With growing life expectancy living in retirement comprises a significant component of one’s life span. As such one needs to plan in advance to ensure financial stability and security during retirement. Investing in an IRA, or an Individual Retirement Account, is one of the tax efficient ways to plan for your retirement. There are many IRA schemes and one that is best for you would depend on your income, nature of work and other personal factors.
Individual Retirement Annuity
Financial security can be achieved through the traditional or Roth IRAs. One such scheme is the individual retirement annuity that is set up with a life insurance company and provides financial security throughout the annuitant’s retirement. It can be tax deferred, or it could be pre-tax as well. This financial product provides money in two forms – fixed annuity or variable annuity.
It is provided by insurance companies as part of their collection of IRA products, and includes the following unique features:
- It does not require an employer’s participation
- Although it does not have any contribution limit or income restrictions as IRAs have, it cannot exceed the maximum annual IRS-allowed contribution cap
- Interest rates can be very very competitive so choosing the life insurance company to invest in should be done carefully
- No tax need be paid on contribution and earnings until retirement, where the age prerequisite starts at 70 ½ years
- There is an option to withdraw funds as necessary
This IRA is preferred by those individuals who simply cannot avail similar programs provided by their current employer for any number of reasons. However, one needs to be aware of the limitations when choosing the Individual Retirement Annuity, like:
- An individual retirement annuity can only be issued in the name of the investor
- The life insurance company is the custodian of the individuals’ retirement fund and the annuitant cannot transfer any portion of the plan to any other individual other than the insurance company
- Only the annuitant or their surviving beneficiaries can receive payments
- Annuity contracts cannot act as loan collaterals
Education IRA (EIRA)
An Education IRA (EIRA) is also known as a Coverdell ESA, since it is not really an IRA at all. In fact, the EIRA is simply a savings account that brings with it the tax saving benefits that are in line with an IRA.
Since 2002, the allowable annual increase from $200 to $2000 has made the EIRA an effective savings scheme for parents and grandparents who are saving or currently supporting the children’s educational expenses. However, certain things need to be borne in mind when working with Educational IRAs:
- Contributions can be made up to April 15th of the contributing year instead of December 31 of the taxable year. Even though the contributing amount is not tax deductible, yet the earnings or withdrawals are tax-free if spent on qualified educational expenses.
- Qualified expenses include: tuition, academic tutoring, books, supplies, uniforms, computer technology that includes equipment or internet access (barring software involving sports, games or hobbies unless proven to be of educational nature).
- A major limitation of the EIRA is that it has to be used for educational purposes only, but anyone can contribute to it and there is no requirement that the contributor has to be earning.
- The income cap for an Educational IRA is much higher now than it used to be – for Single filers, the Modified Adjusted Gross income (MAGI) must be less than or up to $110,000 and for married filers it is up to $220,000.
- Although one may open a number of separate educational IRA accounts for one designated beneficiary, the total contributions in any year towards the single beneficiary cannot be more than $2,000.
- The Tax Relief Act also permits corporations and other tax exempt entities, regardless of their income, to contribute to the Education IRA account, in the contributing year.
- Permission to contribute to the account after a beneficiary reaches the age 18 is allowed only in cases of a special needs beneficiary, and once the beneficiary of the accounts hits the age of 30, it has to be dissolved.
When distributions from an educational IRA and a qualified tuition program are made, it should be noted that they cannot be more than the beneficiary’s qualified higher education expenses in a year. If not, then the excess should be returned before May 31 of the following tax year, as it can then attract taxes.
Employer and Employee Association Trust Account
This traditional IRA account is also known as a Group IRA, and can be set up by an employer, a trade union, or an employee association. They can set up a trust to provide individual retirement accounts for their employees or members of the association. Most of the features are similar to traditional IRAs, except:
- A disclosure statement is usually given to the employee at least 7 days before an IRA account is opened. Certain basic terms and conditions are prerequisite in the disclosure.
- The disclosure should contain a statement that explains when and how you can revoke the IRA, and include the name, address, and telephone number of the person who will receive the notice of cancellation.
- If the IRA is revoked within the revocation period, the issuer or trustee (also known as the sponsor at times) must return the entire amount paid by the employee.
- The contribution made by the employee and the amount repaid has to be mentioned in the IRA forms at the time of revocation.
First, what does an Inherited IRA mean? It is the IRA that is inherited through another individual’s IRA after his or her passing. Inheriting an IRA is no simple matter, especially, if you are a non-spouse beneficiary. However, there are specific rules for Traditional and Roth non-spouse inheritors and also for Traditional and Roth Spouse Inheritors.
Certain generic rules are needed to be observed if you do not want to get involved in the complexities when inheriting an IRA:
- Distributions have to be taken within the inheritor’s lifetime or within 5 years of the demise of the account holder. With an Inherited Traditional IRA, taxes have to be paid on the distribution, but with an Inherited Roth IRA, taxes are not paid on the distributions.
- When it’s your own IRA, you can move it from one account to another within 60 days. However, with an inherited IRA, it always has to be moved from one custodian to another, i.e. “trustee-to-trustee” transfer has to be specified, and it has to be retitled, especially if not a spouse, and indicate that it’s inherited.
- Name your beneficiary/ies when filing with a custodian. Naming a primary as well as alternate beneficiary/ies, gives the heir/s the maximum flexibility, to either take the distribution from the account by Dec. 31 of the year after inheriting, or withdraw over the years and enjoy the income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.
- If inheriting from a 401(k) account, under law the spouse is usually entitled to the money. If no beneficiary has been filed or there is no spouse, then the money goes directly to the children.
- The age factor, especially when it’s the spouse, matters. Your spouse can roll the inherited IRA into their own IRA and postpone withdrawal until the age of 70 ½. Moreover, they should do the rollover only after the age of 59 ½, or pay a 10% early withdrawal penalty.
- There are certain distributions traps that inheritors should be aware of before withdrawal or transfer of the Inherited IRA.
For the beneficiaries, it is essential to know that the IRA has to be retitled right away. Two key points are to be kept in mind when retitling – the name of the IRA’s original owner and the fact that the IRA has been inherited. The only exception to this rule is if the inheritance source is the spouse.
If you’re the account holder, it’s important to make sure that the beneficiaries know what to do with the IRA in case of your demise. Since there could be more than one beneficiary, it’s best to split the IRA before signing up for it.
Retirement plans like the 401(k) provided by employer pose a challenge to the individual if they have to roll funds from it into another retirement plan. If such a rollover were to be done to a traditional IRA, they cannot roll back, as the move is unidirectional. This becomes a problem in scenarios where a later employer-sponsored retired plan offers better returns.
The conduit or rollover IRA fixes this problem. A conduit IRA is nothing more than a holding receptacle for an employee to park his or her funds until they find a better placement. As the name suggests, the individual can roll from an employer retirement plan to a rollover IRA, then rollover to another employer’s plan.
- The conduit IRA is most beneficial to employees who have quit their jobs and hold a qualified plan, and while seeking other employment, require a temporary fund shelter to park their funds until they are settled in the new employer’s qualified plan.
- When you move from one job to another, even if it’s after a 5 year period, you can park your funds in a conduit IRA. Further, when you move into your new job, 5 years hence, you can move those funds tax-free and transfer part or all to the new employer’s plan within 60 days after receiving it and the new employer’s plan accepting those assets.
- The IRS treats all rollover conduit IRAs as Traditional IRAs and thus the same rules with respects to tax benefits and withdrawals apply here too.
- One need not designate the Conduit IRA as such, as long as the original funds which are being rolled over into the new funds are from a qualified plan or known to be from the section 403(b) plan.
- A person also has the right to set up a separate IRA account besides having the conduit IRA account between jobs.
- Another noteworthy feature is that an individual need not rollover all 100% of the money from a qualified plan into the conduit IRA account.
- One major requirement is that the employer retirement allows the rollover. If such an option is not available, the individual can simply roll the rollover IRA into a traditional IRA and let it be.
Rollovers have to meet the 60 day requirements, especially when you move into a new qualified plan. If you have received your 401(k) employer sponsored savings plan check, when quitting a job, then within 60 days this amount needs to be transferred into the new employer’s qualified plan. If not done, nor transferred into a rollover conduit plan, you can incur huge tax consequences.
However, caution must be maintained when rollovers occur. A mandatory 20% withholding becomes necessary, unless a direct rollover is made from one qualified plan to another. If, however, the 20% of the funds is found missing from the Conduit IRA when transferred to the new plan within 60 days, taxes and penalties associated with making an early withdrawal must then be paid.
Standard IRAs require individuals to have a source of income, which can often put non-earning spouses at a disadvantage. To boost household retirement savings, and allow an unemployed spouse to also contribute to the family’s nest egg, the IRS helps make an exception for married couples with the Spousal IRA, which can be either under a Traditional or a Roth IRA fund.
A more formal name under which the spousal IRA has come to be named is the Kay Bailey Hutchison IRA. With a Spousal IRA, it should be borne in mind that this is not a joint account, but rather that everything invested in the account of your spouse belongs entirely to them. Here are some of the key features to consider:
- You have to be married to open a Spousal IRA and a joint tax return has to be filed.
- Instead of the stay-at-home spouse, the earning member in the couple will need to pay for it.
- One major advantage of the Spousal IRA is that the spouse can avail of a variety of investment choices from mutual funds to individual stocks and bonds.
- The annual contribution limit is $5,500, with the additional $1000 if you are 50+ years of age. This amount can go a long way in helping you save for retirement as a couple.
- Although one has to file jointly, the Spousal IRA account must be held separately, and when divorced, the assets in the IRA will be owned by the non-working spouse.
One major difference that needs to be taken into account in the Spousal IRA is the age of the non-working spouse when contributing under the Traditional IRA or the Roth IRA. There is no restriction on age in the Roth IRA for the non-working spouse in the year of contribution, but when contributing to the Traditional IRA, the non-working spouse has to be below 70 ½ years of age.
Contributions to a Traditional IRA are made with pre-tax dollars. This means the IRS allows you to deduct your contribution from your income thus reducing your income tax. A Traditional IRA also allows your gains to be tax deferred until you begin to take distributions. If you participate in a qualified retirement plan at work and if the total income of you and your spouse exceeds a specific threshold, you may either be allowed only a partial deduction or no deduction at all.
Once you withdraw money from the IRA, you trigger additional income tax. The distribution will be considered regular income; it will be added to your other income and may or may not bump you to another tax rate. In other words, you become your own paymaster and should carefully consider the amount of distributions you elect.
RMD’s – Required Minimum Distributions kick in the year after you turn 70 ½. This is a forced distribution – you must take it even if you don’t want to. If you fail to do so, the IRS by default will forfeit half of the mandatory amount that is due for distribution.
Contributions – There are limits to the amount of annual contributions you can make into a traditional IRA. For the year 2012, If you are aged 49 years or below, your maximum contribution is $5000 while if you are 50 years or older, you can contribute $6000.
Contrary to a traditional IRA, the contributions you make into a Roth IRA are after tax dollars and not eligible for an income tax deduction. But you reap the benefits of the plan upon reaching retirement. There are two thresholds that must be met in a Roth IRA. They are: the IRA must be five years old and the IRA owner must attain the age of 59 ½.
When these thresholds are met the Roth advantage really begins. Once again you are your own paymaster but any distributions you take are tax-free. We like to explain it like this: you pay taxes on the seed but the harvest is totally tax-free. Remember you fund a Roth IRA with after tax dollars so if you need to withdraw funds before retirement, you can in a tax-free manner. It is a return of principle limited to your prior contributions.
Like a traditional IRA, there are limits to the amount of annual contributions you can make into a Roth IRA. If you are aged 49 years or below, your maximum contribution is $5000 while if you are 50 years or older, you can contribute $6000 (for 2012).
The age for penalty free withdrawals is at least 59 1/2; if you choose to withdraw money before this age, then you are exempted from the tax-free benefit – in such a case you are required to pay taxes and also a penalty of 10 per cent.
Required Minimum Distributions do NOT apply to Roth IRA’s. Therefore when you reach the age of 70 1/2, you can avoid taking the distribution if you wish. Your Roth IRA can be left to heirs – again tax free however the beneficiaries who inherited Roth IRAs are subject to the minimum distribution rules.
SEP IRA stands for Simplified Employee Pension Individual Retirement Account. It is meant for self-employed people or a person who owns a business and employs others in it. They can make IRA contributions in a similar manner as traditional IRAs for themselves, as well as for their employees. The annual contributions that an employer can make to an employee’s SEP-IRA cannot exceed the lower of
- 25% of compensation -includes bonus and overtime, or
- $50,000 for 2012 and $51,000 for 2013.
In a SEP IRA, it is not mandatory to make contributions every year, but for all those years when contributions are made to the SEP, they must be made to the SEP-IRAs of all eligible employees.
The tax deduction allowed under a SEP IRA is subject to the lower of actual contributions to the employees’ SEP-IRAs or 25% of compensation. The upper limit of the compensation considered for each employee is limited to $250,000 in 2012 and $255,000 for 2013. Investments can be made in a number of things like bonds, stocks, mutual funds and ETFs.
A self directed IRA allows you a great deal of freedom in choosing investment options for a retirement fund. Unlike a traditional IRA, where investment options are limited to stocks, mutual funds and CD’s, in a self directed IRA you are free to invest your money into a host of other investment option which includes property, businesses, precious metals and mortgages. Thus a self directed IRA allows an investor to maximize the return on his retirement portfolio by selectively investing in those assets which are most lucrative at that point in time. The minimum age for deriving the benefits with a tax-free status is 59.5.
SIMPLE IRA stands for Savings Incentive Match Plan for Employees Individual Retirement Account. This IRA plan is provided specifically by the employer and is best suited for small companies. Employees can invest some amount of money from their monthly incomes into the SIMPLE IRA fund and the money grows at a specified interest rate until the person withdraws it upon reaching retirement.