Thursday, December 21, 2006

The other IRAs

Now that I covered what is a Traditional IRA and a Roth IRA are, lets talk about the other types of IRAs. Remember, all investments grow tax-deferred in all IRAs and the age 59 1/2 rule applies.

1) Single Employee Pension IRA (SEP IRA)
This is a Traditional IRA setup by an employer for a firm of employees. Self-employed individuals, partnerships, and sole proprietorships may setup one as well. Employers are allowed to make tax-deductible contributions to each of their employees. Employees do not pay taxes on these contributions, but will pay taxes when they withdraw money from it. Since SEP IRAs are Traditional IRAs, rules for Traditional IRAs are the same as SEP IRAs.

Employees cannot setup a SEP IRA. Instead, they must setup their own Traditional IRA in order to participate in the SEP IRA. When the employee setup a Traditional IRA, the employer will make contributions to employee's Traditional IRA. This is the definition of a SEP IRA. However, it is the employer's own discretion to contribute. So, don't expect the employer to contribute to your Traditional IRA every year. In order for the employee to participate in the plan, he/she must meet these eligibility requirements:

  • Must be at least 21 years old
  • Must earn at least $450/year
  • Has worked with the employer 3 out of 5 previous years prior to the year which contributions are being made. That means, you must worked full-time for three of the 5 previous years.

There is a limit on how much an employer can contribute to the employees. An employer can contribute up to 25% of the eligible employee's compensation, providing the contribution does not exceed $45,000 (for 2007). If the employee is at least 50 years old, he/she can receive an additional $5000. Of course, this is all up to the employer on whether to contribute or not.

2) Savings Incentive Match Plan for Employees IRA (SIMPLE IRA)
In this IRA, employers can make contribution to their employee's retirement plan and their own retirement plan. In SIMPLE IRAs, employees may choose to make a salary reduction contribution and the employer makes matching or nonelective contributions. Since contributions by employees are not taxed, any withdrawals they make will be taxed. Employers may make tax-deductions when they contribute to the plan.

Not all employers can qualify for a SIMPLE IRA. Here are the eligibilty requirements for the plan:

  • The employer employed 100 or fewer employees. All employees employed during at any time during the calendar year are counted for, regardless of whether they qualify to participate in the plan or not.
  • Participating employees must earn at least $5000 in compensation during the preceding year.
  • The employer maintains no other plans, including collective bargaining agreements (Union plans)

If the employer employs more than 100 employees in any calendar year, the employer has two years to fix the problem or they will no longer be eligible to maintain the plan.

There are two ways that an employer can contribute. One way is matching the employee's contribution dollar for dollar up to 3% of the employee's compensation. The employer must give 3% in 2 of the 5 years when the plan is maintained. That means, the employer can't be cheap and only give 1% every year. An employer can't give any matching contribution below 1%.

Here are some examples to explain that last paragraph. Cindy, Joe, and Mary worked for company XYZ in 2006. XYZ decides to take the matching contribution of 3% for that year.
Cindy earns $10,000 and puts away $2000 into the plan. XYZ matches the contribution, but can only contribute $300 (10,000 x 3%).
Joe earns $200,000 and puts away $8000 into the plan. XYZ can only contribute $6000.
Mary earns $20,000 and puts away nothing into the plan. XYZ can only contribute $0.

Second way is a 2% non-elective contribution to all eligible employees, whether or not the employees make contribution. If the employer chooses the 2% non-elective contribution, they can only do so up to a salary cap limit of $225,000 (for year 2007. This amount will be adjusted every year by the US government). This salary cap limit does not apply to matching contribution.

Either way, the employer is required to make contribution for each year the SIMPLE IRA is maintained.

For employees, their contribution limit is $10,000 for 2006, $10,500 in 2007, $11,000 in 2008. If you are age 50 and above, you can contribute an addition $2500.

3) Spouse IRA
Simply put, if you have a spouse that makes little or no money, you can setup a Traditional or a Roth IRA for him or her. If you recall the contribution limit on Traditional and Roth IRAs, you can now double that figure. For example, the contribution limit for any individual who has a Traditional or Roth IRA in 2007 is $4000. Since you have a spouse, you can contribute up to $8000. However, you can only contribute $4000 for yourself and $4000 for your spouse. You cannot put $8000 into your own IRA. If you or your spouse are over age of 50, you can contribute an additional $1000 to yourself and another $1000 to your spouse. Remember income limit applies for Roth IRA, which is currently $160,000 for married couples.

4) Rollover IRA or IRA rollover
This means you can move a qualified plan such as a 401(k) into an IRA without any penalties and taxes. It also means you can move assets from one IRA into another IRA. Currently you can only move your employer's qualified retirement plan into a Traditional IRA and rules for Traditional IRA applies. Here are the different ways to do a rollover:
1. You can move your 401(k) into a Rollover IRA and later move it into another employer's 401(k), 403(b), or 457 plans. That is, the new company you work for allows it. If you make contribution into the Rollover IRA, you cannot move it into another employer retirement plan.
2. You can move your employer's qualified retirement plan (401k, 403b, or 457) into your own IRA. There are two ways to do a rollover. One is called the "indirect rollover." This is where the company will hold 20% of your assets and give you only 80% for taxation purposes. You must make up the 20% balance or you will pay a penalty on the entire rollover. You will have 60 days to move the entire balance of your 401(k) into your IRA. When you do your taxes, you will get the 20% balance back. The other rollover is called a "direct rollover." This is where your entire 401(k) funds are transfered into your IRA.
3. You can withdraw money from your current IRA and move it into another IRA, as long as you deposit this money in the new IRA or the current IRA within 60 days. During the 60 day period, you can use the money for whatever purpose. Failure to meet the 60 day requirement will result in a 10% penalty and the entire proceed is fully taxable.

It is important to know that you can only do a rollover once every 12 months. If you do it more than once every 12 months, your entire IRA account is fully taxable and there will be a 10% penalty as well.

If you want to keep your IRA, but want to change companies, you can do that as many times as you want. This is called an IRA transfer.

5) Inherited IRA
An inherited IRA is either a Traditional or Roth IRA that is given to a designated beneficiary who is not a spouse (such as a family member). So, if you received an IRA asset of the deceased owner and you are not married to that person, you cannot roll it over to another IRA or make tax deductions. There are limited choices on how you wish to receive the proceeds. Only the spouse has the choice of taking ownership of the IRA, cashing in the proceeds, or rolling it over to his/her own IRA.