Individual Retirement Accounts
Individual retirement arrangements (IRAs), qualified plans and annuity contracts enjoy certain tax benefits, including tax deferral, while funds are being accumulated within the plans. Accordingly, with some exceptions, distributions from these tax-favored plans are generally taxable as ordinary income. An individual retirement account (IRA) is a personal retirement savings plan, funded by an annuity or a trust, provides for tax-deferral of earnings and may permit either tax-deductible contributions or tax-free qualified distributions. Unless the taxpayer is age 50 or older by the end of the year, the total contribution to all IRAs made for the year cannot exceed the lesser of $6,000 or the individual’s compensation includable in gross income. If the taxpayer is age 50 or older by the end of 2022, a maximum additional contribution—a catch-up contribution—of $1,000 may be made.
Individual retirement accounts are fundamentally of two types:
Traditional IRAs that may permit tax-deductible contributions and generally taxable distributions, and
Roth IRAs whose contributions are not deductible but whose qualified distributions are entirely tax-free.
Traditional IRA – Contributions & Distributions
Contributions to traditional IRAs are normally fully tax-deductible to a taxpayer unless the taxpayer or the taxpayer’s spouse is an active participant in an employer-sponsored qualified plan and has a modified adjusted gross income in excess of a specified amount for his or her filing status. Distributions from traditional IRAs to which no after-tax contributions have been made are fully taxable as ordinary income. Traditional IRA distributions of after-tax contributions are received taxfree as a return of basis on a pro rata basis, and the remainder of the distribution is taxable.
Premature Distributions
In order to ensure that traditional IRAs are used for the purpose for which they were designed—to accumulate retirement savings—Congress imposed a limitation on their liquidity by specifying a penalty for premature distributions. Usually, in order to avoid a premature distribution penalty, the taxpayer must be at least age 59½ before receiving a distribution from a traditional IRA.
The premature distribution penalty is equal to 10 percent of the amount of the distribution that is includible in the taxpayer’s gross income. In many cases, because all contributions were deductible, the amount of the traditional IRA distribution that would be includible in gross income is the total amount of the distribution.
Premature Distributions Avoiding Tax Penalty
Although, tax penalties generally apply to IRA distributions before age 59 ½, there are certain premature distributions to which the 10 percent penalty tax doesn’t apply. Those distributions include distributions:
Made at the taxpayer’s death;
Attributable to the taxpayer’s disability;
Made for medical care to the extent allowable as a medical expense deduction;
Made for the payment of health insurance premiums by unemployed taxpayers;
Made to pay qualified higher education expenses for the taxpayer, his or her spouse, child or grandchild;
Considered “first-time homebuyer distributions” up to a lifetime maximum of $10,000;
That are part of a series of substantially equal periodic payments made for the life of the taxpayer or the joint lives of the taxpayer and his or her beneficiary; or
That are qualified birth or adoption distributions not exceeding $5,000.
Required Distributions during Owner’s Lifetime
The Internal Revenue Code requires that minimum distributions from a traditional IRA begin no later than the owner’s age 72. The law permits the individual to delay taking these first required minimum distributions (RMD) until April 1st of the year following the year in which he or she turns age 72. The date on which RMDs must commence is known as the “required beginning date.” Lifetime distributions never need to be taken from a Roth IRA.
Roth IRAs
Roth IRAs differ from traditional IRAs in providing their most significant tax benefits when funds are distributed rather than when contributed as is the case in a traditional IRA. A Roth IRA provides income tax deferral of gain before distribution and may provide tax-free distribution of earnings. It does not provide for contribution deductibility, however.
A “qualified” distribution from a Roth IRA is one that is made no earlier than the fifth year following the year for which the owner made his or her first Roth IRA contribution and:
The taxpayer is age 59 ½ or older;
The distribution is a qualified first-time homebuyer distribution;
The taxpayer is disabled; or
The distribution is made to a beneficiary on or after the taxpayer’s death.
There is an additional tax advantage on distributions that Roth IRA owners enjoy, even when the distribution isn’t a qualified distribution: a nonqualified distribution—one that fails to meet the requirements to be a qualified distribution—from a Roth IRA receives FIFO tax treatment under which all contributions are deemed to be distributed tax free before any earnings are distributed.
Limits on Roth IRA Contributions
The maximum amount an individual can contribute to a Roth IRA is the same as a traditional IRA: that is $6,000 (in 2022) or, if he or she is age 50 or older, $7,000. The maximum contribution that may be made to a Roth IRA is reduced, based on the individual’s modified adjusted gross income, according to the following formula:
Contribution reduction = MAGI – applicable dollar amount $15,000 ($10,000 if joint or married filing separate return) x Maximum contribution
The “applicable dollar amount” in the Roth IRA formula is based on the individual’s filing status.
Non-Qualified Roth IRA Distributions of Gain before 59 ½ Subject to Tax Penalty
It was noted earlier that a premature distribution—one made prior to the owner’s age 59 ½—from a traditional IRA would result in a 10 percent tax penalty. The 10 percent premature distribution tax penalty is based on the amount that must be reported as a taxable distribution. The same is true of a Roth IRA. Just as in the case of a traditional IRA, however, the penalty for a distribution of earnings before age 59½ from a Roth IRA is waived if the distribution is:
Attributable to the IRA owner’s death or disability;
Made for medical care to the extent allowable as a medical expense deduction;
Made by unemployed taxpayers for the payment of health insurance premiums;
Used to pay qualified educational expenses;
A qualified first-time homebuyer distribution;
Part of a series of substantially equal periodic payments made for the life or life expectancy of the taxpayer or of the taxpayer and a designated beneficiary; or
A qualified birth or adoption distribution not exceeding $5,000.
No Required Roth IRA Lifetime Distributions
Unlike traditional IRAs, Roth IRAs are not subject to required minimum distribution (RMD) rules during the owner’s lifetime. Funds contributed to and accumulated within a Roth IRA can remain in the account as long as the owner wishes, even after age 72. However, required minimum distributions must be made following the owner’s death.
IRA Rollover Per-Year Limit
Taxpayers are permitted to rollover an existing IRA to another IRA of the same type directly, in a trustee-to-trustee transfer. Trustee-to-trustee transfers from one IRA to another IRA are not subject to withholding, are not subject to the one-per-year limit and may be made at any time.
Alternatively, taxpayers may withdraw funds from an IRA and deposit them in another (or the same) IRA within 60 days of the distribution without having to recognize any income. This withdrawal and deposit treated as a rollover may be done once in any one-year period. IRA rollovers that are not trustee-to-trustee rollovers may be subject to withholding, but the taxpayer must contribute 100% of the amount, including any withheld amount, to the new IRA, or recognize income on the amount not deposited within 60 days of distribution.
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