Business, Legal & Accounting Glossary
An IRA – Individual Retirement Account – is a tax-sheltered investment account available to US taxpayers. Contributions to an IRA are allowed to compound free of taxes until they are withdrawn. IRA contributions may also be tax-deductible. Funds withdrawn from an IRA are taxed as normal income at the rate in effect at the time of withdrawal. A Roth IRA is an IRA where the contributions are taxed, but withdrawals can be made tax free.
IRAs are self-managed investment accounts and allow for a very wide range of activity. In addition to equities, brokers may give IRA holders access to government and corporate bonds and options. Because IRAs are restricted by law from trading on margin, not all options strategies are available.
An Individual Retirement Arrangement (or IRA) is a retirement plan account that provides some tax advantages for retirement savings in the United States.
The individual retirement arrangement and related vehicles were created by amendments to the Internal Revenue Code of 1954 (as amended) made by the Employee Retirement Income Security Act of 1974 (ERISA), which enacted (among other things) Internal Revenue Code sections 219 (26 U.S.C. § 219) and 408 (26 U.S.C. § 408) relating to IRAs.
There are a number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include:
There are two other subtypes of IRA, named Rollover IRA and Conduit IRA, that are viewed as obsolete under current tax law (their functions have been subsumed by the Traditional IRA) by some; but this tax law is set to expire unless extended. However, some individuals still maintain these accounts in order to keep track of the source of these assets. One key reason is that some qualified plans will accept rollovers from IRAs only if they are conduit/rollover IRAs.
What was formerly known as an Educational IRA is now called a Coverdell Education Savings Account.
Starting with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), many of the restrictions of what type of funds could be rolled into an IRA and what type of plans IRA funds could be rolled into were significantly relaxed. Additional acts have further relaxed similar restrictions. Essentially most retirement plans can be rolled into an IRA after meeting certain criteria, and most retirement plans can accept funds from an IRA. An example of an exception is a non-governmental 457 plan which cannot be rolled into anything but another non-governmental 457 plan.
The tax treatment of the above types of IRAs except for Roth IRAs are substantially similar, particularly for rules regarding distributions. SEP IRAs and SIMPLE IRAs also have additional rules similar to those for qualified plans governing how contributions can and must be made and what employees are qualified to participate.
For example, if you are 45 and put $3,500 into your traditional IRA this year so far, you can either put $1,500 more into your traditional IRA or $1,500 in your Roth IRA. There may be an additional administrative step needed so that the trustee which holds the IRA proceeds actually retitles or transfers the $3,500 Traditional proceeds into the Roth category for their internal bookkeeping to survive an IRS audit.
Once money is inside an IRA, the IRA owner can direct the custodian to use the cash to purchase most types of securities and some non-security financial instruments. Some assets cannot be held in an IRA such as collectables (e.g. art, baseball cards, and rare coins) and life insurance. Some assets are allowed, subject to certain restrictions by custodians themselves. For example, an IRA cannot own real estate if the IRA owner receives or provides any immediate gain from/to this real estate investment, for instance as his personal residence or as a property manager who takes personal compensation for this service or adds capital value to the property. The IRS specifically states that custodians may impose their own policies above the rules imposed by the IRS. It should also be noted that custodians cannot provide advice.
Most IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds, and do not permit real estate in an IRA unless it is held indirectly via a security such as a real estate investment trust (REIT). However, self-directed IRA custodians/administrators can allow real estate and other non-traditional assets. They typically charge fees based on asset values. There are certain special restrictions on real estate held in an IRA (the IRA owner cannot benefit from the property in any way, i.e. they cannot use it). Self Directed IRA’s allowing non-security investments are more complicated and to properly set up may require additional expertise and experience that not all CPAs, attorneys, or other advisors would have.
An IRA may borrow money but any such loan must not be personally guaranteed by the owner of the IRA, and also the loan must be secured solely by assets in the IRA (in other words, a non-recourse loan). Also, the owner of the IRA may not pledge the IRA as security against a debt.
Although funds can be distributed from an IRA at any time, there are limited circumstances when money can be distributed or withdrawn from the account without penalties. Unless an exception applies, money can typically be withdrawn penalty-free as taxable income from an IRA once the account owner reaches age 59 and a half. Also, non-Roth account owners must begin taking distributions of at least the calculated minimum amounts by April 1st of the year after reaching age 70 and a half. If the minimum distribution is not taken the penalty is 50% of the amount that should have been taken. The amount that must be taken is calculated based on a factor taken from the appropriate IRS table and is based on the life expectancy of the account owner and possibly their spouse as beneficiary if applicable. At the death of the account, owner distributions must continue and if there is a designated beneficiary, distributions can be based on the life expectancy of the beneficiary.
There are several exceptions to the rule that penalties apply to distributions before age 59½. Each exception has detailed rules that must be followed to be exempt from penalties. The exceptions include
There are a number of other important details that govern different situations. For Roth IRA’s with only contributed funds the basis can be withdrawn before age 59½ without penalty (or tax) on a first in first out basis, and a penalty would apply only on any growth (the taxable amount) that was taken out before 59½ where an exception didn’t apply. Amounts converted from a traditional to a Roth IRA must stay in the account for a minimum of 5 years to avoid having a penalty on withdrawal of basis unless one of the above exceptions applies.
If the contribution to the IRA was nondeductible or the IRA owner chose not to claim a deduction for the contribution, distributions of those nondeductible amounts are tax and penalty-free.
In the case of Rousey v. Jacoway, the United States Supreme Court ruled unanimously on April 4, 2005, that under section 522(d)(10)(E) of the United States Bankruptcy Code (11 U.S.C. § 522(d)(10)(E)), a debtor in bankruptcy can exempt his or her IRA from the bankruptcy estate. The Court indicated that because rights to withdrawals are based on age, IRAs should receive the same protection as other retirement plans. Thirty-four states already had laws effectively allowing an individual to exempt an IRA in bankruptcy, but the Supreme Court decision allows federal protection for IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 gave further protection to IRAs. Up to $1,000,000 of IRA assets can be exempt from a bankruptcy estate; this now includes both Traditional and Roth IRAs. The 2005 Act also increased the FDIC insurance limit for IRA deposits at banks.
Many states have laws that prohibit judgments from lawsuits to be satisfied by seizure of IRA assets. For example, IRAs are protected up to $500,000 in Nevada from Writs of Execution. However, this type of protection does not usually exist in the case of divorce, failure to pay taxes, deeds of trust, and fraud. Assets in the IRA must be deposited before a lawsuit exists to receive this protection.
It is a prohibited transaction for the IRA owner to borrow money from the IRA. Such a transaction disqualifies the IRA from special tax treatment. An IRA may incur debt or borrow money secured by its assets but the IRA owner may not guarantee or secure the loan personally. Income from debt-financed property in an IRA may generate unrelated business taxable income in the IRA.
The rules regarding IRA rollovers and transfers allow the IRA owner to perform an “indirect rollover” to another IRA. This can be used to temporarily “borrow” money from the IRA, once per year. The money must be placed in another IRA account within 60 days, or the transaction will be deemed an early withdrawal (subject to the appropriate withdrawal taxes and penalties) and may not be replaced.
Double taxation still occurs within these tax-sheltered investment accounts. For example, foreign dividends may be taxed at their point of origin, and the IRS does not recognize this tax as a creditable deduction. There is some controversy over whether this violates existing Joint Tax Treaties, such as the Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital.
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This glossary post was last updated: 1st May, 2020 | 4 Views.