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Individual retirement account

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An Individual Retirement Account[1] is a form of "individual retirement plan",[2] provided by many financial institutions, that provides tax advantages for retirement savings in the United States. An individual retirement account is a type of "individual retirement arrangement"[3] as described in IRS Publication 590, Individual Retirement Arrangements (IRAs).[4] The term IRA, used to describe both individual retirement accounts and the broader category of individual retirement arrangements, encompasses an individual retirement account; a trust or custodial account set up for the exclusive benefit of taxpayers or their beneficiaries; and an individual retirement annuity,[5] by which the taxpayers purchase an annuity contract or an endowment contract from a life insurance company.[6]

As of 2010, low savings rates, financial crises, and poor stock market performance had caused retirement savings account values to fall so low that 75% of Americans nearing retirement age had less than $30,000 in their retirement accounts, which Forbes called "the greatest retirement crisis in American history."[7]

Types

There are several types of IRA:

  • Traditional IRA – contributions are often tax-deductible (often simplified as “money is deposited before tax” or “contributions are made with pre-tax assets”), all transactions and earnings within the IRA have no tax impact, and withdrawals at retirement are taxed as income (except for those portions of the withdrawal corresponding to contributions that were not deducted). Depending upon the nature of the contribution, a traditional IRA may be referred to as a “deductible IRA” or a “non-deductible IRA.” It was introduced with the Employee Retirement Income Security Act of 1974 (ERISA) and made popular with the Economic Recovery Tax Act of 1981.
  • Roth IRA – contributions are made with after-tax assets, all transactions within the IRA have no tax impact, and withdrawals are usually tax-free. Named for Senator William V. Roth, Jr., the Roth IRA was introduced as part of the Taxpayer Relief Act of 1997.
    • myRA - a 2014 Obama administration initiative based on the Roth IRA
  • SEP IRA – a provision that allows an employer (typically a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee’s name, instead of to a pension fund in the company's name.
  • SIMPLE IRA – a Savings Incentive Match Plan for Employees that requires employer matching contributions to the plan whenever an employee makes a contribution. The plan is similar to a 401(k) plan, but with lower contribution limits and simpler (and thus less costly) administration. Although it is termed an IRA, it is treated separately.

There are two other subtypes of IRA, Rollover IRAs and Conduit IRAs, that are viewed by some as obsolete under current tax law (their functions have been subsumed by the Traditional IRA), but this tax law is set to expire unless extended. However, some individuals still maintain these arrangements in order to keep track of the source of these assets. One key reason is that some qualified plans will accept rollovers from IRAs only if they are conduit/rollover IRAs.

A self-directed IRA is not a different type of IRA, but rather it permits the account holder to make investments on behalf of the retirement plan into a broader range of investments, typically alternative assets such as real estate, mortgages, LLCs and LPs, notes, and precious metals. Through the proper custodian, any type of retirement account can be self-directed, including the Coverdell Education Savings Account, formerly the Educational IRA, as well as Health Savings Accounts.

Starting with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), many of the restrictions of what type of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into were significantly relaxed. Additional acts have further relaxed similar restrictions. Essentially, most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA. An example of an exception is a non-governmental 457 plan which cannot be rolled into anything but another non-governmental 457 plan.

The tax treatment of the above types of IRAs except for Roth IRAs are substantially similar, particularly for rules regarding distributions. SEP IRAs and SIMPLE IRAs also have additional rules similar to those for qualified plans governing how contributions can and must be made and what employees are qualified to participate.

Funding

Individual retirement arrangements were introduced in 1974 with the enactment of the Employee Retirement Income Security Act (ERISA). Taxpayers could contribute up to $1,500 a year and reduce their taxable income by the amount of their contributions. Initially, ERISA restricted IRAs to workers who were not covered by a qualified employment-based retirement plan. In 1981, the Economic Recovery Tax Act (ERTA) allowed all taxpayers under the age of 70½ to contribute to an IRA, regardless of their coverage under a qualified plan. It also raised the maximum annual contribution to $2,000 and allowed participants to contribute $250 on behalf of a nonworking spouse. The Tax Reform Act of 1986 phased out the deduction for IRA contributions among higher-earning workers who are covered by an employment-based retirement plan. However, those earning above the amount that allowed deductible contributions could still make nondeductible contributions to their IRA. The maximum amount allowed as an IRA contribution was $1500 from 1975 to 1981, $2000 from 1982 to 2001, $3000 from 2002 to 2004, $4000 from 2005 to 2007, and $5000 from 2008 to 2010. Beginning in 2002, those over 50 could make an additional contribution called a "Catch-up Contribution."[8]

Current limitations:

  • An IRA can only be funded with cash or cash equivalents. Attempting to transfer any other type of asset into the IRA is a prohibited transaction and disqualifies the fund from its beneficial tax treatment.
  • Rollovers, transfers, and conversions between IRAs and other retirement arrangements can include any asset.
  • The maximum for an IRA contribution in 2013 is $5,500 for those under age 50, and $6,500 for those over 50. All contributions must be from income.
  • This limit applied to the sum of contributions to Roth IRAs and traditional IRAs.
For example, a person aged 45 who put $3,500 into a traditional IRA this year so far, can either put $2,000 more into this traditional IRA, or $2,000 in a Roth IRA, or some combination of that.
  • The amount of the IRA contributions (both Traditional and Roth) that can be deducted from current-year taxes is partially reduced for levels of income beyond a threshold, and eliminated entirely beyond another threshold, if the contributor and/or the contributor's spouse is covered by an employer-based retirement plan. The dollar amounts of the thresholds vary depending on tax filing status (single, married, etc.) and on which spouse is covered at work (see IRS Publication 590, "Individual Retirement Arrangements").

Valid investments

Once money is inside an IRA, the IRA owner can direct the custodian to use the cash to purchase most types of securities, and some non security financial instruments. Some assets cannot be held in an IRA such as collectibles (e.g., art, baseball cards, and rare coins) and life insurance. Some assets are allowed, subject to certain restrictions by custodians themselves. For example an IRA cannot own real estate if the IRA owner receives or provides any immediate gain from/to this real estate investment. Examples of such gain would be the use of the property as the owner's personal residence or the benefit paid to an owner as property manager in the form of personal compensation for this service. The IRS specifically states that custodians may impose their own policies above the rules imposed by the IRS.[9] It should also be noted that custodians cannot provide advice.

Many IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds, and do not permit real estate in an IRA unless the real estate is held indirectly via a security such as a real estate investment trust (REIT). Self-directed IRA custodians/administrators can allow real estate and other non-traditional assets. For example, some options brokers allow their IRA accounts to hold stock options, which are derivatives, not securities.[10] They typically charge fees based on asset values. There are certain special restrictions on real estate held in an IRA (the IRA owner cannot benefit from the property in any way, i.e. he or she cannot use it). Self Directed IRA's allowing non security investments are more complicated.

While certain types of investments are prohibited in an IRA, real estate is not one of them. As a result, real estate owned by an IRA can generate rental income and gain on a sale which escapes immediate taxation. However, the IRA does not get (or, need) the related deductions (e.g., depreciation, mortgage interest, property taxes, etc.).

An IRA may borrow money but any such loan must not be personally guaranteed by the owner of the IRA, and also the loan must be secured solely by assets in the IRA (in other words, a non-recourse loan). Also, the owner of the IRA may not pledge the IRA as security against a debt.

Even if a particular investment is permitted to be held in an IRA, care should be taken to optimize the location of the investment in a taxable account, a traditional IRA or a Roth IRA. For example, interest on municipal bonds is generally not taxable; it is thus generally not optimal to hold municipal bonds in an IRA.[11]

Distribution of funds

Although funds can be distributed from an IRA at any time, there are limited circumstances when money can be distributed or withdrawn from the account without penalties. Unless an exception applies, money can typically be withdrawn penalty free as taxable income from an IRA once the owner reaches age 59 1/2. Also, non-Roth owners must begin taking distributions of at least the calculated minimum amounts by April 1 of the year after reaching age 70 1/2. If the required minimum distribution is not taken the penalty is 50% of the amount that should have been taken. The amount that must be taken is calculated based on a factor taken from the appropriate IRS table and is based on the life expectancy of the owner and possibly his or her spouse as beneficiary if applicable. At the death of the owner, distributions must continue and if there is a designated beneficiary, distributions can be based on the life expectancy of the beneficiary.

There are several exceptions to the rule that penalties apply to distributions before age 59½. Each exception has detailed rules that must be followed to be exempt from penalties. This group of penalty exemptions are popularly known as hardship withdrawals. The exceptions include:[12]

  • The portion of unreimbursed medical expenses that are more than 7.5% of adjusted gross income
  • Distributions that are not more than the cost of medical insurance while unemployed
  • Disability (defined as not being able to engage in any substantial gainful activity)
  • Amounts distributed to beneficiaries of a deceased IRA owner
  • Distributions in the form of an annuity (see substantially equal periodic payments)
  • Distributions that are not more than the qualified higher education expenses of the owner or their children or grandchildren
  • Distributions to buy, build, or rebuild a first home ($10,000 lifetime maximum)
  • Distribution due to an IRS levy of the plan

There are a number of other important details that govern different situations. For Roth IRAs with only contributed funds the basis can be withdrawn before age 59½ without penalty (or tax) on a first in first out basis, and a penalty would apply only on any growth (the taxable amount) that was taken out before 59½ where an exception didn't apply. Amounts converted from a traditional to a Roth IRA must stay in the account for a minimum of 5 years to avoid having a penalty on withdrawal of basis unless one of the above exceptions applies.

If the contribution to the IRA was nondeductible or the IRA owner chose not to claim a deduction for the contribution, distributions of those nondeductible amounts are tax and penalty free.

Bankruptcy status

In the case of Rousey v. Jacoway, the United States Supreme Court ruled unanimously on April 4, 2005 that under section 522(d)(10)(E) of the United States Bankruptcy Code (11 U.S.C. § 522(d)(10)(E)), a debtor in bankruptcy can exempt his or her IRA, up to the amount necessary for retirement, from the bankruptcy estate.[13] The Court indicated that because rights to withdrawals are based on age, IRAs should receive the same protection as other retirement plans. Thirty-four states already had laws effectively allowing an individual to exempt an IRA in bankruptcy, but the Supreme Court decision allows federal protection for IRAs.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 expanded the protection for IRAs. Certain IRAs (rollovers from SEP or Simple IRAs, Roth IRAs, individual IRAs) are exempt up to at least $1,000,000 (adjusted periodically for inflation) without having to show necessity for retirement.[14] The law provides that "such amount may be increased if the interests of justice so require."[15] Other IRAs (rollovers from most employer sponsored retirement plans (401(k)s, etc.) and non-rollover SEP and SIMPLE IRAs) are entirely exempt.[16]

The 2005 BAPCPA also increased the Federal Deposit Insurance Corporation insurance limit for IRA deposits at banks.

The United States Court of Appeals for the Eleventh Circuit has ruled that if an IRA engages in a "prohibited transaction" under Internal Revenue Code sections 408(e)(2) and 4975(c)(1), the assets in the IRA will no longer qualify for bankruptcy protection.[17]

With respect to inherited IRAs, the United States Supreme Court ruled, in the case of Clark v. Rameker in June 2014, that funds in an inherited IRA do not qualify as "retirement funds" within the meaning of the federal bankruptcy exemption statute, 11 U.S.C. section 522(b)(3)(C).[18]

Protection from creditors

There are several options of protecting an IRA: (1) roll it over into a qualified plan like a 401(k), (2) take a distribution, pay the tax and protect the proceeds along with the other liquid assets, or (3) rely on the state law exemption for IRAs. For example, the California exemption statute provides that IRAs and self-employed plans' assets "are exempt only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor, taking into account all resources that are likely to be available for the support of the judgment debtor when the judgment debtor retires." What is reasonably necessary is determined on a case by case basis, and the courts will take into account other funds and income streams available to the beneficiary of the plan. Debtors who are skilled, well-educated, and have time left until retirement are usually afforded little protection under the California statute as the courts presume that such debtors will be able to provide for retirement.[19]

Many states have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. For example, IRAs are protected up to $500,000 in Nevada from Writs of Execution.[20] However, this type of protection does not usually exist in the case of divorce, failure to pay taxes, deeds of trust, and fraud.

Unlike other IRAs, inherited IRAs do not qualify for an exemption from the bankruptcy estate and thus they are not protected from creditors in bankruptcy.[21]

Borrowing

An IRA owner may not borrow money from the IRA except for a 2-month period in a calendar year.[4] Such a transaction disqualifies the IRA from special tax treatment. An IRA may incur debt or borrow money secured by its assets but the IRA owner may not guarantee or secure the loan personally. An example of this is a real estate purchase within a self-directed IRA along with a non-recourse mortgage.

According to one commentator, some minor planning can turn the 2-month period previously mentioned into an indefinite loan.[22]

Income from debt-financed property in an IRA may generate unrelated business taxable income in the IRA.

The rules regarding IRA rollovers and transfers allow the IRA owner to perform an "indirect rollover" to another IRA. An indirect rollover can be used to temporarily "borrow" money from the IRA, once in a twelve-month period. The money must be placed in an IRA arrangement within 60 days, or the transaction will be deemed an early withdrawal (subject to the appropriate withdrawal taxes and penalties) and may not be replaced.

Double taxation

Double taxation still occurs within these tax-sheltered investment arrangements. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates tax treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital.[23]

Inheriting

If the IRA owner dies, different rules are applied depending on who inherits the IRA (spouse, other beneficiary, multiple beneficiaries and so on).

In case of spouse inherited IRAs, the owner's spouse has the following options:

  • treat the IRA account as his or her own, which means that he or she can name a beneficiary for the assets, continue to contribute to the IRA and avoid having to take distributions. This avoids paying the extra 10% tax on early distributions from an IRA.
  • rollover the IRA funds into another plan and take distributions as a beneficiary. Distributions will be determined by the required minimum distribution rules based on the surviving spouse’s life expectancy.
  • disclaim up to 100% of the IRA assets, which, besides avoiding extra taxable income, enables their children to inherit the IRA assets
  • take all of the IRA assets out in one lump-sum, which can subject the spouse to federal taxes if particular requirements are not met

In case of non-spouse inherited IRAs, the beneficiary cannot choose to treat the IRA as his or her own, but the following options are available:

  • take out the assets in a lump-sum cash distribution, which may lead the beneficiary to be subject to federal taxes that could take away a significant portion of the assets.
  • disclaim all or part of the assets in the IRA for up to 9 months after the IRA owner’s death.
  • if the beneficiary is older than the IRA owner, he or she can take distributions from the account based on the IRA owner’s age.

In case of multiple beneficiaries the distribution amounts are based on the oldest beneficiary’s age. Alternatively, multiple beneficiaries can split the inherited IRA into separate accounts, in which case the RMD rules will apply separately to each separate account.[24]

Statistics

Detailed statistics on IRAs have been collected by the Employee Benefit Research Institute, in its EBRI IRA Database (Center for Research on IRAs),[25] and various analyzes performed. An overview is given in (Copeland 2010). Some highlights from the 2008 data follow:[26]

  • The average and median IRA account balance was $54,863 and $15,756, respectively, while the average and median IRA individual balance (all accounts from the same person combined) was $69,498 and $20,046. The average is significantly higher than the median (over three times higher), reflecting significant positive skew – very large balances increase the average.
    • Average and median balances increased with age, reaching a maximum in the 65–69 age group, before leveling off for 70 and over.
  • Rollovers overwhelm contributions – the overwhelming majority of IRA contributions, in dollar terms, were from rollovers, rather than new contributions – over 10 times as much is added to IRAs from rollovers than new contributions.
    • While many rollovers were small (28.5% were less than $5,000, and 53.1% were less than $25,000), a significant number of rollovers were quite large, with 20.2% being more than $100,000.
  • IRAs were divided by type as 33.6% traditional IRAs, 33.4% rollover IRAs (combined with the traditional IRAs, 67 percent), 23.4% Roth IRAs, and 9.6% SEPs and SIMPLEs.
  • Excluding SEPs and SIMPLEs (i.e., concerning traditional, rollover, and Roth IRAs), 15.1% of individuals holding an IRA contributed to one. The percentage was much higher for Roth IRAs: 7.2% of owners of traditional or rollover IRAs (same for contribution purposes) contributed, while 29.5% of owners of Roth IRAs contributed.
  • Contributions are concentrated at the maximum amount – of those contributing to an IRA, approximately 40% contributed the maximum (whether contributing to traditional or Roth), and 46.7% contributed close to the maximum (in the $5,000–$6,000 range).

Large balances

While the average (mean) and median IRA individual balance in 2008 were approximately $70,000 and $20,000 respectively, higher balances are not rare. 6.3% of individuals had total balances of $250,000 or more (about 12.5 times the median),[26] and in rare cases, individuals own IRAs with very substantial balances, in some cases $100 million or above (about 5,000 times the median individual balance).[27] This typically occurs when founders of companies place shares in their own company in an IRA, and the share value subsequently rises substantially.[27]

Retirement savings crisis

While inflation-adjusted stock market values generally rose from 1978 to 1997, in March 2013 they were lower than during the period 1998 through 2007.[28] This has caused IRAs to perform substantially more poorly than expected when current retirees were investing the bulk of their savings in them.[29] In 2010, the median household retirement account balance for workers aged 55 to 64 was $12,000, which will provide only a trivial supplement to Social Security benefits, but a third of households had no retirement savings at all.[30] 75% of Americans nearing retirement age had less than $30,000 in their retirement accounts, which Forbes called "the greatest retirement crisis in American history."[7]

Similar policies in other countries

See also

Notes

  1. ^ See subsection (a) of 26 U.S.C. § 408 and the Treasury regulation at 26 C.F.R. sec. 1.408-2.
  2. ^ See paragraph 37 of subsection (a) of 26 U.S.C. § 7701.
  3. ^ See 26 C.F.R. sec. 1.408-4.
  4. ^ a b "Publication 590: Individual Retirement Arrangements (IRA)" (PDF). Internal Revenue Service. 2012. p. 8.
  5. ^ See, generally, subsection (b) of 26 U.S.C. § 408 and 26 C.F.R. sec. 1.408-3.
  6. ^ ""Traditional IRAs," Internal Revenue Service website". Irs.gov. Retrieved 2012-12-10.
  7. ^ a b Siedle, Ted (March 20, 2013). "The Greatest Retirement Crisis In American History". Forbes. Retrieved 3 April 2013.
  8. ^ [1][dead link]
  9. ^ "Retirement Plans FAQs regarding IRAs". Internal Revenue Service. Retrieved December 21, 2006.
  10. ^ "What can I trade in an IRA account?". Optionshouse, LLC. Retrieved April 4, 2011.
  11. ^ Template:Cite article
  12. ^ "Publication 590 (2005), Individual Retirement Arrangements (IRAs)". Irs.gov. 2011-12-20. Retrieved 2012-12-10.
  13. ^ "Rousey Et Ux. v. Jacoway" (PDF). Supreme Court Of The United States. October 2005. Retrieved December 21, 2006.
  14. ^ See subsection (n) of 11 U.S.C. § 522.
  15. ^ Id.
  16. ^ 11 USC section 522(n); see also Internal Revenue Code of 1986 sections 408 and 408A.
  17. ^ See Willis v. Menotte (In re Willis), 424 F. App'x 80, docket no. 10-11980 (11th Cir. 2011) (per curiam).
  18. ^ Clark v. Rameker, case no. 13-299, U.S. Supreme Court (June 12, 2014).
  19. ^ Stein, Jacob (2011). A Lawyer's Guide to Asset Protection Planning in California. p. 82. ISBN 098397800X.
  20. ^ Nevada Revised Statutes Section 21.075 - Civil Practice onecle - Court Opinions
  21. ^ "Supreme Court: Inherited IRAs Don't Qualify for Bankruptcy Exemption". Rubino & Company Chartered. 2014. Archived from the original on July 1, 2014.
  22. ^ IRA Loans.
  23. ^ "Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital". Fin.gc.ca. 2008-10-21. Retrieved 2012-12-10.
  24. ^ Presti&Naegele Newsletter How do I? Get the most from my inherited IRA?
  25. ^ "Center for Research on IRAs". EBRI. 2012-11-30. Retrieved 2012-12-10.
  26. ^ a b (Copeland 2010)
  27. ^ a b Maremont, Mark (2012-01-19). "Romney's Unorthodox IRA". Wall Street Journal. Retrieved 2012-01-20.
  28. ^ "S&P 500 Stock Price Index (SP500)/Consumer Price Index for All Urban Consumers: All Items (CPIAUCSL)," 1960-March 2013 FRED Graph, St. Louis Federal Reserve Bank
  29. ^ Walsh, Ben (March 13, 2013). "Counterparties: Retiring the 401(k)". Reuters. Retrieved 3 April 2013.
  30. ^ Black, Duncan (February 5, 2013). "401Ks are a disaster". USA Today. Retrieved 3 April 2013.

References

External links

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