Aplicaciones de Realidad Aumentada

TRADITIONAL IRA

Overview

The Traditional IRA, also known as the Original IRA and/or the Contributory IRA, was the first type of Individual Retirement Arrangement authorized by Congress back in the early 1970’s. The thinking was that Social Security benefits were not going to be adequate for most Americans to retire on.

This chapter will provide an introduction to the Traditional IRA, define what is a

Traditional IRA, review the myriad of rules governing the Traditional IRA-who can and cannot contribute to the Traditional IRA, and how much can be contributed.

Learning Objectives

Upon completion of this chapter, you will be able to:  Define and structure a Traditional IRA;

 Distinguish between a custodial IRA and a trustee IRA;  Determine the eligibility and contribution rules for an IRA;

 Review the definition of MAGI and Phase-out rules for regular annual contributions to a Traditional IRA;

 Explain an excess contribution and the rules to remove an excess contribution; and

 Observe the rules for a Spousal Traditional IRA and contribution limits.

Setting Up a Traditional IRA

A Traditional IRA, also known as a Regular IRA or Contributory IRA, is any type of IRA, except a Roth IRA, SIMPLE IRA and/or an Educational IRA.

There are two types of Traditional IRAs a participant may set up and invest in. They are:  Individual Retirement Account

32

Although the abbreviation “IRA” may refer to either an “individual retirement account” or an “individual retirement annuity,” it is used primarily to refer to the far more popular form, the “individual retirement account” (as discussed below). Thus, the term “IRA annuity” may be used for convenience in distinguishing the annuity from its more popular counterpart.

Individual Retirement Account

An “Individual Retirement Account” (IRA), by definition [IRC § 408 (a); Reg. §1.408-2], is a trust or custodial account set up in the United States for the exclusive benefit of an individual taxpayer (participant) and his or her beneficiaries.

The Individual Retirement Account is created by means of a written IRA document approved by the IRS, which can be either a custodial account or a trusteed account (non- bank).

To be a custodial account, the IRA must meet the following requirements:

 The account must have a custodian. This custodian must be a bank, a federally insured credit union, a savings and loan association or an entity approved by the IRS to serve as a trustee or custodian. (Brokerage and Insurance companies generally fall into this general category.) Note: An individual cannot be trustee of an individual retirement account.

 The custodian generally cannot accept regular annual contributions greater than the statutory ceiling amount of $5,500 in 2015 (same as 2014) (IRC § 219). However, IRA rollover contributions and employer contributions to simplified employee pensions (SEP-IRAs) can be more than the ceiling applicable to Traditional IRAs.

 Contributions that do not involve rollovers must be in cash, which includes checks or money orders.

 The IRA participant must be fully “vested” in the amount in his or her IRA. This means that the participant has a non-forfeitable right to the total assets in his or her account at all times.

 Money in the IRA participant’s account cannot be used to invest in a life insurance contract.

 Assets in an IRA cannot be commingled with other property, except in a common trust fund or common investment fund.

 The IRA participant must begin receiving life expectancy or annuity payments no later than April 1 of the year following the year when he or she turns 70½.

 Participants’ age 50 and older by the end of the tax year can make an additional catch-up contribution of $1,000 in 2015 (same as in 2014) to their individual IRAs.

33

A non-bank trustee in addition to meeting the requirements mentioned above must demonstrate the following characteristics to the IRS:

 Fiduciary ability (including continuity of life, an established place of business in the United States where it is accessible during every business day, fiduciary experience, fiduciary responsibility, and financial responsibility),

 Capacity to account for the interest of a large number of individuals,  Fitness to handle retirement funds,

 Ability to administer fiduciary powers, and  Adequacy of net worth.

In addition, the non-bank trustee must also provide the following:

 Audits will be conducted by a qualified public accountant at least every 12 months,  Funds will be kept invested as long as reasonable for the proper management of the

account,

 Investments will not be commingled with other investments except in a common trust fund and investments will be safely maintained, and

 Separate fiduciary records will be maintained.

The Internal Revenue Code states for purposes of an IRA account, a custodial account is treated as a trust and the custodian for such account is treated as a trustee [IRC § 408(h)]. The IRS maintains a list of entities approved to act as a non-bank IRA Trustee or Custodian.

The IRS has issued a prototype trust agreement (IRS Form 5305) and a prototype custodial agreement (IRS Form 5305A). If a banking institution or other entity wishes to use one of these agreements in lieu of preparing its own prototype agreement, the IRS prototype may be used without prior approval. On the other hand, if the institution prepares its own agreement, it must be submitted to the IRS for approval.

Individual Retirement Annuity

The individual retirement annuity has the same essential tax characteristics as the individual retirement account, as was discussed above, except that it is structured in the form of an annuity contract with a duly licensed life insurance company. Thus, the contributions are in the form of premiums, the accumulating assets are the cash surrender values, and the disbursements are the annuity payments (or the prior death benefit). Each insurance company is required to submit to the IRS a copy of the annuity contract that it wishes to use. After review, the IRS gives its approval and assigns a code number to the contract. For the purposes of securing this approval, IRS Form 5306 must be completed and submitted to the IRS. Because the contract received prior approval, it is not necessary for an individual to submit his or her particular IRA annuity to the IRS for approval.

34

The annuity contract most frequently used for IRA annuity purposes is the “flexible premium retirement annuity contract” with a normal retirement age of 65. Retirement age can, however, be any age from 60 to 70. The contract normally calls for level premiums payable periodically (monthly, quarterly, semi-annually or annually) over the full period from issue date to retirement date. However, under the flexible premium provision, the premiums may increase or decrease in size and the frequency of premium payments may be changed from time to time. Also, the premium may be temporarily suspended or terminated completely, at the option of the owner of the contract, under what is called a stop-and-go provision.

To assure that the contract selected is an investment vehicle qualifying as an IRA annuity, the following restrictions must be incorporated into the contract and made an integral part of it [IRC § 408(b)]:

 The annual premium on behalf of any individual must not exceed the dollar amount of $5,500 in 2015 (same as in 2014) (IRC § 219(b)(1)(A));

 The contract must be non-assignable, non-alienable and non-transferable by the individual (except as to the tax-free rollover privilege);

 The entire value of the contract must be non-forfeitable to the individual;

 Any and all dividends (called “refunds of premiums”) must be applied before the end of the succeeding calendar year to purchase additional benefits or to reduce future premiums; and

 Distributions from the contract prior to or at retirement or at death must be made in accordance with the distribution rules applicable to qualified plans generally [under IRC § 401(a)(9)].

Annuity payments may commence at any age from 59½ to April 1 of the year following the attainment of age 70½, usually on a monthly basis. Of course, various optional types of annuity settlements are usually available on request. The amount of the annuity

payment depends upon the amount of the premiums actually paid. The death benefit prior to the commencement of the annuity payments is most often the aggregate of the

premium payments or the cash surrender value, if greater.

Note: For an IRA annuity, in lieu of a single life annuity contract on the life of the individual, it is permissible for the contract to be applied for and issued in the form of a joint and survivor annuity on the lives of the contract owner and his or her spouse. Under a regular qualified pension plan, ERISA requires the normal type of retirement settlement to be a joint and survivor annuity, unless the retiring employee specifically elects

35

Traditional IRA Eligibility Requirements

There are two requirements a participant must meet to be eligible for a Traditional IRA.  First, he/she must be under age 70½. A participant cannot establish or contribute

to a Traditional IRA during or after the tax year in which he/she reaches age 70½.  The second requirement is that an individual must also have taxable compensation

in order to establish a Traditional or Roth IRA.

Compensation Defined

Under IRC §219(f)(1) the categories of compensation are defined as follows:

 Wages, salaries, etc. Wages, salaries, tips, professional fees, bonuses, and other amounts a participant receives for providing personal services are compensation. The IRS treats as compensation any amount properly shown in Table 2.1 (Wages, tips, other compensation) from Form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans). Scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.

 Commissions. The amount a participant receives that is a percentage of profits or sales price is compensation.

 Self-employment income. If the participant is self-employed (a sole proprietor or a partner), compensation is the net earnings from their trade or business (provided your personal services are a material income-producing factor) reduced by the total of:

o The deduction for contributions made on their behalf to retirement plans, and

o The deduction allowed for one-half of their self-employment taxes.

Compensation includes earnings from self-employment even if the participant is not subject to self-employment tax because of their religious beliefs. When a participant has both self-employment income and salaries and wages, their compensation includes both amounts.

 Self-employment loss. If a participant has a net loss from self-employment, do not subtract the loss from their salaries or wages when figuring their total compensation. However, net losses from one self-employed business may be aggregated with net income from another self-employed business.

 Alimony and separate maintenance. For Traditional IRA purposes (also Roth IRA), compensation includes any taxable alimony and separate maintenance payments one may receive under a decree of divorce or separate maintenance.

 Nontaxable combat pay. If the taxpayer was a member of the U.S. Armed Forces, compensation includes any nontaxable combat pay he/she received. Under the Heroes Earned Retirement Opportunities (HERO) Act, signed into law by President Bush May 29, 2006, military personnel can now count tax-free combat pay when determining whether they qualify to contribute to a Traditional

36

(or Roth IRA). Before this change, members of the military whose earnings came entirely from tax-free combat pay were generally barred from using IRAs to save for retirement. This amount should be reported in box 12 of their Form W-2 with code Q. (See Sample 1 IRS Forms at end of Chapter)

Table 2.1

Compensation for purposes of an IRA*

Includes… Does not include…

Wages, salaries, etc. Interest and dividend income

Self-employment income Earnings and profits from property

Commissions Pension and annuity income

Alimony separate maintenance Deferred compensation

Non-taxable combat pay Income from certain partnerships

*Source: IRS Publication 590

On the other hand, compensation does not include any of the following items:

 Earnings and profits from property, such as rental income, interest income, and dividend income.

 Pension or annuity income.

 Deferred compensation received (compensation payments postponed from a past year).

 Income from a partnership for which the individual does not provide services that are a material income-producing factor.

 Any amounts excluded from income, such as foreign earned income and housing costs.

 Unemployment compensation.

Regular Annual Contributions

Under IRC § 219(b)(1)(A), there is a limit on the amount of a regular contribution the participant may make to a Traditional IRA each tax year. The rule states that any participant with taxable compensation can contribute to their Traditional IRA up to 100 percent of their taxable compensation up to a maximum. Table 2.2 shows the maximum contribution limits for 2014 and 2015.

Table 2.2

Regular Annual Contribution Limit 2014-2015

Year Dollar Amount

2014 $5,500 2015 $5,500

37

Under IRC § 219 (b)(5)(B), there is also a catch-up provision that allows individuals who have reached age 50 and older in the tax year to make an additional contribution. Table 2.3 shows the maximum catch-up contribution limits for 2014 and 2015.

Table 2.3

Catch-up Contribution Limit

Year Dollar Amount

2014 $1,000 2015 $1,000

Source: IRS Publication 590

For 2015 (same as in 2014), the maximum contribution for a participant age 50 and older will be $6,500.

Note: Regular annual contributions must be in the form of money (cash, check, or money order). Property cannot be contributed. However, an individual may transfer or roll over certain property (other than cash) from one retirement plan to the other.

Date of Regular Annual Contributions

Regular annual contributions can be made to a Traditional IRA for a year at any time during the year or by the due date for filing the return for that year, not including extensions. For most people, this means that contributions must be made as follows:

 For tax year 2014 must be made by April 15, 2015, and  For tax year 2014 must be made by April 15, 2016.

Contributions Returned Before Due Date of Return

If an IRA participant makes a regular annual contribution to his or her Traditional IRA, the participant can withdraw those contributions tax free by the due date of their return. If the participant has an extension of time to file their return, the participant can withdraw them tax free by the extended due date. The participant can do this if, for each regular annual contribution he/she withdraws, both of the following conditions apply:

 Participant did not take a deduction for the contribution.

 Participant withdraws any interest or other income earned on the contribution while it was in the IRA when calculating the amount that must be withdrawn. If there was a loss, the net income earned on the contribution may be a negative amount.

38

Deductible Contributions

Deductible regular annual contributions a taxpayer can take for contributions made to his/her Traditional IRA depends on whether he/she (and spouse if applicable) is covered for any part of the year by an employer retirement plan. If the taxpayer (and spouse, if applicable) is not covered by a qualified retirement plan, he/she is allowed to deduct 100% of his or her maximum allowable contribution. However, an employee who participates in a qualified retirement plan, his/her deduction will be subject to the phase- out rules. But, let’s first define an active participant.

Active Participant Defined

Special rules apply to determine whether a participant (employee) is covered by (active participant) an employer-sponsored retirement plan for a tax year. These rules differ depending on whether the plan is a defined contribution plan or a defined benefit plan.

 Defined Contribution Plan. Generally an employee is considered covered by a defined contribution plan if amounts are contributed or allocated to the employee’s account for the plan year that ends within their tax years. Types of defined contribution plans include profit-sharing plans, stock bonus plans, money purchase plans, 401(k) plan, 403(a) plan, 403(b) plan, a SEP IRA and SIMPLE IRA. Note: If an amount is allocated to the employee’s account for a plan year, the employee is considered covered by the plan (active participant) even if they are not vested in the plan.

 Defined Benefit Plan. If an employee is eligible (meets minimum age and years of service requirements) to participate in their employer’s defined benefit plan for the plan year that ends within their tax year, they are considered covered by the plan. This rule applies even if the employee declined to be covered by the plan, they did not make a required contribution, or they did not perform the minimum service required to accrue a benefit for the year. A defined benefit plan is any plan that is not a defined contribution plan. Contributions to a defined benefit plan are based on a computation of what contributions are necessary to provide definite benefits to plan participants. Defined benefit plans include pension plans and annuity plans. Note: If the employee accrues a benefit for a plan year, the employee is covered by that plan even if the employee has no vested interest in (legal right to) the accrual. For those who would not be considered covered by an employer plan are the following:

 Social Security or Railroad Retirement. Coverage under Social Security or Railroad Retirement (Tier I and Tier II) does not count as coverage under an employer retirement plan.

 Reservists. If the only reason an employee participates in a plan is because he or she is a member of a reserve unit of the armed services, they may not be considered covered by a plan. The reservist will not be considered covered by the plan if both of the following conditions are met:

39

o The plan he or she participates in is established for its employees by:  The United States

 A state or political subdivision of a state, or  An instrumentality of either both of the above.

 Volunteer Firefighters. If the only reason an employee participates in a plan is because they are a volunteer firefighter, they may not be considered covered by the plan. The volunteer firefighter would not be considered covered by the plan if both of the following conditions are met:

o The plan the volunteer firefighter participates in is established for its employees by:

 The United States,

 A state or political subdivision of a state, or  An instrumentality of either both of the above.

o The accrued retirement benefits at the beginning of the year will not provide more than $1,800 per year at retirement.

o The employee has not served more than 90 days on active duty.

A simpler way to find out if the participant is an active participant in an employer sponsored qualified retirement plan is to review their Form W-2 they received from their employer. On the Form W-2 there is a “Retirement Plan” box (Box 13) used to indicate whether or not the employee is covered (active participant) for the year. If the box is