March 24, 2004

COMMON QUESTIONS ABOUT IRA’S

BACKGROUND – Individual Retirement Accounts – IRA’s -were started back in the early 80’s. They created a way for people without a retirement plan to put some money away for the future. Initially, the maximum annual contribution for a single person was $2,000. This has increased over the years to $3,000 ($3,500 if over age 50) for tax year 2004 and to $4,000 ($4,500 if over age 50) for tax year 2005.

The idea behind the IRA is that you are able to take a deduction for your IRA contribution while you are working that will reduce your income taxes and provide you savings for retirement. Your savings will grow tax-free and when you start to receive distributions from your IRA, these distributions will be treated as income.

Here are some common questions about IRA’s:

IS MY IRA TAXABLE? The general rule is that, yes, the amount you receive from your IRA is taxable. The most common mistake I see regarding the taxation of IRA benefits is not with the federal tax return, but with the Massachusetts treatment of IRA distributions.

Massachusetts has never allowed a deduction for IRA’s. Complicating the matter further is the fact that the Massachusetts tax return is based upon the federal return. An adjustment has to be made on the Massachusetts income tax return to recover the non-deductible contributions that have been made over the life of the taxpayer.

EXAMPLE: Jim didn’t like IRA’s. He only made one contribution for $2,000 in 1990. This IRA has grown to $5,000 and in 2004, Jim has withdrawn his $5,000 IRA. His federal income tax return will show IRA income of $5,000. This $5,000 income distribution will flow through to the Massachusetts income tax return, but Jim will take a deduction for $2,000 representing previously taxed contributions. Only $3,000 is subject to Massachusetts taxation. It is up to the individual to keep track of how much they have deposited into their IRA. If you had made deductible contributions $20,000 into your IRA, the first $20,000 you receive upon retirement will be non taxable in Massachusetts. After you have recovered all of your contributions, the remainder will be fully taxable.

Some workers are eligible to make contributions to their IRA but not deduct them for federal income tax purposes. These people continue to make these non-deductible IRA contributions because they want their money to grow tax-free. Because these contributions were never deducted, they are not income when you get them back. Of course, the IRS has a different rule than Massachusetts to determine how much is taxable when you have made non-deductible contributions. In Massachusetts, nothing is taxable until you have received back an amount equal to the non-deductible contributions. On the federal side, a ratio is determined each year based upon your deductible and non-deductible contributions and applied to the amount you receive from your IRA.

IRA OF DECEDENT – During life and upon death, the IRA retains its character that who ever receives the IRA is taxable on the distributions that they receive. Dying has no affect upon the IRA. The beneficiary of your IRA will be responsible for payment of the income taxes. There are exceptions to this rule, the most common being the death of one spouse where the surviving spouse is the beneficiary. I this case the surviving spouse may “rollover” the deceased spouse’s IRA into an IRA belonging to the surviving spouse or simply treat is as his or her IRA. No taxes would be paid until the surviving spouse started receiving distributions from this IRA.

HOW MUCH SHOULD I WITHDRAW FROM MY IRA? My advice is that you should never take any distributions from your IRA unless you are over age 70 ½. This is, of course, assuming that you do not need any of this additional (taxable) income for your daily living. If you are a “Saver”, one who spends less than they earn, an IRA lets you keep your savings in a place where there is no income tax on the earnings.

In the year following the year that you turn 70 ½, you are required to begin taking distributions from your IRA. If you do not take out the required minimum distribution you are subject to a 50% excise tax on the amount required to be distributed. Most banks and brokerage firms that hold IRA assets are aware of your birth date and will advise you when you need to start making withdrawals. There are instances where a taxpayer neglected to take the required minimum distribution and never received notice from the company that was holding their IRA. So, what can we learn from this? If you are approaching age 70, contact the company that is holding your IRA and inquire as to when you must start making withdrawals.

IRA DISTRIBUTION PENALTIES – The money in your IRA can be withdrawn at anytime, but if you are under age 59 ½ you will have to pay an additional 10% penalty for early withdrawal. There are several exceptions to the age 59 ½ rule. Even if you receive a distribution prior to age 59 ½, you may not have to pay the penalty if you fall into one of the following exceptions:

1. You have unreimbursed medical expenses that exceed 7 ½ per cent of your income.

2. The distributions are not more than the cost of your medical insurance.

3. You are disabled.

4. You are the beneficiary of a deceased IRA owner.

5. You are receiving distributions in the form of an annuity.

6. The distributions are not more than your qualified higher education expenses.

7. You use the distributions to buy, build, or rebuild a first home.

8. The distribution is due to an IRS levy of a qualified plan.

This is a small sampling of the 100 pages of information that can be found in Publication 590, Individual Retirement Arrangements, available from the IRS and on their web site at www.irs.gov.

This article gives general information and not specific advice on individual matters. Persons wanting individualized advice on matters discussed should contact an advisor experienced in those matters. To the extent this article provides information on legal matters, it is based on law in effect in Massachusetts on the date of posting (laws in effect in other states are often quite different).

Ronald H. Surabian is a CPA and attorney who works at the Elder Law Center in Saugus, Ma. He also holds a masters in accounting and a masters in tax law. He currently serves on the board of directors of the Massachusetts Chapter of the National Academy of Elder Law Attorneys.

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