3641 / What is an individual retirement plan? What is an individual retirement account and a Roth individual retirement account?
Individual retirement plans are tax favored personal savings arrangements that allow an individual to set aside money for retirement.
A traditional individual retirement plan generally allows an individual to contribute both deductible (where eligible) and nondeductible payments to receive the benefit of tax-deferred buildup on income.
Alternatively, a Roth individual retirement plan allows eligible individuals to contribute only nondeductible payments with the benefit of tax-free buildup of income ( Q 3673). A Roth individual retirement plan must clearly be designated as such at the time of establishment, and that designation cannot later be changed; the recharacterization of a Roth IRA will require the execution of new documents ( Q 3662).1 Note that tax reform eliminated the traditional ability to convert traditional IRA funds to a Roth account and later recharacterize the transaction for tax years beginning after 2017.
With respect to both traditional and Roth individual retirement plans, some individuals also may contribute to such plans for their spouses.
There are two kinds of traditional and Roth individual retirement plans: individual retirement accounts (discussed below) and individual retirement annuities ( Q 3642).
An individual retirement account (IRA) is a written trust or custodial account created for the purpose of saving money for retirement that allows individuals to make yearly contributions, up to specific annual limits, that will grow tax-free.
A "traditional" IRA allows an individual to make both pre-tax (where eligible) and after-tax contributions to the account, which will grow free of income taxes, but are taxable when distributed to the participant (see Q 3649, Q 3671). Alternatively, a Roth IRA only allows after-tax contributions, but such contributions also grow tax-free and usually can be distributed tax-free to the extent they are considered "qualified distributions" (see Q 3673).
Contributions to such accounts must be in cash (except for rollovers) and may not exceed the maximum annual contribution limit for the tax year – $5,500 in 2018 and $6,000 (in 2019-2022), $6,500 in 2023, $7,000 in 2024-2025 and $7,500 in 2026 – except for rollover contributions (Q 3992), for contributions to a SIMPLE IRA ( Q 3706), and for employer contributions to simplified employee pensions ( Q 3701).2 A wire order from a broker to a custodian will constitute a "cash contribution" on the date payment and registration instructions are received by the broker, provided an agency arrangement recognized by and binding under state law exists between the broker and the custodian.3
With respect to traditional individual retirement accounts, distribution of an individual's interest must begin by April 1 of the year after the year in which he or she reaches age 73 (72 in 2020-2022, 70½ before 2020) and must be made over a limited period. In addition, distributions must comply with the incidental death benefit requirements of IRC Section 401(a)(9) ( Q 3686).4 With respect to both traditional and Roth accounts, required minimum distribution (RMD) requirements must be met upon death of the owner ( Q 3687).5
The trustee or custodian of an individual retirement account must be a bank, a federally insured credit union, a building and loan association, or an entity that satisfies IRS requirements.6 A trustee or custodian acceptable to the IRS cannot be an individual but can be a corporation or partnership that demonstrates that it has fiduciary ability (including continuity of life, established location, fiduciary experience, and fiduciary and financial responsibility), capacity to account for the interests of a large number of individuals, fitness to handle retirement funds, ability to administer fiduciary powers (including maintenance of a separate trust division), and adequate net worth (at least $250,000 initially).7
The interest of the individual in the balance of his or her individual retirement account must be nonforfeitable, and the assets must not be commingled with other property except in a common trust fund or common investment fund. In such a trust, they may be pooled with trust funds of regular qualified plans.8 No part of the trust funds may be invested in life insurance.9 An account generally may not invest in collectibles without adverse tax consequences ( Q 3649). An account may invest in annuity contracts that, in the case of death prior to the time distributions commence, provide for a payment equal to the sum of the premiums paid or, if greater, the cash value of the contract.10 An account may not use any part of its assets to purchase an endowment contract issued after November 6, 1978.11
Planning Point: Effective for tax years beginning after December 31, 2012, distributions from individual retirement arrangements (as well as from qualified plans, Section 403(b) tax-sheltered annuities, and eligible 457 governmental plans) are exempted from the unearned income Medicare contribution tax imposed under the Affordable Care Act.12 The ACA imposes a tax of 3.8 percent on individuals, estates, and trusts on the lesser of net investment income, or the excess of modified adjusted gross income (AGI + foreign earned income) over a threshold of $200,000 (individual) or $250,000 (joint). Investors may therefore find it beneficial to direct wages and investments into IRAs to reduce income and remain below these thresholds.13
1. IRC § 408A(b); Treas. Reg. § 1.408A-2, A-2.
2. IRC § 408(a)(1).
3. Let. Ruls. 9034068, 8837034.
4. IRC §§ 408(a)(6), 408A(c)(4).
5. IRC §§ 408(a)(6), 408A(c)(4).
6. IRC §§ 408(a)(2), 408(n).
7. Treas. Reg. §§ 1.408-2(b)(2), 1.408-2(e).
8. IRC §§ 408(a)(4), 408(a)(5), 408(e)(6); Rev. Rul. 81-100, 1981-1 CB 326; see also Nichola v. Comm., TC Memo 1992-105.
9. IRC § 408(a)(3).
10. Treas. Reg. § 1.408-2(b)(3).
11. Treas. Reg. §§ 1.408-4(f), 1.408-3(e)(1)(ix).
12. P.L. 111-148.
13. IRC § 1411.