Retiree Portfolio Ten IRA Myths

IRAs have been around since 1974. Nevertheless, more than a quarter-century later, they continue to be misunderstood. To avoid needless administrative aggravation, adverse income tax impacts, and a loss in savings power, make sure you don't fall into the trap of believing these IRA fictions.

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By David Braze (TMF Pixy)
October 22, 2001

The Individual Retirement Arrangement (IRA) was born in 1974 with the enactment of the Employee Retirement Income and Security Act (ERISA). Today, more than a quarter-century later, IRAs seem as commonplace as white bread. Literally millions of Americans take advantage of the tax-deferred savings IRAs offer. Yet, as familiar as they are, IRAs are still not completely understood. Here are 10 of the most common fictions about IRAs.

1. A minor may not open an IRA.
As noted in IRS Publication 590, all that is required to open a traditional or a Roth IRA is taxable compensation. In general, taxable compensation may be defined as income from work. While a person older than age 70 1/2 may not contribute to a traditional IRA, that person may still contribute to a Roth IRA as long as she meets required adjusted gross income limits and has the compensation from work to do so. And neither type of IRA has a minimum age limit. Thus, as long as a child has taxable compensation, that child may contribute to an IRA. And, as we point out in our Investing for Your Kids area, a child's contribution to an IRA can mean some big bucks by the time that child actually retires.

2. A stay-at-home spouse is ineligible for an IRA.
As long as the couple files a joint income tax, an IRA contribution for the stay-at-home spouse is allowed based on the working spouse's taxable compensation. Further, when made to a traditional IRA, that contribution will be fully deductible until the couple's joint adjusted gross income reaches $150,000.

3. I must make my contributions to an IRA by Dec. 31 every year.
While for most folks the tax-year may end on Dec. 31, the IRS actually allows an IRA contribution to be made as late as the date you must file your income tax return for that year without an extension of filing time. That means you have until April 15, 2002, to make an IRA contribution for tax-year 2001.

4. If I take money from my traditional IRA before age 59 1/2, I must always pay an early withdrawal penalty.
As outlined in our IRA area, there are eight exceptions that allow penalty-free withdrawals from an IRA before age 59 1/2. Of particular interest to early retirees are the life expectancy methods, which may begin at any age. While early withdrawals from a traditional IRA will always be subject to ordinary income taxes, qualified withdrawals from a Roth will not.

5. Pre-tax and after-tax contributions to a traditional IRA should not be made to the same account.
When money is taken from traditional IRAs to which both pre-tax and after-tax contributions have been made, part of any distribution will be taxed and part won't regardless of which IRA is used for the withdrawal. In determining those amounts, the IRS requires that all traditional IRAs be treated as one common IRA for making the appropriate computations for the taxable and untaxed portions of the distribution. These procedures are outlined in IRS Publication 590. For this reason, there is no need to maintain separate IRAs for deductible and nondeductible contributions to a traditional IRA.

6. On reaching age 70 1/2, a minimum required distribution (MRD) must be taken annually from each traditional IRA you own.
It's true an MRD must be computed for each traditional IRA owned by someone who is age 70 1/2 or older; however, the MRD for each of those multiple IRAs may be totaled, and that total may then be taken from any one or more of the IRAs.

7. Because I earn more than $160,000 per year and participate in a retirement plan at work, I may not contribute to an IRA.
It's true that anyone with that kind of job income will be ineligible to contribute to a Roth IRA. But as long as that person remains under age 70 1/2, a nondeductible contribution may always be made to a traditional IRA regardless of the amount of the worker's income or participation in an employer's retirement plan.

8. I rolled over an IRA to a new broker two months ago, so I can't move that money again for at least a year or I will be taxed and penalized.
That's true only if you are receiving the money from the IRA in the form of a check. You may, though, arrange for a direct transfer from one IRA custodian to another as often as you want without running afoul of the once-a-year rollover rule. As long as the money flows directly from one agency to another, that transfer will trigger no income taxes or penalties regardless of how often the transfers occur. To learn more about the difference between a transfer and a rollover, read this article.

9. Anyone other than a spouse who inherits an IRA must take all the money out of that IRA after the owner's death (and pay income taxes on a withdrawal from an inherited traditional IRA).
That's entirely up to the IRA provider as specified in the IRA agreement. The law permits someone other than a spouse who inherits an IRA to take minimum required distributions (MRD) from that IRA over the heir's lifetime provided the distributions start by Dec. 31 of the year following the year of death. Lifetime distributions may significantly reduce any applicable income tax burden on heirs while enhancing the potential for further future growth. Otherwise, all the assets in the account must be withdrawn by the fifth year after the original owner's death.

10. Once MRDs begin, either for those attaining age 70 1/2 or for those who inherit an IRA, the required amount for the year must be taken, and that amount cannot be increased or decreased.
The MRD specifies a minimum amount of the withdrawal only. Take less than that amount, and you incur a penalty of 50% on the amount that should have been withdrawn. However, more than the MRD amount may always be taken without penalty.

If that doesn't clear things up, and you feel like you need to talk to a real, live person about your retirement plan, check out TMF Money Advisor.

See you next week. In the interim and as always, post away on the Retirement Investing or the Retired Fools boards.

Best to all...Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. The countdown to his third retirement now stands at five more columns and 39 days. Maybe he'll get it right this time.