Individual Retirement Account

A means by which an individual can receive certain federal tax advantages while investing for retirement.

The federal government has several reasons for encouraging individuals to save money for their retirement. For one, the average life span of a U.S. citizen continues to increase. Assuming that the average age of retirement does not change, workers who retire face more years of retirement and more years to live without a wage or salary.

Uncertainty over the future of the federal

SOCIAL SECURITY system is another reason. U.S. workers generally contribute deductions from their paychecks to the Social Security fund. In theory, this money will come back to them, usually upon their retirement. But a substantial number of politicians, economists, and scholars contend that the Social Security fund is being drained faster than it is being filled, and that it will go broke in a number of years, leaving retirees to survive without government assistance.

Regardless of its future, many people consider the retirement benefits of Social Security to be inadequate, and they look for other methods of funding their retirement years. Many employers offer retirement plans. These plans vary in form but generally offer retirement funds that grow with continued employment. Yet this benefit is not always available to workers. A changing economy has caused some employers to cut back on retirement plans or to cut them out

completely. Often, part-time, new, or temporary workers do not qualify for an employer's retirement plan. And individuals who are self-employed may not choose this job benefit.

To help people prepare for their retirement, Congress in 1974 established individual retirement accounts (IRAs) (EMPLOYEE RETIREMENT INCOME SECURITY ACT [ERISA] [codified in scattered sections of 5, 18, 26, and 29 U.S.C.A.]). These accounts may take a variety of forms, such as savings accounts at a bank, certificates of deposit, or mutual funds of stocks. Initially, IRAs were available only to people who were not participating in an employer-provided retirement plan. This changed in 1981, when Congress expanded the IRA provisions to include anyone, regardless of participation in an employer's retirement plan (Economic Recovery Tax Act [ERTA] [codified in scattered sections of 26, 42, and 45 U.S.C.A.]). The goal of ERTA was

to promote an increased level of personal retire ment savings through uniform discretionary savings arrangements.

A movement to bolster the FEDERAL BUDGET by eliminating many existing tax shelters prompted portions of the TAX REFORM ACT OF 1986 (codified in scattered sections of 19, 25, 26, 28, 29, 42, 46, and 49 U.S.C.A.) and another change in IRA laws. This time, Congress limited some of the IRA's tax advantages, making them unavailable to workers who participate in an employer's retirement plan or whose earnings meet or exceed a certain threshold. Yet, other tax advantages remain, and the laws still allow any one to contribute to an IRA, making it a popular investment tool.

It is difficult to understand the advantages that an IRA offers without understanding a few basics about federal INCOME TAX law. Generally, a person calculating the amount of tax that he or she owes to the government first determines the amount of income received in the year. This is normally employment income. Tax laws allow the individual to deduct from this figure amounts paid for certain items, such as charitable contributions or interest on a mortgage. Some taxpayers choose to take a single standard deduction rather than numerous itemized deductions. In either case, the taxpayer subtracts any allowable deductions from yearly income and then calculates the tax owed on the remainder.

Taking deductions is only one of the ways in which a taxpayer may reduce taxes by investing in an IRA. But IRAs have proven to be popular with taxpayers. This popularity has prompted expansion of the federal tax rules to encourage additional savings and investment through IRAs. In 2003 there were 11 types of IRAs:

1. Individual Retirement Account
2. Individual Retirement Annuity
3. Employer and Employee Association Trust Account
4. Simplified Employee Pension (SEP-IRA)
5. Savings Incentive Match Plan for Employees IRA (SIMPLE IRA)
6. Spousal IRA
7. Rollover IRA (Conduit IRA)
8. Inherited IRA
9. Education IRA
10. Traditional IRA
11. Roth IRA

Despite the many variations, the two most important remain the traditional IRA and the Roth IRA.

In traditional IRAs, a single filer may deduct IRA contributions as long as his or her income is less than $95,000 (to qualify for a full contribution) or $95,000-$110,000 to qualify for a partial contribution. Joint filers may deduct IRA contributions as long as their adjusted gross income is less than $150,000 (to qualify for a full contribution). If their adjusted gross income is between $150,000 and $160,000, they may qualify for a partial contribution.

IRA contribution limits increased in 2002 and will increase over the next few years. For individual taxpayers, contributions are limited to $3,000 for tax years 2003 and 2004. In tax years 2005 through 2007, contributions are capped at $4,000. They are eventually capped at $5,000 for individual taxpayers in 2008 through 2010.

Various plans may constitute employer-maintained retirement plans, such as standard pension plans, profit-sharing or stock-bonus plans, annuities, and government retirement plans. Someone who does not participate in such a plan—whether by choice or not—is entitled to contribute to an IRA up to $3,000 a year or 100 percent of her or his annual income, whichever is less. The amount contributed during the taxable year may then be taken as a deduction.

A married taxpayer who files a joint tax return with a spouse who does not work may deduct contributions toward what is called a spousal IRA, or an IRA established for the spouse's benefit. If neither spouse is a participant in an employer-provided retirement plan, up to $4,000 may be deductible.

Taxpayers who contribute to Traditional IRAs usually realize tax benefits even when the law does not permit them to take deductions. That is because income earned on Traditional IRA contributions is not taxed until the funds are distributed, which usually occurs at retirement. Income that is allowed to grow, untaxed, for several years, grows faster than income that is taxed each year.

To avoid abuses and excessive tax shelters, Congress has placed limits on the extent to which IRAs can be used as a financial tool. Individuals with IRAs may currently make contributions limited to $3,000 a year; contributions exceeding that amount are subject to strict financial penalties by the INTERNAL REVENUE SERVICE each year until the excess is corrected. The owner of an IRA generally may not withdraw funds from that account until age 59¹/2. Premature distributions are subject to a ten percent penalty in addition to regular income tax. Taxpayers may be able to avoid this premature distribution penalty by "rolling over," or transferring, the distribution amount to another IRA within 60 days.

An individual may elect not to withdraw IRA funds at age 59¹/2. However, the law requires IRA owners to withdraw IRA money at age 70¹/2, either in a lump sum or in periodic (at least annual) payments based on a life-expectancy calculation. Failure to comply with this rule can result in a 50 percent penalty on the amount of the required minimum distribution. Contributions to an IRA must stop at age 70¹/2.

In 1997, Congress provided for a new type of IRA—the Roth IRA, named for former Senator William V. Roth, Jr. The Roth IRA was part of the Taxpayer Relief Act of 1997, Pub.L. No. 105-34, 111 Stat. 788 (codified as amended in scattered sections of 26 U.S.C.). Contributions to a Roth IRA are not deductible from gross income, and the Roth IRA allows no deductions for contributions. Instead, Roth IRAs provide a benefit that is unique among retirement savings schemes: If a taxpayer meets certain requirements, all earnings from the IRA are tax-free when the taxpayer or his or her beneficiary withdraws them. There are other benefits as well, such as no early distribution penalty on certain withdrawals, and no need to take minimum distributions after age 70¹/2.

The chief advantage of the Roth IRA is the ability to have investment earnings escape taxation. However, taxpayers may not claim a deduction when they contribute to Roth IRAs. Whether it is more advantageous to use Roth IRAs or traditional IRAs depends on each taxpayer's personal situation. It also depends on what assumptions the taxpayer makes about the future, such as future tax rates and the taxpayer's earnings in the interim.

One may open a Roth IRA if he or she is eligible for a regular contribution to a Roth IRA or a rollover or conversion to a Roth IRA. A taxpayer is eligible to make a regular contribution to a Roth IRA even if he or she participates in a retirement plan maintained by his or her employer. These contributions may be as much as $3,000 ($3,500 if 50 or older by the end of the year). There are just two requirements: the taxpayer or taxpayer's spouse must have compensation or ALIMONY income equal to the amount contributed; and the taxpayer's modified adjusted gross income may not exceed certain limits. These limits are the same as in traditional IRAs: $95,000 for single individuals and $150,000 for married individuals filing joint returns. The amount that a taxpayer may contribute is reduced gradually and then completely eliminated when the taxpayer's modified adjusted gross income exceeds $110,000 (single) or $160,000 (married filing jointly).

A traditional IRA may be converted to a Roth IRA if modified adjusted gross income is $100,000 or less, and if the taxpayer is either single or files jointly with his or her spouse. Although taxpayers converting traditional IRAs to Roth IRAs must pay tax in the year of the conversion, the long-term savings often greatly out-weigh the conversion tax.