How much can you deduct?
Before you read on, you should figure out your Adjusted Gross Income (AGI) if you are earning lots of money (somewhere above $50,000). The IRS website in Publication 590 (2005 edition) on page 15 shows you how to figure out your AGI.
If you are currently covered by an employer's retirement plan, your allowable deductions may be further limited. If you or your spouse are covered by an employer's retirement plan, you may be entitled to a partial deduction or no deduction. This depends on your income and filing status. First thing you need to do to figure out whether you can make deductions or no deductions is your Modified Adjusted Gross Income (your final income after all deductions are made). Don't ask me on how to get this number since I never done it before. But if you do figure out this number, determining whether your contributions are deductible or not will be easy.
- If your filing status is single or head of household, and your AGI is $50,000 or less, your contributions to the Traditional IRA is fully deductible. If your AGI is above $50,000 but less than $60,000, your contributions are partially deductible. If your AGI is $60,000 and above, then none of your contributions are deductible.
- If you are married filing a joint return or a qualified widower, and your AGI is $70,000 or less, your contributions are fully deductible. If your AGI is above $70,000 but less than $80,000, your contributions are partially deductible. If your AGI is $80,000 and above, then none of your contributions are deductible.
- If you are married filing separately and your AGI is less than $10,000, your contributions are partially deductible. If your AGI is above $10,000, none of your contributions are deductible.
If you are not covered by a retirement plan at work, then the figures on the previous paragraph changes.
- If your status is single or head of household: AGI does not matter, so your entire contributions to the annual limit are fully deductible.
- If your status is married and filing a joint return or a qualified widower: If your AGI is $150,000 or less, then your contributions are fully deductible. If your AGI is above $150,000 but less than $160,000, your contributions are partially deductible. If your AGI is above $160,000, then none of your contributions are deductible.
- If your status is married and filing separately: If your AGI is less than $10,000, your contributions are partially deductible. If your AGI is above $10,000, then your contributions are not deductible.
Rule age 70 1/2
In Traditional IRAs, the Rule Age 70 1/2 applies. This rule say you cannot make any more contributions after age 70 1/2 and must start withdrawing at least the minimum distribution requirement. It also means you can not apply for a Traditional IRA after age 70 1/2. To figure out the minimum distribution requirement, you need three things. 1) Your account balance on December 31 of the previous year. 2) Appendix C of Publication 590 (page 85-100). Find out which table best describes your filing status. For most of you, it would be Table III on page 100. 3) A calculator. Here is the formula to figure out the minimum distribution requirement: (Your account balance on Dec 31 of the previous year) DIVIDED BY (your life expectancy as stated in the appropriate Table, which is usually Table III).
Example: Lets say you become age 70 1/2 in 2006. Your ending account balance on Dec 31, 2005 was $86,000. The minimum distribution requirement is: ($86,000/27.4) = $3138.69. You may start making withdrawals when you become age 70 1/2. If you do not, you must take the minimum distribution by April 1, 2007. This date is called the "Required beginning date." Remember, this is only the mimimum. You can always take more out, but this will not affect the minimum requirement distribution.
Continuing with this example. In 2007, you are age 71. Your account balance on Dec 31, 2006 was: $83,000. The minimum distribution for 2007 is: ($83,000/26.5) = $3132.08. You must take this minimum amount by December 31, 2007 (not April 1, 2008). Failure to meet this minimum amount will result in a 50% tax on the amount you have not taken. Let's say in 2006 you only took $2000 from your Traditional IRA. Your minimum requirement is $3132.08. Since you did not meet the minimum requirement, the amount you will be taxed on is $1132.08 (3132.08 - 2000). You will owe: $566.04 in taxes. And that's as far as I will go with the Rule 70 1/2.
When you make withdrawals from your Traditional IRA, your withdrawals may be subjected to income tax. You will pay taxes on the gains, interests, dividends, and any part of your contributions you made tax-deductible. The only tax-free withdrawals you have is the contributions you didn't make tax-deductible. If you make withdrawals before age 59 1/2, you will be hit with a 10% tax. Click here to learn more about Rule 59 1/2.
Few key pointers you should remember about Traditional IRAs
1) Almost every working citizen can get it, except for people who are age 70 1/2 and above.
2) Your contributions may be fully, partially, or not deductible. This depends on your AGI, your filing status, whether you are covered by your employer's retirement plan, and whether or not you receive social security.
3) Minimum distribution requirement kicks in when you reach age 70 1/2.
4) Your withdrawals are taxable except on the contributions you didn't make tax-deductible.