Understanding Traditional IRAs

We have all heard of IRAs, or Individual Retirement Accounts, but many do not understand what they really are, how they work or the benefit they provide. Simply stated an IRA is an investment you set up to provide funds to you when you retire. If you qualify, the tax Code provides current tax incentives by way of deferred taxation of the gains on the investment and deductions from current income for contributions made to the IRA. The following may help you determine whether you can benefit from setting up an IRA.

How is an IRA set up?

An IRA account can be set up at a bank, financial institution, life insurance company, mutual fund or stock broker. The institution in which you choose to set up the IRA will provide the necessary forms to open the IRA account.

Who is eligible for an IRA?

There is no age requirement for contributing to an IRA. Prior to 2020 contributions to an IRA could not be made by someone who was 70.5 years old. These age limits no longer exist. However, in order to be eligible to contribute to an IRA the person must have earned income. A person who has no earned income may contribute to an IRA if their spouse has earned income and they file a joint return. Both spouses may contribute to their IRAs, but their combined contributions cannot exceed the taxable compensation reported on the joint return.

How much can be contributed to an IRA?

The maximum yearly amount that may be contributed to an IRA for 2021 and 2022 is $6,000. If the person is 50 years old or older, the contribution limit is $7,000. Any contributions rolled over into the IRA from another qualified retirement plan do not count towards the yearly contribution limit.

Do contributions have to be made every year?

No, you are not required to make contributions every year.

What is the deadline for contributing to an IRA?

You have until the due date of the return to contribute to an IRA which is usually April 15. This year the tax return filing due date is April 18. Hence, you have until April to make a contribution for 2021. An extension to file the return until October 15 does not extend the time to contribute to an IRA. The April deadline for IRA contributions for the prior year cannot be extended.

Is the IRA contribution deductible?

Whether a contribution to an IRA is deductible depends on your filing status, your income and whether you or your spouse are covered by a retirement plan at work. The links below will help you determine whether a contribution will be deductible.

If you are covered by a retirement plan at work then:

For 2021: https://www.irs.gov/retirement-plans/2021-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-covered-by-a-retirement-plan-at-work

For 2022: https://www.irs.gov/retirement-plans/plan-participant-employee/2022-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work

If you are not covered by a retirement plan at work then:

For 2021: https://www.irs.gov/retirement-plans/2021-ira-deduction-limits-effect-of-modified-agi-on-deduction-if-you-are-not-covered-by-a-retirement-plan-at-work

For 2022: https://www.irs.gov/retirement-plans/plan-participant-employee/2022-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-not-covered-by-a-retirement-plan-at-work

Are the earnings in the IRA account taxable?

The earnings in the IRA accumulate tax free. Earnings are not taxed until distributions are made from the IRA.

When can withdrawals/distributions from the IRA be made?

Distributions/withdrawals can be made from the IRA at any time. All distributions made from the IRA are taxable and reported in the year in which the distribution was made. If the distribution is made prior to the owner’s reaching 59.5 years of age, a 10% early withdrawal penalty will be imposed on the distribution.

There are several exceptions to the early withdrawal penalty. The most common ones are death, disability, qualified higher education expenses, qualified first time homebuyer ($10,000), and certain medical expenses and health insurance premiums. For a full list of exceptions see: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

Must an IRA make distributions?

Required minimum distributions from an IRA must be made once the owner reaches 72 years of age so long as their 70th birthday was after July 1, 2019. The required minimum distribution rules for beneficiaries of IRAs are more complicated and beyond the scope of this article. To view the rules see: https://www.irs.gov/retirement-plans/required-minimum-distributions-for-ira-beneficiaries

As a result of COVID certain laws were passed which affect retirement plans and IRAs. These are beyond the scope of this article. You can read more about these changes here: https://www.irs.gov/newsroom/coronavirus-related-relief-for-retirement-plans-and-iras-questions-and-answers

 Are there limits on an IRA’s investments?

An IRA cannot invest its assets in life insurance or collectibles. Collectibles includes artwork, antiques, gems, metals (with some exceptions), coins (with some exceptions) and other tangible personal property. Investing in collectibles results in a deemed distribution of the amount invested in the year it was invested. The 10% penalty would apply if the owner has not reached 59.5 years of age.

Generally, IRAs invest in traditional assets such as stocks, bonds, mutual funds and ETFs. It is possible for an IRA to invest in non-traditional assets such as real estate. IRAs that invest in non-traditional assets are known as “self-directed” IRAs. A self-directed IRA would still need to be held by an IRS approved custodian, but the custodian institution would be one that permits investments in other than the traditional investments. There is greater potential for growth in an IRA holding non-traditional investments, but there is also greater risk, especially with running afoul of the prohibited transaction rules and the lack of duties owed to the owner by the IRA’s custodian. The SEC has also warned of a higher potential for fraud with self-directed IRAs. See: https://www.sec.gov/investor/alerts/sdira.html

The rules regarding retirement plans can be complex. The purpose of this article is to provide an overview regarding IRAs and is not meant to replace consultation with a qualified professional.

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