Module 1: Traditional IRAs

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Almost anyone with earned income under age 70½ can establish and contribute to a traditional Individual Retirement Account. Employees and self-employed persons can open IRAs for themselves, even if they already participate in tax-qualified, employer-sponsored plans. Participants in governmental plans also may open an IRA. An individual may open more than one IRA, as long as he or she does not exceed the annual contribution limits.

No one over age 70½ may establish a new, traditional IRA or contribute to an existing traditional IRA. With this one exception, age plays no factor in an individual’s ability to open an IRA. As a result, children are eligible to open IRAs if they earn compensation from after-school jobs or summer employment. Retired persons also may set up IRAs as long as they are under age 70½ at the end of the year in question and receive earned compensation (part-time jobs, consulting fees, etc.). Individuals over age 70½ may not establish an traditional IRA or make new contributions. They may, however, set up a rollover IRA by rolling over a distribution from another qualified plan.

In the case of a married couple, if both spouses are employed, each spouse may set up his or her own IRA and contribute up to the annual limit. If only one spouse works, the employed spouse can set up a “spousal IRA” for a nonworking spouse. Spouses may not open a joint IRA account. A “spousal IRA” is essentially two separate IRA accounts, each subject to the annual contribution limits.

In order to establish or contribute to an IRA, a person must receive earned income during the year. This includes wages, salaries, professional fees, and other amounts received for personal services. Earned compensation also includes such items as sales commissions, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, as well as tips and bonuses. Taxable alimony or separate maintenance payments under a divorce decree are also considered earned income.

Earned income also includes compensation received by self-employed persons from a trade or business in which the individual renders income-producing services. Mere ownership of a business is not enough — the self-employed individual must actually “work” at the business. A self-employed person's IRA contribution is based on his or her income after retirement plan contributions have been deducted.

For example, Jake Grossman, age 62, is a retired free-lance writer. He maintains a Keogh account as well as an IRA. Jake earned $4,000 for articles he wrote this year. He contributed 20% into his Keogh or $800. For purposes of his IRA, he has earned compensation of $3,200 ($4,000 - $800). He may contribute only $3,200 toward his IRA.

For persons who are active partners in a partnership and who provide income-producing services to the partnership, earned compensation includes the active partner’s share of partnership income. Partnership income is not considered “earned compensation” for IRA purposes if a partner merely invests in a the business and does not provide services to the partnership.

Earned income does not include return or profits from property, such as rent, dividends or interest. Also excluded are disability payments, foreign income and other amounts not includible in the taxpayer’s gross income. Compensation for IRA purposes does not include deferred incentives such as stock options or stock appreciation rights. Also, earned compensation does not include pension or annuity payments, or other forms of deferred compensation. The IRS does disallow IRA deductions when the taxpayer cannot prove the receipt of earned compensation.

Individuals who have earned income and are under age 70½ at the close of a tax year may make new contributions to a traditional IRA. Individuals who are 70½ or older may open an IRA with funds rolled over from a qualified retirement plan, however, these individuals may not make new contributions to an traditional IRA (but might be eligible to contribute to a Roth IRA. Roth IRAs are discussed below.)

Individuals may have more than one IRA account, however, the annual limit applies to the total contributions made to all IRAs for the year. Opening additional IRAs does not increase the amount that can be contributed.

The tax code limits the amount that may be contributed, but does not require an individual to make contributions to an IRA — regardless of the availability of a deduction. However, if a person does not contribute the maximum in a given year, they may not “make-up” the difference with excess contributions in subsequent years.

Example: Ed Sanders earned $30,000 in 2006 and contributed only $3,000 to his IRA. In 2007, he again earns $30,000. His 2007 contribution limit is still $4,000. Sanders may not contribute an extra $1,000 to his IRA in 2007 to make up for the contribution he “missed” in 2006.

If an individual contributes more than is permitted, the excess is subject to a 6% excise tax. This tax is cumulative. The excess contribution (and any earnings generated by it) should be withdrawn by that year’s tax filing date (usually April 15th of the following year). If not, the 6% tax applies each year the excess remains in the account, until it is “corrected”. Excess contributions in the past may be corrected by underfunding the account in the future. (Previous under-fundings cannot be used to correct a current excess.)

An individual who invests in an annuity or endowment contract under an individual retirement annuity cannot contribute more than the annual contribution limit toward its cost for the tax year, including the cost of life insurance coverage (these are discussed on p. 36)

Contributions to an IRA generally must be in the form of “cash”, which includes checks or money orders, wire transfers order and even credit cards. An IRA contribution made by credit card advance is acceptable as long as the bank honors the charge. It is not necessary for the taxpayer to repay the credit card advance before the due date of the year’s tax return.

Because new IRA contributions must be made in the form of cash, contributions of property, such as stock or bonds, to an IRA are not allowed. Of course, the IRA custodian may use the cash contribution to purchase securities requested by a self-directed IRA owner. Securities may also be rolled over or transferred to an IRA from an existing qualified plan or another IRA.

IRA owners may make contributions to an IRA for a tax year at any time during the year or by the normal filing date for that tax year. The deadline for IRA contributions is not lengthened by any extensions. For most people, contributions to an IRA must be made by April 15 of the year following the relevant tax year. Contributors may rely on a post office cancellation mark to prove timely contributions sent by mail. An electronic transfer is treated as a cash contribution to an IRA on the date that payment and registration instructions are received by the custodian or its agent.

Since there is a delay between the close of the tax year and the filing date, IRA owners who contribute to an IRA between January 1 and April 15 must indicate the year for which the contribution is being made. If the IRA owner does not notify the sponsor as required, the sponsor must assume that the contribution is for the tax year in which the contribution is made.

Example: Martha Adams makes a contribution to her IRA on March 1, 2007. However, she does not inform the IRA sponsor whether the contribution is for 2006 or 2007. As a result, the sponsor must assume that Martha made the contribution for 2007.

A taxpayer can file a tax return claiming an IRA contribution before the taxpayer actually makes the IRA contribution. However, the taxpayer must then contribute to an IRA by the due date of the return.

Example: Liz Dickenson, a calendar year taxpayer earning $25,000, files her 2006 tax return on February 15, 2007. On her tax return, she claims a full $3,000 IRA deduction, even though she has not yet actually made the contribution. On April 10, 2007, Liz sends a check for $3,000 to her bank, designating it as an IRA contribution for 2006. Liz's IRA contribution was timely because she made it before April 15, 2007, the due date for her return.

If Liz did not make a contribution to her IRA by April 15th, she must file an amended tax return to eliminate the IRA deduction. Failure to do so, results in the underpayment of her taxes and may subject the her to additional taxes and penalties.

Similarly, taxpayers who file their return early and did not claim a deduction for IRA contributions, may file amended returns to reflect subsequent contributions made before the April 15th filing deadline. Upon filing of the amended return, the taxpayer is entitled to a refund for the overpayment of taxes.

Spousal IRAs are available to married couples who file a joint return, and one spouse has no earned income or has less income than their spouse. The maximum contribution made to an individual retirement plan covering a “working” and “non-working” spouse is limited to the lesser of: 100% of the combined compensation of both spouses, or $8,000 (more if either is age 50 or older).

Example: In 2007, Juan Enriquez is employed and earns $35,000. Maria, his wife, is a homemaker earning $2,500 from a part-time job. They file jointly, and may set up a spousal IRA — each may contribute $4,000 to an IRA (for a total of $8,000).

Example: Rayston and Melissa Jackson are a married couple. Rayston, age 72, earned $7,500 from a part-time job in 2007. Melissa, age 66 has no earned compensation. Even though Rayston cannot contribute to his traditional IRA because he is over age 70½, Melissa may still contribute up to $5,000 to a spousal IRA ($5,000 due to the “catch-up” provision).

Divorced individuals may continue to contribute to a previously established spousal IRA. They may contribute the lesser of $4,000 or an amount equal to their earned compensation for the tax year. Alimony is considered compensation for IRA contribution purposes.

Non-spouse beneficiaries who inherit an IRA may not make new contributions into the inherited account. They may contribute to their “regular” IRAs, but not the inherited account. Surviving spouses who inherit an IRA may make additional, annual contributions to the inherited account.

Generally speaking, individuals may contribute up to $4,000 or 100% of earnings to an IRA. All or part of that IRA contribution may be tax deductible, depending on the individual’s level of income and whether he or she participates in an employer-sponsored retirement plan.

An immediate tax deduction for contributions is a key advantage of an IRA. Indeed, for many, the current tax deduction is the motivating factor for making a contribution. In 1986, the last year for which all IRA contributions were deductible, Americans deposited $38 billion into IRAs. In 1987, when many depositors could no longer deduct their contributions, IRA deposits fell to $14 billion.

Contributors who are not covered by another qualified retirement plan during the year may deduct the full amount of any contributions made that year. If the individual is an active participant in an qualified plan, he or she may make a deductible contribution to an IRA — depending on his or her level of income. At certain income “thresholds” the deduction is phased out and eventually eliminated. For purposes of these rules, an employee is an “active participant” if he or she is eligible to be covered by a:

Contributors should review their status each year. Individuals who were active participants in previous years may not be so in the future due to changes in employment, changes in existing employer plans, etc. To be considered an active participant, the employee must be eligible to be covered by the plan at any time during the year.

Active participant status does not depend on whether an individual's rights under the plan are nonforfeitable (“vested”). Nor does an active participant's status depend on whether monies were contributed to the plan on behalf of the employee.

Example: Shannon is a participant in her employer's 401(k) plan. Shannon is only 40% vested in the plan. She makes no contribution to the plan this year. However, she is considered an “active participant” in the 401(k) plan for IRA deductibility purposes.

Example: Leroy qualifies for his employer's profit-sharing plan. Due to financial difficulties, Leroy's employer elects not to make profit-sharing contributions this year. Leroy is still considered an "active participant" in the profit-sharing when deciding if his IRA contributions this year are deductible.

The active participant status of one spouse is not attributed to the other spouse. Special income “phase-out” rules apply in situations where an individual is not an active participant, but whose spouse is an active participant (these are discussed below).

If an IRA holder is receiving retirement benefits from a previous employer’s plan, but is not eligible under his or her current employer’s plan, the IRA holder is not considered to be an active participant in any employer’s plan — i.e., the holder may fully deduct any IRA contributions.

If an individual is not an active plan participant for any part of the year, the individual can take a full deduction for all IRA contributions that year, regardless of income. However, if an individual is an active participant, the individual may be able to take a full deduction, a partial deduction or no deduction at all, depending income (which includes taxable Social Security benefits*).

Individuals who are below the so-called the “threshold level” can make fully deductible IRA contributions. In 2007, the threshold level for single persons is $50,000 and for married persons who file jointly the threshold is $80,000. For individuals who are married and file a separate tax return, the threshold level was zero. These levels are adjusted annually for inflation.

If an IRA contributor's modified adjusted gross income exceeds the threshold level, the contribution may be partially deductible. The “phase-out range” for single taxpayers is $50,000 to $60,000. For married taxpayers filing jointly the “phase-out range’ is $80,000 to $100,000. The partial deduction is found by comparing the taxpayer’s income with the threshold amount. The deduction is reduced by 40¢ for every dollar the taxpayer’s income exceeds the threshold — for those over age 50, the deduction is reduced by 50¢ for every dollar the taxpayer’s income exceeds the threshold (these apply in 2006 and 2007. In 2008 the disallowance increases to 50¢ for every dollar of excess income, and 60¢ for those age 50 and older.)

Example: Jim Jones is a 37-year-old active participant in his company’s 401(k) plan. He contributes $4,000 to his IRA in 2007. He files an individual return with an adjusted gross income of $57,000. Since his income exceeds the $50,000 threshold by $7,000, his deduction is reduced by $7,000 x 0.40 or $2,800. Jim is able to claim an IRA deduction of $1,200 for 2007 ($4,000 contribution — $2,800 disallowance).

If Jim were age 50 or older, he could contribute $5,000. Assuming he contributed the maximum, his deduction is reduced by 50¢ for every dollar of income over the threshold, so the reduction would be $7,000 x 0.50 or $3,500 — and $1,500 would be deductible ($5,000 contribution — $3,500 disallowance).

Deductions for IRA contributions by an individual who is not an active participant, but whose spouse is, are phased out at adjusted gross incomes between $150,000 and $160,000. In other words, “non-participant” spouses may take a full deduction for their IRA contributions, if their joint income is under $150,000. (This phase-out rule does not apply to married individuals who file separately and live apart at all times during the tax year. For these filers, contributions of an active participant’s spouse are always non-deductible.)

Example: Norton is covered by a 401(k) plan at work. His wife, Trixie, is a full-time homemaker. They file a joint return in 2007 with an adjusted gross income of $180,000 and contribute $4,000 to each of their IRAs. Neither Norton nor Trixie is entitled to make deductible contributions to an IRA for the year because they exceed the upper income threshold of $160,000.

Assume Norton and Trixie's joint income is $125,000. Trixie can make a deductible contribution to the IRA for the year because she is not an active participant, and their combined income is below the $150,000 threshold. But Norton cannot make a deductible contribution because he is an active participant and his income exceeds the threshold for active participants ($100,000 for married couples filing jointly). He may contribute to his IRA, but cannot deduct the contribution.

If their joint income had been $155,000, Trixie would have been entitled to a partial deduction for her contribution (their income is in the phaseout range of $150,000 - $160,000), Norton's contribution would still be non-deductible.

While not as advantageous as a deductible contribution, individuals may make nondeductible contributions to a traditional IRA. This is an option for individuals whose IRA deductions are reduced or eliminated because of the phase-out described above (or are unable to contribute to a Roth IRA because of income restrictions).

Since distributions from an non-deductible IRA will be partially taxed as earnings and partially tax-free return of contribution, the contributor must maintain records of his or her “cost basis”. Form 8606 is used to report nondeductible IRA contributions to the IRS — this form is filed with the contributor’s tax return. The taxpayer may designate an IRA contribution as nondeductible or revoke the designation at any time up to the filing date for the tax year. This allows an individual to make a contribution to an IRA at any time during the year without having to know how much will ultimately be deductible. Taxpayers calculate how much is deductible when they fill out their tax return.

Moreover, an individual is not required to report the nondeductible status of the contribution to the bank or institution holding the IRA. So, both deductible and nondeductible contributions may be made to a single IRA.

Individuals may also be able to make nondeductible contributions to Roth IRAs. The ability to contribute to a Roth IRA is phased out for single taxpayers with adjusted gross incomes exceeding $95,000 and joint filers with AGI exceeding $150,000 (these limits will be adjusted for inflation beginning in 2008). Investments in a Roth IRA grow tax-deferred and distributions from a Roth IRA may be taken tax-free under certain circumstances. This makes a Roth IRA a better opportunity for the taxpayer than a non-deductible, traditional IRA. Still, individuals who cannot (or do not) make contributions to a deductible IRA or a Roth IRA may choose to make contributions to a nondeductible IRA.

It is important to note that there are a number of disadvantages involved in nondeductible IRA contributions. There is paperwork involved in keeping track of nondeductible contributions. Also, the fact that the contributions do not reduce taxable income makes other investment vehicles possibly more attractive, especially in light of the fact that IRA contributions are subject to early withdrawal penalties.

Taxpayers who fail to file Form 8606 are subject to a penalty of $50. Individuals who overstate the amount of nondeductible contributions (and consequently inflate the amount of tax-free distribution when the funds are withdrawn) must pay a $100 penalty. If a taxpayer fails to file Form 8606 when nondeductible contributions are made, the IRS will fully tax all distributions from those contributions. For taxpayers in this situation, it may make sense to file the delinquent forms and pay the penalties before taking a distribution. This will establish a cost basis in account — and then only the earnings portion of the distribution, not the entire amount, will be taxed (see discussion of Distributions below).

Most financial institutions (including commercial banks, savings and loans, mutual savings banks, mutual funds, credit unions, life insurance companies and security dealers) provide custodial services for IRA accounts. For purposes of deposit insurance, IRAs are treated separately from a depositor’s “regular” bank accounts. For example, the FDIC insures depositors’ IRA balances held by a bank for up to $100,000 (all of a depositor’s IRAs at the bank are treated as one account). This is in addition to deposit insurance on other, “regular” accounts the depositor may hold at the bank. (For more regulations affecting IRA custodians, including advertising rules, please refer to Module 2.)

Although a wide array of investments are available for IRAs, some make more sense that others. For example, tax-exempt bonds held in an IRA might not be the most advantageous investment — the tax-exempt element of these bonds is unnecessary because IRAs, by their nature, are already tax deferred; and tax-exempt instruments usually earn less than other types of assets. Taxpayers may not deduct capital losses sustained in an IRA account, so speculative investments may not be prudent. In addition, the tax code prohibits investment of IRA funds in certain assets.

The tax code generally bans IRAs from investing in collectibles. The term “collectible” includes works of art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, or other items of tangible personal property.

Example: Bob Barnes, age 32, directs the trustee of his IRA to invest $1,000 of his IRA assets in baseball cards. On January 17, 2007, the IRA purchases $1,000 the baseball cards for the Barnes' IRA. Barnes is considered to have received a $1,000 distribution from his IRA for 2007, which is includible in Barnes' gross income for 2007. Barnes also faces a penalty for a premature distribution from an IRA.

There a couple of exceptions to the ban on collectibles. Investors may purchase certain coins in their IRAs: U.S. one-ounce, ½-ounce, ¼-ounce, and 1/10th-ounce gold bullion coins; the U.S. one-ounce silver coin; and American Eagle bullion coins. IRAs must purchase the coins from (or sell the coins to) authorized broker-dealers in American Eagle coins. IRA holders may also invest in certain platinum coins and in gold, silver, platinum, or palladium bullion. To qualify, the bullion must be equal to or exceed the minimum fineness required for futures contracts in those metals and the bullion must be in the physical possession of the IRA trustee.

No part of an IRA’s assets can be invested in life insurance. In cases where a life insurance policy is distributed as part of another qualified plan's assets, that policy may not be rolled over into an IRA. The recipient may roll over the cash value of the contract into an IRA if the policy is surrendered.

S Corporations (sometimes called “Subchapter S corporations”) are “pass through” entities — allowing the corporation to bypass corporate taxation and distribute business profits directly to shareholders (who are then responsible for taxes on their share of business profits), The tax code prohibits trusts from owning shares of a “S corporation”. So IRAs, which must hold assets in a custodial trust, cannot invest in shares of an “S corporation” stock.

Although the tax code places few restrictions on the nature of acceptable investments, it does prohibit transactions with certain parties. Since most IRA investors deal with institutional trustees or custodians who have agreed to honor these requirements, the prohibited transaction rules normally do not cause problems for IRAs holders. Institutions simply will not allow prohibited transactions to take place — if they are aware of the circumstances. Dealings between an IRA and a disqualified person, such as the IRA holder or a related party, may constitute a prohibited transaction. As an example, a IRA owner may not borrow money from the account or lend it to companies he or she may control. Similarly, IRA holders may not use IRA assets to purchase stock in closely-held companies that they or their family control. It is possible the trustee may not be fully aware of the circumstances and allow a prohibited transaction to take place. The IRA holder is responsible for any violation, not the trustee.

Example: Jennifer Gardner directs the trustee of her IRA to lend $50,000 to a shopping center developer. The loan is evidenced by a note, secured by a mortgage on the developer’s home, and, given the nature of the transaction, yields a reasonable return. A privately negotiated, secured note earning fair market rate of return, while not a common investment in an IRA, is permitted. However, if the developer is Jennifer's brother, the transaction is prohibited — not because of the type of investment, but due to the related parties.

The penalty imposed on persons who borrow from their IRAs, or lend funds to related parties, is the disqualification of the entire IRA. The entire value of the account, as of the first day of the taxable year, plus any earnings for the year, are taxed as income to the holder that year. The account’s tax status is disqualified as of the first day of the year, so any contributions to the account that year are also disallowed. Unless the individual has attained age 59½ or is disabled, the “constructive distribution” is also subject to the 10% penalty tax on premature distributions.

Example: On July 1, 2007, Ben Green, who is age 36 and not disabled, borrowed $600 from his IRA. The value of his IRA on January 1, 2007, was $20,000. Ben must include $20,000 (plus any earnings of the account since January 1, 2007) in income for 2007. In addition, he is required to pay a premature distribution penalty tax of $2,000 (10% of $20,000).

The rule is a little less stringent when IRA assets are pledged as security against a loan taken by the IRA holder. Only the pledged value, not the entire account, is disqualified. In the earlier example, if Ben had borrowed $600 from a bank and pledged his IRA as collateral, only $600 (plus earnings) would be taxable as a distribution that year — plus the 10% penalty.

Many IRA participants self-direct the investment of the assets in his or her account even though those assets are under the nominal control of the IRA trustee or custodian. With a few exceptions (discussed above), IRAs may be invested in a wide array of conventional and some non-conventional investments.

Self-directed IRAs let investors make their own investment decisions. For example, IRA investors may order purchases or sales to increase or reduce cash positions in much the same way as they could through regular brokerage accounts. Given an agreeable trustee, IRA investment alternatives are far-ranging — including private mortgages and real estate holdings. From an employee’s perspective, freedom of investment choice may be the most clear-cut advantage of investing in an IRA over coverage by another type of qualified plan. Even where an IRA is not self-directed, an IRA owner has a choice of trustee or custodian.

Mutual funds, through their IRA programs, offer the advantage of a wide choice of investment options. Some funds offer the IRA owner the investment flexibility of switching IRA balances between different types of funds just by making a phone call. Many funds charge only a small annual fee for maintaining the IRA, while others may not impose an annual maintenance fee. However, many funds have a sales charge or “load” that can reduce the amount of an IRA investment. Some funds also impose redemption charges upon sale of shares.

A self-directed brokerage account is an IRA usually established through a sponsoring stock brokerage firm or financial institution. These sponsors will allow investment in shares of stock, corporate and government bonds, certain option strategies, and real estate partnerships. A few sponsors will even allow direct investment in residential or commercial real estate or other less conventional vehicles.

Although the self-directed brokerage account offers maximum flexibility, many of the investment decisions call for the expertise of a knowledgeable investor. A self- directed brokerage account can also be expensive for active traders because a commission is charged by brokerage firm every time a transaction is completed.

Self-directed accounts with brokers may offer broader options than families of mutual funds. However, for an individual who frequently switches investments, investing IRA funds in no-load mutual funds shields assets from transaction costs.

Two major issues are raised with regard to the payment of IRA fees and commissions. First, are these fees and commissions deductible? Second, do these fees and commissions count as IRA contributions for purposes of the IRA contribution limits? The answer to these questions depends on whether the fees are (1) trustee’s or administrative fees, or (2) commissions.

The separate payment of the IRA’s trustee or administrative fees is a miscellaneous itemized deduction. Only the excess over 2% of adjusted gross income is deductible. Withdrawal of funds from the IRA to pay trustee fees is not a prohibited transaction, however, the fees are not currently deductible by an IRA owner — as they would be if paid for by the IRA owner through a separate billing.

The payment of trustee fees is not a contribution to an IRA. Therefore, IRA contributors may deposit the full annual contribution limit into the IRA and, in addition, pay the trustee fees directly without violating the excess contribution rules. Fees paid for investment advice on the IRA also qualify for this treatment.

Unlike trustee fees or other administrative expenses, brokerage fees incurred in connection with a securities transaction are not deductible. These expenses are regarded by the IRS as part of the price of the security bought or sold and not as administrative costs. In addition, the amount of commissions must be aggregated with the customer’s actual IRA contributions for the tax year, for purpose of the IRA contribution limits.

The tax code permits a person establishing an IRA to designate beneficiaries who will inherit the account assets upon the death of the IRA holder. These assets pass directly to the named beneficiary outside the probate system (i.e., regardless of the terms of the account holder’s last will and testament) unless the account holder’s estate is named as beneficiary. The value of the assets in the IRA is included in the deceased holder’s taxable estate for purposes of determining any estate taxation.

Any number of individuals may be the beneficiary of an IRA. For instance, an IRA owner may name a surviving spouse, children or grandchildren, non-family members, domestic partners, their estate, trusts or charitable organizations as beneficiary. An IRA owner’s right to change beneficiaries continues until death. The choice of beneficiary may affect the calculation of minimum required distributions when the IRA holder reaches age 70½, depending on whether the beneficiary is a surviving spouse or someone else. This is also true of the legal and tax treatment of an IRA beneficiary, upon the IRA holder’s death. (see discussion of Distributions below)

IRA holders must be aware that failure to name a new beneficiary if the primary beneficiary dies may lead to accelerated distribution of the proceeds and adverse income tax consequences. Similarly, if children are named as equal primary beneficiaries, the beneficiary form should provide for the distribution of the share of a beneficiary who predeceases the account owner. IRA beneficiary forms may be customized to provide that, for example, the share of a primary beneficiary who dies before the account owner will go to either his or her descendents, or, if the beneficiary dies without children, to the other beneficiaries.

The intent of Congress in creating IRAs was to provide retirement income. Presumably, distributions will be taken by the IRA holder upon retirement. To discourage “premature withdrawals”, the tax code imposes a 10% penalty tax on most withdrawals taken before the IRA holder reaches age 59½. By the same token, the funds invested in IRAs are to be used for retirement. The law mandates minimum distributions to be paid to a traditional IRA holder beginning no later than age 70½ (or retirement if later). Failure to take the minimum distribution is subject to a 50% penalty tax. These penalty taxes are in addition to the “regular” income tax due in the year of distribution.

Distributions from IRAs established with tax deductible contributions are fully taxable to the recipient as ordinary income. Contributions to deductible IRAs are made with before-tax dollars. The earnings in the account have grown tax-deferred. Since taxes have not been paid on either contributions or earnings in the account, the entire amount is subject to tax when withdrawn.

On the other hand, contributions to non-deductible IRAs are made with after-tax dollars, which grow tax-deferred. When withdrawn, a portion of the distribution reflects return of contributions (which have already been taxed) and a portion represents taxable earnings. Only the earnings portion is taxable as ordinary income when distributed. The following formula is used to find the non-taxable portion of distributions from non-deductible IRAs:

Example: Barb opens her first IRA in 2005 making a $3,000 deductible contribution. In 2006, she makes a $2,000 IRA contribution to another IRA account, none of which is deductible. Also in 2006, Barb's employer contributed $7,700 to a SEP-IRA. In 2007, Barb makes no IRA contributions and withdraws $1,000 from the IRA she opened in 2005. On December 31, 2007, the current value of all of her IRAs is $15,000. To find the nontaxable portion of the $1,000 distribution taken in 2007:

Please note: when applying this rule, the IRS treats all IRAs held by an individual as being one contract. Likewise, all distributions during the same taxable year are treated as one distribution. The IRS makes no distinction regarding which particular account received a contribution, or which account distributed funds. The law looks to the aggregate amounts in all IRAs, not individual account balances. Because of this, an individual who has ever contributed to a non-deductible IRA must make a similar calculation for any year in which any distribution is taken from any account.

Some IRA owners elect to receive distributions from their accounts over a number of years (sometimes called installment or periodic distributions). A common method is by an annuity over the life of the employee or possibly over the lives of the employee and a designated beneficiary. Regardless of whether the payout is over the life of one person, the lives of two people, or a fixed number of years, the amount of the tax due is determined under the annuity rules. Under these rules, a portion of each payment -- corresponding to after-tax contributions -- is received tax free. The remainder is taxed as ordinary income.

Example: Della Street, an employee of Mason & Associates Co., has contributed to her IRA for a number of years. She retires in 2007 and elects to recieve her IRA benefits in the form of an annuity. At the time of her retirement her account balance is $174,000, of which $45,000 is due to her after-tax contributions. The remaining $129,000 represents deductible contributions and earnings (including earnings on the after-tax contributions). She purchases an annuity from an insurance company that pays $25,000 per year for ten years. The taxable portion of each annual payment is determined as follows:

Cost basis in the contract (after-tax contributions only)..........	$45,000
Expected return ($25,000 x 10 years)........................	$250,000
Exclusion ratio ($45,000 / $250,000).........................	18%
Annual exclusion (18% x $25,000)................................	$4,500
Taxable portion of annual payment ($25,000 -$4,500)..............................	$20,500

In the case of lifetime annuities, the expected return is determined by using IRS life expectancy tables. For annuities starting after 1986, if an employee's after-tax contributions have been recovered, the entire annuity payment is taxable. This generally occurs if the annuitant outlives the life expectancy. However, if the annuitant dies before recovering all after-tax contributions, the annuitant's estate may claim a deduction on the annuitant's final income tax return for the unrecovered contribution.

As with lump-sum payouts, a beneficiary of a participant who receives an annuity because of the participant's death is entitled to a $5,000 death benefit exclusion. The exclusion is taken by increasing the employee's investment in the contract.

To discourage IRA holders from liquidating their nesteggs prior to retirement, the IRS imposes a 10% penalty tax on most “premature” distributions, that is, those taken before the IRA owner reaches age 59½. Exceptions to this penalty are made for distributions:

Unless the a premature distribution qualifies for one of these exceptions, the distribution is subject to a 10% penalty tax in addition to the ordinary income tax due on the distribution. Once the IRA holder reaches age 59½, withdrawals are no longer subject to the penalty tax. Distributions taken after age 59½, for any reason, are simply taxed as ordinary income.

If an IRA holder dies before the minimum required distributions must begin (i.e., before age 70½) and no beneficiary was named, the entire account must be distributed to the IRA holder’s estate no later than December 31st of the fifth year following the holder's death. This is the “5-year rule”.

If a beneficiary was named by the IRA holder, the IRA assets may be distributed in a number of ways. Beneficiaries may choose to receive a lump-sum distribution or a series of payments, based on the beneficiary’s life expectancy. All distributions (in excess of any non-deductible contributions) from the inherited IRA are taxable in the year the beneficiary receives them.

If the sole beneficiary is a surviving spouse, the spouse is assumed to simply “step into the shoes” of the deceased IRA holder. The periodic payments must begin no later than December 31 of the year the deceased IRA owner would have reached age 70½ (or December 31 of the year following the year of the IRA owner’s death if this is later). These distributions are based on the spouse's single life expectancy.

Spousal beneficiaries may also elect to treat the account as his or her own IRA. In this case, the spouse becomes the new IRA holder with the power to name new beneficiaries, make new contributions to the account, or roll new assets into, or from, the inherited account. If the spouse elects to treat the inherited IRA as his or her own account, minimum distributions based on the spouse’s life expectancy must begin when the spouse reaches age 70½.

A surviving spouse who converts an inherited IRA into his or her own name, may designate a new beneficiary. This could extend the distribution period, allowing substantial asset values to build up in the account. The decision to delay or accelerate the distributions from an inherited account obviously depends on the surviving spouse’s circumstances — need for current income, desire to conserve assets that can eventually pass to younger generations, or other personal considerations.

If the beneficiary is not the account owner’s spouse (or the spouse is named jointly with others), periodic distributions must begin no later than December 31 of the year following the year of the IRA owner's death. These are based on the beneficiary’s single life expectancy. Or, the beneficiary can opt to take the account proceeds no later than December 31 of the 5th year following the owner’s death (the “5-year rule” discussed above).

Non-spousal beneficiaries may only receive distributions (lump-sum or periodic) from an “inherited IRA”. They may not make new contributions to the account, roll over funds into the account or rollover the inherited account assets into another IRA. Non-spousal beneficiaries may not change the contingent beneficiaries of the inherited account that were named by the original (now deceased) IRA holder.

For beneficiaries without a life expectancy, such as charities or an estate, the distribution must be completed under the “five-year rule” discussed above. If a trust is named as beneficiary, the ultimate beneficiaries of the trust are considered to be the beneficiaries of the IRA proceeds — and their life expectancies are used to calculate the required distributions. In the case of more than one named beneficiary, the beneficiary with the shortest life expectancy will be used to calculate distributions.

If the holder dies after the start of required minimum distributions (age 70½) , individual beneficiaries and trusts calculate continued distributions based on their life expectancies. Non-individuals beneficiaries (estates and charities) must take continued distributions from the account based on deceased holder’s life expectancy. Alternately, beneficiaries may choose to take the funds more rapidly.

If a beneficiary inherits an IRA from a person who had a “cost basis” in the IRA because of nondeductible contributions, that basis remains with the IRA. Unless the beneficiary is the decedent’s spouse and chooses to treat the IRA as his or her own, the beneficiary cannot combine this basis with any basis maintained in other IRAs. A beneficiary who takes a distribution from an inherited IRA and his or her own IRA, both of which have “cost basis”, the beneficiary must determine the taxable and nontaxable portions of these distributions separately.

The total value of any IRAs, including death benefits payable as an annuity are included in a decedent's gross estate for estate tax purposes. This is true whether the survivor payments are paid into the decedent’s estate or directly to beneficiaries. In addition, any payments made to the decedent's estate are subject to income taxes paid by the estate. Beneficiaries who receive IRA distributions (lump-sum or periodic payments) must include the distributions in their taxable income.

When an IRA is transferred to due to a legally binding divorce or separation agreement it is not taxed. Neither the IRA owner nor the recipient is subject to taxes, nor the 10% withdrawal penalty, upon transfer of ownership. Starting from the date of the transfer, the IRA is treated as the account of the former spouse who receives it — at which point, any withdrawals by the recipient are subject to all of the usual rules that apply to any other IRAs. The IRA account(s) may be transferred (directly from trustee-to-trustee) or rolled over into the ex-spouse’s existing IRA, or the IRA account could simply be retitled in the name of the recipient spouse.

Distributions can be taken from an IRA, without penalty, before age 59½ if the payments are made in a series of substantially equal installments over the participant’s life expectancy (or joint life expectancy). However, the payments must be made at least annually and the participant faces severe penalties if the payment schedule is changed before he or she reaches the age of 59½.

Distributions may be taken in any amount after age 59½ without penalty — other than ordinary income taxes. In an effort to encourage the use of IRAs for retirement purposes, a 50% excise tax is imposed on insufficient IRA distributions. A traditional IRA holder must begin to take first taxable distributions no later than April 1st of the calendar year following the year in which the individual attains age 70½. Older workers may delay the first distribution until they retire, if this is later than age 70½. Subsequent distributions must be made by December 31st of each year thereafter.

The minimum distribution for each year is determined by dividing the value of all IRA accounts by the life expectancy of the holder. All calculations are based on calendar years. The account balance used to figure the minimum distribution is the closing balance as of the last day of the previous calendar year. (This date is used even for the year that the IRA owner turns 70½ or retires, where the first minimum distribution may be postponed until the following April 1st.)

Example: John Smith reaches age 70½ in 2006. He takes his first minimum distribution (for 2006) on April 1, 2007. For purposes of determining the minimum distribution for 2006, John uses the IRA value as of December 31, 2005 (the last day of the year preceding 2006).

When the first required distribution is deferred until some time during subsequent year, the account balance must be adjusted for the delayed distribution when calculating the subsequent year's distribution.

Example: Assume the value of John Smith's IRAs grew to $156,800 on December 31, 2006. If John Smith delayed his first (2006) distribution until April 1, 2007, his second minimum distribution (for 2007) would be:

John must withdraw at least $6,000 no later than December 31, 2007. Subsequent distributions must be taken each calendar year. Had John taken his 2006 distribution in calendar year 2006, he would not have had to adjust the account balance for 2007. Since distributions in subsequent years cannot be delayed, there is no need to adjust calculations in the later years.

It is important to note that in the prior examples, by delaying the first distribution to April 1, 2007, John Smith took two distributions in calendar year 2007 (the delayed first payment for 2006 and the payment for 2007). This may force John into a higher tax bracket in 2007, affect the tax status of Social Security benefits, or availability of means tested government programs. Even if an IRA holder is permitted to delay the first distribution, it might be best to take the first distribution in calendar year rather than delaying it until the following April 1st.

Life expectancies are found using the IRS’s Uniform Minimum Distribution tables — using the attained age of the participant. Another IRS table is used only when the account holder has named his or her spouse as sole beneficiary, and the spouse is more than 10 years younger than the account holder. In all other situations, the Uniform Minimum Distribution table must be used. (This rule significantly simplifies the rules in effect prior to 2002.)

As time passes, an IRA holder’s life expectancy shortens — so each year the holder simply applies the life expectancy found in the table using his or her current age. Note the decreasing life expectancies in the earlier examples. (This is also simplifies the rules in effect in 2002.)

DISTRIBUTION PERIOD

(single life)

AGE	Life Expectancy
70	26.2
71	25.3
72	24.4
73	23.5
74	22.7
75	21.8

LIFE EXPECTANCY TABLE FOR JOINT LIVES

If participant and beneficiary are:

	55	56	57	58	59	60
70	29.9	29.1	28.4	27.6	26.9	26.2
71	29.7	29.0	28.2	27.5	26.7	26.0
72	29.6	28.8	28.1	27.3	26.5	25.8
73	29.5	28.7	27.9	27.1	26.4	25.6
74	29.4	28.6	27.8	27.0	26.2	25.5
75	29.3	28.5	27.7	26.9	26.1	25.3

In the case of an IRA holder with multiple IRA accounts, the holder must calculate the minimum distribution for each account. The IRS allows the holder to add the minimum distributions for each account together and withdraw the aggregate required amount from any one or combination of IRAs. This affords the holder an opportunity to possibly affect his or her asset allocation within the overall retirement plan, depending on the investments within the different accounts. Also, if there is a difference between the life expectancies of the various IRAs (e.g., one IRA may have a younger spouse named as beneficiary, while another IRA names someone else as beneficiary) the accountholder can slow the amount of future distributions by taking withdrawals from IRAs with shorter life expectancies.

In general, the IRS requires IRA custodians to withhold federal income tax on IRA distributions. For annuities or other periodic distributions from an IRA, recipients may elect to not have taxes withheld. Lump-sum distributions are always subject to a 20% withholding rate — recipients of lump sum distributions may not opt out of withholding. Likewise, distributions payable outside the United States or its possessions may not elect to forego withholding. Rollovers are subject to 20% withholding, direct transfers of IRA assets between trustees are not.

IRA rollovers and transfers are tax-free movement of an individual's funds from one IRA to another IRA or from a qualified retirement plan to an IRA. Subject to strict rules, individuals may receive money from an IRA or plan, hold it for a short period of time, and then deposit the funds in an IRA without paying a penalty or including the amount in taxable income — this is a “rollover”. Movement of funds directly from trustee to trustee are called “transfers”.

IRA transfers and rollovers permit individuals to change IRA investments during the year, to consolidate several different types of IRA investments into one, to change the IRA trustee or to alter the mix of their IRA investments.

A rollover involves moving assets from an existing qualified retirement plan or IRA to the individual — and then from the individual to the new retirement plan or IRA. Since the individual actually possesses the IRA assets during a rollover, the IRS requires the “old” trustee to withhold income taxes on the “distribution”. By contrast, there is no withholding in a transfer directly from trustee-to-trustee.

A withdrawal and re-deposit into the same IRA is considered a tax-free rollover (if accomplished within 60 days). If the amount withdrawn from an IRA is not rolled over within the 60-day period to another IRA, it must be included in the individual’s gross income in the year of receipt. The IRS has very little authority to waive or grant extensions to the 60-day period.

Example: Ted Zipp, age 64, received a distribution from his IRA on December 1, 2006. Ted failed to roll over the distribution by January 29, 2007 (the 60-day period). Thus, the distribution was includible in Ted's gross income for 2006 (i.e., the year the distribution was taken — not the end of the 60-day period). Likewise, if Ted had rolled over only a portion of the distribution, any amount he retained is taxable for 2006.

All rollover distributions are subject to 20% income tax withholding. In effect, the IRS holds 20% of the distribution “hostage” against any tax liability owed on the rollover. If the individual accomplishes the rollover within 60 days, he or she may file for a refund from the IRS. However, this means that only 80% of the distribution is available for re-investment. The recipient may add additional personal funds to make up the difference, but this is not always convenient. The easiest way to avoid the withholding is to “transfer” the IRA assets, instead of rolling them over.

IRAs and qualified plans, such as 401ks, and tax-sheltered annuities (TSAs), must provide recipients with the option of having distributions “transferred” directly to another eligible retirement plan.

A transfer differs from rollover in that the funds are paid directly from one IRA or another, rather than being paid to the account holder who then deposits the funds in another plan. The amount transferred is not included in the recipient's gross income. There is no limitation on how frequently individuals may direct their plan trustee or custodian to transfer their retirement plan assets. Direct transfers are not subject to income tax withholding. For these reasons, transfers are the preferred method of redeploying retirement plan assets.

A transfer may be accomplished by wiring a transfer directly to the recipient trustee or by mailing a check negotiable only by the recipient trustee. A plan administrator may also distribute a check to the account holder, with instructions to deliver the check to an eligible retirement plan. The “transfer check” must be payable to the trustee of the eligible retirement account for the benefit of (FBO) the recipient.

Example: Jane Brown directs her employer's 401(k) plan to transfer funds to her IRA at ABC Brokerage. The plan's trustee may cut a check made out to: "ABC Brokerage as trustee of Individual Retirement Account of Jane Brown", and give this check to Jane who delivers it to ABC.

Sometimes a retirement plan trustee will distribute property other than cash to the account holder. In these cases, the account holder may rollover the property into another IRA. If property other than money is distributed to the individual from the old plan, the same property must be redeposited to the new plan. For example, if stock is received from the old IRA, the same stock must be rolled over to the new IRA.

Prohibited investments may not be rolled over. In the case of life insurance — which allowable in other qualified plans, but not IRAs — only the cash value of a surrendered life insurance policy may rollover into an IRA.

If a qualifying rollover distribution includes property, the employee is permitted to make a bona fide sale of the property and roll over, within the usual 60-day period after the distribution, the proceeds of the sale to an IRA.

Example: On June 15, Ron Archer received a $90,000 lump-sum distribution from a his company's noncontributory profit-sharing plan, consisting of $50,000 cash and $40,000 of stock. On July 22, Archer sold the stock for $44,000. Archer may “rollover” $94,000 cash tax-free into his IRA. The $4,000 capital gain on the stock is not recognized and there is no tax on the lump-sum distribution, provided the rollover is completed by August 14th — 60 days after the distribution. (If the sale had resulted in a loss, it also would have been unrecognized.)

Any distribution of property from a noncontributory qualified retirement plan that is not rolled over is taxed as ordinary income to the full extent of its fair market value. This becomes the “cost basis” of the property in the hands of the employee. Any gain or loss on a later sale is a capital gain or loss. The same principles will apply if only part of the assets are rolled over to an individual retirement plan.

The tax code allows employees who change employers to move their retirement assets from the old employer’s plan and into the new. Sometimes, employees will temporarily place a distribution from the old employer’s plan into an IRA, and later transfer that to the new employer’s plan. This type of temporary “parking” of assets is a Conduit IRA. In order for the employee to be able to transfer the IRA assets to a new employer's qualified plan, the IRA assets must not be “contaminated” with other IRA contributions. For this reason, employees should set up a Conduit IRA exclusively for those assets that may be transferred to an employer's plan in the future.

Example: Todd Fischer leaves the service of Toyco, Inc. and receives a lump-sum distribution of $100,000 from Toyco's tax-qualified, noncontributory plan. Todd immediately puts all of the $100,000 into a Conduit IRA. Five years later, Todd goes to work for Rivaltoy, Inc. If Rivaltoy’s plan permits it, Todd can rollover all or part of those assets to Rivaltoy's plan, provided the assets in his Conduit IRA represent only the distribution from his previous employer and subsequent earnings. As with any other rollover, the assets must be redeposited within 60 days.

If the Conduit IRA contains other assets, the rollover into Rivaltoy’s plan is not permitted. During the years between leaving Toyco and beginning employment with Rivaltoy, Todd may have wanted to contribute to an Individual Retirement Account. He could set up a separate IRA for this purpose, so as to not “contaminate” the Conduit IRA’s assets.

A distribution from a qualified plan may be rolled over tax-free to multiple Conduit IRAs if completed within the 60-day period This enables an individual to utilize different kinds of IRAs and investment media. These IRAs will be eligible for later tax-free rollovers to another qualified plan if no additional contributions are made to them.

Please note: Unless the distribution from the old plan is a direct transfer to the Conduit IRA, it is subject to mandatory withholding of 20%. As a result, only 80% of the distribution is available in this in a rollover, unless the taxpayer puts additional funds, to offset the withholding, into the Conduit IRA.

Some special rules apply to distributions during the first two years an individual’s participation a SIMPLE IRA. Assets may be rolled over from one SIMPLE IRA to another SIMPLE IRA. A participant must wait two years before rolling over a distribution from a SIMPLE account to a "regular" IRA without penalty.

Participants who take premature withdrawals from a SIMPLE account will be assessed a 25% penalty tax if the withdrawal takes place in the first two years. Thereafter, the "normal" 10% penalty applies to premature distributions. The 25% tax does not apply to distributions made after the participant reaches age 59½, due to death or disability, etc., regardless of how long the individual participated in the SIMPLE plan. SIMPLE IRAs are discussed in Module 2

Individual Retirement Annuities are special insurance contracts designed to conform with the requirements of IRAs. These take the form of individual annuities, (or in some cases joint last survivor annuities covering the participant and spouse) and endowment contracts. Endowment contracts essentially are annuities that also provides life insurance protection.

In short, these rules simply provide equal treatment between Individual Retirement Annuities offered by insurance companies and traditional Individual Retirement Accounts offered by banks, brokers and other financial institutions. A participation certificate in a group annuity contract is treated as an Individual Retirement Annuity if the group contract meets the above rules and there is a separate accounting of the benefits allocable to each participant under the group contract.

Endowment contracts are the one exception to the rule that prohibits life insurance within an IRA. Although endowment contracts provide life insurance coverage, the cost of that protection is not tax deductible. Holders of endowment contracts must allocate their contributions into “insurance” and “non-insurance” segments. The non-insurance portion may be deductible. The cost of the life insurance protection under a qualified endowment contract is not.