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Ask the Tax Pro: IRA Basics
by: Robert D. Flach
 

QUESTION:

I got to thinking about IRAs. I think this is how it works-

Traditional IRA contributions are from dollars not taxed. Distributions from this type IRA are then taxed upon withdrawal.

ROTH IRA contributions are from dollars taxed during the year you make the contribution. Distributions from this type of IRA are not taxed upon withdrawal.

Am I correct?

ANSWER:

Part I - Traditional IRA

Contributions to a "traditional" IRA are either deductible or non-deductible. If you are an active participant in an employer-sponsored pension plan, such as a 401(k), a 403(b) or a SEP, the amount of your traditional IRA contribution that is deductible is phased-out once your "modified" Adjusted Gross Income (MAGI) for tax year 2005 reaches $50,000.00 if filing as Single or Head of Household, or $70,000.00 if married and filing a joint return.

Deductible contributions are made with "pre-tax" dollars. If all of your contributions to all of your IRA accounts over the years were fully deductible, then all IRA distributions are fully taxable. Amounts that were "rolled-over" to an IRA from a pre-tax employer plan like a 401(k) are treated as deductible contributions.

Non-deductible contributions are made with "after-tax" dollars. You have already paid income tax on these contributions. Accumulated non-deductible contributions make up your "basis" in the IRA. If some of your IRA contributions over the years were non-deductible, then a portion of any IRA distribution is a tax-free return of your after-tax contributions. The tax-free portion is determined by a special formula and is calculated on IRS Form 8606.

Many taxpayers have more than one IRA account, and each account may have a different mix of deductible and non-deductible contributions. However, when you calculate the tax-free portion of a traditional IRA distribution all monies in all traditional IRA accounts are lumped together.

You must begin to take annual minimum distributions from your traditional IRA once you reach age 70 1/2. Once you turn age 70 1/2 you can no longer make contributions to a traditional IRA, even if you continue to work and have earned income. Upon your death your beneficiaries will be taxed on distributions from an inherited traditional IRA.

Part II - ROTH IRA

You can contribute to a ROTH IRA if your MAGI is less than $110,000.00 if Single or Head of Household or $160,000.00 if Married Filing Joint.

Contributions to a ROTH IRA are made with "after-tax" dollars. ROTH IRA contributions are never deductible. Qualified distributions from a ROTH IRA are totally tax-free.

A qualified distribution is one that is made after a 5-year holding period, beginning on the first day of the first year you make a contribution, and is made after you reach age 59 1/2, or due to death or disability or for a qualified "first-time" home purchase. The earnings portion of a non-qualified distribution is fully taxable and may also be subject to a 10% penalty.

You do not have to begin taking annual minimum distributions from a ROTH IRA when you reach age 70 1/2. You never have to touch the money in a ROTH IRA during your lifetime. You can continue to contribute to a ROTH IRA after you turn age 70 1/2 as long as you have earned income. If you are still working at age 80 you can contribute to a ROTH IRA. Beneficiaries do not have to pay income tax on distributions from an inherited ROTH IRA.

Copyright (c) 2005 by Robert D Flach LLC

Robert D Flach is a tax professional with 34 tax seasons of experience preparing 1040s for individuals in all walks of life. He writes THE WANDERING TAX PRO weblog (http://rdftaxpro.tripod.com/weblog), the free online monthly newsletter STUFF AND SUCH (http://rdftaxpro.tripod.com/stuffandsuch), and the website http://www.robertdflach.net, which has a wealth of tax planning and preparation advice and information. He also writes and publishes THE FLACH REPORT, a quarterly print tax newsletter.


About The Author

Richard Chapo is the lead attorney for the law firm http://www.SanDiegoBusinessLawFirm.com - a firm providing legal advice to California businesses. This article is for general education purposes and does not address every facet of the subject matter. Nothing in this article creates an attorney-client relationship.