Skip Lovette, CPA
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You might be able to muddle through retirement without knowing each and every line of Uncle Sam's tax code. But you'll likely give the federal government more than its fair share of your nest egg if you don't know some simple tips.
If a person engages in what's called a prohibited transaction with his or her IRA, it may no longer qualify for tax benefits. And no one, perhaps save the U.S. Treasury Department, wants that to happen. People to understand what is a prohibited transaction.
Besides prohibited transactions, here are some facts:
• When are funds in an IRA taxed?
Funds accumulated in a traditional IRA generally are not taxable as ordinary income until they actually are distributed. Funds accumulated in a Roth IRA may or may not be taxable on distribution, depending on whether they've meet certain requirements including the five-year waiting rule, he says.
• How are earnings on a traditional IRA taxed?
An IRA offers tax-free build up on contributions. The earnings on a traditional IRA are tax-deferred to the owner; that is, they are not taxed until the owner begins receiving distributions. Of note: IRAs are subject to taxes for what's called unrelated business income.
• What is compensation for purposes of IRA eligibility rules and deduction limits?
Compensation, for purposes of the eligibility rules and deduction limits that apply to IRAs, means wages, salary, professional fees, or other amounts derived from, or received for, personal services actually rendered. "Compensation" also includes alimony paid under a divorce or separation agreement that is includable in the income of the recipient under IRC Section 71. For those who are self-employed, "compensation" includes earned income from personal services, but in computing the maximum IRA or SEP contribution, such income must be reduced by: Any qualified retirement plan contributions made by such individual on his or her own behalf
2) The 50% of self-employment taxes deductible by the individual.
• Are fees or commissions paid in connection with an IRA deductible?
The IRS has ruled that the payment of administrative or trustee fees incurred in connection with an IRA may be claimed as a miscellaneous itemized deduction if such fees are separately billed and paid.
If separately billed and paid, the payment of such fees does not constitute a contribution to the IRA and thus will not be an excess contribution or reduce the amount that may be contributed to the account or, in the case of a traditional IRA, deducted. Deduction of administrative fees is subject to the 2% floor on miscellaneous itemized deductions.
• Is interest paid on amounts borrowed to fund an IRA deductible?
The IRS has ruled that interest paid on amounts borrowed to fund an IRA is not designated as tax-exempt income. The deduction of such interest is not subject to the general prohibition against deducting interest incurred or carried to purchase tax-exempts. Because such interest is 'on amounts borrowed to buy or carry property held for investment,' it would seem that it should be classified as 'investment interest expense' and the deduction limited.
• What is the penalty for making excessive contributions to an IRA?
If contributions are made in excess of the maximum contribution limit for traditional IRAs or Roth IRAs, the contributing individual is liable for a nondeductible excise tax of 6% of the amount of the excess. But it's not to exceed 6% of the value of the account or annuity, determined as of the close of the tax year. Note that a contribution by a person ineligible to make the contribution is considered an excess contribution even if it is made through inadvertence.
• When can IRA contributions be withdrawn or reduced?
Any IRA contribution may be withdrawn, together with the net income attributable to such contribution, on or before the due date for filing the federal income tax return of the contributing individual and the amount will be treated as if never contributed, regardless of the size of the contribution. Such a distribution is not included in gross income and is not subject to the 10% early distribution excise tax. A distribution of an excess contribution also is not subject to the 6% excess contribution excise tax.
The accompanying distribution of the net income, however, is includable in income and is subject to penalty as an early distribution. Net income attributable to a contribution is determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution, Net income may be a negative amount.
• How are amounts distributed from a traditional IRA taxed?
Distributions from a traditional IRA generally are taxed under Internal Revenue Code Section 72, according to Byrnes. And under these rules, he says a portion of the distribution may be excluded from income. "The amount excludable from the taxpayer's income for a year is that portion of the distribution that bears the same ratio to the amount received as the taxpayer's investment in the contract, that is, nondeductible contributions, bears to the expected return under the contract," he says. "In no case will the total amount excluded exceed the unrecovered investment in the contract."
• How are amounts distributed from a Roth IRA taxed?
Where a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, however, traditional IRAs are not aggregated with Roth IRAs. But all Roth IRAs are aggregated with each other. Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second in order if there has been more than one conversion. Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules continue to treat earnings as being withdrawn after contributions.
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