’s Essay, Research Paper
The Facts About Educational and Roth IRA’s
In 1997 great things came into play for the taxpayers. The Tax Reform Act of 1997, which was inacted by the IRS, allowed single taxpayers and married taxpayers a considerable amount of tax relief for the Educational and Roth IRA’s. Individual Retirement Accounts, also known as IRA’s, are accounts opened in an individual’s name only and provide tax-deferred savings for retirement. The contributions may be fully deductible, partially deductible, or nondeductible.
All IRA’s have the same basic characteristics that enable customers to save money while gaining benefits that may include tax-deferred savings and tax deductions. An IRA is a product in which customers place additional products into, such as CD’s, stocks, bonds and mutual funds. These products are placed into IRA’s to meet customers’ retirement, education, or other future needs. The customers are able to select these products based on their tolerance to risk and their individual investment goals. The IRA will hold these products and provide the potential tax shelter and savings incentives.
In order to explain the great qualities of the Roth IRA and the Educational IRA, you must know just a few things about the Traditional IRA. The Traditional IRA is the original product offered to help individuals set aside funds for retirement. To be eligible to contribute to the Traditional IRA the customer must be 70 1/2 or younger, and have an earned income. With the Traditional IRA any withdrawals are subject to income tax in the year in which they are being withdrawn. In addition there are some penalties which may apply if the individual is under the age of 59 1/2 when the funds are withdrawn. There are only seven ways the customers may withdrawal from their Traditional IRA before age 59 1/2 with out being penalized a 10% premature-distribution penalty. These seven ways would be death, disability, medical expenses over 7.5% of AGI, health insurance premiums for certain unemployed individuals, first time home buyer (up to $10,000), higher education expenses, and substantially equal periodic payments. With the Traditional IRA the maximum contribution allowed is the lesser of earned income or $2,000. This contribution is not tax-deductible (smartmoney, the ira super page, 2000). With a Traditional IRA there are required minimum distributions which must begin in the year that the customer turns 70 1/2. The customer may defer the first year’s distribution until April 1 of the following year after they turn 70 1/2; the IRS penalizes 50% of the distribution amount that should have been withdrawn for the year. Also with the Traditional IRA there are certain taxes which become due after a certain age. After age 59 1/2 income tax is due on earnings and the original contributions are withdrawn tax-free (smartmoney, the ira super page, 2000).
In 1998 an additional way for individuals to save for retirement was introduced to the public as a Roth IRA. These Roth IRA’s are a terrific tax break, especially for individuals previously shut out of the deductible IRA game because their incomes were too high. Here’s why. Unlike traditional IRA’s, Roth contributions are nondeductible. But the earnings build up tax-free (SmartMoney, you wanted to know, 2000). Another great point about the Roth IRA is the fact that any withdrawals are free of federal income tax under certain circumstances. To be free from federal tax the Roth IRA must have been open at least five years and your age must be 59 1/2 or older. To be eligible for a Roth IRA you must have an adjusted gross income (AGI) between $95,000 and $110,000 for single filers and between $150,000 and $160,000 for joint filers. Also with the IRA you are not able to contribute more than $2,000 annually per person. With the Roth IRA there are no taxes due if funds are held in the account for at least five years and you are at least age 59 1/2. Original contributions can be withdrawn tax-free and penalty-free at any time (SmartMoney, the ira super page, 2000). The Roth IRA is designed to provide a tax-advantage for people whose income is too high to deduct a Traditional IRA contribution. Because the Roth IRA requires no lifetime distributions, it allows a larger tax-free benefit to pass directly to the heirs. Unlike the Roth IRA, the Traditional IRA requires minimum distributions at the age of 70 1/2.
There are many other great features of the Roth IRA. One of these is the fact that first-time home purchases are considered tax-free and penalty-free withdrawals from Roth IRAs. Another great aspect of the Roth IRA is that you can still make contributions to the account after you turn 70 1/2 as long as you have a earned income and your AGI is under the eligible amount required. There is only one main factor you must consider when purchasing a Roth IRA at that age, and that is your “health”. This is because you have to wait five years until you can make tax-free withdrawals. And to add on to that, your beneficiaries are not taxed on the assets from your Roth IRA. There are two main types of Roth IRA’s that are offered for individuals. They are the Contributory Roth IRA, and the Conversion Roth IRA. The Contributory Roth IRA is for an individual who opens a new Roth IRA. The Contributory Roth IRA is available to Traditional IRA owners with an income of $100,000 or less whether they are filing with single or joint status that want to convert to a Roth IRA. After 1998 the individual is taxed in the year in which they had their IRA converted into a Roth IRA.
If you have a Traditional IRA and you want to convert it over to a Roth IRA then all you need to know is just a few little facts. When you convert your regular IRA over to a Roth, you will have to pay tax on any earnings and pretax contributions. This is in lieu of paying taxes upon later withdrawals from the Roth account. You should not tap your IRA to pay the conversion tax, however. If you do so before age 59 1/2, you will generally owe a 10% penalty on that amount (SmartMoney, roth iras: to convert or not). Every dollar you rollover into the Roth from the regular IRA is called a blended dollar. A percentage of the amount rolled over into the new Roth account will be taxed. There is only one exception, and that is if your IRA is worth less than the amount of your after-tax contributions. So don’t think you can avoid the conversion tax. It is not wise to convert into a Roth account now if you plan on dropping into a lower tax bracket when you retire, because you will have to pay income taxes at your current high rate instead of your lower rate after you retire. Another important fact you will need to know when converting over to a Roth is that you will only pay income tax on the difference between the account’s value on the date of conversion and the total amount of your nondeductible contributions. When you are converting your nondeductible IRA into a Roth you will not need to bother or worry bout capital gains.
After converting from a Traditional IRA to a Roth IRA you may want to go back to the Traditional IRA. This is called recharacterizing. When recharacterizing the earnings from the converted amount must also be transferred back to the Traditional IRA, and the transfer must be completed by the taxpayer’s tax-filing deadline, including any extensions. There are other ways of transferring or moving one IRA to a different IRA. This method is called IRA-to-IRA Rollovers. This is the most common method used. With IRA-to-IRA rollovers there are not any age, tax year or dollar amount restrictions on transactions. With a rollover, the IRA owner takes direct possession to the assets and has 60 days to roll them over to a new IRA. The IRA owner is allowed only one rollover per 12-month period. This 12-month period begins the day the IRA owner originally withdraws the assets from the IRA. Once the IRA owner receives the funds, he or she has 60 calendar days to complete the rollover contribution. When doing a rollover you must know that the conversion income could push you into a higher tax bracket and disqualify you from other tax benefits such as the dependent child and college tuition tax credits (smartmoney, roth iras: to convert or not, 2000). When you are the owner of an IRA you also have the option of a Direct Rollover. A direct rollover differs from both a rollover and a transfer. Instead of moving a IRA-to-IRA, a direct rollover moves all or part of the assets form an employer sponsored plan [such as a 401(k) plan] to either and IRA or an eligible retirement plan. When you choose the direct rollover plan the federal income tax withholding of 20% is not required. All of the eligible rollover assets are paid directly to the trustee/custodian of the new plan.
Another new option for saving is the Education IRA. Unlike Traditional or Roth IRAs, the Education IRA is not a retirement planning tool; it is more accurately described as an education investment account (troweprice, education iras, 2000). Education IRAs are for children under the age 18 and provide tax-free savings for higher education, as long as withdrawal conditions are met. Individuals may contribute $500 per child per year for educational savings in addition to making contributions to a Traditional IRA, Roth IRA, or employer-sponsored plan. Parents, grandparents, other family members, friends, and a child him/herself may contribute to the child’s Education IRA, provided that the total contributions for the child during the taxable year do not exceed the $500 limit (DJI webcenter, what’s hot, 2000). To be eligible for the Education IRA you must meet a certain amount of criteria. First, the contribution is designated for a child who is under the age of 18. Second, no state pre-paid tuition contribution is made during the same year that an Education IRA is made. Third, individual with earned income who is making the contribution is subject to AGI limits; however, earned income is not required. Fourth, single individuals with AGI of $95,000 or less may contribute to an Education IRA. Partial contributions are available for those earning between $95,000 and $160,000. And last, married individuals filing jointly with AGI of $150,000 or less may contribute to an Education IRA. Partial contributions are available for those earning between $150,000 and $160,000.
With the Education IRA the amounts being deposited in the account grow tax-free until distributed, and the child will not owe tax on any withdrawal from the account if the child’s qualified higher education expenses at an eligible education institution for the year equal or exceed the amount of the withdrawal (DJI webcenter, what’s hot, 2000). With the Education IRA any withdrawals that exceed the intended child’s qualified higher education expenses in a taxable year will be subject to income tax and a 10% penalty. One of the great benefits of the Education IRA is the fact that if the intended user of the Education IRA does not use it, then the IRA account balance can be rolled over to an Education IRA of another family member who can use it. When the Education IRA is rolled over to the other family member, that family member must be under the age of 18 and must use that Education IRA before the age of 30 or the funds will be liquidated. In case for some reason you contribute more than $500 to an Education IRA on behalf of a child in a calendar year. The contributions will be treated as excess contributions and will be subject to a 6 percent excise tax for each year the excess amount remains in the account (DJI webcenter, what’s hot, 2000).
Another important fact about the Education IRA is that only cash, checks, or money orders are allowed to purchase IRAs. You are not allowed to make contributions with securities such as shares of stocks or mutual funds. A child may have any number of Education IRAs, but in any taxable year the total amount of contributions to all Education IRAs that the child is a beneficiary of can not exceed the amount of $500. The “qualified higher education expenses” means expenses for tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible educational institution. Qualified higher education expenses may also include room and board (generally the school’s posted room and board charge, or $2,500 per year for students living off-campus and not at home) if the designated beneficiary is at least half-time student at an eligible educational institution (DJI webcenter, what’s hot, 2000). To find out if a certain college is considered an eligible education, then you may check section 481 of the higher education act of 1965. Most of the eligible educations include major universities and postsecondary educational institutions.
With the Education IRA if the child or student dies before all assets of the Education IRA were withdrawn, the balance in the Education IRA may be distributed to any other beneficiary (person or estate) that is named in the plan document. If the named primary of contingent beneficiary is a qualified family member, the beneficiary may elect to treat the Education IRA as his or her own. Also with the Education IRA if the child/beneficiary finishes their higher education and there is assets remaining in the account, then there are two options which they can choose from. The first option is to withdrawal the remaining amount, but it will be subject to income tax and an additional 10 percent tax that represents earnings. The second option is to have the remaining amount rolled over into another IRA. In addition to the two options just discussed the Education IRA can be designated to another beneficiary instead of rolling it over.
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http://www.troweprice.com/college/cpklib2.html [2000, February 8].
Dow Jones Industrial Webcenter (2000). What’s Hot! [Internet]. Available:
http://www.irs.ustreas.gov/plain/hot/not97-603.html [2000, February 7