Roughly 45 million Americans have IRAs and chances are you’re one of them. What is an IRA and how do you get one? There are now several types of IRAs:

1. The Traditional IRA allows you to contribute yearly the smaller of $5,000 or the amount of your taxable compensation. If over age 50, you are permitted to contribute up to $6,000. The contribution amount is linked to inflation and changes annually. The contributions are “before taxes” meaning the money put into your IRA is not counted as taxable income. You’ll pay income taxes when the IRA money is withdrawn in retirement. Until withdrawn the money grows tax-deferred, meaning no taxes are paid on earnings.

2. The Roth IRA is exactly like a traditional IRA with one major exception: your contributions are “after tax” meaning the amount you put into a Roth IRA is counted as taxable income and withdrawals are tax-free. You can split your annual contributions between Traditional and Roth IRA, but combined you cannot exceed the contribution limit.

3. A Roll Over IRA can be either a Traditional or Roth. You can move money from one retirement account like a 401(k) into an IRA or you can move from a Traditional IRA to a Roth, but not from a Roth to a Traditional.

4. An Inherited IRA is an IRA bequeathed to you at the death of the person who owned the IRA. Both spouses and non-spouses can inherit IRAs.

5. SIMPLE IRA is offered by employers to employees, but is beyond the scope of this article.

If you have an IRA you got it in one of three ways: (1) started an IRA and made contributions to it, (2) rolled money from another retirement plan into an IRA or (3) you inherited an IRA. IRA money may be invested in a wide variety of things but most people opt for conservative places.

Here are ten IRA rules you need to know:
1. If you have another retirement plan at work you can still contribute to an IRA but if your income is too high the contributions may be “after tax”.

2. You can only contribute to an IRA if you have “earned income”, investment income does not qualify you.

3. You can contribute to a traditional IRA until the year you reach 70-1/2 but can contribute to a Roth after 70-1/2 if your income is not too high.

4. You can “roll over” or transfer money from another retirement plan into an IRA at any age – this should only be done with the help of a financial professional.

5. All withdrawals from a Traditional IRA are subject to income taxes when withdrawn whereas Roth withdrawals are tax-free. Traditional IRA withdrawals increase “taxable income” and may increase taxes on your Social Security benefits whereas Roth withdrawals are not “taxable income” and do not count in determining the taxes on your Social Security benefits.

6. You can convert a Traditional IRA to a Roth IRA at any time, but you’ll have to pay taxes on the amount you convert.

7. You must start taking Required Minimum Distributions, called RMDs, from your Traditional IRA when you reach 70-1/2 years of age. There are no withdrawal requirements for Roth IRAs during your lifetime.

8. If one spouse dies the surviving spouse may claim the IRA of the deceased spouse as their own. They can convert it to a Roth IRA if they wish.

9. If a non-spouse beneficiary inherits an IRA, they are allowed to “stretch” the withdrawals over their remaining lifetime. A non-spouse beneficiary cannot convert an inherited Traditional IRA to a Roth. Money in an IRA is passed forward based on the named beneficiary and not by a person’s will.

10. If you take withdrawals from your IRAs prior to age 59-1/2, there may be a tax penalty. There are methods to avoid these penalty taxes; thus, if you want to take early withdrawals please consult with your financial advisor. After age 59-1/2 you can withdraw as much as you wish from your IRA without penalty. You may take withdrawals from your IRA while you are working, and if over 59-1/2 there are no tax penalties.

These are the “rules”, let’s now talk about several IRA aspects of interest.

What about transferring money from another retirement plan into an IRA? You can do this at anytime, provided the retirement plan where the money is now permits the transfer. The most common places from which you would transfer are 401(k) and 403(b) plans – the latter being for school teachers and certain non-profit employees. Here is something you need to hear loud and clear: Money at ex-employers should be transferred immediately. There are many reasons for this including:

1. As an ex-employee, employer contributions have stopped;
2. You are paying fees and other expenses that are un-necessary;
3. If you died your spouse or beneficiaries could be paid lump sum which means they’ll have a large and unnecessary tax liability;
4. If no beneficiary is named, your estate could get taxed twice on the same money – income taxes and estate taxes;
5. If the company failed, your retirement money could be in jeopardy.

Transferring to a Traditional or Roth IRA can be done quickly, without cost or hassle but I recommend you get help from your financial advisor. If you have money with an ex-employer, you need to move it NOW – no exceptions.

What is a Stretch IRA and how does it work? First of all, all IRAs should have a named beneficiary – be sure and check to make sure yours does. This detail is sometimes omitted when converting to a Roth IRA – so please confirm you have a named beneficiary. You can name any beneficiary you want: spouse, child, grandchild, church, charity, friend or whomever. If the spouse is your beneficiary, at your death your IRA becomes theirs and would be treated as if they had owned it from day one.

If you die and your IRA has a named beneficiary, they are allowed to take the money from your IRA over their remaining lifetime. The formula is very simple: how much is in the IRA divided by their remaining life expectancy. For example, let’s say you have $100,000 in your IRA and the beneficiary is your 10-year old grandchild that is expected to live another 75 years. They would then have to take 1/75th of $100,000, or 1.33%, in year one. The next year they’d take 1/74th and so on. Since the withdrawal rate is low, chances are the IRA will continue to grow for many years and as it does the annual withdrawals will increase as well. As you can see, the younger the beneficiary the longer and greater will be your legacy. What happens if the person who inherited your IRA dies prematurely? Their beneficiary can continue to take the same payments the deceased beneficiary was getting until all the money has been withdrawn. If the IRA was a Roth, all withdrawals will be tax free – what a gift to leave as your legacy.

Why might you want to convert to a Roth IRA? There are many reasons but here are the principal ones:

1. When money is withdrawn by you, your surviving spouse or a non-spouse beneficiary there are no income taxes, not even on the earnings. So if your $100,000 grows to $500,000 while in a Roth, zero taxes are paid on the growth. How sweet is that?

2. Roth IRAs have no required minimum distributions – you don’t have to start withdrawing money at 70-1/2, or at anytime during your lifetime. No doubt many of you are taking RMDs from your Traditional IRAs and wish you didn’t have to.

3. If you are now paying taxes on your Social Security benefits, converting to a Roth might lower your tax bill.

4. Since you don’t have to take the Roth IRA money during your lifetime, this could be your emergency fund if not needed for retirement. If not used in your lifetime, your heirs will enjoy your tax-free legacy.

5. Which way do you suppose taxes are headed? If you said higher, I’d agree with you. So why not pay the taxes now on your Traditional IRA money before rates go higher? If you don’t know for sure which way taxes are headed, just convert some to a Roth IRA.

6. The only disadvantage to a Roth is that you must pay taxes on the amount converted, but you can convert a portion each year to keep your taxes in the lowest possible bracket. You’ll want to discuss this with your financial or tax advisor.

Roth IRAs are not for everyone, but if you’re concerned about taxes going higher, tired of taking RMDs you don’t need or want to leave a tax-free legacy for your loved ones, you should investigate converting some or all of your Traditional IRA money to a Roth.

What about the required minimum distributions (RMDs) you must take? If you don’t need the money for your retirement you have several good options including:
1. If medically qualified you could use RMDs to purchase a long-term care insurance policy. Long-term convalescent care is something that a majority of retirees will need – especially the gender that lives longer: that’s you ladies! The best strategy for LTC coverage is to purchase what is called linked-benefit coverage: insurance that covers you for LTC if needed, but if not, pays your heirs a death benefit. Ask your financial advisor for details.

2. If you think future taxes will rise, why not use the RMD to pay the taxes on converting to Roth IRA? You could stretch the conversion over several years to make sure you stay in the lowest possible tax bracket. At the end you’d have no RMD requirements and all the money, plus earnings, would be tax-free when used by you or your heirs. An added benefit could be lower taxes on your Social Security benefits.

3. If insurable, you could use the unneeded RMDs to purchase life insurance that will provide your heirs a tax-free legacy. There are many options including multi-generational ones that can stretch to grandchildren and beyond. Of course, you can also name a favorite charity, church, research organization or friend as to receive the tax-free life insurance benefits. By the way, you do not have to be in perfect health to qualify for life insurance.

4. You could use the unneeded RMDs to establish a college fund for your grandchildren, establish a savings account that could later be used for a down-payment on a home or any number of future financial needs. You can even buy a life insurance policy that will pay your grandchildren a stipulated amount of money on every birthday for the rest of their life – now that is a legacy that will keep your name in circulation long after you’re gone.

Of course there are other important things about IRAs, but hopefully I’ve given you a basic foundation about what you can and cannot do. Here are the things to remember:

1. If you have retirement money at an ex-employer, you need to move it to an IRA immediately. Your financial advisor can help you.

2. The Stretch IRA is for the next generation and you must have a named beneficiary for it to work.

3. The Roth IRA is an excellent way to reduce future taxes, leave a tax-free legacy and lower taxes on your Social Security benefits.

4. If you’re taking required minimum distributions not needed for retirement, there are several excellent ways you can use them to benefit you and/or your heirs.

I sincerely hope the foregoing gave you some good ideas. Remember, one of the biggest mistakes most retirees make is trying to solve financial and tax puzzles without the help of a professional. I hope you will find and work with a financial advisor.

Shelby J. Smith, Ph.D.
June 2011

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