When Do Retirees Pay Taxes on a Traditional IRA?

IRA assets have grown to more than $4 trillion since passage of ERISA.

Individual Retirement Accounts (IRAs) were created by passage of the Employee Retirement Income Security Act (ERISA) in 1974. At that time, individuals were either covered by pension plans from employers or saved for retirement on their own. Among other benefits, ERISA allowed for a tax-deductible contribution of up to $2,000 per individual per year to an IRA. Taxes on earnings would be deferred until an individual retired. Taxes are paid on all withdrawals at retirement. There have been numerous revisions to IRA rules, including contribution limits, so a refresher is in order to avoid any surprises, either at tax time or retirement.

Usually Tax Deductible

Deductions for IRAs can only be taken on long form 1040.

IRA contributions are deductible as an adjustment to gross income, but only if you have earned income. Wages, salaries, tips, commissions, military pay and any compensation related to performing a service are considered earned income. Interest, dividends, rental income, partnership income where you don't provide material services to the partnership and pension income is considered unearned and not countable toward qualification for an IRA. If you or your spouse are covered by any form of qualified retirement plan from your employer, the deductibility of contributions is phased out depending on your income and filing status. Contributions may still be made, and earnings will still grow tax-deferred, but deductions are not allowed. Withdrawals that represent non-deductible contributions are tax free. Withdrawal of earnings that were tax-deferred are taxed as ordinary income. There is a detailed chart in IRS Publication 590 with the phase-out income limits for each filing status.

Contribution Limits

For tax year 2010 and later, individuals under age 50 with earned income may contribute 100 percent of income, up to $5,000 per year, to an traditional IRA. Married couples, filing jointly, may each contribute up to $5,000 per year. A non-working spouse may establish an IRA, with the same limits. Contributions can be divided in any way up to 100 percent of the working spouse's income, with an individual limit of $5,000 each. Anyone 50 years and older may include a catch-up provision, which increases the limit to $6,000 per year. There is also a special catch-up rule for employees of bankrupt companies who were participating in a 401(k) plan with a matching contribution. This allows for a maximum $8,000 contribution for 2009 tax year only, but there are additional qualifiers before the contribution is allowed that are spelled out in detail in Publication 590.

The Tax Man Cometh

Complex rules may require professional help regarding IRAs and taxes.

If you are now retired and over age 59 1/2, you may start withdrawing from your IRAs without penalty. For fully deductible IRAs, withdrawals are fully taxable. If non-deductible contributions were made, you must calculate what portion of each IRA withdrawal is taxable earnings and what is tax-free return of principal, based on the detailed records of contributions you have been keeping over the years. For example, if you contributed a total of $50,000, of which $10,000 was non-deductible, and your total IRA is now worth $100,000, your non-taxable portion would be 10 percent of each withdrawal (10,000/100,000). Many individuals choose to wait the maximum amount of time before taking withdrawals to put off paying the taxes due. This is age 70 1/2, when IRA rules say you must begin making minimum withdrawals based on your life expectancy.

Consult an Accountant

The rules for IRAs have become more complex since passage of ERISA. If you have any questions and you cannot get a definitive answer by reading Publication 590, consult a qualified CPA. Over-contributions to IRAs are taxed at 6 percent, while under-withdrawals at age 70 1/2 are taxed at 50 percent. Many financial firms will do the calculations for you, but it is your money and your problem if the information is incorrect.

References

• Internal Revenue Service: Publication 590 Individual Retirement Arrangements