Individual retirement accounts (IRAs) offer a great way for an investor to prepare for the future.
However, IRAs also can be potentially confusing, while requiring attention from investors who often may prefer to spend minimal time and effort. The following tips are intended to help you and other investors manage an IRA account successfully.
What do you stand to gain by managing a successful IRA account? The simple answer is financial security, but you could also add peace of mind and the ability to help out family members in need to that list.
To help you plan properly and learn how to navigate the complex rules and regulations surrounding individual retirement accounts, I have assembled a list of crucial knowledge surrounding nine different facets of IRAs. All of this info is based on my based on my book “IRA: A Quick Reference Guide for 2016,” which can be found here.
- Sources of Income
In order to contribute to an IRA, the IRA contributor or their spouse (if filing taxes as married, filing jointly) must have income from any combination of the following:
- ‘Earned’ income from employment. This can be found in box 1 (minus box 11 if applicable) of the W2 tax form.
- Net ‘earned’ income from self-employment (Schedule C or C-EZ or Schedule F). In the case of a partner or partnership (Schedule K-1), any money made is considered to be “earned” income only after it has been reduced by any contributions to a self-employment retirement plan and reduced by half of the self-employment tax that is deducted on the IRA owner’s form 1040.
- Income earned during the year of the contribution
- 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.
Note that for a traditional IRA (TIRA) account, any contribution made must be before the year one reaches age 70 ½. Roth IRA (RIRA) accounts have no age limit to RIRA contributions.
- Types of Direct Contributions Allowed
All IRA contributions must be in cash, although some IRA custodians will allow stock, bonds or mutual fund shares to be transferred to an IRA “in-kind.” In such instances, the IRS will treat it as though the securities were sold first, the cash contributed to the IRA and the securities then repurchased in the IRA account.
- Contributions MAY NOT be from
- Investment income, pensions, royalties, rents (unless listed as business income on schedule C), interest or income from deferred compensation (box 11 of form W2)
- Former spouses or family members
- Worker’s Compensation, Unemployment Benefits or disability benefits, even if they must be included as taxed income.
- Long-term disability benefits, paid prior to age 65 and reported on form W2 box 1, is eligible to be contributed to an IRA.
- 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
- Maximum Contribution Amount
For 2016, the limit an individual can contribute is $5,500. For those age 50 or older during the year of contribution, the limit is $6,500. Limits are indexed each year in increments of $500.
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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
Contributions may be made at any time between Jan. 1 of the contribution year and April 15 of the following year. If made after Dec. 31 but before April 15 of the next year, the contributor must designate which year the contribution was for.
- Reporting of Contributions
All contributions will be reported by the IRA custodian to the Internal Revenue Service (IRS) and to the IRA owner.
- Reported each year on form 5498
- Form 5498 is 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).
- Undoing Contributions
- Contributions that are 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 a contribution is withdrawn between Jan. 1 and Oct. 15 of the next year, it will be considered a re-characterization, requiring completion and filing of form 8606.
- All earnings associated with the contribution withdrawal must also be withdrawn and reported as income that year. These earnings 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 re-characterized 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.
- Inheriting an IRA
One may not make contributions to an IRA they inherit, unless the IRA is inherited from a deceased spouse and the inheriting spouse elects to roll it into and treat the inherited IRA as his or her own.
- Inheriting an IRA through Divorce
IRAs received as a result of a divorce decree are rolled into the recipient’s own IRA and treated as his or her own. As such, they are subject to all of the same IRA rules.
Bruce Miller is a certified financial planner (CFP) and the author of IRA: A Quick Reference Guide for 2016.