Dollars and Sense

Chapter 3

Individual Retirement Accounts

  There are many ways to save money. An individual can put their money in a sock under their mattress or bury coffee cans full of dollar bills in the back yard. Of course, that is not the method recommended!

  Any type of savings is better than none. However, it is best to seek not only interest gains but also tax advantages when available. Americans have many valuable tools available, including Roth and traditional IRAs (Individual Retirement Accounts), Keogh plans in some cases, perhaps 401(k) plans, and some types of deferred compensation plans.

IRAs are legal due to the IRCs

  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.  IRA’s were specifically created, however, by the Tax Reform Act (TRA) of 1986. In December 2019, a significant change to IRAs and other retirement accounts occurred when the minimum distribution age was changed from 70½ to age 72. In 2022 it was changed to age 73. In 2033, the age will change to age 75.

IRA Choices

  There are a number of different types of IRAs, which may be either employer-provided or self-provided plans. The types include:

• Roth IRA: Roth contributions are made with after-tax assets. The Roth IRA has no tax impact for the year of contribution or while held in the account, but withdrawals are usually tax-free since the amount deposited was already taxed prior to deposit. The Roth IRA is named for Senator William Roth.
• Traditional IRA: Traditional IRA contributions are usually tax-deductible in the year of contribution. All transactions and earnings within the IRA have no tax impact since traditional IRAs are tax sheltered; earnings are not taxed until withdrawn. At retirement withdrawals are taxed as income, except for those portions of the withdrawal corresponding to contributions that were not deducted.  Depending upon the nature of the contribution, a traditional IRA may be referred to as a "deductible IRA" or a "non-deductible IRA."
• SEP IRA: SEP stands for Simplified Employee Pension. The SEP IRA allows an employer (usually a small business or self-employed individual) to make retirement plan contributions into a Traditional IRA established in the employee's name. It is the small company’s version of a pension fund.
• SIMPLE IRA: This is a simplified employee pension plan that allows both employer and employee to make contributions, similar to a 401(k) plan, but with lower contribution limits and simpler, less costly administration. Although it is termed an IRA, it is treated separately and is a type of SEP.
• Self-Directed IRA: The self-directed IRA permits the account holder to make investments on behalf of their retirement plan.

  The Roth IRA was established by the Taxpayer Relief Act of 1997 (Public Law 105-34). A Roth IRA may usually invest in a variety of vehicles, including securities, annuities, common stocks, and mutual funds. As with all IRAs, there are specific eligibility and filing status requirements mandated by the IRS. The tax structure of the Roth IRA is its most quoted advantage.

  The contribution limit for those who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan, according to an IRS publication, is increased from $23,000 in 2024 to $23,500 in 2025. The catch-up contribution limit for employees who are 50 years old or more has increased from $7,000 to $7,500. Employer contributions are not included in these amounts.

  The limitation regarding SIMPLE retirement accounts for 2025 increased to $16,500, which is up from the previous 2024 amount of $16,000. Of course, each advancing year can bring changes, so it is important for agents to keep abreast of changes each year.

  For tax years 2024 and 2025, the combined annual contribution limits for Roth and traditional IRAs is $7,000 annually or $8,000 annually for those aged 50 or older. Roth IRA contribution limits are reduced or eliminated at higher income levels.

  The 2025 highly compensated and key employee limits are[1]:

1. $230,000 for key employee officer compensation;

2. $160,000 for highly compensated employees; and

3. $350,000 for annual compensation limits.

Tax Free Retirement

Roth IRAs, which first appeared in 1998, began a new way of saving for retirement – with non-taxable income. Prior to Roth IRA’s savers primarily had two choices:

· Put investment funds into a regular taxable mutual fund or brokerage account, paying taxes on the investment income each year, and with tax liability when the shares were sold after their value had risen. 

· Or the investor could set money aside in special tax-deferred accounts, including annuities through insurance companies. Traditional IRAs gave the investor flexibility, but they had low contribution limits (just $1,500 per year when IRAs were first created). Even though the limits are higher now for IRAs with contribution levels best for those over age 50 or nearing retirement, there are still caps. Employee 401(k) plans, on the other hand, have much higher annual contribution limits but the investor typically is confined to whatever investment choices their employer provides. Both options keep the investor from paying tax on the income they have earned until funds are taken out of the account, potentially giving the investor decades before he or she must pay tax on the earned income.

  The Roth IRA takes taxes out of the equation entirely since funds are taxed prior to being deposited.  Unlike traditional IRAs and 401(k) plans, the investor does not receive any sort of up-front tax break for making contributions to their Roth IRA. The investor never has to pay income tax on the income from their Roth investments even when withdrawn.

  An individual can invest in a Roth IRA in two ways: by making an annual contribution or by converting an existing traditional IRA or 401(k) account if earnings allow it.  Individuals should consult with their tax accountant for details.

  There may be a disadvantage to converting to a Roth IRA: income taxes on the amount converted must be paid.  Some may question paying taxes that otherwise would not be due until later in life, but there are a couple of reasons why converting to a Roth might be advisable. Taxes could go up in the future so paying taxes today with today’s dollars might be a smart thing to do for some investors. New taxes on investments could rise at some point. If the investor is eligible for a low rate currently, it might be cheaper in the long run to give up tax deferral and pay the tax now. If portfolio values happen to be down, the investor is likely to pay fewer taxes than when they are up, so this should also be considered.

  In most tax matters, it is wise to speak with a tax professional to make sure adding more income does not have unintended consequences. An agent should never offer tax advice unless he or she has the background or education to do so.

  One of the smartest decisions a young worker can make is to invest in either a traditional or Roth IRA. For many investors, the Roth IRA works well. Investing small amounts early in life prevents the necessity of investing larger amounts later in life, often just prior to retiring.  An IRA is more flexible than a 401(k) and many other retirement plans due to the IRA’s ability to invest in a variety of financial vehicles.

  Those who are new to the work force often feel they have more important places to put their earnings but saving just a few dollars out of every paycheck can provide large returns through time and interest earnings. Whether a traditional IRA or Roth IRA is chosen, the benefits will be much greater than waiting until age forty or fifty to begin retirement savings (as the majority of people do). 

  While there are many vehicles for retirement savings an IRA is one of the best. A 25-year-old who saves $5,000 every year in a tax advantaged plan until he or she retires, making average or better annual returns on the investment, will have accumulated around $1 million by age 65. 

  Whatever vehicle is used to save for retirement, the important thing is saving something so there will be assets available. This begins with setting a realistic goal, creating a plan to achieve the goal, and sticking with the plan even when it seems difficult to save and more desirable to spend.

Differences Between the Roth and Traditional IRAs

  Unlike traditional IRAs, contributions to Roth IRAs are not tax-deductible. Withdrawals are usually tax-free, but there are certain stipulations, including at least a five year “seasoning period” for principal withdrawals. The owner's age must be at least 59½ for withdrawals on the growth portion above principal. The Roth IRA has fewer withdrawal restrictions than a traditional IRA since taxes were already paid on the principal deposits.  Transactions inside the Roth IRA account (such as capital gains, dividends, and interest) do not incur a current tax liability.

  As with all things, there are both advantages and disadvantages with the Roth IRA. Roth advantages include:

• Direct contributions to a Roth IRA may usually be withdrawn tax free at any time. Rollover or converted contributions prior to age 59½ held in a Roth IRA may be withdrawn tax and penalty free after the five-year seasoning period.  Earnings may be withdrawn tax and penalty free after the seasoning period or after age 59½ or another qualifying event. Traditional IRAs are taxed as ordinary income and include a penalty for withdrawals made prior to age 59½. In contrast, stocks or mutual funds held in a regular taxable account for at least a year would be taxed at the lower long-term capital gains rate. This higher tax rate for withdrawals from a traditional IRA is a quid pro quo for the deduction taken against ordinary income when putting money into the IRA.
• If money has been converted to a Roth IRA from a traditional IRA, the Roth IRA owner may withdraw up to the total of the converted amount without penalty, as long as the "seasoning" period has passed on the converted funds.
• Direct contributions to a Roth IRA (not including rollovers) may be withdrawn at any time with no tax or penalty since they have already been taxed.
• Up to $10,000 in earning withdrawals are considered qualified (tax-free) if the money is used to acquire a principal residence. The principal residence must be acquired by the Roth IRA owner, their spouse, or their lineal ancestors and descendants. The owner or qualified relative who receives such a distribution must not have owned a home in the previous two years.
• Contributions may be made to a Roth IRA even if the owner participates in a qualified retirement plan, such as a 401(k). Contributions may also be made to a traditional IRA in this circumstance, but they may not be tax deductible.
• When spouses both own Roth IRAs and one of them dies naming the other as sole beneficiary of their Roth IRA, the two Roth IRAs may be combined into a single account without penalty.
• Since Roth IRAs are taxable at the time of deposit (traditional IRAs usually receive a tax deduction upon deposit) owners who anticipate a higher tax rate in retirement than during their working years will benefit from a Roth IRA since funds from Roth IRA’s are not taxed upon withdrawal. There is no current tax deduction for Roth deposits; money going into the Roth IRA is taxed at the taxpayer's current marginal tax rate. They avoid taxation at any anticipated higher future effective tax rate upon withdrawal.
• The Roth IRA does not require distributions based on age. Other tax-deferred retirement plans, including 401(k) plans, require withdrawals to begin at age 73 in 2022 (and then to age 75 in 2033) or sooner. An individual who does not need the money may leave it on deposit in the Roth IRA for their heirs, allowing it to continue accumulating income tax free. Beneficiaries will be subject to the minimum distribution rules.
• Whether Roth contributions are more beneficial than traditional IRA deposits often depends upon the tax rate applied in retirement. Roth contributions have already been taxed so it may be equivalent to a larger contribution than a traditional IRA that will be taxed upon withdrawal. For example, a contribution of $5,000 to a Roth IRA in 2009 may be equivalent to a traditional IRA contribution of $6,667 (assuming a 25 percent tax bracket at both contribution and withdrawal). It was not possible to contribute $6,667 to a traditional IRA due to contribution limits, so the post-tax Roth contribution may be larger. However, many people end up in a lower tax bracket in retirement, so they may not realize as much of this benefit. Even so, regardless of whether marginal tax rates increase or decrease in retirement, Roth IRA earnings are not taxed, which is often a benefit for the Roth IRA owner.

Roth IRA disadvantages include:

• Roth IRA deposits are not tax deductible for the year of contribution. By contrast, contributions to a traditional IRA are tax deductible (within income limits). Therefore, someone who contributes to a traditional IRA instead of a Roth IRA receives an immediate tax savings equal to the amount of the contribution multiplied by their marginal tax rate; an individual who contributes to a Roth IRA does not realize this immediate tax reduction. Also, by contrast, contributions to most employer sponsored retirement plans (such as a 401(k), 403(b), SIMPLE IRA or SEP IRA) are tax deductible with no income limits because they reduce a taxpayer's adjusted gross income.
• Eligibility to contribute to a Roth IRA phases out at certain income limits. By contrast, contributions to most tax-deductible employer-sponsored retirement plans have no income limitations.
• Contributions to a Roth IRA do not reduce a taxpayer's adjusted gross income (AGI). Contributions to a traditional IRA or most employer-sponsored retirement plans will reduce the taxpayer's AGI. One of the key benefits of reducing one's AGI (aside from the obvious benefit of reducing taxable income) is that a taxpayer who is close to the threshold income of qualifying for some tax credits or tax deductions may be able to reduce their AGI below the threshold at which he or she may become eligible to claim certain tax credits or tax deductions that may otherwise be phased out at the higher AGI had the taxpayer instead contributed to a Roth IRA. Likewise, the amount of those tax credits or tax deductions may be increased as the taxpayer slides down the phaseout scale. Examples include the child tax credit, the earned income credit, and the student loan interest deduction.
• A taxpayer who chooses to make a Roth IRA contribution while in a moderate or high tax bracket will likely pay more income taxes on the earnings used to make the Roth IRA contribution as compared to a traditional IRA contribution. A contribution to a traditional IRA or employer-sponsored tax-deductible retirement plan results in an immediate tax savings equal to the taxpayer's current marginal tax bracket multiplied by the amount of the contribution. Many people have less income in retirement than during their working years and thus end up in a lower tax bracket during retirement. Even though taxes are due when funds are withdrawn from a traditional IRA the rate of taxation is low enough that the Roth IRA might not have ended up being an advantage over the traditional IRA. The higher the taxpayer's marginal tax rate, the greater the disadvantage.  
• A taxpayer who pays state income taxes and contributes to a Roth IRA (instead of a traditional IRA) will have to pay state income taxes on the amount contributed to the Roth IRA in the year the money was earned. If he or she retires to a state with a lower income tax rate, or no income taxes, any Roth IRA benefit related to the state taxes will be lost. He or she might have done better with a traditional IRA since no state taxes were avoided. 
• Of course, there is no way to know if the contributor will live until retirement age.  The perceived Roth IRA tax benefit may never be realized if he or she dies prior to retirement or soon thereafter. The tax structure of a Roth only serves to reduce the estate, which may not have been subject to much tax anyway. An individual must live until the Roth IRA contributions have been fully withdrawn to fully realize all tax benefits. With a traditional IRA, tax might never be collected at all if the owner dies prior to retirement with an estate below the tax threshold or goes into retirement with income below the tax threshold (to benefit from this exemption, a beneficiary must be named in the appropriate IRA beneficiary form). The estate tax exemption will not apply to beneficiaries inheriting the IRA solely through a will. Additionally, beneficiaries will be subject to income taxes unless the inheritance is a Roth IRA. Heirs will have to pay taxes on withdrawals from traditional IRA accounts and must continue to take mandatory distributions although they will now be based on the beneficiary’s life expectancy rather than the deceased contributors. Additionally, it is always possible that tax laws could change by the time one reaches retirement age.
• There is always the possibility that Congress may change the rules governing tax free withdrawal from Roth IRAs. Therefore, contributions to traditional IRAs are guaranteed tax benefits, whereas contributions to Roth IRAs must wait for a number of years before realizing potential tax benefits. In other words, investors assume the risk that the Roth IRA rules could change during the interim.

Double Taxation

  Double taxation could occur within some 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 as they apply to taxes on income and capital. 

  Canadians who have a U.S. issued Roth IRA will be affected by a new rule in 2008 which states that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions. Therefore, distributions from a Roth IRA (as well as other similar plans) to a Canadian resident will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the United States. Canadian residents may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA, but not distributed, until and to the extent that a distribution is made from their Roth IRA.  

  Individuals making contributions to Roth IRAs while they are Canadian residents (other than rollover contributions from another Roth IRA) will lose the IRA’s status as a pension for purposes of the Treaty with respect to the accretions from the time such contribution are made. Income by growth or additions is subject to Canadian tax laws. In effect, the Roth IRA will be divided into two sections: a "frozen" pension that will continue to enjoy the benefits of the exemption for pensions and a non-pension (essentially a savings account) that will not.

Roth IRA Eligibility

  Congress has limited who can contribute to a Roth IRA based upon income. A taxpayer can only contribute the maximum amount if their modified adjusted gross income (MAGI) is below a specified level. Once the modified adjusted gross income hits the top of the range no contribution is allowed. Excess Roth IRA contributions may be recharacterized into Traditional IRA contributions as long as the combined contributions for all individual retirement accounts combined do not exceed that tax year's limit.

  Once a Roth IRA is established the balance in the account remains tax-sheltered, even if the taxpayer's income rises above the threshold later. The thresholds are for annual contribution eligibility to contribute, not for eligibility to maintain the Roth account.

Conversion Limits

  There are established income levels that must be met in the year of contribution before converting from a Traditional to Roth IRA. The contributor should consult with his or her tax advisor for current MAGI limitations. TIPRA 2005 eliminates the MAGI limit and filing status restrictions on conversions as of 2010. So, regardless of income, contributions could be made to a traditional IRA in previous years and then rolled over in 2010.

  Every type of financial vehicle, as we have said, has both advantages and disadvantages.  Here are some advantages of the Traditional IRA:

• A primary advantage of a traditional IRA rather than a Roth IRA is the tax deductibility in the contribution year. For example, a person who is in the marginal tax bracket of 25 percent and contributes $4,000 to a traditional IRA will see a benefit of about $1,000 for the tax year, meaning they will pay around $1,000 less in taxes. It is possible to contribute more than the $4,000 in our example. Because qualified withdrawals are taxed as ordinary income (the taxpayer's highest rate) the long-term benefits of the traditional IRA are only comparable to those of a Roth IRA (whose qualified distributions are tax free) if the current year tax benefit of $1,000 is reinvested.

• If a taxpayer expects to be in a lower tax bracket in retirement than during their working years, then a traditional IRA offers an increased incentive over the Roth IRA.

• With the Traditional IRA the taxpayer gets the tax benefit in the immediate tax year; he or she does not have to wait until withdrawals are made to realize a tax advantage.

• As previously stated, there may be some risk that Congress will change the current tax status of Roth IRAs, removing their tax-free distributions. We cannot know if Congress will make changes, but if changes are made, it is likely to affect only new contributions; existing contributions are not likely to be affected.

Traditional IRA disadvantages include:

§ Traditional IRAs have eligibility requirements for their tax-deductibility. If an individual is eligible for a retirement plan at work, his or her income must be below a specific threshold for filing status.

§ All withdrawals from a Traditional IRA are included in gross income and subject to federal income tax except for any nondeductible contributions; there is a formula for determining how much of a withdrawal is not subject to tax.  Traditional IRAs are not attractive to everyone, especially if their investment style is buy-and-hold or dividend-seeking. Holding stocks in an IRA means the investor may lose any favorable tax treatment given to dividends and capital gains.

§ For individuals with lots of disposable income, a Roth IRA in effect shelters more assets from taxes on gains than a Traditional IRA does. Suppose an individual is eligible to contribute either to a Roth IRA or a Traditional IRA. If the investor chooses the Traditional IRA, then he or she receives an upfront tax deduction. When the money is withdrawn from the Traditional IRA it will be taxed at marginal rates.  On the other hand, if the investor chooses the Roth IRA, then there is no upfront tax deduction, but the money and gains are all exempt from taxation upon withdrawal in retirement. For the Traditional IRA to outdo the Roth IRA the investor must be in a lower tax bracket in retirement than in their contribution year.  If he or she is in a lower tax bracket the Traditional IRA becomes an advantage rather than a disadvantage.

§ Perhaps the greatest disadvantage of the traditional IRA is its forced distributions based on age. Withdrawals must begin at age 73 (it was previously required at age 70½ and with The SECURE Act of 2019 it was changed to 72, with another change coming in 2033 to age 75) based on a complicated formula. If an investor fails to make the required withdrawal, half of the mandatory amount will be confiscated automatically by the IRS. The Roth is completely free of these mandates because no taxes will be owed so the IRS realizes no financial gains when funds are withdrawn.

§ In addition to the distribution being included as taxable income, the IRS will also assess a 10 percent early withdrawal penalty if the investor is under the age of 59½ when funds are withdrawn. The IRS will waive this penalty under some conditions, including a first-time home purchase (up to $10,000), higher education expenses, death, disability, unreimbursed medical expenses, health insurance, annuity payments and payments of IRS levies, all of which must meet certain stipulations.

Transfers Versus Rollovers

  Transfers and rollovers are two ways of moving IRA sheltered assets between financial institutions.

  A transfer is normally initiated by the institution receiving the funds. A request is sent to the disbursing institution for a transfer and a check (made payable to the other institution) is sent in return. This transaction is not reported to the IRS because the transfer is not considered a withdrawal.

  A rollover (sometimes called a 60-day rollover) is another way to move IRA money between institutions. The institution holding the IRA funds distributes funds by check payable directly to the participant. The participant has 60 days to make a rollover contribution to another financial institution and still retain IRA status (avoiding penalties and taxation). This type of transaction can only be done once every 12 months with the same funds. Unlike the transfer, a rollover is reported to the IRS by the distributing institution. Once the distribution is rolled into an IRA, the participant will be sent a Form 5498 to report on their taxes to nullify any tax consequence of the initial distribution.

IRA Loans

  IRA loans are prohibited. Prohibiting loans allows IRS to disqualify the plan if a loan is made and then tax the assets. Some individuals utilize “creative banking” by withdrawing funds from their IRA and redepositing them within the 60-day rollover period. This maintains the IRA status and avoids taxation as long as the participant redeposits within that 60-day time period. One 60-day rollover is allowed every rolling 12 months, per allocation of funds within the IRA. For example, if the participant has $100,000 in his or her IRA, he or she may withdraw $10,000 with 60 days to return it to the same or different IRA. After returning the first $10,000, he or she could then withdraw another (supposedly different) $10,000 and repeat the process. Assuming each rollover is in $10,000 increments from the $100,000 account, the participant could repeat this process 10 times within a single year. If the participant rolled the entire $100,000 account within 60 days, he or she would have to wait another year before repeating the process.

Coverdell Education Savings Account

  The Coverdell Education Savings Account was formerly known as the Educational IRA. It is a tax-deferred trust account created by the U.S. government to help families fund educational expenses for beneficiaries who must be 18 years old or younger when the account is established. The age restriction may be waived for special needs beneficiaries, but qualification must be first established. There can be more than one education savings account (ESA), but the total of all accounts may not exceed a yearly contribution of $2,000.

  Taxation, as in many areas, can change for ESAs too, but at this point if a person contributed to an educational account, it is tax deferred. If $500 was contributed to an educational savings account and it appreciated to $5,000 at some point, the earnings would not be taxed until the account’s owner was enrolled in a post-secondary institution.

  When the contributions are distributed, they are tax-free assuming they are less than the account holder’s annual adjusted qualified education expenses, including tuition, books, equipment necessary to the schooling, special needs services, and even academic tutoring. ESA account funds can be used for primary and secondary schools, so grades K to 12, as well as higher education, such as college. Coverdell ESAs are only available to families that fall under a designated income level.

  If the distributions turn out to be higher than the expenses, the gains are taxed at the account holder’s rate, not the contributor’s rate, which is generally higher.

  In December 2019, the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) expanded 529 plan regulations, and now 529 plans can be used to pay off up to $10,000 in student loans and to pay for qualified expenses related to apprenticeship programs, as long as they are approved by the U.S. Department of Labor.

  There are no restrictions on the income level of the contributors to 529 plans, but fees can be extracted from 529 accounts. The investments can lose money as there is no guaranteed returns in these plans. It is permissible to have 529 plans as well as ESAs for the same beneficiary’s educational expenses.

  Contributions to Coverdell ESAs must be made in cash and are not deductible. This does not mean that literally ‘cash’ must be deposited; it means that funds cannot be transferred from other plans. Contributions must come from earned income. Individuals, corporations, and trusts may make contributions to ESAs without the restriction on adjusted gross income.

  When the beneficiary reaches age 30, any remaining funds in the ESA must be disbursed, unlike 529 plans. The exception would be a beneficiary who qualifies as a special needs beneficiary. The account funds can also be transferred to another individual in the beneficiary’s family. For example, they could be transferred to a younger brother of the first beneficiary that is aging out.

IRA Funding Limitations Exist

  Individual Retirement Accounts have contribution limits; it is not possible to invest as much as one wishes to.

• IRAs can only be funded with cash or cash equivalents. It is not possible to fund an IRA with any other type of asset. Attempting to do so would be a prohibited transaction and would result in the loss of the IRA’s beneficial tax treatment.
• Rollovers, transfers, and conversions between IRAs and other retirement accounts can include any qualified asset.
• There are maximum contribution amounts for IRAs. All contributions must come from earned income.
• The contribution limit applies to the sum of all IRAs combined. The investor may not put the maximum amount into a Roth IRA, for example, plus another maximum amount into a traditional IRA; the total amount contributed may not exceed the limitation. 

IRA Investments

  Some IRAs allow the account owner to direct how their IRA money is invested. The IRA owner may direct the custodian to use the cash to purchase most types of securities, for example, as well as some non-security financial instruments. Some types of assets obviously would not work in an IRA, including art or rare coins. Cash value life insurance may not be included in IRAs either, even though the cash may already exist in the policies.  IRAs cannot own real estate if the IRA owner receives any immediate gain from the real estate investment. For example, the investor’s personal residence cannot fund an IRA. Any property that provides the investor with personal compensation for management duties or other services or adds capital value to the property may not fund the Individual Retirement Account. IRA custodians may have additional restrictions. Custodians may legally impose their own restrictions above and beyond the rules imposed by the IRS. Custodians cannot provide legal or investing advice; they merely carry out their established custodial duties.

  Most IRA custodians limit available investments to traditional brokerage accounts such as stocks, bonds, and mutual funds, and do not permit real estate in the IRA unless it is held indirectly in such things as a real estate investment trust (REIT). IRA custodians or administrators may allow real estate and other non-traditional assets in some cases, but investors should not automatically assume this. Self-Directed IRAs allowing non-security investments are more complicated. Some investments may require special expertise to properly set up. Not all custodians or administrators will have this ability. 

  The IRA owner may not pledge his or her IRA as security against personal debt.

Fund Distributions

  Although funds may be distributed from an IRA at any time, penalties will occur if distributions are made prior to age 59½. Once the investor becomes age 59½ money can typically be withdrawn penalty free as taxable income from a non-Roth IRA (Roth IRA distributions are not taxable) once the account owner reaches age 59½. Also, non-Roth account owners (investors) must begin taking distributions from their traditional IRA of at least the calculated minimum amounts by age 73 (and in 2033 it will be age 75). Otherwise, there will be a penalty of 50 percent of the amount that should have been withdrawn. The IRS provides a table to calculate the appropriate withdrawal amount. It is based on the life expectancy of the investor and, if applicable, their spouse’s life expectancy as beneficiary. Upon the death of the account owner distributions must continue. If there is a designated beneficiary, distributions may be based on the life expectancy of the beneficiary rather than the investor.

  There are several exceptions regarding distribution penalties on withdrawals prior to age 59½. Each exception has detailed rules that must be followed to escape early distribution penalties. The exceptions that may include distribution of IRA funds prior to age 59½ include:

• Unreimbursed medical expenses that are more than 7.5 percent of adjusted gross income (AGI) might allow IRA funds to be withdrawn and used to pay these bills.
• Distributions for medical insurance premiums while unemployed, as long as they are not more than the actual cost. In other words, all the IRS funds withdrawn must apply only to the premium amount.
• Disability (defined as not being able to engage in any substantial gainful activity).
• Amounts distributed to beneficiaries of the deceased IRA owner.
• Distributions in the form of an annuity.
• Distributions for qualified higher education expenses for the IRA investor, their children, or grandchildren as long as the distributions do not exceed the actual cost of schooling.
• Distributions to buy, build, or rebuild a first home ($10,000 lifetime maximum) and
• A forced distribution due to an IRS levy on the plan. 

  Roth IRA owners may withdraw contributed funds prior to age 59½ since no taxes will be due upon withdrawal (taxes were previously paid). There will also be no penalties for early withdrawal from a Roth IRA with funds withdrawn on a first-in, first-out basis. A penalty could apply on any growth (the taxable amount) withdrawn prior to age 59½ if an exception did not apply. Amounts moved from a traditional IRA to a Roth IRA must stay in the account for a minimum of 5 years to avoid penalties on withdrawn funds prior to age 59½ unless one of the above exceptions applies.

  If the contribution to the IRA was nondeductible or the IRA investor chose not to claim a deduction for their contribution, distributions from such funds are tax and penalty free.

Bankruptcy

  Individual Retirement Accounts may be exempted from the bankruptcy estate, due to a previous U.S. Supreme Court ruling. This is because unpenalized withdrawals are based on age rather than financial need. Therefore, IRAs have the same legal protection as other retirement plans. Laws vary from state to state so it is always important to know your state’s laws. The Supreme Court ruling is a federal protection, but most states also have IRA protections in place. This ruling includes both traditional and Roth IRAs. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 provided additional protection for IRAs, saying up to $1,000,000 in IRA assets could be exempt from any bankruptcy estate. The 2005 Act also increased the FDIC insurance limit on IRA deposits at banks.

Creditor Protection

  Many states prohibit seizure of IRA assets through legal judgments. Again, laws vary from state to state so it is important to know the laws of one’s own state. Creditor protection would not apply in the case of divorce, failure to pay taxes, deeds of trust, or fraud. Only funds deposited in the IRA prior to the lawsuit being filed would be protected.  It would not be possible to deposit funds into an IRA to protect them from an existing legally executed lawsuit or judgment.

End of Chapter 3

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