In order to promote savings for retirement of the aging population of U.S. the Congress enacted tax incentives for individuals who set up an Individual Retirement Account (IRA) make contribution to the account. Initially there was only on type of  IRA but in the past few years additional type of IRAs are allowed.

At the present time there are three types of IRAs:

1.      Traditional Deductible IRA for the taxpayer or spouse

2        ROTH IRA for the taxpayer or spouse

3        Education IRA

      All qualified IRAs have to meet certain requirements about agreement, type of investments, trustees and custodians etc. In general , only certain financial institutions can act as the trustees or custodians for IRAs.

How does each type of IRA work?

Traditional IRA:

Savings in a traditional deductible IRA is a tax deferred account where the taxpayer deducts eligible contribution to the IRA from his or her taxable income during the working age. The income and appreciation on the contribution within the IRA grows tax deferred. The taxpayer pays the tax when the funds are withdrawn from the IRA. There are rules about contribution and distribution of the IRA. What are those rules?

Rules on Contribution:

1.      Maximum contribution for a year is $2000 for each taxpayer. Exception to that maximum is for the spousal contribution for a non-working spouse.

2.      Maximum deductible contribution cannot exceed the taxpayer's compensation. For Ira purposes that "compensation" includes salary, wages, self employment income and excludes foreign earned income not includible in the gross income and  deferred compensation

3.      There are additional restrictions for the persons who are active participants in certain types of retirement plans and his or her income exceed certain amounts. The policy of not allowing deduction for IRA contribution by persons with certain threshold of income who are participating in other retirement plans is that  these individual are already saving and do not need tax break of IRA savings. The deductible contribution phase out effective for 2000 are as follows;

Single                                                                                    $32,000-$42,000

Married filing Jointly-

 - For active participant spouse                                                   $52,000-$62000

 - For the spouse who is not participant                                   $150,000- $160,000

Married filing separate separately                                              $32,000 - $42,000

4. Deadline for Contribution:

Contribution for IRA must be made during the tax year or after the tax year but before the due date for filing tax return of the IRA owner- generally the April 15^th of next year.

The deadline is not changed by the fact that the taxpayer has obtained permission to extend the tax filing date.

5.   No contribution is allowed after the taxpayer reaches age of 70 1/2.

5.   Excess Contribution :

Any contribution in excess of the allowable amount together with its earnings is required to be withdrawn by the due date of filing the return. Any such amounts not withdrawn are subject ongoing penalties by IRS.

Rule On Distributions:

1.      Distribution must commence no later than April 1 following the calendar year in which the owner reaches age 70 ½.. Certain minimum annual distribution must be made to the owner or the death benefit beneficiary of the owner is computed every year based on the IRS rules.

2.      All  distributions from traditional IRA are includible in taxpayer's gross income in the year of  distribution. With certain exceptions distributions before age 59 ½  are subject to 10% penalty. The exceptions to the penalty for early withdrawals apply to use of money for following purposes:

• Certain qualified medical insurance payments by eligible unemployed individuals.
• Certain qualified  educational expenses of individual, spouse, child,or grandchild.
• Certain expenses of first time homebuyer expenses up to $10,000.
• Qualified rollover from one IRA to another.

3.      IRA cannot be used as collateral for any loan. Such a loan will be subject to the all  the rules of distribution.

  Roth IRA:

As an additional incentive for saving for middle income families for their retirement in future the congress enacted a new type of IRA named after Senator Roth. The basic principle of Roth IRA is that the contribution is not deductible and qualified distributions are not taxable. In general it is always better to avoid the tax than to defer the tax. In case of  Traditional IRA even though the taxpayer get a deduction for the contribution, all the distributions are subject to income tax. In the case of Roth IRA all the accumulation of income and appreciation over the years before the qualified distribution date escape the future income taxes. In most of the cases Roth IRA  result in better choice than the traditional IRA.

  Contribution limits:

Contribution limits on traditional and Roth IRA are coordinated. Thus, the maximum total yearly contribution made by an individual to both type of IRAs is $2000.

  How does Roth IRA differ from traditional IRA?

1.      Roth IRA is never a deductible .

2.      Roth IRA contribution can be made even after age 70 1/2.

3.      Income limit for Roth Ira contribution phase out ranges are as follows: 

Single                                                 $95,000 - $110,000

Married filing jointly                             $150,000 - $160,000

Married filing separately                                 $0  - $10,000

4.      Qualified distributions from Roth IRA are not subject to tax or early withdrawal penalty. Requirements for qualified distribution are:

• Must meet 5-year holding period .
• Meet one of the following requirements:

a.      Attain age of 59 1/2 before the distribution

b.      Disrtribution upon owner's death

c.      Distribution after individual is disabled

d.      Distribution for qualified first time home buyer

5.      Distribution from Roth IRA not meeting above qualifications are subject to tax and penalties as follows:

Distributions in excess of individual's own contributions are subject to income tax and a 10% penalty.

EDUCATION IRA:

Joint filers with a modified income of less than $150,000 and single filers with modified income of less than $95,000 may contribute up to $500 per designated beneficiary under age 18 . The contribution to notes: Education IRA is not deductible. Earnings on the contribution will be distributed tax free if they are used to pay for the post secondary education expenses of the beneficiary. Income exclusion is not available for any year in which the HOPE or lifetime learning credit is claimed. If the distribution is not used for qualifies education expenses plus 10% is included in income. Additional 10% do not apply if certain additional conditions are met.