The federal tax code offers several types of tax-favored individual retirement accounts such as Traditional, Roth, Simple and SEP. Each type of IRA has unique parameters, some of which are described below.
• Traditional (or regular) IRA – Contributions to a traditional IRA can be funded with either pre-tax (deductible) or after-tax (nondeductible) dollars, depending on eligibility and election of the taxpayer. For 2013, the annual IRA contribution per person is limited to the lesser of earned income, or $5,500 ($6,500 if you are age 50 or older during the year). With limited exceptions, funds that are withdrawn prior to age 59½ are assessed a 10 percent premature distribution excise tax. There also is a requirement to make minimum withdrawals after age 70½.
Deductible contributions are allowed annually if you (and your spouse) are not an active participant in an employer-sponsored retirement plan, or if you (and your spouse) are an active participant in an employer plan, and your modified adjusted gross income (AGI) falls below published levels. Qualifying contributions are deducted from your current year income thus saving you tax in the initial year of contribution and are placed into a separate IRA account. All funds, including growth, will be taxed when distributions are made.
Nondeductible contributions are allowed regardless of whether a person (or spouse) is covered by another plan and regardless of AGI. The contributions are not deducted on the income tax return which means they are after tax dollars and will not be taxed later when distributed. However, the growth accumulates tax free until distribution when it will be taxed at ordinary rates.
At the time of withdrawal, if both deductible and nondeductible contributions have been made, then the withdrawals are taxed only on the deductible portion and on the growth. Additionally, a traditional IRA may be converted to a Roth IRA, regardless of the amount of your AGI. Taxes are paid in the year of conversion.
• Roth IRA – Contributions to a Roth IRA always will be after tax, whether they are original contributions or conversions from other retirement plans. There are no age restrictions for contributions; however, the funds must come from earned income. Furthermore, there are income restrictions for contributing directly to a Roth as well as limitations on the amount of the contribution.
One benefit is that there are no required minimum distributions as is the case with traditional IRA accounts. Another benefit is that growth is tax free which results in no tax liability at the time of qualified withdrawals. Non-qualifying distributions will result in a 10 percent penalty in addition to the tax due on the growth.
• Simple IRA - A Simple IRA is an employer or self-employed plan which includes an elective deferral by the employee and a statutory match by the employer. An employer must either match contributions dollar for dollar on the first 3 percent (some exceptions apply) of deferral elected by the employee, or make a non-elective contribution of 2 percent to all eligible employees whether they make a deferral election or not. The maximum elective employee deferral for 2013 is $12,000 if under age 50, or $14,500 if age 50 or over).
• SEP IRA – SEP IRAs are written plans that are 100 percent funded by the employer. All contributions vest immediately, can vary from year to year, and are discretionary. The percentage must be the same for all qualified employees. There is no catch-up contribution permitted. SEPs may be established, and deposits made, up to the due date of the return including extensions. For 2013, the employer contributions for employees are limited to 25 percent of compensation or $51,000. A SEP is advantageous to small business owners because of the high contribution limit.
In addition to the nuances described above, there are additional estate tax planning strategies that can be explored. As with all tax matters, you may wish to consult a CPA or competent tax preparer to ensure you are compliant with the law.
• Michael J. Flood, CPA, MST, is a partner with Caufield & Flood Certified Public Accountants in Crystal Lake. He can be reached at 815-455-9538, or via e-mail at Michaelf@cfcpas.com, or by visiting CFCPAS.com.