Wednesday, February 15, 2012

Your IRA Retirement Account and Taxes

Individual Retirement Accounts (IRAs) function as personal, tax-qualified retirement savings plans. The earnings on these investments grow, tax-deferred, until the eventual date of distribution. Moreover, certain individuals are permitted to deduct all or part of their contributions to the IRA.

IRAs are set up as trusts or custodial accounts for the exclusive benefit of an individual and his or her beneficiaries. You can set up an IRA simply by choosing a bank, mutual fund company, brokerage house or other financial institution to act as trustee or custodian. The institution will give you the necessary forms to complete. A lesser-known alternative is to purchase an individual retirement annuity contract from a life insurance company. An individual cannot be his own trustee.

As an alternative option, you may be able to set up a "Roth IRA," contributions to which are not deductible, but from which withdrawals at retirement won't be taxed.

Contributing to Your IRA

The most that you can contribute to your retirement IRA in 2011 is the smaller of $5,000 or an amount equal to your compensation includible in income for the year. Also, if you are at least age 50 during the year you can make an additional $1,000 "catch-up" contribution, increasing your allowable contribution limits to $6,000 in 2011.

The same general contribution limits apply if you have more than one IRA, or more than one type of IRA. The contribution must be from "compensation," which means wages, salaries, commissions, net self-employment income, and other sources of earned income. It does not include deferred compensation, retirement payments, or portfolio income such as interest or dividends. When both a husband and wife have compensation, the limit applies separately to each, so that in 2011 as much as $10,000 can be contributed ($12,000 if they are both at least 50 years of age).

If one spouse does not work or has very little income, a married couple filing jointly may still contribute up to $5,000 for each spouse's account (or $6,000 if at least age 50), as long as the couple's joint earned income exceeds their joint IRA contributions. Separate accounts must be used for each spouse.

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An IRA can be established, and/or a contribution made, after year-end. It must be made no later than the due date for filing the income tax return for that year, not including extensions. This generally means that you have until April 15th of the following year to make the contribution, and to deduct it on your tax return if you qualify for the deduction.

You don't have to contribute the full amount every year. You may skip a year or even several years. You may resume making contributions in a later year, but you cannot "catch up" for years no contribution was made.

If you contribute more than the allowable amount, a 6 percent excise tax penalty will be assessed. This penalty is due for the year of the excess contribution and for each year thereafter until corrected. However, you can generally avoid this tax by removing any excess contributions by the due date of the return for the tax year for which they were made.

No contributions may be made to: (1) an inherited IRA, (2) in a form other than cash, or (3) during or after the year in which the individual reaches age 70-1/2.

IRA Transfers and Rollovers

The shifting of funds from one IRA trustee/custodian directly to another trustee/custodian is called a transfer. It is not considered a rollover because nothing was paid over to you. You can have as many transfers as you like each year; transfers are tax-free, and there are no waiting periods between transfers. They don't have to be reported on your tax return.

A rollover, in contrast, is a tax-free distribution to you of assets from one IRA or retirement plan that you then contribute to a different IRA or retirement plan. Under certain circumstances, you may either roll over assets withdrawn from one IRA into another, or roll over a distribution from a qualified retirement plan into an IRA. Distributions of pre-tax assets from certain qualified plans that were rolled into an IRA can generally be rolled backed to that qualified plan.

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If the distribution from a qualified plan is made directly to you, the payer must withhold 20 percent of it for taxes. You can avoid the withholding by having the payer transfer the funds directly to the trustee/custodian of your IRA, or having the check made out to the trustee/custodian of your IRA or other qualified plan.

To avoid tax, a distribution paid to you (including the 20% withheld) must be rolled over within 60 days of receipt of the distribution. Any portion not timely rolled over, including the 20% withheld will be subject to income taxes. Rollovers, whether taxable or not, must be reported on your tax return, as follows: Enter the total amount of the distribution on Line 15a of Form 1040 or Line 11a of Form 1040A; then enter the taxable amount, if any (for example, any amount that was not rolled over) on Line 15b or Line 11b. If you are rolling over a distribution from an employer's plan to an IRA, the distribution and the taxable portion (if any) are reported on Lines 16a and 16b of Form 1040, or Line 12a and 12b of Form 1040A.


Rollovers not completed within 60 days can have horrible tax consequences. First of all, they are treated as taxable distributions. On top of the regular income tax on the entire amount, you may also have to pay a 10 percent excise tax penalty if the distribution was considered premature. If you place the amount into another IRA account, you must treat it as a brand-new IRA contribution for the tax year in which it is made, and another 15 percent excise tax penalty will apply to any portion of the amount that exceeds $5,000 ($6,000 for those age 50 and above) in 2011. These defective rollovers must be reported on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

A rollover from one IRA to another IRA enables you to change your investment strategy and may enhance your rate of return. It can also be used to obtain a short "bridge loan" from yourself, since you'll have the use of the funds for any purpose you want, for up to 60 days. This type of rollover may be made only once a year, but the once-a-year rule applies separately to each IRA you own. If property other than cash is received, that same property must be rolled over. Except for an IRA received by a surviving spouse, an inherited IRA cannot be rolled over into, or receive a rollover from, another IRA.

Distributions from an eligible retirement plan of a deceased participant/owner can be rolled over by a nonspouse beneficiary. If a direct trustee-to-trustee transfer is made to an IRA that has been established to receive the distribution on behalf of a beneficiary who is not the participant/owner's surviving spouse, the following treatment applies:

The transfer is treated as an eligible rollover distribution;

The transferee IRA is treated as an inherited account; and

The required minimum distribution rules applicable where the participant/owner dies before the entire interest is distributed apply to the transferee IRA; the special rules for surviving spouse beneficiaries do not apply.

Withdrawals/Distributions from an IRA

In general, all withdrawals from a regular, deductible IRA account are fully taxable and reported on Line 15b of Form 1040, or Line 11b of Line 1040A.

However, if you made any nondeductible contributions to IRAs over the years, a portion of your withdrawal will be treated as a withdrawal of the nontaxable cost basis of your IRAs, and no tax or penalties will apply to this portion.

You must compute the taxable and nontaxable portions of the withdrawals by completing IRS Form 8606, Nondeductible IRAs, and attaching it to your tax return. This can be a complicated process, so make sure that you follow the instructions to the form very closely.

A 10 percent penalty applies to withdrawals considered premature, but there are a large number of exceptions that avoid the penalty.

Withdrawals from Roth IRAs are subject to another set of rules.

If taxable contributions were made to any of the IRAs, more complications exist.

Mandatory withdrawals must be made after you turn 70-1/2.