Unlocking IRAs Planning for Retirement (Yours and Your Clients'), 0716 SCBJ, SC Lawyer, July 2016, #38
| Author | J. Aaron Nelson Jr. and Elizabeth M. Nelson, J. |
J. Aaron Nelson Jr. and Elizabeth M. Nelson, J.
Most lawyers would like to retire one day. Planning for this retirement is essential in order to ensure it occurs. Retirement accounts are generally classified into two categories: employer-sponsored and non-employer-sponsored. For the majority of solo and small firm practitioners, employer-sponsored accounts are not a feasible option, and therefore individual retirement accounts (IRA) are the only tax-deferred option these practitioners have to save for retirement. Other practitioners may have clients with questions regarding retirement options. IRAs are an excellent way to provide for retirement savings and manage the income tax consequences associated with the accounts. This article will summarize the general rules applicable to IRA contributions and distributions, discuss IRAs in specific contexts, such as divorce and bankruptcy, and highlight common IRA pitfalls. It will first generally discuss several different types of tax-deferred retirement accounts, then will turn its focus to IRAs.
There are three major types of tax-deferred retirement accounts: (1) qualified plans (under ERISA), (2) non-qualified plans and (3) IRAs. Qualified plans are employer-sponsored plans that provide retirement benefits for their employees, usually through defined benefits or defined contributions. An example of a qualified plan is a 401(k) plan, but other types of qualified plans exist. In general, with qualified plans, funds are not taxed until they are withdrawn from the plan. Non-qualified plans are also tax-deferred employer-sponsored retirement plans, but are typically reserved for meeting specific retirement needs of executives or other key employees. Unlike qualified plans, non qualified plans are not subject to ERISA guidelines, and thus have additional requirements in order to take advantage of tax deferrals. Examples of non-qualified plans include supplemental executive retirement plans, certain executive bonus plans and split-dollar life insurance arrangements.
Unlike the retirement plans discussed above, IRAs are not employer-sponsored. They are established by an individual.1 The funds to establish an IRA can come from any source; however, because of the tax advantages of such accounts discussed below, it is best to fund IRAs with otherwise-taxable income. Although there are many different types of IRAs, this article will focus on traditional IRAs and, to a lesser extent, Roth IRAs. SEP (simplified employee pension) IRAs and SIMPLE (savings incentive match plan for employees) IRAs are similar to employer-sponsored plans. Contributions to SEP and SIMPLE IRAs have their own set of special rules that are not discussed in this article. Distributions from SEP and SIMPLE IRAs are similar to the rules that apply for distributions from traditional IRAs, but are likewise not discussed.
Contributions
With traditional IRAs, one can make deductible and non-deductible contributions. Regardless of the tax consequences of the initial contribution, the funds continue to grow tax-deferred while in the account. In order for contributions to an IRA to be deductible, the owner must either: (1) not be an active participant in an employer-sponsored plan (such as a 401(k) plan); or (2) have an adjusted gross income (AGI) less than certain thresholds ($98,000 in 2016 for individuals who are married filing jointly).2
If a contribution to a traditional IRA would be a non-deductible contribution, then it is more advantageous to make such contribution to a Roth IRA rather than making such contribution to a traditional IRA because non- deductible contributions do not give a current tax benefit to the IRA owner. If one's AGI does not exceed $184,000 (married filing jointly), then contributions can be made to a Roth IRA. While contributions to Roth IRAs are not tax-deductible, the account grows tax-deferred and withdrawals from the Roth IRA are not fully-taxable (unlike withdrawals from traditional IRAs). This is discussed in more detail below.
There are limitations on the amounts that can be contributed to IRAs (of all types). In 2016, the annual limit is $5,500 per individual (or the individual's taxable income, if less). After turning age 70½, individuals are no longer allowed to contribute to a traditional IRA; however, it is permissible to contribute to Roth IRAs.3
Distributions
While the contribution limits for IRAs are lower than the limits for deductible contributions to 401(k) plans, IRAs do provide some advantages over 401(k) plans. For example, it is much easier to withdraw funds from an IRA than a 401(k). Early withdrawals (called "distributions") from 401(k) plans are generally limited to hardships. Distributions from an IRA can occur at any time and for any reason, but possibly could incur a penalty.
Distributions can generally be classified into one of three types: (1) early, (2) permissible and (3) required. Distributions of any type (early, permissible or required) from traditional IRAs are subject to income tax on the full amount distributed. Distributions from Roth IRAs are tax-free if paid out after: (1) a five-year period that begins with the first year the taxpayer made a contribution to the Roth IRA; and (2) the taxpayer turns age 59½ (or the death or disability of the taxpayer). If a distribution does not meet these two requirements, only the earnings that are distributed are taxable, but the contributed amount may still be distributed tax-free. For example, if a taxpayer (over age 59½) contributed $5,000 to a Roth IRA in year one and in year three, $5,500 (the additional $500 of which was...
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