Monday, May 19, 2008

Traditional IRA and Roth IRA

This article covers two types of individual retirement arrangements (IRA) that you can use to save money for your retirement: Traditional IRA and Roth IRA. You can contribute to Trad IRA and Roth IRA if you have taxable compensation during the year.

What is compensation? The compensation includes wages, salaries, tips, professional fees, bonus and income for personal services. If you are self-employed or a partner, then the compensation your net earning from your trade or business reduced by total of deductions for retirement plans and one half of your self-employment taxes. The compensation does not include rental income, interest, dividend, pension, annuity, capital gains, deferred compensation, investment income (where you did not provide services) and foreign earned income and housing costs that you exclude from income.

Traditional IRA
A traditional IRA is also known as ordinary or regular IRA and is not a Roth IRA or a SIMPLE IRA. The contributions to traditional IRA can be deductible and the amounts in the IRA, including earnings and gains, are not taxed until they are distributed.

For 2009 and 2010, the limit of the contribution to traditional IRA is your taxable compensation for the year and the maximum is $5,000 ($6,000 if you are 50 or older in 2010). On a joint return for 2010 the total combined contributions made for the year to your IRA and your spouse's IRA can be as much as $10,000 ($11,000 if only one of you is 50 or older, or $12,000 if both of you are 50 or older). Contributions cannot be made to your traditional IRA for the year in which you reach age 70½ or for any later year.

Contributions can be made to your traditional IRA for a year at any time during the year or by the due date for filing your return for that year, not including extensions. Thus for the year 2008, the contribution can be made between January 1, 2008 to April 15, 2009. For the contributed amount to your traditional IRA between January 1 and April 15, you should tell the sponsor which year (the current year or the previous year) the contribution is for. You can file your return claiming a traditional IRA contribution before the contribution is actually made, but the contribution must be made by the regular due date of your return.

The deductible IRA contributions are reported on Form 1040, line 32 or Form 1040A, line 17.

Retirement Plan at Work
If you are covered by a retirement plan at work or on a joint return, if you or your spouse or both are covered by a retirement plan at work, your deductions to traditional IRA may reduce (phase out) if your modified adjusted gross income (AGI) is above a certain amount.

Nondeductible Contributions
You may have nondeductible contribution if the total contributions to your IRA are more than your total permitted contributions. To designate contributions as nondeductible, you must file Form 8606 even if you do not have to file a tax return for the year. When you file, you can even designate otherwise deductible contributions as nondeductible.

Early Withdrawal
If you withdraw from the IRA before the age of 59½, it is early withdrawal. Early Withdrawal is subject to 10% penalty, and is reported on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Also the withdrawal will be taxed at your normal income tax rate. However, in some case there is no penalty on early withdrawals.
*If distributions are not more than your qualified higher education expenses related to enrollment or attendance at an eligible post secondary school. It includes tuition and fees, books, supplies and equipment.
*You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income. The distributions are not more than the cost of your medical insurance.
*You are disabled.
*You are the beneficiary of a deceased IRA owner.
*You are receiving distributions in the form of an annuity.
*You use the distributions to buy, build, or rebuild a first home for yourself, your spouse, your or your spouse’s child, grandchild, parent or ancestor. The distribution up to $10,000 is not subject to 10% additional tax. (If both you and your spouse are first-time home buyers, each of you can
receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.)
*The distribution is due to an IRS levy of the qualified plan.
*The distribution is a qualified reservist distribution.

Care When You Must Withdraw from IRA
When withdrawing from IRA, you should plan in such a way that you pay minimum income tax. Withdraw in the year you have minimum income. If you must withdraw the entire amount, do it in two or more years.

Excess Contributions
If the excess contributions for a year are not withdrawn by the date your return for the year is due (including extensions), you are subject to a 6% tax. You must pay the 6% tax each year on excess amounts that remain in your traditional IRA at the end of your tax year. The tax cannot be more than 6% of the value of your IRA as of the end of your tax year.

You can withdraw an excess contribution made during a tax year and you also withdraw interest or other income earned on the excess contribution by the date your tax return for that year is due, including extensions. In that case you will not pay any excess contribution tax.

Insufficient Distributions (Excess Accumulations)
You must begin receiving distributions by April 1 of the year following the year in which you reach age 70½. The required minimum distribution for any year after the year in which you reach age 70½ must be made by December 31 of that later year. If distributions are less than the required minimum distribution for the year, you may have to pay a 50% excise tax for that year on the amount not distributed as required.

If you are unable to take required distributions because you have a traditional IRA invested in a contract issued by an insurance company that is in state insurer delinquency proceedings, and you meet the requirement, then the 50% excise tax does not apply. If the excess accumulation is due to reasonable error, and you have taken, or are taking, steps to remedy the insufficient distribution, you can request that the tax be excused on Form 5329.

Withdrawals from IRA
You will get Form 1099-R from the IRA administrator. You will report this as income on line 15 of Form 1040. If any taxes are withheld, report on line 64 of Form 1040. You may also need to file Form 5329 to report tax on early withdrawals, excess contributions, and insufficient distributions. The additional tax is reported on Form 1040, line 60.

Inherited IRAs
If you inherit a trad. IRA, you are called a beneficiary. If you inherit someone other than your deceased spouse, you can not treat the inherited IRA as your own. Any taxable distributions your receive must be reported as ordinary income on your tax return. However, you can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of deceased IRA owner for the benefit of you as beneficiary.

Inherited from spouse. If you inherit trad. IRA from you spouse, you have the choices:
1. Treat it as your own by designating yourself as the account owner,
2. Treat it as your own by rolling over to your trad. IRA, or some eligible retirement plans, and
3. Treat yourself as the beneficiary. You must report the distribution as ordinary income on your tax return. The distribution is not subject to early withdrawal penalty of 10%.

Roth IRA
You can set up Roth IRA at any age and you can leave amount in your Roth IRA as long as you live. You can not deduct the contributions to a Roth IRA. Also the qualified distributions from Roth IRA are tax free. For 2008, the limit of the contribution to IRA (Roth IRA and/or Trad IRA) is your taxable compensation for the year and the maximum is $5,000 ($6,000 if you are 50 or older in 2008).

Contribution to Roth IRA are not reported on Form 1040. Keep track of your annual contributions and make sure you don't exceed the limit. You may qualify for the "Retirement Savings Credit" (Form 8880). For your Roth contribution IRS will get information from your plan administrator.

For 2007, your contributions to Roth IRA begin to phase out if your modified AGI is more than
$156,000 for married filing jointly or qualifying widower (contribution limit is nil at $166,000),
$99,000 for single, head of household, or married filing separately and you did not like with your spouse at any time during the year (contribution limit is nil at $114,000), or
$0 for married filing separately (contribution limit is nil at 10,000).

For 2008, your contributions to Roth IRA begin to phase out if your modified AGI is more than $159,000 for married filing jointly or qualifying widower (contribution limit is nil at $169,000), $101,000 for single, head of household, or married filing separately and you did not like with your spouse at any time during the year (contribution limit is nil at $116,000), or $0 for married filing separately (contribution limit is nil at 10,000).

Qualified Distributions
Qualified distributions from Roth IRA are not taxable. It must meet the following requirements.
1. Distribution is made after the 5-year period beginning with the first taxable year for which contribution was made to a Roth IRA set up for your benefit, and
2. Made on or after the date you reach 59 1/2, made because you are disabled, made to a beneficiary or to your estate after your death, or pay up to $10,000 (lifetime limit) of certain qualified first-time homebuyer amount.

Distributions to Beneficiaries. A beneficiary of Roth IRA, other than spouse, must distribute all interest with in five calender years after the owner's death unless the interest is payable to a designated beneficiary as an annuity over the life or life expectancy of the designated beneficiary. If paid as an annuity, the distributions must begin before the end of the calendar year following the year of death.

If the sole beneficiary is the spouse, he or she can either delay distributions until the decedent would have reached age 70½, or treat the Roth IRA as his or her own.

(For any clarification and more information, refer IRS Publication 590 Individual Retirement Arrangements (IRAs)(Including Roth IRAs and Education IRAs)

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