The principal tax advantages of a traditional Individual Retirement Arrangement (IRA) are that contributions may be fully or partially tax deductible, and earnings in the account can grow tax-free until distributed.

You can set up a traditional IRA and make contributions if you received taxable compensation and you are under age 70 ½.  If you are married and both you and your spouse have taxable compensation and are under age 70 ½, you can each set up an IRA.  Both spouses cannot participate in the same IRA.

How Much Can be Contributed to an IRA and Deducted for Tax Purposes?

General Limit

The amount you can contribute to a traditional IRA and deduct for income tax purposes is limited to a certain dollar amount per year, or your taxable compensation for the year, whichever is lower.  If you reach age 50 before the end of the year, the dollar amount limit on your deductible contribution is generally $500 higher.  This is called the general limit.  The fixed dollar amount is subject to change, and is published in the instructions and publications issued by the Internal Revenue Service (IRS) each year.

Spousal Limit

If you are married filing jointly and your taxable compensation is less than your spouse’s, the maximum amount you can contribute to your IRA for the year is the lesser of the fixed dollar amount per the general limit, or the total taxable compensation of both you and your spouse, reduced by your spouse’s contribution to an IRA and any contributions made to a Roth IRA on behalf of your spouse.

This means that, a married couple filing a joint return can contribute up to the maximum amount each to their IRA’s, even if one spouse had little or no income, provided one spouse had enough taxable compensation to cover the fixed dollar-amount limits for both.

Contributions More or Less than the Maximum

If you contributed less than the maximum amount allowed for one year, you cannot contribute more than the maximum allowable amount in a subsequent year to make up the difference.  The contribution limit applies year-by-year.

But, if you contribute more than the maximum allowable amount one year, you can apply the excess to a later year, but you may be subject to a penalty or additional tax.

If You Are Covered by Another Retirement Plan

If you are covered by a retirement plan (qualified pension, profit-sharing plan, 401(k), annuity, SEP, SIMPLE) at work or through self-employment, you can still have an IRA and make contributions, but the amount you can contribute tax-free is gradually reduced, or phased out, when your modified adjusted gross income is over a certain amount.  This amount depends on whether your filing status is married filing jointly or qualifying widower, single or head of household, or married filing separately.

You figure your modified adjusted gross income by taking your adjusted gross income and adding back the following adjustments:

• IRA deduction
• Student loan interest deduction
• Tuition and fees deduction
• Foreign earned income exclusion and housing exclusion or deduction
• Exclusion of qualified savings bond interest on Form 8815
• Exclusion of employer-provided adoption benefits on Form 8839.

If you are covered by another retirement plan, and you know your filing status and modified adjusted gross income, you can determine whether you can claim a full or partial IRA deduction by referring to the tables in IRS Publication 590, Individual Retirement Arrangements (IRAs).  If you can claim a partial deduction, you can use the Worksheet in the same publication to determine the amount you can deduct.

Reporting Non-Deductible Contributions

You can contribute the full amount allowable to your IRA under the general limit or the spousal limit, even though you can only deduct part of it or none of it for income tax purposes.  The difference is a non-deductible contribution and must be reported on Form 8606, Nondeductible IRAs.  You have to file Form 8606 even if you do not otherwise have to file an income tax return.

If you do not file Form 8606 to report your non-deductible contributions, all your contributions will be treated as deductible and all distributions will be taxable.  You can choose to report contributions as non-deductible, even though they are deductible.  By making non-deductible contributions, you have a cost basis in your IRA.  Then, when distributions are subsequently made, part of the distribution would be taxable and part would be non-taxable, as a return of cost.

Determining Whether You Are Covered by Another Retirement Plan

If you are covered by an employer plan, the “Retirement Plan” box on your Form W-2 should be checked.  Determining the years for which you are covered depends on whether the plan is a defined contribution plan or a defined benefit plan.

Under a defined contribution plan, a separate account is set up for each beneficiary.  The amount to be contributed to the plan is defined, and the level of benefits depends on the amount contributed and the earnings on the account.  Defined contribution plans include profit-sharing plans, stock bonus plans, and money purchase pension plans.  You are considered covered for the year if the defined amounts are contributed or allocated to your account for the plan year.

Under a defined benefit plan, the level of benefits is defined and the plan administrator determines the amount that needs to be contributed to the plan in order to provide those benefits.  Defined benefit plans include pension plans and annuity plans.  You are considered covered for the year if you are eligible to participate, even if you declined to participate, did not make a required contribution, or did not meet the minimum service requirement to accrue benefits under the plan.  The fact that you were eligible to participate means that you were covered under the plan for purposes of determining the phase-out of the maximum contribution you can make to your IRA.

What is Taxable Compensation for IRA Purposes?

Having taxable compensation is a requirement for setting up an IRA.  The amount of your taxable compensation also determines the amount of your deductible contribution, which according to the general limit is the lower of your taxable compensation or the fixed dollar amount.  For IRA purposes, compensation is generally defined as what you earn from working, and includes the following:

• Wages, salaries, tips, professional fees, bonuses, or any amounts you receive as compensation for rendering personal services.  This compensation is generally reported in box 1 of your Form W-2, Wage and Tax Statement.
• Commissions you receive, expressed as a percentage of profits or the sales price.
• Net earnings from self-employment, assuming that personal services are a significant income-producing factor, minus the total of the deduction for contributions made on your behalf to retirement plans set up under your business, and the deduction you are allowed for one-half of the self-employment tax.
• Alimony and separate maintenance payments you receive.

For IRA purposes, compensation does not include:

• Earnings on property, such as rental income, interest, and dividends.
• Pension or annuity income.
• Deferred compensation payments that you receive.
• Income from a partnership in which your personal services are not a material income-producing factor.
• Amounts you exclude from income, such as the foreign earned income exclusion claimed on Form 2555.

How To Set Up an IRA

There are different types of  Individual Retirement Arrangements that you can set up with your bank or financial institution, insurance company, mutual fund, or stockbroker.  Your traditional IRA can be:

• An individual retirement account.  This is a trust or custodial account set up for the exclusive benefit of you or your beneficiaries.  It must meet the following IRS requirements:
• The trustee or custodian must be a bank, financial institution or other entity approved by the IRS.
• Contributions must be in cash, not property such as securities, and must not be more than the maximum allowable amount per year, except for rollover contributions.
• You must have a non-forfeitable right to the account.
• You cannot use the money in the account to buy a life insurance policy.
• The account must be separate – the assets (securities) in your IRA cannot be combined with other property, except in a common trust fund or common investment fund.
• You must start receiving distributions by April 1 of the year after you reach age 70 ½.
• An individual retirement annuity, that you set up by purchasing an annuity or endowment contract from a life insurance company.  A retirement annuity must also meet IRS requirements:
• You must have a non-forfeitable interest in the entire contract.
• The annuity contract must provide that you cannot transfer any part of it to another person other than the entity that issues the annuity.
• The premiums you pay for the annuity must be flexible so if your compensation changes, your premiums can also change.
• As in the case of an individual retirement account, your annuity is subject to annual limits on contributions, and you must begin to receive distributions the year after you reach age 70 ½.
• Part of a simplified employee pension (SEP).  This type of arrangement allows your employer to make contributions to a SEP-IRA that your employer sets up for you.  The rules for contributions and withdrawals are generally the same as for traditional IRAs, and the contributions are deductible by your employer.  If you are a sole proprietor, you can open a SEP-IRA and make contributions for yourself.
• Part of a trust account set up by your employer, labor union, or other employee association to provide retirement benefits.  These accounts must meet the same requirements as individual retirement accounts.

When Can Contributions Be Made to an IRA?

Contributions can be made at any time during the year, and contributions for the current year can be made the following year, up until the normal due date for your tax return (April 15).  If you make a contribution between January 1 and April 15, you should tell the account sponsor which year (current or previous) it is for.

You cannot make contributions the year you reach age 70 ½ or any year after that.

Non-deductible Contributions

Although your deduction for IRA contributions may be reduced or eliminated, contributions can be made to your IRA up to the general limit or, if it applies, the spousal IRA limit.  The difference is your nondeductible contribution.  You must file Form 8606 to report nondeductible contributions even if you do not have to file a tax return.

How are Distributions from an IRA Taxed?

Distributions you receive from your IRA after you reach age 59 ½ are generally subject to tax as ordinary income.  Whether the distribution is fully or partially taxable depends on whether you have made non-deductible contributions.

But distributions that are properly and timely rolled over are not subject to tax.

Fully or Partially Taxable IRA Distributions

If all your contributions to your IRA were deductible, the distributions you receive (after you reach age 59 ½) will be fully taxable.  If you have made non-deductible contributions you have an investment, or cost basis in the IRA, and part of a distribution will be a return of cost, and therefore non-taxable.  If you have made non-deductible contributions, you will need to file Form 8606.

If you receive a distribution and also make contributions to your IRA the same year, you will first need to complete the worksheet, “Figuring the Taxable Part of Your IRA Distribution” to determine the taxable and non-taxable portions of the distribution, and your remaining basis in the IRA after the distribution, and then file Form 8606.

Withdrawing Contributions Made During the Year

If you make a contribution and then withdraw it before the due date for filing your tax return for that year, the distribution is not taxable.  In this case, you must not take a deduction for the contribution, and you must withdraw any earnings on the contribution.  You calculate the earnings on the contribution on a prorated basis, comparing the fair market value of the IRA immediately before the contribution is removed to the fair market value immediately after the contribution was made.  These distributions are tax-free because they are a return of contributions (and earnings) made during the year, and  are not subject to the 10% additional tax.

Early Distributions

You can receive distributions (make withdrawals) from your IRA at any time.  But if the distributions are made before you reach age 59 ½, you will have to pay a 10% additional tax on the distribution.  This additional tax applies on the portion of the distribution that is included in gross income, and is reported on Form 5329.

But there are exceptions.  The 10% tax on early distributions does not apply in the following situations:

• You receive a distribution from your IRA to cover un-reimbursed medical expenses that are more than 7.5% of your adjusted gross income.  The additional tax would not apply on the distribution, to the extent of the excess medical expenses.
• You receive a distribution that is not more than the cost of your medical insurance, when you have lost your job.
• You receive a distribution when you are disabled, before reaching the age of 59½.
• You receive the assets of an IRA as the beneficiary when the owner dies.
• You are receiving distributions in the form of an annuity, even if you are not yet  59 ½ years of age.
• You used the distribution to pay qualified higher education expenses.  In determining the portion of the distribution not subject to the additional tax, you would include higher education expenses paid with earnings from your work, personal savings, loans, gifts, or an inheritance, and you would exclude expenses paid with scholarships, grants, educational assistance, and tax-free distributions from a Coverdell savings account.
• The IRA distributions are used to buy, build, or re-build a first home.  If neither you nor your spouse had a present interest in a home for 2 years prior to the acquisition date of the home you are buying, building, or re-building with the IRA distribution, you are considered first-time homebuyers, and each of you can receive distributions of up to $10,000 without having to pay the additional tax.

Distributions When You Reach Age 70 ½

You are required to start receiving at least the minimum distributions from your IRA by April 1 of the year after you reach age 70½.  If you do not receive distributions, or you receive less than the minimum required amount, you may be subject to a 50% excise tax on the excess accumulations or insufficient distributions.  This tax is reported on Form 5329.