Traditional Individual Retirement Accounts (IRAs)

Farm Business Management Update, August 2000

By Alex White

Since 1982, traditional Individual Retirement Accounts (IRAs) have been powerful retirement planning tools for individuals. However, many Americans do not understand what an IRA is, how an IRA might help them, and whether a traditional IRA is a wise investment for them. This bulletin answers some of the more frequently asked questions about traditional IRAs.

What is a traditional IRA?

A traditional IRA provides federal taxpayers with a tax-advantaged method of investing for retirement. It is intended to provide individuals with a substantial portion of their retirement living needs. Remember, Social Security benefits are meant to be a supplement to individual savings, not a substitute for them! By investing funds in a traditional IRA, an individual may be able to reduce his/her current income taxes, and he/she will be able to defer income taxes on his/her earnings until the future. Generally, a person cannot withdraw funds from a traditional IRA before the age of 59 1/2 without facing an early withdrawal penalty.

A traditional IRA is different from a Roth IRA, an Education IRA, a SEP-IRA and a SIMPLE-IRA.

Who can open an IRA?

Opening an IRA has no minimum age limit. Anyone who is less than 70 1/2 and receives "taxable compensation" during the year is eligible to open a traditional IRA. Taxable compensation simply refers to earned income or income that is reported on Form W-2. Examples of taxable compensation include salaries, wages, commissions, self-employment income, and alimony received. Compensation does not include passive earnings such as rental income, interest income, dividend income, pension or annuity income.

What are the tax benefits of a traditional IRA?

Traditional IRAs offer two significant tax benefits: tax deductions and tax deferral.

Tax Deductions: For many individuals, annual contributions to an IRA are tax-deductible. This means their taxable income (adjusted gross income or AGI) is decreased by making contributions to an IRA. Thus, they can reduce the amount of income taxes they pay each year. For example, assume a person is in the 28 percent marginal tax bracket. By making a $2,000 annual contribution to his/her IRA, he/she can reduce his/her income taxes by $560 per year. Annual IRA contributions may or may not be deductible, depending on whether the taxpayer or the taxpayer's spouse was covered by an employer retirement plan at any time during the year.

Tax Deferral: The earnings of a traditional IRA are not taxed until the funds are withdrawn from the account. This procedure effectively defers, or delays, income taxes until the future. An advantage of tax-deferral is that people are likely to be in a lower marginal tax bracket when they retire; thus, the total amount of taxes they will owe on the earnings of their IRAs will be reduced. For example, assume the investment in an IRA earns $500 this year. The taxpayer does not owe any income taxes on those earnings as long as he/she does not withdraw that money from his/her account. Tax deferral allows him/her to increase his/her investments much faster than if he/she invested in a taxable account because he/she earn returns on money that otherwise would have been paid to the government in the form of income taxes.

The maximum annual contribution is the lesser of $2,000 or 100% of one's compensation for the year. Thus, if someone only earned $1,000 last year, the maximum IRA contribution he/she can make is $1,000 for that tax year. Remember, a person cannot make contributions to a traditional IRA if he/she is over 70 1/2.

In what assets can someone invest his/her IRA contributions?

An IRA is not an investment asset; it is a retirement investment plan. Individuals must decide where their annual contributions are going to be invested. The most common investment assets for IRAs are corporate stocks, bonds, mutual funds, and certificates of deposit (CDs). Each of these assets has different potential returns and different levels of risk. In general, corporate stocks have higher historical earnings than other investments, but they are also riskier than the other investments. The individual is responsible for choosing his/her investment assets - but professional advice is recommended for those who are uncomfortable with financial decisions.

Can a non-working spouse make IRA contributions?

As long as one spouse received compensation (earned income) during the year, the non-working spouse can contribute to an IRA. The maximum annual contribution for a non-working spouse is the lesser of $2,000 or the total compensation reported as gross income (minus any IRA contributions). Therefore, the maximum annual contribution for a married couple is $4,000 -- that is, no more than $2,000 per person per year.

Can a person make annual contributions that are less than the maximum allowed?

The IRS does not require taxpayers to make the maximum annual contribution. However, if they make less than the maximum contribution in one tax year, they cannot make more than the maximum contribution in a following year in an attempt to catch up.

Once an IRA is started, do contributions have to be made every year?

IRA contributions do not have to be made every year, even if taxpayers are eligible.

When can people begin to withdraw funds from my IRA?

People can begin to withdraw funds from their traditional IRA without penalty at age 59 1/2. They will pay ordinary income taxes on the amount they withdraw from their account. For example, assume Joe is 60 years old and in the 15 percent tax bracket. If he withdraws $10,000 from his traditional IRA, he will owe $1,500 in federal income taxes.

Withdrawal of funds from a traditional IRA must begin at age 70 1/2. The IRS has a formula for determining the minimum amount people must withdraw each year after reaching age 70 1/2.

What are the penalties for withdrawing money from an IRA before the minimum age?

Generally speaking, withdrawing funds from a traditional IRA before the age of 59 1/2 results in an early withdrawal penalty plus ordinary income taxes on the amount withdrawn. The early withdrawal penalty is 10 percent of the amount withdrawn. For example, assume Jane is 50 years old, in the 15 percent tax bracket, and she withdraws $10,000 from her IRA this year. She will owe $1,000 in early withdrawal penalties and $1,500 in ordinary income taxes. Thus, out of a $10,000 withdrawal, she will be left with $7,500 after penalties and income taxes.

Can children have a traditional IRA?

There is no minimum age limit for opening an IRA, so children may open an IRA if they earned income during the year. The income they earn must be consistent with the job/duties they perform.

Can funds from another retirement plan be converted into a traditional IRA? In most cases, funds can be converted in a Rollover IRA: rolling funds from one retirement plan into an IRA. Taxpayers may roll over all or part of the funds from an existing IRA with no penalty, as long as the funds are reinvested within 60 days of withdrawal. They cannot deduct the amount that they roll over from their income taxes.

If taxpayers receive eligible rollover distributions from an employer's retirement plan, such as a 401(k), or 403(b), they may roll these funds into a traditional IRA with no penalty. The retirement plan administrator can provide written details of the rollover process.

Where can someone open a traditional IRA?

An IRA can be opened at commercial banks, federally-insured credit unions, savings and loan associations, or any entity approved by the IRA to act as a trustee or custodian, including certain investment brokers and insurance agents. The tax year for which the contribution is being made must be clearly specified. For example, if Joe makes an IRA contribution on March 1, 2000 for tax year 1999, the contribution form must clearly indicate that his contribution is for tax year 1999.

Can people have more than one IRA?

People may have as many IRAs as they want. However, total annual contributions to all IRAs cannot exceed $2,000 per year. For example, assume Jane has a traditional IRA with a bank and another IRA with a savings and loan. The maximum annual contribution she can make is $2,000. That means she can contribute $1,000 to each IRA, or $1,500 to one and $500 to the other, or any combination that does not exceed $2,000 in one year.

Taxpayers should have a separate IRA if they are making non-deductible contributions. This practice will greatly ease the record keeping efforts when they begin to withdraw funds from accounts. They can have a Roth IRA and a traditional IRA at the same time. Taxpayers can make contributions to both IRAs in the same year, as long as the total combined contributions do not exceed $2,000.

Are other retirement investments and IRAs possible at the same time?

Taxpayers can have a traditional IRA at the same time they participate in other retirement plans. However, their contributions may not be tax-deductible, depending on their filing status and adjusted gross income.

Contact the author at axwhite@vt.edu .

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