Hans Kasper, MS-CPA, PS

Regular IRAs
 

Individuals who receive compensation, including alimony, that is includible in gross income and who are under age 70 1/2 during the tax year are entitled to make contributions to traditional individual retirement accounts (IRAs). Amounts earned in a traditional IRA are not taxed until distributions are made.  Generally, contributions to a traditional IRA may be deducted. However, when the individual, or the individual's spouse, is an active participant in an employer-maintained retirement plan, the deduction may be reduced or eliminated. Nondeductible contributions may be made to a traditional IRA and/or Roth IRA.

IRA Contributions. For tax years 2005 through 2007, the maximum combined contribution by an individual to his or her traditional and Roth IRAs is $4,000. For 2008, it will be $5,000. Starting in 2009, the maximum contribution will be subject to an annual inflation adjustment. An individual who will be at least age 50 by the end of the tax year is allowed to make additional contributions to a traditional or Roth IRA. For 2002 through 2005, the maximum annual amount of the catch-up contribution is $500. After 2005, the maximum amount will be $1,000.

Example 1:   Bob will be 50 years old on December 28, 2005. Assuming he meets the income requirements, his maximum contribution to his traditional IRA and/or Roth IRA for 2005 is $4,500 ($4,000 in regular contributions and $500 in catch-up contributions).

Example 2:   Assume the same facts as in Example 1, except that Bob will not reach age 50 until December 28, 2006. In this situation, his maximum contribution to his traditional IRA and/or Roth IRA for 2005 is $4,000. For 2006, his maximum contribution is $5,000 ($4,000 in regular contributions and $1,000 in catch-up contributions).

Individuals have until the due date of their tax returns to make contributions to their IRAs for the return year (e.g., April 15). Filing extensions are not taken into account. If the contribution is made by the due date, it will be treated as having been made on the last day of the tax year for which the return is filed. A deduction may be claimed for a contribution even though the contribution had not yet been made when the return is filed. However, the contribution must be made by the due date of the tax return.

If a contribution to a traditional IRA is less than the allowable maximum for that year, the individual cannot contribute more the next year to make up the difference. If a contribution is more than the allowable maximum, the excess contribution may be withdrawn on or before April 15 or carried over and deducted in later years to the extent that the actual contributions in those later years are less then the allowable maximum. However, the excess contribution is subject to a six percent tax each year until it is corrected. The individual reports the six percent tax on Form 5329 LK:NON: WKFORM 260 , Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.

Compensation. For purposes of determining an individual's eligibility to make contributions to an IRA, the term “compensation” includes earned income and alimony. The term does not include pensions, annuities or other forms of deferred compensation. However, under a safe-harbor rule, the IRS will accept as compensation the amount properly shown on the Form W-2 LK:NON: WKFORM 10612  box 1 for wages, tips, and other compensation less any amount properly shown for nonqualified plans. The compensation of a self-employed person is the individual's “earned income.” Legislation passed in 2006 provides that combat zone compensation earned by a member of the Armed Forces and excluded from gross income under Code Sec. 112 will be treated as compensation for purposes of the limit on IRA contributions. The rule applies to all tax years beginning after 2003, and allows individuals who received combat pay during 2004 or 2005 to make IRA contributions for those years at any time before May 29, 2009.

Allowable Investments. Although IRAs may hold almost any investment, they are generally prohibited from investing in “collectibles” (e.g., antiques and stamps). However, certain U.S. gold and silver bullion coins minted since October 1986 may be held by an IRA. An IRA may also hold certain platinum and state-issued coins, as well as gold, silver, platinum, and palladium bullion.

Deemed IRAs. Qualified plans may allow employees to make voluntary contributions to a separate account that will be deemed to be a traditional IRA or Roth IRA if the account meets all the requirements of the particular type of IRA. An employee's contributions to this account will count towards the maximum annual contributions that may be made to IRAs (e.g., $4,000 ($4,500 for individuals age 50 or older) for 2005.

Taxation of Distributions

 If an individual never made nondeductible contributions to a traditional IRA, then any distributions from the IRA are fully taxable to the owner or beneficiary. However, if nondeductible contributions were made, the owner has a cost basis in the IRA. An individual's cost basis in distributions made from a traditional IRA is the sum of the nondeductible contributions made to the IRA minus any prior withdrawals or distributions of nondeductible contributions. The recovery of this basis is not recognized as taxable income. As a result, the individual must determine how much of the IRA distribution is nontaxable. The taxable and nontaxable portions of the distribution are generally determined under the same rules that apply to annuity payments. When applying these rules.

(1)  all traditional IRAs of an individual (including SEPs and SIMPLE accounts) are treated as a single contract;

(2)  all distributions during the individual's tax year are treated as one distribution;

(3)  the value of the contract, the income on the contract, and the investment in the contract are calculated (after adding back distributions made during the year) as of the close of the calendar year in which the tax year of the distribution begins; and

(4)  total withdrawals excludable from income in all tax years cannot exceed the taxpayer's investment in the contract in all tax years.

Reporting Requirements. Form 8606, Nondeductible IRAs, is used to report the taxable portion of an IRA distribution if the individual ever made nondeductible contributions.

Example :   Jane Albright owns two traditional IRAs. During the past few years, Jane made a deductible contribution of $1,000 to IRA #1 and a nondeductible contribution of $500 to IRA #2. During 2005, Jane withdrew $1,500 from IRA #1 and made a $2,000 nondeductible contribution to IRA #2. At the end of 2005, Jane's cost basis in the IRAs was $2,500 (i.e., the total of her nondeductible contributions to both IRAs). On December 31, 2005, the account balance of IRA #1 is $8,500, and the account balance of IRA #2 is $6,000. The nontaxable portion of her $1,500 withdrawal is $234 ($2,500 (cost basis) ¸ $16,000 (account balance + withdrawal) ´ $1,500 (withdrawal)). The balance of the distribution ($1,266) is included in Jane's gross income for 2005.

Estate Tax. If the distributee is the beneficiary of the IRA owner and the value of the IRA is included in the owner's estate for federal estate tax purposes, the distributee is entitled to deduct the estate tax allocable to the IRA.

Return of Contributions. A distribution from a traditional IRA that represents the return of a contribution made for a particular tax year will not be included in the individual's income if

(1)  the distribution is made before the due date (including extensions) of the individual's tax return for that year;

(2)  no deduction is allowed with respect to the contribution; and

(3)  the distribution includes any net income earned by the contribution.

The net income earned by the contribution is included in income for the tax year in which the contribution was made even if the distribution is received in the following year.

Effective late 2006

If a NON-spouse beneficiary of a deceased person is to receive money from an IRA and elects a direct rollover to their own IRA, the rolled over amount is not taxable to the beneficiary as long as the IRA is titled with the decedent's name; for example, "IRA for Tom Jones as beneficiary of John Jones."  If the beneficiary does not perform a direct rollover and title the account correctly, then the beneficiary will be taxed and penalized on the IRA; usually 25% tax and 10% penalty.

Recognizing Loss on IRA. An IRA owner can recognize a loss on traditional IRA investments, but only when all amounts from all of the owner's traditional IRA accounts have been distributed and the total distributions are less than any unrecovered basis in the accounts. The recognized loss is claimed on Schedule A as a miscellaneous itemized deduction, subject to the two-percent floor ( IRS Pub. 590 (Individual Retirement Arrangements)). If the individual never made nondeductible contributions to any of the traditional IRAs, the realized loss can not be deducted because the individual has no tax basis in the IRAs.