Types of IRAs

IRA as Part of an Employer-Sponsored Retirement Plan

Which is the Best IRA for You?

Summary of Traditional IRA and Roth IRA as of 2001

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IRA UPDATE 2002

Americans are living longer and personal savings are increasingly important as a source of retirement income. An Individual Retirement Account (IRA) can be an excellent vehicle in which to put part of your personal savings for retirement. Tax legislation in 2001 gave more flexibility to IRAs. The 2001 regulations simplify required minimum distribution and beneficiary designation rules. Keep in mind that other (IRA, etc.) income in retirement may affect the amount of tax you pay on your Social Security retirement benefits.

Rules for Investing in an IRA:

• All contributions to an IRA must be earned income.
• Contributions may be made until April 15 for the previous year.
• You may have more than one IRA, but an individual under age 50 cannot contribute more than a total of $3,000 per year, $6000 for a couple In 2002, if you are over age 50, you can contribute an additional $500.
• Wide selection of investments such as stocks, bonds, mutual funds and certain coins and bullion.
• Contributions are 100% deductible if you are not participating in an employer sponsored retirement plan.
• If your adjusted income is low enough and you meet other eligibility requirements, you can receive a tax credit of up to 50% of your contribution to an IRA or other eligible retirement plan.

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Types of IRAs:

Traditional - the original type of IRA. Contributions may or may not be 100% tax deductible depending upon limitations based on your income, your tax filing status, and whether you participate in a qualified retirement plan. Your adjusted gross income (AGI) limits determine whether your contributions can be tax-deductible. For couples whose filing status is married filing jointly, [no deduction if married, filing separately] the amount you can deduct begins to decrease once your income is $54,000 until it reaches zero at $64,000 for 2002. The deductibility phase-out limits increase to $80,000-$100,000 by 2007. For single filers, it's $34,000-$44,000 in 2002 to $50,000-$60,000 in 2005.

Earnings (and contributions if they were not taxed) are taxed at your marginal tax rate when you make withdrawals. You must, by law, start to take withdrawals by April 1of the year after you are age 70½. You can withdraw funds without a 10% early withdrawal penalty, if you use the money for qualified higher educational expenses or for a qualified first-time home purchase.

Spousal - for a spouse with no earned income. Contribution limit is $3,000 a year in 2002. You can deduct contributions to a spousal IRA even if the working spouse participates in an employer's retirement plan. The deduction is phased out at adjusted gross incomes between $150,000 and $160,000. To contribute a total of $6000 to two IRAs, there must be $6000 of earned income by the working spouse.

Rollover - an IRA designed to keep your 401(k) or 403(b) plan tax-advantaged status after a job change, retirement, or receipt of an IRA from a deceased spouse. The rollover should be a direct trustee-to-trustee transfer. If the rollover is not a direct transfer, 20% is withheld to pay income taxes. In addition, a 10% penalty is charged on the amount withheld for taxes if you are under age 59½. If you replace the 20% amount within 60 days, there is no penalty, but you don't get the 20% back until you file your taxes. Partial rollovers may be possible. Hardship distributions or loans cannot be rolled over to an IRA.

Roth (back-loaded) - available since 1998. All other IRA rules apply except:

• Contributions are not tax-deductible.
• Withdrawal is not mandatory at age 70½; contributions can be made after age 70½.
• The income caps that decide who is eligible to contribute are much higher. Eligibility phases out for singles with incomes between $95,000 and $110,000 and for joint filers with incomes between $150,000 and $160,000. Minors may contribute if they meet the earned income requirement.
• Qualified distributions are not included in income or subject to a 10% early distribution penalty. To be qualified, you must have had the IRA for five years and meet one of these four requirements:
  • Distribution is made on or after age 59½;
  • Distribution is made to a beneficiary (or estate) on or after death;
  • Distribution is made because you become disabled; or
  • Distribution is to pay for "qualified first-time home buyer expenses" (lifetime limit, $10,000).
• Earnings are tax free to you and your Roth IRA beneficiary(s).

Traditional IRAs may be converted to Roth IRAs if your modified adjusted gross income is less than $100,000 (not including the rollover amount). You'll owe taxes on any deductible contributions and investment earnings in the year you make the transfer. You can make partial conversions each year for several years to spread out the tax burden. If married, you must file jointly. Rollover Roth IRAs must be kept as a separate IRA. Distributions are considered from contributions first, then converted amounts, and then earnings on the money in the Roth IRA.

Education IRA or Coverdell Education Savings Accounts (ESA) - a trust or custodial account specifically to pay for future education of a child (not retirement account even though it is called an IRA). Parents, friends, and grandparents can make non-deductible contributions of up to $2,000 per child in 2002 (birth up to age 18) per year if the donor meets the income guidelines. For 2002, individuals with an adjusted gross income of up to $95,000, phased out at $110,000, or couples with an adjusted gross income of $190,000, phased out at $220,000, can make annual contributions. You can make a contribution in a year when you also contribute to a qualified state tuition program.

Withdrawals are tax-free if used for qualified elementary and secondary school expenses, including tuition at private and parochial schools. You must withdraw all the money within 30 days of the child turning age 30 or the investment return on the ESA will be included in their taxable income, plus a 10% penalty will apply. Unused money can be rolled over into another family member's ESA. An ESA can be used in the same year when the Hope Credit or Lifetime Learning Credit is used. Note that money in a child's name could limit eligibility for college scholarships or financial aid. The Extension fact sheet, "Tax Breaks for Higher Education" has more information on tax breaks for college expenses. Check the home section at http://www.urbanext.uiuc.edu.

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IRA as part of an employer-sponsored retirement plan:

You may contribute to one of the employer-sponsored IRA plans and a Roth or traditional IRA.

SIMPLE - (Savings Incentive Match Plan for Employees of Small Employers) - It gives small businesses an affordable way to offer retirement benefits through employee salary reductions and matching employer contributions. The contribution limit for SIMPLE plans will increase from $6,500 in 2001 to $10,000 in 2005. For participants over the age of 50, "catch-up" a contribution will be allowed of $500 in 2002 up to $2,500 in 2006.

SEP (Simplified Employee Pension) - It is an easy low-cost retirement plan option for employers who can contribute to his/her own IRA and the IRAs of employees, up to 15% of pay and a dollar amount.

Which is the best IRA for you?

A traditional IRA may best suit your needs if you:

• Think your income in retirement will be in a lower tax bracket than it is now.
• Are eligible for a deductible IRA and will be in a lower tax bracket in retirement.
• Are close to retirement and have a short time horizon before withdrawing funds.
• Are not eligible for a Roth IRA because your income is over the limit on eligibility, but you are eligible for a non-deductible traditional IRA.
  

A Roth IRA may best suit your needs if:

• Your income tax bracket will stay the same or go up when you make future withdrawals.
• You are a long way from retirement.
• You're not eligible for a deductible IRA and are eligible to contribute to a Roth IRA.
• You are over age 70½, have earned income, and want to put money in a tax-free IRA.
• You want to lower your income tax load in retirement.
• You do not want to be required to take minimum withdrawals each year after age 70½.
• You want to stretch out tax deferral as long as possible for you and your beneficiary's lives.
  

Strategies to consider:

Consider consolidating your IRAs (Roth IRAs must be kept separate from traditional; rollover IRA's should be kept separate) if you have more than one. Keeping track of deposits and withdrawals for taxes will be less complicated. You'll pay less in fees too.

The Roth IRA five-year holding period begins in January of the year of your first contribution. Consider making at least a minimum contribution as early as possible to start the time clock on your account holding period. For example, a contribution in December of 2002 is counted as being from January 2002.

Decisions about IRA withdrawals have implications for taxes and estate planning. With the Economic Growth & Tax Relief Act of 2001, the government released substantial revisions to the regulations for calculating required minimum distributions for traditional IRAs and the determination of a designated beneficiary for distributions after death. You might find it beneficial to consult a certified financial planner or other qualified professional.

The information in this update is based on current tax law. Consider the possibility of future tax law changes as you make your IRA and other retirement planning decisions.

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Summary of Traditional IRA and Roth IRA as of 2002

Written by: Charlotte F. Crawford, CFP™ , Extension Educator, Consumer & Family Economics.
Originally reviewed by Karen Chan, CFP™ , Consumer & Family Economics Educator, University of Illinois Extension. Revised by Katie Shepherd, CFP™ 2001. Copyright University of Illinois Extension, March 2002.

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Consumer and Family Economics
Department of Agricultural and Consumer Economics
University of Illinois Extension
University of Illinois Urbana-Champaign