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7.8 Individual Retirement Accounts (IRAs)

Individual Retirement Accounts (IRAs) are retirement savings arrangements established by individuals rather than employers. For this reason, IRAs are not classified as qualified retirement plans. Instead, they are governed by Section 408 of the Internal Revenue Code, which establishes the rules and requirements for how these accounts operate.

Because IRAs are individually established, a person may open and contribute to an IRA independently of any retirement plan offered by an employer. In other words, participation in an employer-sponsored qualified plan—such as a 401(k)—does not prevent an individual from setting up an IRA.

Individuals may choose between different types of IRAs, most commonly a Traditional IRA or a Roth IRA, depending on their eligibility and tax preferences. Each type follows the regulatory framework outlined in Section 408 while offering distinct tax treatment for contributions and distributions.

Traditional IRAs​

A Traditional Individual Retirement Account (IRA) allows individuals with taxable earned income to contribute toward retirement savings. In many cases, contributions to a Traditional IRA may be tax-deductible, which can reduce the contributor's taxable income for the year. However, the ability to deduct contributions may be limited or phased out if the individual participates in an employer-sponsored retirement plan and their income exceeds certain IRS-established thresholds.

Funds contributed to a Traditional IRA grow on a tax-deferred basis, meaning that investment earnings are not taxed while they remain in the account. Instead, taxes are deferred until the funds are withdrawn.

The Internal Revenue Service (IRS) sets a maximum annual contribution limit for Traditional IRAs. Individuals who are age 50 or older are also permitted to make an additional catch-up contribution, allowing them to contribute more to their retirement savings.

When funds are withdrawn from a Traditional IRA, the distributions are generally taxed as ordinary income in the year they are received.

Required Minimum Distributions (RMDs)​

Traditional IRA account owners are required to begin taking Required Minimum Distributions (RMDs) by April 1 of the year following the year in which they reach age 73. These mandatory withdrawals ensure that retirement funds, which have grown tax-deferred, are eventually subject to taxation. If an individual fails to withdraw the required minimum amount, the Internal Revenue Service (IRS) may impose a 25% penalty tax on the portion that was not withdrawn.

Premature Distributions: Withdrawals taken from an IRA before age 59½ are generally considered premature distributions and are typically subject to an additional 10% early withdrawal penalty, in addition to ordinary income tax on the amount withdrawn.

Permissible IRA Investments: Once an IRA has been funded, the account owner may choose from a variety of investment options. Common permissible investments include mutual funds, common stocks, certificates of deposit (CDs), and annuities. However, for insurance licensing and state examination purposes, life insurance is not considered a permissible investment within an IRA.

Penalty-Free Early Withdrawals: Although early withdrawals are usually subject to a penalty, the IRS allows certain qualified exceptions where the 10% early withdrawal penalty may be waived. Examples include:

  • Death or permanent disability of the account owner
  • Up to $10,000 used for a first-time homebuyer down payment
  • Unreimbursed medical expenses or payments for health insurance premiums
  • Qualified higher education expenses

Roth IRA​

A Roth Individual Retirement Account (Roth IRA) is a retirement savings plan available to individuals of any age who have earned income. Contributions to a Roth IRA are made with after-tax dollars, meaning they are not tax deductible. The Internal Revenue Service (IRS) establishes maximum annual contribution limits, and individuals who are age 50 or older may contribute an additional catch-up amount.

One of the primary advantages of a Roth IRA is its tax-free treatment of qualified distributions. If the account has been open for at least five years and the account owner is age 59½ or older, withdrawals of both contributions and earnings are completely tax free.

Certain situations also allow tax-free and penalty-free withdrawals of earnings, including:

  • The death of the account owner
  • Permanent disability of the account owner
  • A qualified first-time home purchase

If a withdrawal does not meet the requirements for a qualified distribution, it is considered a nonqualified distribution. In these cases, the earnings portion of the withdrawal is subject to ordinary income tax and may also be subject to a 10% early withdrawal penalty, unless a qualifying exception applies.

Individuals who maintain both a Traditional IRA and a Roth IRA must follow the combined contribution limits established by the IRS. This means the total contributions to all IRAs in a given year cannot exceed the maximum annual contribution limit for a single IRA.

Rollovers and Transfers of IRAs​

The Internal Revenue Service (IRS) allows IRA funds to be moved from one account to another through either a rollover or a transfer. When completed according to IRS rules, these transactions allow individuals to move retirement assets without triggering taxes or early withdrawal penalties.

IRA Rollover: A rollover occurs when funds from an IRA or qualified retirement plan are distributed to the account owner, who then redeposits the funds into another IRA or eligible retirement plan. When the distribution is paid directly to the account owner, the individual has 60 days from the date of receipt to deposit the funds into another IRA to avoid taxation and potential penalties. This type of transaction must be reported to the IRS and is generally limited to one rollover within a 12-month period. In many cases, a 20% federal withholding may apply when the funds are paid directly to the account owner. To avoid withholding and simplify the process, individuals may instead choose a direct rollover. In a direct rollover, the funds are transferred directly from one qualified plan to the trustee or custodian of another retirement plan or IRA. Although this transaction is still reported to the IRS, it is not treated as taxable income, and the 60-day redeposit rule does not apply.

IRA Transfer: An IRA transfer involves moving assets directly from one IRA to another IRA of the same type, such as from one Traditional IRA to another Traditional IRA. The funds are transferred directly between financial institutions, and the account owner does not take possession of the money. Because the funds never pass through the account owner, IRA transfers are not taxable events and are not subject to the 60-day rollover rule. Additionally, transfers may be completed as often as desired, making them a common method for moving IRA assets between custodians.

Quiz​

1. Which statement best explains why Individual Retirement Accounts (IRAs) are not considered qualified retirement plans?

A. They are funded only with employer contributions

B. They are established by individuals rather than employers

C. They are not regulated by the Internal Revenue Service

D. They cannot hold investment assets

Correct Answer: B

Rationale: IRAs are not classified as qualified plans because they are established and funded by individuals, not employers. Qualified plans, such as 401(k) plans, are employer-sponsored. IRAs are instead governed by Section 408 of the Internal Revenue Code, which sets the rules for these accounts.

2. Which of the following best describes the tax treatment of contributions and withdrawals for a Traditional IRA?

A. Contributions are tax deductible and withdrawals are tax free

B. Contributions are not deductible and withdrawals are tax free

C. Contributions may be tax deductible and withdrawals are taxed as ordinary income

D. Contributions are tax deductible and withdrawals are taxed at capital gains rates

Correct Answer: C

Rationale: Contributions to a Traditional IRA may be tax deductible, depending on income and participation in an employer-sponsored plan. Investment earnings grow tax deferred, and distributions are taxed as ordinary income when withdrawn.

3. When must a Traditional IRA owner begin taking Required Minimum Distributions (RMDs)?

A. January 1 of the year they turn age 65

B. April 1 of the year after they reach age 73

C. December 31 of the year they reach age 59½

D. April 1 of the year they open the account

Correct Answer: B

Rationale: Traditional IRA owners must begin taking Required Minimum Distributions by April 1 of the year following the year they reach age 73. If the required amount is not withdrawn, the IRS may impose a 25% penalty on the amount that should have been distributed.

4. Which of the following conditions must generally be met for a qualified tax-free distribution from a Roth IRA?

A. The account must be open for at least 3 years and the owner must be age 65

B. The account must be open for at least 5 years and the owner must be age 59½

C. The account must be open for at least 10 years and the owner must be retired

D. The owner must withdraw only contributions

Correct Answer: B

Rationale: For a Roth IRA distribution to be completely tax free, the account must have been open for at least five years and the account holder must be age 59½ or older. If these requirements are not met, the earnings portion of the distribution may be taxable and subject to penalties.

5. Which statement correctly distinguishes an IRA rollover from an IRA transfer?

A. A rollover moves funds directly between institutions, while a transfer is paid to the account owner

B. A rollover allows unlimited transactions each year, while transfers are limited to once per year

C. A rollover may involve the account owner receiving the funds and redepositing them within 60 days, while a transfer moves funds directly between financial institutions

D. A rollover is only allowed between Roth IRAs

Correct Answer: C

Rationale: In an IRA rollover, funds may be distributed to the account owner, who must redeposit them into another IRA within 60 days to avoid taxes and penalties. Rollovers are generally limited to one per 12-month period. In contrast, an IRA transfer moves funds directly between financial institutions, the account owner never receives the money, and the transfer is not taxable and can occur as often as desired.