Retirement Plans: IRA’s
Retirement plans benefit from special tax advantages but also are subject to special restrictions. For instance, there are rules that allow tax breaks for contributing to retirement plans and rules that allow retirement plan income to grow on a tax-deferred basis, but there also are rules that limit annual contributions and rules that dictate the timing and amount of distributions you take from those plans.
IRAs are very popular because they are so easy to setup and also easy to maintain. A person does not need employer approval to open an IRA and you can contribute as much as you want to the account, as long as you do not exceed the annual limits). Below are the three main types of IRAs.
Traditional IRA. With this type of IRA you are able to let your assets grow on a tax-deferred basis. This is advantageous because you will not have to pay taxes on your assets until you withdraw funds from your account.
Contribution eligibility depends on earned income, statutory limits, and age. You can only contribute, at a maximum, as much as your earned income. Earned income is defined as income from wages and self-employment income in the period of one year. Earned income does not include investment income. If you are age 50 or older then you may also be allowed to contribute what are called catch-up contributions. Additionally, your spouse can also use your income to make contributions of his or her own. However, you and your spouse are only eligible for make contributions if you have not reached age 70 at the end of the year of the said contribution.
Considering other options besides the traditional IRA may be in your best interest.
One factor that may affect your decision is the deductibility of your contribution. Your income level and other factors will determine if your contribution to a traditional IRA will be fully deductible. If neither you nor your spouse is eligible to participate in an employer-sponsored plan, your contribution is deductible no matter how much income you earn. But if you or your spouse is eligible, your tax deduction for making an IRA contribution may be reduced or completely eliminated depending on your adjusted gross income (AGI).
If you are not able to make a deductible contribution (or a Roth contribution), then you may choose to make a nondeductible contribution. Making a nondeductible contribution will still afford you the advantage of tax-deferred growth. Also, if you withdraw funds after you reach age 59 1/2, only earning will be taxed. You are able to withdraw all nondeductible contributions free of tax.
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Roth IRA. You are able to contribute the same amount to a Roth IRA as you are able to contribute to a traditional IRA. The real difference between the two is their eligibility rules, such as the lack of an age limit with respect to contributions. This disregard for the age limit is only applicable if you meet the earned income requirement.
You also must remember that the total annual contributions to your IRA may never exceed the defined limit. In order to get around these limits you are able to split your contribution between a traditional and Roth IRA.
It is important to keep in mind that you are not able to claim a deduction for your contributions with a Roth IRA. However, you are able to withdraw all IRA earnings without tax after you reach age 59. This only applies if you have had the account for at least 5 years.
Traditional IRAs also have required minimum distribution rules that must be followed, Roth IRAs do not have such restrictions.
The exact formula for calculating the contribution amount is very complicated. However, if you were to use 20% of your net self-employment earnings as a guess it would be a close estimate.The formula for calculating the exact contribution amount is too complex for our purposes, but a rough estimate of 20% of your net self-employment earnings is a good start.
Simplified Employee Pension SEP IRA. A SEP IRA enables self-employed entrepreneurs an avenue to make significant IRA contributions that would not be permitted under a traditional or Roth IRA plan. As far as tax purposes are concerned, SEPs are treated the same as the other types of IRAs. The main difference is that SEPs allow a much higher contribution limit than the other two.The formula for calculating the exact contribution amount is too complex for our purposes, but a rough estimate of 20% of your net self-employment earnings is a good start.
This data is distributed for informational purposes only; Doeren Mayhew is not rendering legal, accounting, or other professional advice or opinions and assumes no legal responsibility. Contact Doeren Mayhew for more information.
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