Common Questions about Traditional IRA's

Planning for retirement can be both exciting and overwhelming. There are so many investment options out there, so how do you know where to start or what they all mean? This article will tackle one type of retirement investment, the Traditional IRA, and try to answer some common questions about it in order to familiarize you with the basics of this type of investment.

What is a Traditional IRA?

A Traditional IRA is a type of individual retirement account that has different tax rules than other types of IRA's. The main advantage of Traditional IRA's is that contributions of money to the account may be tax deductible in the year that they are made. For example, if you contribute $1000 to your Traditional IRA in 2007 and your income was $25,000, then you will only pay federal income taxes on $24,000. However, after you reach a certain income level, the amount of the contribution that you can deduct phases out until the deduction is eventually eliminated. Since you receive this tax benefit up front, in later years when you begin making withdrawals from the IRA, those withdrawals are considered income and are subject to federal income tax.

How does a Traditional IRA work?

You can set up a Traditional IRA at a financial institution such as a bank, or you can set it up through a stockbroker at an investment firm. Together, you and your financial advisor will discuss what your investment goals are and decide what types of investment are best for you. Then, you will fill out the appropriate paperwork and make an initial deposit of money which your financial advisor will invest. Then, you can make periodic contributions of more money according to the contribution rules.

When you make a contribution to your Traditional IRA, you deposit money into it. This money is then invested in a variety of ways, usually in mutual funds or certificates of deposit. The investments make money by earning interest, receiving dividends or increasing in share value, and the earnings are reinvested and not withdrawn from the account for a number of years. This reinvestment causes the compounding effect, which generally results in the investment's value skyrocketing as the years pass.

What is a contribution to a Traditional IRA?

A contribution is money that you deposit in your Traditional IRA account. There are two qualifying rules for contributing to a Traditional IRA:

1. You receive earned income during the year, and
2. You are under 70 ½ years of age by the end of the year.

Earned income includes wages, salaries, tips, commissions, self-employment income, alimony, separate maintenance payments and nontaxable combat pay. Earned income does NOT include interest, dividends, pensions, annuities, deferred compensation, income from property, or income from certain partnerships.¹

Are there any other limitations to making a contribution to a Traditional IRA?

Yes, there are other limitations that may apply to you. The rules can get complicated, so we will not cover them all here, but these are the common limitations that apply to many investors. Check with your financial advisor for more information. ²

Maximum Contribution

For 2007, if you are 49 years of age or younger, you can contribute up to $4000 in 2007 and $5000 in 2008. If you are over 49 years of age, you may contribute up to $5000 in 2007 and $6000 in 2008.

Date Restrictions

Contributions can be made for the current year during the current year. The only exception is that contributions for a certain year are permissible until April 15 of the following year. For example, you may make a 2007 Traditional IRA contribution until April 15, 2008. If April 15 happens to fall on a weekend or holiday, the deadline is extended to the next working day after April 15. This cut-off date for contributions coincides with the due date for your federal tax return.

Contributions to a Traditional IRA

If you have both Traditional and Roth IRA's, you cannot contribute more than $4000 ($5000 if you are age 50 or older) combined to both of them in 2007. This means that you cannot contribute $4000 to your Traditional IRA and another $4000 to a Roth IRA. You can contribute $2000 to the Traditional and $2000 to the Roth, or split it up however you want, as long as the total does not exceed $4000.

Age Restrictions

You cannot contribute to a Traditional IRA at any time after you reach age 70 ½.

When can I withdraw my money from a Traditional IRA?

You can withdraw your money at any time. However, if you withdraw money before reaching age 59 ½, you will be subject to a 10% tax penalty on the money you withdraw. For example, if you withdraw $500 from your Traditional IRA when you are age 45, you will generally have to pay $50 to Uncle Sam as a tax penalty. You may not owe the 10% penalty if you qualify under the early distribution rules.³

What is an early distribution?

An early distribution is any money you withdraw from your Traditional IRA before reaching age 59 ½. When you reach age 59 ½, withdrawals are automatically tax-free. Early distributions are subject to a 10% tax penalty, but if you withdraw money for any of the following situations, you will NOT owe the 10% tax:⁴

1. You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
2. The distributions are not more than the cost of your medical insurance.
3. You are disabled.
4. You are the beneficiary of a deceased IRA owner.
5. You are receiving distributions in the form of an annuity.
6. The distributions are not more than your qualified higher education expenses.
7. You use the distributions to buy, build, or rebuild a first home.
8. The distribution is due to an IRS levy of the qualified plan.
9. The distribution is a qualified reservist distribution.

How do you maintain a Traditional IRA?

You do not have to do anything special to maintain your Traditional IRA. You can make an initial contribution, and you are not required to make any other contributions. However, there are usually fees charged by the financial institution that is the custodian of your IRA, so check with them to find out what their maintenance fees are.

Can I start a Traditional IRA if I already participate in another retirement plan, such as a pension plan or profit sharing plan like 401(k)?

Yes, you can start one but your ability to take the Traditional IRA deduction on your federal income tax may be reduced or eliminated if you or your spouse is covered by an employer sponsored retirement program like 401(k)'s. See the next question for details.

How does a Traditional IRA affect my federal income tax?

Money contributed to a Traditional IRA can be deducted from your income on your federal income tax. However, there are limitations to how much of the contribution you can deduct based on several different factors. The limitations are based on your modified adjusted gross income, or MAGI, and whether you or your spouse is covered by a retirement program at work. These tables are based on 2006 figures. Note that the IRS may change the income level for 2007.⁵

2006 Traditional IRA Income Tax Deduction Phase-Out and Elimination

If You Are Covered By an Retirement Plan through Your Job

If you file as married filing jointly or qualifying widow(er) and are covered by an employer retirement plan, then your Traditional IRA deduction will be reduced when your MAGI equals $75,000 and will be eliminated when your MAGI equals or exceeds $85,000.

If you file as married filing separately and are covered by an employer retirement plan, then your Traditional IRA deduction is reduced when you make one penny of income and will be eliminated completely when your MAGI equals or exceeds $10,000.

If you file as single or head of household and are covered by an employee retirement program, then your Traditional IRA deduction will be reduced when your MAGI reaches $50,000 and will be eliminated completely when your MAGI equals or exceeds $60,000.

2006 Traditional IRA Income Tax Deduction Phase-Out and Elimination

If You Are NOT Covered By an Retirement Plan through Your Job

If you are not covered by a retirement plan at work and neither is your spouse, you can take the full Traditional IRA deduction no matter what your income level is if you file as married filing jointly or separately.

If you are married filing jointly and you are not covered by a retirement plan at work but your spouse is covered by a retirement plan at his or her work, then the phase-out of your Traditional IRA deduction begins when modified adjusted gross income is $150,000 and is completely eliminated if your MAGI equals or exceeds $160,000.

If you file married filing separately and you are not covered by a retirement plan at work but your spouse is covered by a retirement plan at work, then the phase-out of your Traditonal IRA deduction begins when MAGI is one penny and is eliminated when it reaches $10,000.

If you file single, head of household or qualifying widow(er) and are not covered by an employer retirement plan, then you may take the full Traditional IRA deduction no matter what your income level is.

Do I have to stop making contributions after reaching a certain age?

You cannot make contributions after you reach age 70 ½.⁶

Do I have to withdraw money from my Traditional IRA at a certain age?

Yes, you must start withdrawing money by April 1 of the year following the year in which you reach age 70½, or you will be subject to a tax penalty. Also, you must take a minimum distribution each year that is figured by a formula.⁷

What is a minimum distribution from a Traditional IRA?

You must begin receiving distributions from your Traditional IRA at age 70 ½. The minimum distribution is the amount of money that you are required to take out. It is based on a formula that divides the end of year IRA balance by a life expectancy figure found in Appendix C of IRS Publication 590 “Individual Retirement Arrangements”.⁸ If you do not take the minimum distribution, you may be subject to a 50% tax penalty on the amount you should have withdrawn. For example, if your minimum distribution was $1000 and you did not take it, you may have to pay Uncle Sam $500 as a penalty.⁹

What happens to my Traditional IRA after I die?

You may designate primary and secondary beneficiaries who will inherit your Traditional IRA after your death. A primary beneficiary is the person who will receive the Traditional IRA after your death, usually a spouse or children. In the event that your primary beneficiary dies before you do, you can name a contingent beneficiary who will inherit the Traditional IRA if the primary beneficiary is deceased.¹⁰

This article covers the basics of Traditional IRA's and is meant to be an introduction to the main questions you may have about them. Use it as a starting point for learning about Traditional IRA's, but since it is not meant to be a comprehensive guide, check with your financial advisor if you need further clarification about your specific situation.

References

United States Internal Revenue Service, Publication 590, Individual Retirement Arrangements (IRAs),”Traditional IRA's”, http://www.irs.gov/publications/p590/ch01.html