you contribute. It can be a key component of your financial plan. In order to contribute to an IRA, you must receive earned income at least equal to the amount of the contribution. The contribution limit for 2013 is $5,500 for individuals under age 50 and $6,500 for those 50 and older. (See “Getting Started” below for more information about contribution limits.)
In general, an IRA offers two significant advantages: tax-deductible contributions and tax-deferred earnings/growth. Eligibility to deduct an IRA contribution may be modified by participation in an employer-sponsored (qualified) retirement plan, marital status, and adjusted gross income (AGI). Anyone who owns an IRA, however, can enjoy the advantages of tax-deferral. Deductible IRA assets and their earnings are not recognized as ordinary income until they are distributed to the account holder.
Roth IRAs – In 1998 Congress created the Roth IRA. This investment vehicle represents an opportunity to create tax-free income without having to invest in municipal bonds. The minimum earned income requirements and contribution limits are the same as for a traditional IRA (see above). However, contribution eligibility “phases out” based upon very specific AGI ranges related to marital status. Participation in an employer-sponsored qualified plan is irrelevant, and contributions are not deductible.
Direct Rollover IRAs – If you leave or retire from a company that sponsors a qualified plan, you may continue to defer income taxes by executing what is known as a direct rollover to an IRA. In general, any distribution from a qualified employer-sponsored retirement plan is subject to an immediate 20% income tax withholding requirement, and the assets are subject to income tax on your next return. However, if you execute a direct rollover to an IRA, there is no withholding, and the IRA assets (along with earnings and growth) continue to be sheltered from recognition as ordinary (taxable) income until they are distributed.
Prior to the year in which an individual reaches age 70½, anyone who receives earned income may contribute to an IRA. You may continue to contribute to a Roth IRA after age 70½ as long as you have earned income equivalent to your contribution amount. For the current contribution limits, visit www.irs.gov/retirement.
The contribution for any given year must be made no later than the tax return filing deadline of the following year. (For example, you may make a 2013 contribution on or after January 1, 2013, but no later than April 15, 2014.) Working with your financial advisor, you can choose between a Roth IRA and a traditional IRA and decide where to set up the IRA and how to invest your contributions.
Withdrawing from Your IRA
You may begin withdrawing funds from an IRA without penalty anytime after reaching age 59½. (Withdrawals made prior to age 59½ may be subject to ordinary income tax and 10% tax penalty.) You must calculate your Required Minimum Distribution (RMD) in the year in which you reach age 70½ and each year thereafter. The calculation is based on the account value and factors found in the IRS' "Uniform Lifetime" or "Joint and Last Survivor" expectancy table. Only the initial RMD may be postponed until April 1 of the next calendar year. All other RMDs must be distributed in the calendar year for which they are determined. Failure to meet the minimum distribution requirement will result in a 50% penalty in addition to any ordinary income tax liability.
Impact on Your Beneficiaries
At your death, the assets in your IRA will pass to your named beneficiary or beneficiaries. (Be sure to name specific beneficiaries rather than leaving the proceeds to be left to your “estate.” Review the beneficiaries periodically to keep them up to date.)
A spousal beneficiary may keep the inherited IRA in the name of the deceased spouse or may choose to roll the assets over into his or her own IRA. Non-spousal beneficiaries may also roll over to an inherited IRA.
At death, distribution of retirement plan proceeds to a beneficiary can result in sobering tax consequences: Every dollar received is subject to ordinary income taxation. For example, if a child-beneficiary inherits a $500,000 traditional IRA account from a parent and elects (or is forced into) a “lump sum” distribution, income taxes can reduce the value of that IRA by as much as 33%. Moreover, if estate taxes are applied to the IRA, the plan’s value could be reduced by 50% or more! There are ways to avoid this, including use of a “stretch IRA” or IRA trust. Talk with your financial advisor about these and other options.
Ready to Take Action?
Clearly, it’s important to plan within the context of your overall financial strategy as you choose which kind of IRA to set up, anticipate and avoid costly mistakes in handling rollovers when you change jobs, and look ahead to tax implications for your beneficiaries.
Email an advisor or call us at 800-388-3085.
Sources: bbtscottstringfellow.com; irs.gov/retirement