CONTRIBUTIONS AND DEDUCTIONS FROM TAXES
Two factors determine whether your IRA contributions can be deducted from your income taxes:
1) Adjusted Gross Income. Contributions to an IRA made in 1987 and after are not fully deductible if the individual participates in an employer-sponsored retirement plan. Individuals who are covered by such a plan must use their adjusted gross income (AGI) on their tax forms to determine how much may be deducted.
2) Whether another employer-sponsored retirement plan covers the IRA holder. Contributions are fully deductible if you are single and not covered by another employer plan. If you are married and neither you nor your spouse is covered by another employer plan, contributions are also fully deductible.
However, there are some additional limits. Though the rules seem complicated, they essentially say that as your salary increases, the amount you are allowed to deduct from your IRA contributions will decrease. This, and the formula for reducing deductions, is discussed in the next two sections.
DEDUCTION LIMITS: SINGLE OR MARRIED AND FILING SEPARATELY
In the case of people who are covered by other employer retirement plans, deductibility of IRA contributions is limited by their adjusted gross income. The amount you can deduct is phased out if your AGI is above $31,000 (in 1999).
Here is how it works for single people and married people who file their taxes separately:
For each $50 above $31,000, your deduction is reduced by $10. At $41,000, deductibility drops to $0. For example, if your AGI is $31,100 in 1999, the maximum you could deduct is $1980.
The phase-out amount has been rising since 1998 and will continue rising until 2005, when it will stand at $50,000 for that year and afterward (or until the federal government changes it).
DEDUCTION LIMITS: MARRIED AND FILING JOINTLY
For married couples that file jointly, limits on deducting contributions depend on whether the IRA holder is covered by an employee retirement plan.
For a couple who files a joint tax return and who is also covered by an employer plan, the phase-out begins at $51,000 in 1999 and rises to $80,000 in 2007. As with single filers, each $50 of income reduces the deductibility of contributions by $10, so that at $10,000 above the phase-out point, deductibility falls to $0. However, in 2007, the $50 increments just described will change to $100 increments. Thus, a married couple filing jointly and making $100,000 or more in 2007 will not be able to deduct anything at all. To illustrate, a couple earning $52,000 of AGI in 1999 will be able to deduct only $1,800 of their contributions.
If just one spouse is covered by an employer plan, that spouse is subject to the rules above. The spouse not covered has a phase-out point beginning at $150,000 of joint adjusted gross income. Deductibility is reduced by $10 for each $50 of extra AGI.
Because the income growth that an IRA makes it tax-deferred, financial advisors often suggest putting as much as legally possible into your IRA, no matter how much you are allowed to deduct from your taxes. The extent of deductibility does not affect the tax-free status of your IRAs earnings. Speaking of taxes, click here to learn how they are applied to IRAs.
HOW ARE IRAs TAXED?
The tax issues of IRAs can be complicated. We have broken them down into four categories:
- Taxing of Deductible and Non-Deductible Contributions
- Taxes on Excess Contributions
- Rollovers
- Premature Withdrawals and Insufficient Distributions
TAXING OF DEDUCTIBLE AND NON-DEDUCTIBLE CONTRIBUTIONS
When you withdraw money from a traditional IRA, it is taxed, but only if it was deductible. The general rule is, whatever was deductible from taxes at contribution time will be taxed at withdrawal time, and whatever was not deductible at contribution time will not be taxed at withdrawal. If your IRA consists of some contributions that were deductible and some that weren't, your withdrawals must be separated accordingly so the proper portions can be taxed. The IRS provides formulas for this separation.
TAXES ON EXCESS CONTRIBUTIONS
Holders of IRAs are not allowed to contribute more than the maximum amount. Those who do will be assessed a 6 percent tax on any excess amount. If this excess remains in the account for following years, it will be taxed in those years as well.
Of course, you cannot deduct excess contributions from your taxes.
ROLLOVERS
A rollover is the moving of an IRA from its current custodian (the company holding it) to another. The following requirements must be met so that the IRA may keep its tax-deferral:
- The account may be rolled over only once per year.
- The funds must be placed into the new IRA within 60 days.
- The opening balance of the new account must be equal to the amount of money received from the previous IRA. If it is less, penalty taxes will be applied.
- The rollover between IRA accounts must be direct.
Read below learn about the penalties involved with premature IRA withdrawals.
PREMATURE WITHDRAWALS AND INSUFFICIENT DISTRIBUTIONS
Premature withdrawals are those that occur before the individual reaches age 59 ½. The IRS levies a penalty tax of 10 percent of the amount withdrawn if funds are withdrawn prematurely. No penalty tax is charged in the following situations:
- Age 59 ½
- Periodic payments made in the form of a life annuity
- Deductible medical expenses
- Buying a home for the first time if the home is to be a principal residence. The limit is $10,000 over the home buyer's life.
- Qualifying health insurance premiums if the individual is unemployed for at least twelve weeks
- Disability or death
Individuals are required to take distributions from their accounts at least once per year once they reach the age of 70 ½, and they must withdraw certain minimums figured by the IRS. If they fail to, they will be penalized for insufficient distributions. This penalty is half of the amount they did not withdraw. For example, if you are required to withdraw $300 during a certain time and only withdraw $200, you will be required to pay half of the $100 difference, or a penalty of $50.
Three ways to calculate the minimum distribution required after age 70 1/2 are:
- Conversion to a life annuity (or life and joint survivor)
- Amortization using the life expectancy (or joint life) and an assumed reasonable rate of return.
- Division of the account balance by your life expectancy each year.
This concludes our study of traditional IRAs.
