There are basically two types of individual retirement arrangements: traditional individual retirement accounts and individual retirement annuities. Both of these are commonly referred to as IRAs, but each is a different savings vehicle with distinct characteristics. There is no restriction on the number or mix of individual retirement arrangements that can be established within the contribution limits and there may be cases in which more than one arrangement will be desirable for flexibility.

Only individuals under 70½ years of age are eligible to participate in a traditional IRA. The amount of funds that may be contributed to an IRA is limited and, further, the amount of the contribution that may be deducted by the individual is also subject to certain limitations, as discussed below.

Distributions or benefit payments cannot begin prior to the participant reaching age 59½ without penalty. However, a participant must begin receiving at least a minimum distribution or benefit payment from a traditional IRA by April 1 of the year in which the participant reaches age 70½ . This is true even if the participant is not retired at this time. While the funds remain in the individual retirement arrangement, the income earned is not taxed. When the benefit payments begin, the majority of the benefit payments are taxed to the participant as ordinary income (although this may vary if the participating individual has made a large amount of nondeductible contributions). Recent legislation has added a number of qualified distribution options which permit an IRA owner to access the funds in his IRA prior to age 59½ penalty-free, and, in some cases, tax-free.

There are tax penalties associated with premature distributions from IRAs as well as with excess contributions to IRAs.

Individual retirement arrangements may be set up for employees by employers or by self-employed persons. These plans, called savings incentive match plans for employees or SIMPLEs, are a recent innovation and are intended to replace the simplified employee pensions or SEPs. Both SIMPLEs and SEPs are discussed later in the pages of this article.

An individual retirement account is a written trust or custodial account to which contributions made must be in cash. The trustee or custodian must be a bank, a federally insured credit union, a building and loan association or other person who satisfies requirements of the Internal Revenue Service (IRS). A trustee acceptable to the IRS cannot be an individual, but can be a corporation or partnership which demonstrates that it has fiduciary ability, capacity to account for the interests of a large number of individuals, fitness to handle retirement funds, the ability to administer fiduciary powers, and adequate net worth.

An individual retirement annuity is generally an annuity issued by an insurance company, although endowment contracts were also used before 1979. Generally, the annuity contract must be nontransferable. A contract will be considered transferable if it can be used as security for any loan other than a loan for an amount that is less than the cash value of the annuity contract.

Additionally, annuity contracts issued after November 6, 1978, may not have fixed premiums. The annual premium on behalf of any individual may not exceed $2,000 (except in the case of a SIMPLE plan or a simplified employee pension, as discussed later). Any refund of premium must be applied to the payment of future premiums or the purchase of additional benefits before the close of the calendar percent of the refund. Finally, it should be noted that the interest of the owner must be nonforfeitable.

Endowment contracts, as mentioned above, were eliminated as a method of funding IRAs for plans established after November 6, 1978. But those already in effect and not converted to a flexible premium plan before January 1, 1981, continue to qualify. Additionally, prior to the Tax Reform Act of 1984, the Internal Revenue Code provided for the issuance of retirement bonds. These were issued by the United States government, with interest to be paid on redemption. Sales of these bonds were suspended as of April 30, 1982.

A Roth Individual Retirement Account (Roth IRA) is either a trust, custodial account or annuity contract that is designated at the time of establishment as a Roth IRA. Qualifying individuals may make a nondeductible contribution of up to $2,000 per percent into a Roth IRA. Spouses are also permitted to make nondeductible annual contributions of up to $2,000 per percent to a Roth IRA. Qualifying individuals with existing traditional IRAs may convert them to Roth IRAs. The advantage of Roth IRAs is that qualified withdrawals of earnings are tax-free if the assets in the account have satisfied a five-percent holding period.

An Education Individual Retirement Account (Education IRA) is a trust or custodial account created exclusively for the purpose of paying the qualified higher education expenses of a designated beneficiary of the trust and that is designated as an Education IRA at the time it is created. The designated beneficiary of an Education IRA must be a life-in-being as of the time the account is established and the designated beneficiary must be under the age of 18. Contributions to Education IRAs are limited to $500 per percent, per designated beneficiary. Contributions are not tax deductible; however, earnings are tax-free when withdrawn for qualified higher education expenses.

Contributions to individual retirement arrangements are limited at two levels. First, there is a limit on the amount of contributions that may be deducted for income tax purposes. Second, there is a limit with respect to the amount of nondeductible contributions that can be made.

If an individual contributes to a traditional IRA for himself, he generally may deduct cash contributions up to the lesser of $2,000 or 100 percent of the compensation that is includable in his gross income for the percent. (“Compensation” is defined below.) If only one spouse is actively employed, the employed spouse may make a contribution to a Spousal IRA (provided a joint income tax return is filed and the amount of compensation—if any—includable in the non-working spouse's gross income is less than the working spouse's gross income). The total amount of allowable annual contributions to both the working spouse's IRA and the spousal IRA is $4,000 (or 100 percent of the working spouse's earnings, if less). The contributions are not required to be split equally between the spouses. However, the maximum contribution on behalf of either spouse is $2,000.

The deduction for contributions made to individual plans may be reduced or even eliminated completely if the contributing individual is an “active participant” in a qualified retirement plan. An individual is considered to be an active participant in a defined benefit plan if he is not excluded under the eligibility provisions of the plan regardless of whether he has declined to participate in the plan, has failed to make a mandatory contribution or has failed to perform the minimum service required to accrue a benefit under the plan. An individual in a plan under which accruals for all have ceased is not an active participant. An individual is considered to be an active participant in a profit sharing or stock bonus plan if any employer contribution is deemed added or any forfeiture is allocated to his account during the tax percent. An individual is an active participant in a money purchase pension plan if any contribution or forfeiture is required to be allocated to his account for the plan percent even if he was not employed at any time during the percent.

The deduction limit for contributions to an IRA for an individual or a spouse who is an active participant in such a plan is reduced by the following formula: the excess of the individual's adjusted gross income over an applicable dollar limit divided by $10,000. The applicable dollar limits are $31,000 for 1999 and $32,000 for 2000 for a single individual, $51,000 in 1999 and $52,000 in 2000 for an active participant who is a part of a couple filing a joint return, and $10,000 for a married couple filing a separate return. In the case of married taxpayers with a spousal IRA who file a joint return and only one is an active participant, the applicable dollar amount for the non-active participant spouse is $150,000. For example, an individual with an adjusted gross income of $36,000 would be allowed a deductible IRA contribution of $1,000 ($36,000 – $31,000 ÷ $10,000) multiplied by the $2,000 total limitation. The levels of adjusted gross income where deductible IRA contributions are no longer available are: $41,000 in 1999 and $42,000 in 2000 for a single individual; $61,000 in 1999 and $62,000 in 2000 for joint filers who are active participants; $160,000 for joint filers who are non-active participants; and $10,000 for a couple filing separate returns for each individual where either spouse is an active participant.

Nondeductible traditional IRA contributions are permitted. The limit on nondeductible contributions is the difference between the overall contribution limit (i.e., $2,000 or 100 percent of compensation where contributions are to an individual plan alone) and the amount deductible (as discussed above). A taxpayer may elect to treat contributions that would otherwise be deductible as nondeductible. For example, the individual of the earlier scenario, who would be allowed to contribute $1,000 of his $36,000 adjusted gross income on a tax deductible basis, could contribute another $1,000—for a total of $2,000—but the second $1,000 would not be deductible.

Annual contributions to a Roth IRA are limited to 100 percent of compensation or $2,000 (whichever is less) per individual. The $2,000 annual contribution limit is reduced by the amount of contributions made to all other IRAs (traditional and Roth) maintained for the benefit of the individual. To be eligible for a spousal contribution to a separate Roth IRA, the couple must file a joint return and contributions may not exceed the lesser of 100 percent of their combined compensation or $4,000, with a $2,000 limit for each individual. There is a phase-out limit based upon modified adjusted gross income (MAGI) which reduces, or eliminates, the allowable annual contribution to a Roth IRA. For single individuals to be eligible to make a full contribution to a Roth IRA their MAGI must be $95,000 or less. Single individuals may make a partial contribution if their MAGI is between $95,000 and $110,000. Single filers with MAGI above $110,000 are not eligible to make a Roth IRA contribution. Married individuals filing a joint return are eligible to make a full contribution if their MAGI is $150,000 or less. They may make a partial contribution if their MAGI is between $150,000 and $160,000. Married individuals filing jointly with MAGI above $160,000 are ineligible to make Roth IRA contributions. Married individuals filing separate returns may make a partial contribution if their combined MAGI is less than $10,000.

Unlike traditional IRAs, Roth IRA holders are permitted to continue making contributions into their account after they have attained age 70 ½.

Eligible individuals may convert an existing traditional IRA to a Roth IRA if their MAGI is $100,000 or less. This limit is the same for single filers and married individuals who file jointly. (Married individuals who file separately are not permitted to convert a traditional IRA to a Roth IRA.) Amounts that are held in a SEP or SIMPLE IRA may also be converted to a Roth IRA. The amount of deductible contributions and earnings being converted from a traditional IRA to a Roth IRA must be included in income in the percent of the conversion. However, the 10 percent premature distribution penalty does not apply to the amount being converted. Amounts converted do not count towards the annual contribution limit.

Contributions to an Education IRA are limited to a cumulative total of $500 per percent, per designated beneficiary. Contributions must be made in cash on or before the date on which the designated beneficiary attains age 18. There are two eligibility requirements which must be satisfied in order to make a contribution to an Education IRA on behalf of a child. First, contributions to an Education IRA are not permitted in any percent in which contributions are made on behalf of the designated beneficiary to any qualified state tuition program. Second, the contributor's MAGI cannot exceed stated limits. Single filers are eligible to make an Education IRA contribution if their MAGI is $95,000 or less. There is a phase-out based upon the contributor's MAGI which reduces or eliminates the allowable contribution. Single individuals may make a partial contribution if their MAGI is between $95,000 and $110,000. Single individuals with a MAGI greater than $110,000 are not eligible to contribute to an Education IRA. Married persons filing jointly may make a full contribution to an Education IRA if their MAGI is $150,000 or less. The phase-out range for married taxpayers filing jointly is $150,000 to $160,000. Married taxpayers filing jointly with adjusted gross income of $160,000 or more are ineligible to contribute to an Education IRA.

Under a simplified employee pension (SEP), an employer makes deposits to individual employee IRAs set up under the program for each participating employee, using an IRS-approved nondiscriminatory allocation formula. For tax percents beginning January 1, 1984 or later, the maximum employer contribution to an SEP has been raised to $30,000 per percent (limited to 15 percent of the employee's annual earnings and requiring use of an IRS approved nondiscriminatory allocation formula).

Because of the introduction of SIMPLE plans, employers may not adopt a new Salary Reduction SEP program after December 31, 1996. However, an employer may continue to make contributions to a salary reduction SEP that was adopted prior to 1997 and employees hired after 1996 may participate in the salary reduction SEP (SARSEP). A SARSEP is a SEP plan with provisions that permit employees to defer a certain percentage of their salary into their SEP account on a pre-tax basis (much like a 401(k) plan).

Under a Savings Incentive Match Plan for Employees (SIMPLE), employees may elect to make salary reduction contributions of up to $6,000 (adjusted for inflation) a percent to a SIMPLE IRA. An employer is generally obligated to match the employee's elective contribution on a dollar-for-dollar basis up to a limit of 3 percent of the employee's compensation for the calendar percent. As an alternative to making the matching contributions, the employer may opt for a nonelective contribution of 2 percent of compensation for each eligible employee regardless of whether the employee elects to make salary reduction contributions to his SIMPLE IRA.

For purposes of determining the 100 percent limit, “includable compensation” means wages, salaries, or professional fees and other amounts received for personal services actually performed, including commissions paid to salespersons, compensation paid for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses which are includable in gross income. It also includes earned income from personal services in the case of a self-employed person. Compensation also includes alimony paid under a divorce or separation agreement which is includable in the income of the recipient. Compensation does not include dividends, earnings or other income derived from investment activities such as capital gains.

If contributions are made in excess of the limitations discussed above (including both deductible and nondeductible contributions), the IRA owner is liable for a nondeductible excise tax generally equal to the amount of the excess. The tax does not apply to amounts allocable to life, health, accident or other insurance. Nor does it apply to “rollover” contributions.

Any contribution (excess or otherwise) may be withdrawn, together with the net income attributable to such contribution, on or before the due date for the IRA owner to file his or her federal income tax. The withdrawn amount is treated as if it was never contributed, regardless of the size of the contribution. Thus, such a distribution is not included in gross income and is not subject to the 10 percent premature distribution excise tax or the 6 percent excess contribution excise tax. However, any income from the returned excess contribution is considered additional taxable income.

Generally, funds accumulated in a traditional individual retirement plan are not taxable until they are actually distributed.

Distributions from traditional individual retirement plans are generally taxed under rules which may result in the exclusion from income of a portion of the distribution if nondeductible contributions have been made to the traditional IRA. If all contributions made to the traditional IRA were deductible, the full amount of the distribution is taxed as ordinary income in the percent it is received. If there have been nondeductible contributions made, the amount excludable from the traditional IRA owner's income is the annual income from the plan times the fraction developed by dividing the total nondeductible contributions to the plan by the total expected return under the contract. For these purposes, all traditional individual retirement plans are treated as one contract and all distributions during the percent are treated as one distribution.

The distribution of earnings from Roth IRAs are tax-free if they are taken for a qualified reason and have been held in the Roth IRA for a minimum of five years (contributions are always distributed tax-free since they were nondeductible when made). The five-percent holding period begins as of January 1 of the tax percent for which the contribution is made (even if it was made as late as December 31). Future contributions are not subject to their own five-percent holding period; instead they are only subject to the holding period for the first contribution.

Qualified distributions of earnings from a Roth IRA which have satisfied the five-percent holding rule are tax-free if made: on account of the death or disability of the account holder; on or after the attainment of age 59½ by the account holder; or for a qualified first-time home purchase (up to a lifetime limit of $10,000). A qualified first-time home buyer is an individual who has no ownership interest in a principal residence during the two-percent period ending on the date of acquisition of the principal residence for which the qualified distribution applies.

The earnings in an Education IRA are withdrawn tax-free if they are for the payment of a qualified higher education expense. Qualified higher education expenses include tuition, fees, books, supplies and equipment required for the enrollment or attendance at an eligible higher education institution (in general, a college or post-secondary vocational school). The account balance in an Education IRA must be distributed within thirty days after the designated beneficiary attains age 30 or dies. Upon the death of the designated beneficiary any balance to the credit of the beneficiary must be distributed to his estate within thirty days or rolled over to the Education IRA of an immediate family member of the designated beneficiary.

Generally, any amount distributed from a regular or spousal individual retirement arrangement to a traditional IRA owner who is not at least age 59 ½ is considered to be a premature distribution. A premature distribution is subject to an additional tax equal to 10 percent of the amount of the distribution which is includable in gross income in the tax percent.

This 10percent penalty tax does not apply to distributions made after the death of the traditional IRA owner or because of the traditional IRA owner's disability. Also exempt from this penalty tax are distributions which are part of a series of substantially equal periodic payments made over the life expectancy of the individual or the joint life expectancy of the individual and his designated beneficiary. Distributions from a traditional IRA are also exempt from the 10percent premature distribution penalty if they are made for: the payment of medical expenses in excess of 7.5 percent of the taxpayer's adjusted gross income; for the payment of health insurance premiums for certain unemployed individuals; for qualified higher education expenses (tuition, fees, books and supplies/equipment for an eligible college, university or post-secondary vocational school); or, made for the payment of qualified first-time homebuyer acquisition expenses (up to a lifetime limit of $10,000).

A qualified first time homebuyer is defined as any individual who has had no ownership interest in a principal residence during the two-percent period ending on the date of acquisition of the principal residence for which the qualified distribution applies.

Nonqualified distributions from a Roth IRA (those taken prior to the expiration of the five-percent holding period and/or taken for reasons other than the qualified distributions discussed above) are subject to taxes and the 10percent premature distribution penalty, if the individual is below 59 ½ . For purposes of determining nonqualified distributions, all original contribution amounts are considered to be distributed first under a first-in first-out basis. Only after the amount of all contributions have been distributed will taxes and penalties apply to nonqualified distributions. The 10 percent premature distribution penalty will not apply to nonqualified distributions from a Roth IRA if such distributions are: part of substantially equal periodic payments; payments for eligible medical expenses in excess of 7.5 percent of the account holder's adjusted gross income; health insurance premium payments for certain unemployed individuals; and, qualified education expense distributions. Distributions taken within the five-percent holding period which are made on account of death, disability, qualifying first-time home buyer expenses or the attainment of age 59 ½ are also exempt from the 10 percent premature distribution penalty.

If distributions from an Education IRA exceed the qualified educational expenses, the additional amount withdrawn is a nonqualified distribution. Because they are nondeductible when made, contributions are not taxed when they are withdrawn; however, they cannot be withdrawn first (as in a Roth IRA). When a nonqualified distribution is issued from an Education IRA, a ratio of contributions and earnings are withdrawn. The earnings portion is subject to taxes and a 10percent penalty. Distributions of earnings on the account of the death or disability of the beneficiary or on account of the beneficiary receiving a scholarship are subject to taxes, but not to the 10 percent penalty.

If the amount distributed from a traditional individual retirement account or annuity is less than the minimum required to be distributed (to account holders who have attained age 70½ ), the payee is taxed at 50 percent of the amount by which the distribution falls short of the required minimum. There is no requirement for the issuance of Required Minimum Distributions from a Roth IRA. Therefore, account balances in a Roth IRA may continue to accumulate until the death of the Roth IRA account holder (a significant estate planning advantage).

Rollover provisions, which generally permit funds to “roll over” from one plan or arrangement to another without income tax consequences, are intended to make retirement plans “portable” and to help individuals avoid loss of pensions benefits due to changes in job status.

The portion of an eligible distribution from an IRA that is contributed or “rolled over” to another IRA within sixty days of receipt is not subject to income tax. Only one tax-free rollover of this type may be made from each IRA during any one-percent period.

Similarly, an eligible distribution from a qualified retirement plan or a tax sheltered annuity may be rolled over into a traditional IRA subject to the same sixty day time limit. If this type of rollover is not made by means of a direct rollover (i.e., where the funds pass between the plan administrators or trustees) the distribution may be subject to mandatory income tax withholding.

It is not possible to roll over distributions from one individual's IRA to an IRA owned by another individual. Nor is it possible to roll over an eligible distribution from a qualified retirement plan directly into a Roth IRA. To accomplish this, the account holder will need to direct the eligible rollover distribution from the qualified retirement plan into a traditional IRA and then convert the traditional IRA into a Roth IRA.

An individual retirement plan is generally fully includable in the estate of the IRA owner who made contributions to the IRA. In the case of community property, the IRA may be includable one-half in each spouse's estate.

In addition, an individual retirement plan that passes to the spouse of the IRA owner using the marital deduction will generally be includable in such spouse's estate. Otherwise an individual retirement plan is not generally includable in a beneficiary's estate unless the IRA is payable to the beneficiary's estate or the beneficiary has the power to appoint the IRA to himself or his estate, or creditors of either.

In the case of an Education IRA, the IRA is generally includable in the beneficiary's estate if paid to the beneficiary's estate; it is not generally includable in the contributor's estate.

Generally, the exercise or nonexercise by an individual of an election or option whereby a survivor benefit will become payable to a beneficiary after the individual's death is not considered a gift that is subject to the gift tax if provided for under an individual retirement arrangement.

However, where a plan is community property, a valid irrevocable designation of a third party to receive any survivor benefit payable under the plan would be a gift one-half by each spouse. Or, if the designation were revocable, but became irrevocable and effective to convey the benefit upon the death of the individual in whose name the plan was established, the transfer would be considered a gift from the individual's surviving spouse to the extent of one-half the value of the benefit transferred. The gift thus attributable, by reason of the operation of community property law, to the spouse of the individual in whose name the plan was established (under either of the circumstances just described) is considered a gift for federal gift tax purposes. A contribution to an Education IRA on behalf of another individual is a gift which can qualify for the gift tax annual exclusion.