The ABCs of IRAs by Nancy M. Valdes, CPA
Individual Retirement Arrangements, or IRAs, are financial accounts that taxpayers may set up with an IRS-approved financial advisor, financial institution or life insurance company to save money for retirement. However, because not all IRAs are created equally, taxpayers should take the time to learn the following terms and definitions.
A contribution is the money individuals put into their IRAs, whereas a distribution is the amount of money that taxpayers withdraw from these accounts. Each type of IRA has different rules for eligibility and the tax treatment of contributions and distributions, and taxpayers who take distributions before they reach retirement age may be subject to tax and penalties on those amounts.
There are four types of IRA’s: Traditional IRAs, Roth IRAs, Simplified Employee Pensions (SEP-IRAs) and Savings Incentive Match Plan for Employees (SIMPLE IRAs).
Traditional IRAs allow individuals to take an immediate tax deduction for the full amount of their contribution in the years they make those contributions. The amount taxpayers can take as a deduction on contributions depends on various factors, including annual income and the taxpayer’s access to an employer’s retirement plan. Earnings grow tax-deferred until account owners turn 59½ years of age, at which point withdrawals are subject to tax. After age 70 ½, account owners must annually take required minimum distributions (RMDs) from their traditional IRAs.
In contrast, contributions to Roth IRAs are taxable in the years they are made, and account owners receive the benefit of tax-free withdrawals during their retirement years, as long as they are at least 59 ½ years old and owned the account for a minimum of five years. With Roth IRAs, owners are not subject to RMDs; they may take tax-free withdrawals of any sum, or they may instead leave their savings in the Roth IRAs to pass onto their spouses or other family members.
For 2018, annual contributions to Traditional IRAs and Roth IRAs are limited to $5,500 of earned income (plus an additional $1,000 when taxpayers are age 50 or older). These amounts are indexed annually for inflation.
Savings Incentive Match Plans for Employees (SIMPLE IRAs) are retirement savings plans set up by small businesses for the benefit of their employees, in which employees and employers make contributions to a traditional IRA. They are ideal for small businesses that do not have a significant number of employees and do not have the resources to manage a more complex qualified plan.
Simplified Employee Pensions (SEP-IRAs) allow owners of small businesses, such as sole proprietorships, partnerships, limited liability companies, S corporations and C corporations, to make contributions toward their own retirement and that of their employees’ without the costs and complexity of managing a qualified plan. Each employee owns and controls his or her own SEP-IRA. Self-employed business owners can contribute to SEP-IRAs as much as 20 percent of their net income, up to $55,000 in 2018. The rules for withdrawals are similar to those for traditional IRAs in that taxpayers must be at least 59 ½ to take avoid penalties and RMD will be required after taxpayers turn 70 ½.
On a final note, taxpayers should meet with experienced advisors and accountants to understand the rules for transferring and/or rolling over withdrawals from one IRA into another and how the IRS treats IRAs that a taxpayer inherits from a deceased family member.
About the Author: Nancy M. Valdes, CPA, is a senior manager with Berkowitz Pollack Brant’s Tax Services practice, where she works with U.S. and foreign-based entrepreneurs and closely held businesses to manage cash flow, protect assets and maintain tax efficiency. She can be reached at the CPA firm’s Miami office at (305) 379-7000 or via email at email@example.com.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.