Individual Retirement Account

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An individual retirement arrangement (IRA) is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States. The term 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, by which the taxpayers purchase an annuity contract or an endowment contract from a life insurance company.[1]

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[edit] Types

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 2004 to 2007, and $5000 from 2008 to 2010. Beginning in 2002, those over 50 could make an additional contribution called a "Catch-up Contribution."[2]

There are two other subtypes of IRA, named Rollover IRA and Conduit IRA, that are viewed as obsolete under current tax law (their functions have been subsumed by the Traditional IRA) by some; 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.

What was formerly known as an Educational IRA is now called a Coverdell Education Savings Account.

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.

[edit] Funding

For example, if you are 45 and put $3,500 into your traditional IRA this year so far, you can either put $1,500 more into your traditional IRA or $1,500 in your Roth IRA. There may be an additional administrative step needed so that the trustee which holds the IRA proceeds actually retitles or transfers the $3,500 Traditional proceeds into the Roth category for their internal bookkeeping to survive an IRS audit.

[edit] 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.[3] 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.[4] 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.[5]

[edit] 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 and a half. 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 and a half. 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. The exceptions include:[6]

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.

[edit] 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.[7] 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.[8] The law provides that "such amount may be increased if the interests of justice so require."[9] Other IRAs (rollovers from most employer sponsored retirement plans (401(k)s, etc.) and non-rollover SEP and SIMPLE IRAs) are entirely exempt.[10]

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

If an IRA engages in a "prohibited transaction," the assets in the IRA will no longer qualify for bankruptcy protection, according to one Federal Circuit Court of Appeals. See Willis v. Menotte, 11th Circuit Court of Appeals, 2011.

[edit] Protection from creditors

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.[11] However, this type of protection does not usually exist in the case of divorce, failure to pay taxes, deeds of trust, and fraud. Assets in the IRA must have been deposited before a lawsuit exists to receive this protection.[citation needed]

[edit] Borrowing

An IRA owner may not borrow money from the IRA except for a 2-month period in a calendar year.[12] 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 mentioned in the preceding paragraph into an indefinite loan.[13]

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.

[edit] Rollovers as Business Start-Ups (ROBS)

ROBS is an arrangement in which prospective business owners use their 401(k) retirement funds to pay for new business start-up costs.[14] ROBS is an acronym from the United States Internal Revenue Service for the IRS ROBS Rollovers as Business Start-Ups Compliance Project.

ROBS plans, while not considered an abusive tax avoidance transaction, have been considered questionable because they may solely benefit one individual – the individual who rolls over his or her existing retirement 401(k) withdrawal funds to the ROBS plan in a tax-free transaction. The ROBS plan then uses the rollover assets to purchase the stock of the new business. A C corporation must be set up in order to roll the 401(k) withdrawal.

[edit] ROBS Project Findings: New Business Failures

Preliminary results from the ROBS Project indicate that, although there were some success stories, most ROBS businesses either failed or were on the road to failure with high rates of bankruptcy (business and personal), liens (business and personal), and corporate dissolutions by individual Secretaries of State. Some of the individuals who started ROBS plans lost not only the retirement assets they accumulated over many years, but also their dream of owning a business. As a result, much of the retirement savings invested in their unsuccessful ROBS plan was depleted or ‘lost,’ in many cases even before they had begun to offer their product or service to the public.[15]

[edit] 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.

[edit] Similar schemes in other countries

[edit] See also

[edit] Notes

  1. ^ “Traditional IRAs,” ‘’Internal Revenue Service website’’
  2. ^ http://www.cbo.gov/OnlineTaxGuide/Page_2A.htm
  3. ^ "Retirement Plans FAQs regarding IRAs". Internal Revenue Service. http://www.irs.gov/retirement/article/0,,id=111413,00.html. Retrieved December 21, 2006. 
  4. ^ "What can I trade in an IRA account?". Optionshouse, LLC. http://www.optionshouse.com/faq/what-can-i-trade-in-an-ira-account/. Retrieved April 4, 2011. 
  5. ^ Knowles; Veliotis (January 2010). "Roth IRA Conversions in 2010: Issues and Opportunities". CPA Journal: pp. 19-23. 
  6. ^ Publication 590 (2005), Individual Retirement Arrangements (IRAs)
  7. ^ "Rousey Et Ux. v. Jacoway". Supreme Court Of The United States. October 2005. http://www.supremecourt.gov/opinions/04pdf/03-1407.pdf. Retrieved December 21, 2006. 
  8. ^ See subsection (n) of 11 U.S.C. § 522.
  9. ^ Id.
  10. ^ 11 USC section 522(n); see also Internal Revenue Code of 1986 sections 408 and 408A.
  11. ^ Nevada Revised Statutes Section 21.075 - Civil Practice onecle - Court Opinions
  12. ^ "Publication 590: Individual Retirement Arrangements (IRA)" (PDF). Internal Revenue Service: p. 45. 2008. http://www.irs.gov/pub/irs-pdf/p590.pdf. 
  13. ^ IRA Loans.
  14. ^ http://www.irs.gov/retirement/article/0,,id=231594,00.html
  15. ^ http://www.irs.gov/retirement/article/0,,id=231594,00.html

[edit] References

[edit] External links

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