Individual Retirement Plans
Individual retirement plans allow any income-earning citizen to start a tax-advantaged retirement account with many of the same benefits and drawbacks as company-sponsored retirement plans. Whether or not you're covered by a defined benefit plan or by another plan that relies on the trustworthiness of many different managers at your company, individual retirement accounts are a great way to build a separate investment account that puts you in the driver's seat.
Individual Retirement Accounts (IRAs)
Unlike employer-sponsored plans, you are responsible for opening a traditional individual retirement account (IRA) and making annual contributions. Contributions reduce your gross taxable income, and IRA investments grow tax-free until withdrawn, at which point they are taxed as ordinary income. As with 401(k) and related plans, in the event you file for bankruptcy, your IRA assets should be protected from seizure.
Contributions to your IRA can be as high as 100 percent of your gross income, not including investment gains and dividends, up to $4,000 per year if you're under 50 years old, and $5,000 per year if older. These limits increase in 2008 to $5,000 and $6,000, respectively. If you have more than one traditional IRA, these limits apply to the total contributions you make in a given year to the accounts.
Contributions can be made to your IRA at any time during the related year through the date for filing your tax return for the year, excluding extensions. The date changes, so always check when your contribution is due early in the year.
If you're single or “head of household” for tax purposes, are covered by an employer's retirement plan, and earn a “modified adjusted gross income” (MAGI) of more than $60,000, you cannot deduct your IRA contributions. Contribution maximums are reduced below the $4,000 to $5,000 threshold when your MAGI is between $50,000 and $60,000 and you're covered by an employer's plan
When computing your IRA maximum, MAGI includes wages, salaries, commissions, self-employment income, alimony, and separate maintenance payments received under a decree of divorce or separate maintenance. Earnings not considered taxable income include earnings from property, interest and dividend income, pension or annuity income, and deferred compensation.
According to the Federal Reserve, 53 percent of workers aged 55 to 64 have no retirement savings account. That's zero retirement savings! Of the 47 percent who do have a retirement fund, the median amount saved is $25,000, about a tenth of what you need to be able to retire and live somewhat comfortably, but certainly not luxuriously.
If you change jobs and your new employer doesn't offer a 401(k) retirement plan, you can “roll over” your funds from the previous employee-sponsored retirement plan into a new “Rollover IRA.” Rollovers should directly transfer the account funds from the original plan into the new IRA within sixty days. If you don't roll all the assets into the new account within the allotted time, the shortfall will be taxed as ordinary income and you'll face the 10 percent early withdrawal penalty.
Unlike 401(k) plans, you cannot borrow from an IRA, nor can you sell property to an IRA, use the IRA to secure a loan, or use the IRA to purchase property for personal use.
As long as you have earned taxable income in a given year, you can continue to contribute to an IRA until you are age 70.5. You can withdraw funds from your IRA when you reach age 59.5 without incurring a penalty. If you have not begun tapping the account, you are required to start taking distributions from your non-Roth IRA by April 1 of the year following the year you reach age 70.5.
Other IRA qualifications or restrictions include the following:
If you make more than $110,000, you can't contribute any funds.
If your modified adjusted gross income is between $95,000 and $110,000 and you file taxes as single, head-of-household, or married filing separately, and you didn't live with your spouse at any time during the year, your maximum contribution is restricted.
You cannot borrow money from your IRA.
If you receive an IRA as part of a divorce or separate maintenance decree, the IRA becomes yours, and the transfer is tax-free.
If you were divorced or legally separated within a year, and didn't remarry before the end of the calendar year (December 31), and you contributed funds to your ex-spouse's IRA that year, you cannot deduct any contributions you made to your ex-spouse's IRA.
If you inherit an IRA from someone who wasn't your spouse, you can't roll the funds over into your own account. You'll be required to withdraw funds over time, and withdrawn amounts will be taxed as ordinary income.
If you are making your contribution around tax time, it's very important to specify which year the contribution covers. Be sure to tell the brokerage firm that holds your IRA whether it's for the year just passed or the current year. Although many people fall into the habit of only making contributions when submitting taxes days before the IRS deadline, keep in mind that the earlier in the year contributions are invested, the greater financial returns you can potentially earn.
A Roth IRA has the same basic requirements and restrictions as a traditional IRA but with some crucial differences. With a traditional IRA, you fund the account with pretax dollars (by deducting the contribution) meaning you pay less in taxes up front. With a Roth IRA, you fund the account with post-tax dollars (by not deducting the contribution), which means you'll pay more in immediate taxes.
However, unlike a traditional IRA, you will not pay any taxes on Roth IRA interest earnings or capital gains — as long as you do not withdraw funds within five years of depositing them and are over age 59.5 at the time of withdrawal. If you do withdraw funds before those requirements have been met, you will be required to pay a 10 percent early withdrawal penalty and taxes on withdrawn gains and any interest income. The benefits increase substantially if you are young and have many years to acquire gains.
The Difference Between Traditional and Roth IRAs
The amount you can contribute, the early withdrawal penalty, and most other aspects of the Roth IRA are identical to the traditional IRA, with a few exceptions:
With a traditional IRA, you cannot contribute to IRA accounts past age 70.5; with a Roth IRA, you can continue to contribute to the account at any age.
With a traditional IRA, you have to begin liquidating the funds by taking at least minimum annual withdrawals at age 70.5; with a Roth IRA, you do not have to begin withdrawing funds at age 70.5.
With a traditional IRA, early withdrawals (before age 59.5) are taxed as ordinary income and incur a 10 percent penalty on the amount withdrawn; with a Roth IRA early withdrawals (before age 59.5, or less than five years after the account was established) incur a 10 percent penalty and only the gains are taxed.
With a traditional IRA, upon deposit, you do not pay taxes on contributions; with a Roth IRA, upon deposit, you pay taxes on contributions.
With a traditional IRA, upon withdrawal after age 59.5, you pay ordinary income taxes on contributions, plus taxes on interest earnings and capital gains; with a Roth IRA, upon withdrawal at age 59.5, you do not pay taxes on the contributions, interest earnings, or capital gains.
You can convert a traditional IRA into a Roth IRA if your MAGI for Roth IRA purposes is less than $100,000 and you aren't married, filing a separate return. You would pay full ordinary income taxes on your funds in the year of conversion, but you wouldn't have to pay again when you withdraw after you reach age 59.5.
It may be worthwhile to convert to a Roth IRA if you have a year with low earnings or large tax deductions and a relatively small traditional IRA, so you can take advantage of your personal exemptions and deductions. However, the taxes you'll incur are high enough that if your account is substantial, you should consult with a tax professional to see whether conversion of your IRA to a Roth IRA is best for you.
Using Your Roth IRA to Pay for College
If you are at least age 59.5 and have had your Roth IRA for at least five years, you can withdraw contribution funds and interest earnings or capital gains tax-free and penalty-free to fund your child's education.
“Qualified higher education expenses” or QHEEs consist of the following: tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution, as well as for special needs costs incurred by, or for, special needs students in connection with their enrollment or attendance. The qualifying student needs to be enrolled at least half time. Room and board constitute QHEEs.
However, if you are not age 59.5, or have not had your Roth IRA for at least five years, you can use your Roth IRA funds for “qualified higher education expenses” (QHEEs) without incurring the early 10 percent withdrawal penalty as long as enough QHEEs are paid out of pocket. QHEEs can be paid tax and penalty-free using a Roth IRA to the extent that they are not covered by payments from Coverdell ESAs, tax-free parts of scholarships and fellowships, pell grants, employer-provided educational assistance plans, veterans' educational assistance plans, and any other tax-free payment (other than a gift or inheritance) at any age. Taxes are owed under any circumstance when money is withdrawn before age 59.5 from your Roth IRA.
If you will be age 59.5 or older when your child attends college or graduate school, saving for your children's education in your Roth IRA might make sense. If you withdraw funds at age 59.5 or later and the funds are used for qualified college or graduate school expenses — tuition, mandatory fees and equipment, books, and supplies — the withdrawal won't be taxed.
You can also withdraw funds from your Roth IRA tax-free if you are at least age 59.5 and paying for your own college or graduate school expenses. To qualify for favorable tax treatment, withdrawn funds must be used to pay for expenses at a school authorized to disburse financial aid. (See fafsa.ed.gov for a list of eligible schools.)
Since mothers tend to be overly generous in regard to their children, funding a 529 plan or a Coverdell account is a more direct and conflict-free way to make sure that your children will be able to afford higher education without draining your retirement resources.
As always, if you withdraw funds from your Roth IRA before you reach age 59.5, you'll owe ordinary income taxes on the share of earnings that you withdraw from the account. Basically, Roth IRA contributions are funds that are contributed post-taxes so you never owe taxes on the contributions, but if you withdraw any funds prior to age 59.5, or prior to having the Roth IRA five years, you do owe taxes on the investment gains.
However, if the withdrawn amount is spent on qualified educational expenses, the standard 10 percent early withdrawal fee does not apply. The amount of earnings attributable to early Roth IRA withdrawals is taxed at high ordinary income rates, making early Roth IRA withdrawals a bad choice in most cases, even when paying for college expenses.
Since funds withdrawn from a Roth IRA count as income on financial aid applications and are weighed more heavily in financial aid formulas than your assets, your child may not receive as much financial aid as she would if you weren't adding Roth IRA funds to the mix. Also keep in mind that using Roth IRA funds to pay for your child's college expenses means you may eventually have to choose between keeping your retirement funds sufficient to cover your needs or funding your child's education.