IRA's

Traditional IRAs:

Both deductible and non-deductible contributions (up to a combined maximum of $3,000) can be made to traditional IRAs. The contributions are provided by the individual and cannot be continued once he or she has reached age 70 ½. Once the funds are contributed into an IRA account they grow on a tax-deferred basis, meaning that no taxes are paid on these funds until they are withdrawn. When the owner reaches age 70 ½, he or she must begin taking required minimum distributions. If, however, no distribution is taken or if the distribution is not large enough (as determined by using an age-based IRS distribution table), the IRS imposes a tax penalty equal to 50% of the amount by which the required minimum distribution amount exceeds the actual amount distributed. As with other IRAs, distributions received prior to age 59 ½ are generally subject to a 10% tax penalty (excise tax) imposed by the IRS for premature withdrawals. Other qualified plans and deferred annuities can be rolled into a traditional IRA.

 

What is a Roth IRA?

Named for Senator Roth of Delaware, a Roth IRA is a retirement plan comparable to a 401(k), 403(b) or traditional IRA, but with some fundamental differences. With 401(k)s, 403(b)s and other qualified plans, an individual receives a tax deduction every year that he or she makes a contribution to his or her plan. This immediate tax savings is attractive, but both the contributions and the earnings of these plans will be taxed upon distribution.

With the Roth IRA, however, the contributions are made with dollars after they have been taxed. But once these dollars are in a Roth IRA, they grow tax free. And then later, all distributions (from both contributions and earnings) are received completely free of all income taxes! (As long as the account has been established for five years and the owner is at least age 59 ½.) Roth IRA withdrawals are also tax free if the owner is deceased or disabled or if the distribution will be used for first-time homebuyer expenses. How much can one contribute to a Roth IRA?

Today individuals can contribute up to $3,000 and married couples can contribute up to $6,000 to their Roth IRAs. A catch-up provision also allows participants age 50 and above to add an additional $500 per year (with inflation adjustments) to their Roth IRA.

Furthermore, people with adjusted gross incomes less than $100,000 can convert all or a portion of their qualified retirement plans to a Roth IRA. (Generally, any retirement plan that can be rolled over to an IRA can be converted to a Roth IRA. This includes 401(k)s, 403(b)s, SEPs, etc.) While income taxes must be paid on the amount converted, the opportunity for tax-free growth and tax-free distributions could make this a wise choice. (Be sure to consult with a tax advisor to determine the tax consequences of a Roth IRA conversion for individual circumstances.) How does “tax deductible” compare to “tax free”?

To answer that question, consider a simple example of two individuals, Paul and Julia, who are both age 70 and who both have a $150,000 balance in their IRA. Paul has a traditional IRA and as such, he deducted all of his contributions over the years. Certainly these tax deductions have provided him with a valuable tax advantage each time he made a contribution, but when Paul takes the money out of his IRA, his entire $150,000 nest egg is taxable. This means that if he is in a 33% tax bracket, $50,000 of his IRA will be used to pay taxes, and only $100,000 will remain for his own use.

Julia, however, converted her traditional IRA to a Roth IRA years earlier. Again, her current balance is also $150,000. She has met all of the requirements to withdraw her Roth IRA nest egg completely tax free. This means that the dollar value of Julia’s Roth IRA is identical to the dollar value of Paul’s traditional IRA, but when she withdraws her funds, the after-tax value is 50% greater! The value of Julia’s Roth IRA is 50% greater because she can withdraw the entire $150,000 without paying any income taxes. A full 100% of the distributions is available to support Julia’s retirement lifestyle.

Of course, it is only fair to consider the taxes Julia would have been required to pay when she converted her traditional IRA into a Roth IRA. Assume she was age 55 when she made the conversion. At that time she had $75,000 in her traditional IRA. If she were in a 33% tax bracket at the time, she would have been required to pay $25,000 in taxes. She could have taken $25,000 from her IRA to pay the taxes, but that would have left her with only $50,000 remaining in her Roth IRA. The long-term result would likely be that she would have less than $150,000 in her Roth IRA by age 70. In effect, the advantage of the Roth IRA is largely lost if Julia used her IRA money to pay the taxes due at conversion.

But what if Julia had transferred the entire $75,000 from her traditional IRA to her Roth IRA and used other (non-IRA) funds to pay the $25,000 in taxes? This means she would have less in her other savings, but she also would have had $25,000 more in her Roth IRA, earning tax-free interest. And at age 70, Julia would have the full benefit of her $150,000 nest egg as opposed to Paul, who would only benefit from $100,000. (Note: the numbers used in this example are intended solely to illustrate a concept and not to project actual individual benefits.) What other advantages do Roth IRAs provide?

Roth IRAs provide one additional advantage that might ultimately prove to be the most important benefit — Roth IRAs are not subject to required minimum distribution rules during the owner’s life.

Traditional IRA rules require that the owner start taking required minimum distributions no later than age 70 ½, or pay a 50% tax penalty. Roth IRA participants, however, can choose to never take a withdrawal from their plan for as long as they live. Assuming they have sufficient income from other sources to provide for their retirement needs, they can allow their Roth IRA to continue to grow tax free for as long as they like before passing the entire Roth IRA balance to their heir! The heir could then enjoy an even greater period of tax-free growth by stretching the withdrawals from the inherited Roth IRA over his or her lifetime. (Please visit the “Stretching Your IRAs” link for more information.) This capability provides the potential for tremendous wealth building power.

 

Why choose a Roth IRA?

With a Roth IRA you can enjoy the benefit of a nest egg that grows tax free until it is distributed to you and possibly your heirs — completely tax free! It is a plan that could help make your retirement more secure while allowing you to build a legacy that one day could be passed on to your loved ones.

 

SEP (Simplified Employee Pension) IRAs

SEPs provide a simplified method for an employer to make contributions to a tax-favored retirement plan for his or her employees. Instead of setting up a profit-sharing or money-purchase plan with a trust, an employer can adopt a SEP agreement and make contributions directly to an individual retirement account or an individual retirement annuity set up for each eligible employee (including himself or herself). (It is important to note that SEPs cannot be designated as Roth IRAs.) Employers can deduct contributions they make for their employees. If he or she is self-employed, his or her personal contributions can be deducted as well. Contributions made to a SEP cannot exceed the lesser of 15% of the employee’s compensation or $40,000.

The SEP has the same distribution and premature distribution rules as traditional IRAs. SEP (Simplified Employee Pension) IRAs:

 

SIMPLE (Savings Incentive Match Plan for Employees) IRAs

A SIMPLE plan is another way for an employer to help his or her employees contribute to a tax-favored retirement account. (It is important to note that SIMPLE IRAs cannot be designated as Roth IRAs.) SIMPLE plans can be set up by an employer who has 100 or fewer employees that receive at least $5,000 annually in compensation from the employer. Under this plan, employees can choose to make salary reduction contributions. In addition, the employer will contribute matching or nonelective contributions. The maximum amount employees can choose to have an employer contribute on their behalf is $7,000. Furthermore, participants who are at least age 50 can make a catch-up contribution of up to $500 annually. The contributions to a SIMPLE plan can be deducted, and employees can exclude these contributions from their gross income.

Simple IRAs have the same distribution and premature distribution rules as traditional IRAs.

 

What is the “Stretch IRA” concept?

Individual Retirement Accounts (IRAs) were initially created to allow individuals to use the advantage of tax deferral to accumulate funds for retirement. By age 70½, IRA owners were required by law to begin taking RMD (required minimum distributions), which caused the IRA owner to withdraw all of the IRA account balance over the period of his or her life expectancy. If an individual did not take RMD or if the amount distributed was not large enough, he or she faced a severe tax penalty equal to 50% of the amount by which the RMD amount exceeded the actual amount distributed.

These distribution rules were fine for individuals who needed this income to maintain their retirement lifestyles, but what if their other sources of income were sufficient to meet their needs? It would not matter; individuals would still have been forced to take the sizeable IRA distributions and pay the applicable taxes. To make matters worse, the amount of the required minimum distributions increased annually. Not only would an individual have to pay taxes on increasing distributions they did not need, but they would also lose the benefits of future tax deferral and compounding on the amounts distributed.

This simply did not fit into the plans of many IRA owners. Fortunately, the rules governing IRA distributions were changed in January 2001. The new rules establish much smaller required minimum distributions and allow individuals to maintain and maximize the benefits of their IRA by making it possible to "stretch" those mandatory distributions over the life expectancies of themselves and their beneficiaries. In short, the 2001 rules allow an individual to withdraw less, pay fewer taxes and ultimately pass greater wealth on to his or her loved ones. Hence the term — Stretch IRA.

 

How does one "stretch" an IRA?

Consider the example of an IRA owner named Jim. Assume that Jim is age 70, has $100,000 in his IRA and does not have a named beneficiary. Under the old rules, (using the term certain method,) Jim would be required to take a distribution of $6,530 from his IRA this year. Each year more and more of his IRA balance must be distributed, which means less money remains to benefit from future tax deferral and compounding.

Under the new rules, however, Jim is only required to take a distribution of $3,649 from his IRA this year. That is 44 percent fewer dollars distributed, which means 44 percent fewer dollars subject to current taxation and 44 percent more dollars that will remain in the IRA to benefit from future tax-deferred growth and compounding. (Jim will face annual increases in the distribution amount under the new rules as well, but the amounts will increase more slowly than under the old rules.)

The ability to leave more funds in an IRA to benefit from future tax-deferred growth and compounding can have a major impact on the future value of the IRA. The new rules as of January 2001 make it possible for individuals to stretch the distributions over the life expectancies of themselves and their spouse, or of themselves and their beneficiaries.

In the case of many IRAs, the owner’s spouse is the designated beneficiary. Under the new rules, the age of a spouse beneficiary determines which IRS table is used to determine the owner’s required minimum distribution amounts. If the spouse is less than 10 years younger (as well as with most beneficiaries), the owner uses the Uniform Lifetime Table, and his or her payment amounts are based on his or her sole life expectancy. If the spouse beneficiary is more than 10 years younger, however, the owner uses the Joint Life Expectancy Table to determine the applicable life expectancy factor — which results in smaller annual distributions. Regardless of which table is used during the lifetime of the owner, each spouse beneficiary is entitled to complete a “Spousal Rollover” at the owner’s death. The term “Spousal Rollover” means that if the IRA owner dies before his or her spouse beneficiary, the spouse can assume ownership of the IRA and begin new minimum distributions based on his or her own age. This Spousal Rollover option stretches the IRA income over a longer distribution period, and provides an income stream, increased independence and security for the spouse.

For example, assume now that 70-year-old Jim has named his 65-year-old wife, Betty, as his beneficiary. If Jim takes only the required minimum distributions (based solely on his life expectancy because Betty is less than 10 years younger) from his $100,000 IRA over a 15-year period (earning 6 percent interest), he would receive a total of $92,944 from his IRA, leaving an account balance of $121,733. If Jim then died at age 85, Betty could complete a Spousal Rollover, taking new minimum distributions based on her life expectancy until her own death five years later. In this instance, the IRA would pay out $92,944 during Jim’s lifetime and $39,977 to Betty, and still have a balance of $121,503 at Betty’s death. Using this method, the total overall value of the IRA has been stretched to $254,474. However, if Jim and Betty do not need the distributions from this IRA to support their retirement lifestyle, Jim can choose instead to name his 35-year-old son, Steve, as his beneficiary. (In several states, in order for someone other than the spouse to be designated as the primary beneficiary, the spouse must waive his or her community property interest and give his or her consent.)

As expected, Jim predeceases his son. As the beneficiary, Steve (now age 50) inherits the IRA and can elect to stretch the distributions over his own life expectancy. As a relatively young man with a long life expectancy, Steve’s annual distributions are less than what his father had been required to take. This means a greater amount of money is left in the IRA to continue to benefit from future tax-deferred growth and compounding, so over Steve’s life expectancy of 33 years, he would receive a total of $419,292 from the IRA.

Depending on individual circumstances, there may be an opportunity to stretch the distributions over an even longer period of time, thus taking advantage of even greater tax deferred growth and compounding. Here’s how — assume that instead of naming his son as his beneficiary, Jim chooses his 23-year-old granddaughter named Beth. As long as Jim predeceases his granddaughter, Beth will inherit the IRA. As the designated beneficiary, Beth can elect to stretch the distributions over her own life expectancy. At the end of Beth’s life, the original $100,000 IRA will have been stretched over 76 years to a total value of $1,462,118!

As one can see, the new rules provide a tremendous opportunity for individuals to use the tools of tax deferral and compounding to create a legacy that will continue to benefit their loved ones for years and even generations to come.

 

Who should "stretch" their IRA?

Taking advantage of the new rules to stretch IRA distributions over time is not for everyone, but if you already have all the income you need to maintain your lifestyle and you want to take advantage of tax-deferred growth and compounding to pass greater wealth on to your loved ones, you may want to learn more about how the new IRA rules can work for you.