Traditional and Roth Individual Retirement Accounts (IRAs): A Primer

Summary

In response to concerns over the adequacy of retirement savings, Congress has created incentives to encourage individuals to save more for retirement through a variety of retirement plans. Some retirement plans are employer-sponsored, such as 401(k) plans, and others are established by individual employees, such as Individual Retirement Accounts (IRAs).

This report describes the primary features of two common retirement savings accounts that are available to individuals. Although the accounts have many features in common, they differ in some very important aspects. Both traditional and Roth IRAs offer tax incentives to encourage individuals to save for retirement. Contributions to traditional IRAs may be tax-deductible for taxpayers who (1) are not covered by a retirement plan at their place of employment or (2) have income below specified limits. Contributions to Roth IRAs are not tax-deductible and eligibility is limited to those with incomes under specified limits.

The tax treatment of distributions from traditional and Roth IRAs differs. Distributions from traditional IRAs are generally included in taxable income whereas distributions from Roth IRAs are not included in taxable income. Some distributions may be subject to an additional 10% tax penalty, unless the distribution is for a reason specified in the Internal Revenue Code (for example, distributions from IRAs after the individual is aged 59 ½ or older are not subject to the early withdrawal penalty).

Individuals may rollover eligible distributions from other retirement accounts (such as an account balance from a 401(k) plan upon leaving an employer) into IRAs. Rollovers preserve retirement savings by allowing investment earnings on the funds in the retirement accounts to accrue on a tax-deferred, in the case of traditional IRAs, or a tax-free basis, in the case of Roth IRAs.

The Retirement Savings Contribution Credit (also known as the Saver's Credit) is a non-refundable tax credit of up to $1,000. It was authorized in 2001 to encourage retirement savings among individuals with income under specified limits.

This report explains the eligibility requirements, contribution limits, tax deductibility of contributions, and rules for withdrawing funds from the accounts. It also describes the Saver's Credit and provisions enacted after the Gulf of Mexico hurricanes in 2005 and the Midwestern storms in 2008 to exempt distributions to those affected by the disasters from the 10% early withdrawal penalty.

Introduction

Individual Retirement Accounts (IRAs) are tax-advantaged accounts that individuals (or married couples) can establish to accumulate funds for retirement. Depending on the type of IRA, contributions may be made on a pre-tax or post-tax basis, and investment earnings are either tax-deferred or tax-free.¹

(in billions of dollars)

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Traditional IRAs

Roth IRAs

Traditional IRAs are funded by workers' contributions, which may be tax-deductible. The contributions accrue investment earnings in an account, and these earnings are used as a basis for retirement income. Among the benefits of traditional IRAs, two are (1) pre-tax contributions provide larger bases for accumulating investment earnings and, thus, provide larger account balances at retirement than if the money had been placed in taxable accounts; and (2) taxes are paid when funds are distributed. Since income tax rates in retirement are often lower than during working life, traditional IRA holders are likely to pay less in taxes when contributions are withdrawn than when the income was earned.

Individuals under 70½ years old in a year and receive taxable compensation can set up and contribute to IRAs. Examples of compensation include wages, salaries, tips, commissions, self-employment income, alimony, and nontaxable combat pay. Individuals who receive income only from non-compensation sources cannot contribute to IRAs.

Individuals may contribute either their gross compensation or the contribution limit, whichever is lower. In 2015, the contribution limit is $5,500 unchanged from 2014. Since 2009, the contribution limit has been indexed to inflation, although the change in the Consumer Price Index was insufficient for a cost-of-living adjustment to the 2011 or 2012 contribution limit. Individuals aged 50 and older may make additional $1,000 catch-up contributions. For households that file a joint return, spouses may contribute an amount equal to the couple's total compensation (reduced by the spouse's IRA contributions) or the contribution limit ($5,500 each, if younger than the age of 50, and $6,500 each, if 50 years or older), whichever is lower. Contributions that exceed the contribution limit and are not withdrawn by the due date for the tax return for that year are considered excess contributions and are subject to a 6% "excess contribution" tax. Contributions made between January 1 and April 15 may be designated for either the current year or the previous year.

Because IRAs were intended for workers without an employer-sponsored pension to save for retirement, contributions to an IRA may only come from work income, such as wages and tips. The following non-compensation sources of income cannot be used for IRA contributions:

• earnings from property, interest, or dividends;
• pension or annuity income;
• deferred compensation;
• income from partnerships for which an individual does not provide services that are a material income-producing factor; and
• foreign earned income.

IRAs can be set up through many financial institutions, such as banks, credit unions, mutual funds, life insurance companies, or stock brokerages. Individuals have an array of investment choices offered by the financial institutions and can transfer their accounts to other financial institutions at will.

Several transactions could result in additional taxes or the loss of IRA status. These transactions include borrowing from IRAs; using IRAs as collateral for loans; selling property to IRAs; and investing in collectibles like artwork, antiques, metals, gems, stamps, alcoholic beverages, and most coins.⁶

IRA contributions may be non-tax-deductible, partially tax-deductible, or fully tax-deductible, depending on whether the individual or spouse is covered by a pension plan at work and the level of adjusted gross income (AGI). Individuals are covered by a retirement plan if (1) the individuals or their employers have made contributions to a defined contribution pension plan or (2) the individuals are eligible for a defined benefit pension plan (even if they refuse participation).

Filing Status

2014 Adjusted Gross Income

2015 Adjusted Gross Income

Deduction Allowed

Any amount

Any amount

Full deduction

$181,000 or less

$183,000 or less

full deduction

More than $181,000 but less than $191,000

More than $183,000 but less than $193,000

Partial deduction

$191,000 or more

$193,000 or more

No deduction

Married filing separately with a spouse who is covered by a plan at work

Less than $10,000

Less than $10,000

Partial deduction

$10,000 or more

$10,000 or more

No deduction

Withdrawals from IRAs are subject to income tax in the year that they are received.⁸ Early distributions are withdrawals made before the age of 59½. Early distributions may be subject to an additional 10% penalty.

To ensure that IRAs are used for retirement income and not for bequests, IRA holders must begin making withdrawals by April 1 of the year after reaching the age of 70½ (i.e., the required beginning date). The minimum amount that must be withdrawn (i.e., the required minimum distribution) is calculated by dividing the account balance on December 31 of the year preceding the distribution by the IRA owner's life expectancy as found in IRS Publication 590.⁹ Although females live longer on average than males, the IRS does not separate life expectancy tables for males and females for this purpose.¹⁰ Required minimum distributions must be received by December 31 of each year. Failure to take the required minimum distribution results in a 50% excise tax on the amount not distributed as required. Congress suspended the Required Minimum Distribution (RMD) provision for 2009.¹¹

Beginning in 2007, distributions from IRAs after the age of 70½ could be made directly to qualified charities and excluded from gross income. This provision for Qualified Charitable Distributions expired December 31, 2013.¹²

Early distributions are withdrawals made before the age of 59½. Early distributions—just like distributions after the age of 59½—are subject to federal income tax. To discourage the use of IRA funds for pre-retirement uses, most early distributions are subject to a 10% tax penalty.¹³ The early withdrawal penalty does not apply to distributions before the age of 59½ if they

• occur if the individual is a beneficiary of a deceased IRA owner;
• occur if the individual is disabled;
• are in substantially equal payments over the account holder's life expectancy;
• are received after separation from employment after the age of 55;
• are for unreimbursed medical expenses in excess of 7.5% of AGI;
• are for medical insurance premiums in the case of unemployment;
• are used for higher education expenses;
• are used to build, buy, or rebuild a first home up to a $10,000 withdrawal limit;
• occur if the individual is a reservist called to active duty after September 11, 2001;
• were distributions to residents in areas affected by Hurricanes Katrina, Rita, and Wilma from around the storms' landfalls to January 1, 2007; or
• were distributions to residents in areas affected by the Midwestern floods in 2008 from after the applicable disaster date and before January 1, 2010.

While individuals may make early withdrawals from IRAs without a reason, they will be subject to the 10% tax penalty unless they meet one of the conditions above. There are no other general "hardship" exceptions for penalty-free distributions from IRAs.

Rollovers are transfers of assets from one retirement plan to another upon separation from the original employer. Rollovers are not subject to the 59½ rule, the 10% penalty, or the contribution limit. Rollovers can come from traditional IRAs, employers' qualified retirement plans (e.g., 401(k) plans), deferred compensation plans of state or local governments (Section 457 plans), tax-sheltered annuities (Section 403(b) plans), or the Thrift Savings Plan for federal employees.

A January 2014 U.S. Tax Court decision requires that, in certain circumstances, individuals are limited to a total of one rollover per year for their IRAs.¹⁵ Rollovers subject to this rule are those between two IRAs in which an individual receives funds from an IRA and deposits the funds into a different IRA within 60 days. The one-rollover-per-year limit applies to rollovers between two traditional IRAs or two Roth IRAs. It does not apply to rollovers from a traditional IRA to a Roth IRA. The limitation does not apply to trustee-to-trustee transfers or rollovers from qualified pension plans (such as from 401(k) plans).

When the owner of an IRA dies, ownership passes to the account's designated beneficiary or, if no beneficiary has been named, to the decedent's estate. Federal law has different distribution requirements depending on whether the new owner is a

• designated beneficiary who is the former owner's spouse;
• designated beneficiary who is not the former owner's spouse; or
• non-designated beneficiary.

Owner Dies Before Required Beginning Date

Owner Dies after Required Beginning Date

Spouse is named as the designated beneficiary

Treat as own, does not have to take any distribution until the age of 70½, but is subject to the 59½ rule, or

Keep in decedent's name and take distributions based on own life expectancy. Distributions do not have to begin until decedent would have turned 70½.

Treat as own, does not have to take any distribution until the age of 70½, but is subject to the 59½ rule, or

Keep in decedent's name and take distributions based on own life expectancy.

A nonspouse is named as the designated beneficiary

Take distributions based on life expectancy for beneficiary's age as of birthday in the year following the year of the owner's death, reduced by one for each year since owner's death.

If the nonspouse beneficiary does not take a distribution in year of owner's death, then all IRA assets must be distributed by the end of the fifth year of the year following the IRA owner's death.

Take distributions based on the longer of

(1) beneficiary's life expectancy, or

(2) owner's life expectancy using age as of birthday in the year of death, reduced by one for year after the year of death.

Beneficiary is not named

Must distribute all IRA assets by the end of the fifth year of the year following the IRA owner's death.

Take a yearly distribution based on the owner's age as of birthday in the year of death, reduced by one for each year after the year of death.

Notes: The required beginning date is the date on which distributions from the account must begin. It is April 1 of the year following the year in which the owner of an IRA reaches the age of 70½.

Filing Status

2014 Modified Adjusted Gross Income (AGI)

2014 Contribution Limits

2015 Modified Adjusted Gross Income (AGI)

2015 Contribution Limits

Single, head of household, married filing separately (and did not live with spouse at any time during the year)

Less than $114,000

$5,500 ($6,500 if 50 years or older) or AGI, whichever is smaller

Less than $116,000

$5,500 ($6,500 if 50 years or older) or AGI, whichever is smaller

At least $114,000 but less than $129,000

Reduced contribution limit

At least $116,000 but less than $131,000

Reduced contribution limit

$129,000 or more

Ineligible to contribute

$131,000 or more

Ineligible to contribute

Married filing separately and lived with spouse at any time during the year

Less than $10,000

Reduced contribution limit

Less than $10,000

Reduced contribution limit

$10,000 or more

Ineligible to contribute

$10,000 or more

Ineligible to contribute

Less than $181,000

$5,500 each ($6,500 each if 50 and older) or AGI, whichever is smaller

Less than $183,000

$5,500 each ($6,500 each if 50 and older) or AGI, whichever is smaller

At least $181,000 but less than $191,000

Reduced contribution limit

At least $183,000 but less than $193,000

Reduced contribution limit

$191,000 or more

Ineligible to contribute

$193,000 or more

Ineligible to contribute

Individuals aged 50 and older can make additional $1,000 catch-up contributions. The AGI limit for eligibility has been adjusted for inflation since 2007; beginning in 2009, the traditional and Roth IRA contribution limit has also been adjusted for inflation. A worksheet for computing reduced Roth IRA contribution limits is provided in IRS Publication 590.

Roth IRAs must be designated as such when they are set up. As with traditional IRAs, they can be set up through many financial institutions. Transactions prohibited within traditional IRAs are also prohibited within Roth IRAs.

Individuals may convert amounts from traditional IRAs, SEP-IRAs, or SIMPLE-IRAs to Roth IRAs.¹⁷ Since 2008, individuals have been able to rollover distributions directly from qualified retirement plans to Roth IRAs. Amounts that would have been included in income if the conversion had not been made must be included in income. Conversions can be a trustee-to-trustee transfer, a same trustee transfer by redesignating the IRA as a Roth IRA, or a rollover directly to the account holder. Inherited IRAs cannot be converted.

The rules for rollovers that apply to traditional IRAs, including completing a rollover within 60 days, also apply. Additionally, withdrawals from a converted IRA prior to five years from the beginning of the year of conversion are non-qualified distributions and are subject to a 10% penalty.

Tax-free withdrawals from one Roth IRA transferred to another Roth IRA are allowed if completed within 60 days. Rollovers from Roth IRAs to other types of IRAs or to employer-sponsored retirement plans are not allowed.

The three kinds of distributions from Roth IRAs are (1) return of regular contributions, (2) qualified distributions, and (3) non-qualified distributions. Returns of regular contributions and qualified distributions are not included as part of taxable income.

Distributions from Roth IRAs that are a return of regular contributions are not included in gross income nor are they subject to the 10% penalty on early distributions.

Qualified distributions must satisfy both of the following:

• they are made after the five-year period beginning with the first taxable year for which a Roth IRA contribution was made,¹⁸ and
• they are made on or after the age of 59½; because of disability; to a beneficiary or estate after death; or to purchase, build, or rebuild a first home up to a $10,000 lifetime limit.

Distributions that are neither returns of regular contributions nor qualified distributions are considered non-qualified distributions. Although individuals might have several Roth IRAs from which withdrawals can be made, for tax purposes non-qualified distributions are assumed to be made in the following order:

• 1. the return of regular contributions,
• 2. conversion contributions on a first-in-first-out basis, and
• 3. earnings on contributions.

Non-qualified distributions may have to be included as part of income for tax purposes. A worksheet is available in IRS Publication 590 to determine the taxable portion of non-qualified distributions. A 10% penalty applies to non-qualified distributions unless one of the exceptions in 26 U.S.C. Section 72(t) applies. The exceptions are identical to those previously listed for early withdrawals from traditional IRAs.

If the owner of a Roth IRA dies, the distribution rules depend on whether the beneficiary is the spouse or a nonspouse. If the beneficiary is the spouse, then the spouse becomes the new owner of the inherited Roth IRA. If the spouse chooses not to treat the inherited Roth IRA as their own, or if the beneficiary is a nonspouse, then there are two options. The beneficiary can distribute the entire interest in the Roth IRA (1) by the end of the fifth calendar year after the year of the owner's death, or (2) over the beneficiary's life expectancy. As with an inherited traditional IRA, a spouse can delay distributions until the decedent would have reached the age of 70½.

Distributions from inherited Roth IRAs are generally free of income tax. The beneficiary may be subject to taxes if the owner of a Roth IRA dies before the end of (1) the five-year period beginning with the first taxable year for which a contribution was made to a Roth IRA or (2) the five-year period starting with the year of a conversion from a traditional IRA to a Roth IRA. The distributions are treated as described in the "Non-Qualified Distributions" section, above.

Filing Status

2014 Income Limits

2015 Income Limits

Percentage Credit

Single, Married Filing Separately, Qualifying Widow(er)

$1 to $18,000

$1 to $18,250

$18,001 to $19,500

$18,251 to $19,750

$19,501 to $30,000

$19,751 to $30,500

more than $30,000

more than $30,500

Head of Household

$1 to $27,000

$1 to $27,375

$27,001 to $29,250

$27,376 to $29,625

$29,251 to $45,000

$29,626 to $45,750

more than $45,000

more than $45,750

Married Filing Jointly

$1 to $36,000

$1 to $36,500

$36,001 to $39,000

$36,501 to $39,500

$39,001 to $60,000

$39,501 to $61,000

more than $60,000

more than $61,000

As part of the response to the 2005 hurricanes that affected the communities on and near the Gulf of Mexico, Congress approved provisions that exempted individuals affected by the storms from the 10% early withdrawal penalty for withdrawals from IRA. In 2008, Congress approved similar provisions in response to the storms and flooding in certain Midwestern states. Following Hurricane Sandy in October 2013, the Internal Revenue Service (IRS) eased certain requirements for hardship distributions from defined contribution plans. The IRS was unable to exempt distributions from retirement plans from the 10% early withdrawal penalty because such an exemption requires congressional authorization.

Qualified Distributions Related to Hurricanes Katrina, Rita, and Wilma

In response to Hurricanes Katrina, Rita, and Wilma, Congress approved the Gulf Opportunity Zone Act of 2005 (P.L. 109-135). The act amended the Internal Revenue Code to allow residents in areas affected by these storms who suffered economic losses to take penalty-free distributions up to $100,000 from their retirement plans, including traditional and Roth IRAs. The distributions must have been received after August 24, 2005 (Katrina), September 22, 2005 (Rita), or October 22, 2005 (Wilma), and before January 1, 2007. The distributions are taxable income and can be reported as income either in the year received or over three years (e.g., a $30,000 distribution made in May 2006, can be reported as $10,000 of income in 2006, 2007, and 2008). Alternatively, part or all of the distribution may be repaid to the retirement plan within three years of receiving the distribution without being considered taxable income.

Qualified Distributions Related to the Midwestern Disaster Relief Area