The Investment Company Institute (ICI) reported in June 2017 that total US retirement assets exceeded $26 trillion and accounted for 34% of all household financial assets as of March 31, 2017. The largest share of these retirements assets – 31% or $8.17 trillion – was allocated into Individual Retirement Accounts (IRAs).
This is the first in a short series of articles that will provide a quick guide to the common IRS rules governing the establishment, contributions and withdrawals, management and transference to beneficiaries of IRAs. This series is intended to be a basic guide, with each topic consisting of a summary with bullet-point lists of the main facts for that IRA topic and a series of answers to some of the frequent questions, most of which are from my experience in helping clients to better understand their IRAs.
These articles are not intended to be a comprehensive explanation of all IRA nuances and concerns. This series of articles highlights only the important rules and limitations of IRAs so that investors can easily identify whether a given rule is applicable to their case and can search for a more detailed explanation or seek professional assistance.
The fist topic we will tackle addresses IRA contributions.
To be eligible to contribute to an IRA, the contributor or their spouse – for married couples filing jointly – must have income from any combination of the following income sources or direct contributions:
- “Earned” income from employment shown in box 1 (minus box 11 if applicable) of IRS’s form W2.
- Net “earned” income from self-employment (Schedule C or C-EZ or Schedule F), or Schedule K-1 for a partner of a partnership, after it has been reduced by any contributions to a self-employment retirement plan and reduced by ½ of self-employment tax that is deducted on the IRA owner’s form 1040.
- Taxable Alimony or taxable support payments.
- Non-taxed military combat pay, as shown on form W2 Box 12 code Q, when there is no other eligible compensation income.
- Direct contributions must be in CASH
- Some IRA custodians will allow stock, bond or mutual fund shares to be transferred to an IRA “in-kind.” However, the IRS will treat this as though the securities were sold first, the cash contributed to the IRA and the securities then repurchased in the IRA.
The IRS also excludes a whole group of asset types from IRA contributions. The following asset sources CAN NOT be used as IRA contributions:
- Investment income, pensions, royalties, rents (unless business income on schedule C), interest or income from deferred compensation (box 11 of form W2).
- Worker’s Compensation, Unemployment Benefits or disability benefits, even if they must be included as taxed income.
- Long-term disability paid prior to age 65 that is reported on form W2 box 1 is eligible for IRA contributions.
- S-Corporation dividends.
- Earnings distributed on a schedule K-1 to limited partners who do not materially participate in the partnership.
- Foreign income excluded from U.S. income tax.
While Traditional IRAs (TIRA) contributions CANNOT be made beginning the year one attains age 70 ½ and thereafter, Roth IRAs (RIRA) – IRAs made with after-tax contributions – have no age limit on contribution.
In addition to specific rules about types of allowed contributions, there are limits on maximum contributions allowed per year, rules regarding timing of contributions, reporting requirements for IRA custodians, steps for undoing contributions and many more regulations.
Maximum Contribution Amount
- For 2017, the annual Maximum Contribution Amount is $5,500 per individual.
- For individuals 50 or older during the year of contribution, the maximum is $6,500.
- The contribution amount may be divided between multiple IRAs or between TIRAs and RIRAs, but the total of these, per individual, may not exceed the annual maximum contribution amounts shown above.
Timing of Contributions
- Between Jan. 1 of the contribution year and April 15 of the next year.
- The contributor must specify the contribution year for all contributions made after Dec. 31 but before April 15 of the following year.
IRA Reporting Requirements
The IRA custodian must report all contributions to the IRS and the IRA owner.
- Contributions are reported each year on form 5498
- These forms are important for tracking the total cumulative contributions (the “basis”) made to one’s RIRA, in the event a future non-qualified withdrawal is made and the ‘basis’ must be known.
- Form 8606 tracks the cumulative after-tax contributions to one’s TIRA(s)
- Contributions made in error, or for which the contributor simply wishes to withdraw them, may be withdrawn at any time after the contributions have been made
- If withdrawn by the end of the year, it will be a simple refund of the contribution
- If withdrawn between Jan. 1 and Oct. 15 of the next year, it will be considered a recharacterization, requiring completion and filing of form 8606.
- All earnings associated with the contribution withdrawal also must be withdrawn and reported as income that year and may be subject to a 10% early withdrawal penalty (see below).
- If the contribution to be undone was deducted in the year of contribution, the IRA owner has until Oct. 15, three years following the deduction year, to file an amended return. However, if the contributions and any associated earnings are recharacterized to another form of IRA, then they do not have to be withdrawn first, only moved from one tax-favored IRA to another. This must be done by Oct. 15 following the contribution year.
- Excess or disallowed contributions, if not withdrawn by Oct. 15 of the next year, will be assessed a 6% excise penalty each year until withdrawn. However, only the excess or disallowed contribution must be withdrawn, not the earnings.
- An excess contribution for one year may be used as the next year’s contribution without having to first withdraw it, providing the 6% penalty has been paid and the IRA owner qualifies for a contribution the next year.
Contributions to an inherited IRA are not allowed. The only exception is an IRA that is inherited from a deceased spouse and the inheriting spouse elects to roll it into his or her own IRA.
IRAs received as a result of a divorce decree are rolled into the recipient’s own IRA and treated as his or her own and thus are subject to all the same IRA rules.
In the next article, I will answer some frequent questions about IRA contributions.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.