11.2 IRAs, Roth IRAs, and Required Minimum Distributions

The Traditional Individual Retirement Account (IRA)

A Traditional Individual Retirement Account (IRA) lets an individual with earned income save for retirement with potential tax advantages. Contributions may be tax-deductible depending on income and whether the person is covered by an employer plan. Earnings grow tax-deferred, and distributions are taxed as ordinary income. The annual contribution limit is a flat dollar amount set by the IRS, with an extra catch-up contribution allowed for those age 50 and older.

Contribution Mechanics and Penalties

Key IRA rules tested heavily:

• Contributions require earned income (wages, salary, self-employment) — investment income does not count.
• A spousal IRA lets a non-working spouse contribute based on the working spouse's income on a joint return.
• Excess contributions above the limit trigger a 6% excise tax each year they remain.
• A withdrawal before age 59½ is generally hit with a 10% early-withdrawal penalty plus ordinary income tax, unless an exception applies (death, disability, first-home up to a limit, qualified higher education, certain medical costs).

The Roth IRA

A Roth IRA flips the tax timing. Contributions are made with after-tax dollars (never deductible), but qualified distributions are completely tax-free, including all earnings. A distribution is qualified if the account has been open at least five years and the owner is at least age 59½ (or meets death, disability, or first-home exceptions). Roth eligibility phases out at higher income levels.

A Crucial Roth Advantage

Unlike a Traditional IRA, a Roth IRA is not subject to required minimum distributions during the owner's lifetime. Because the owner already paid tax on contributions, the IRS does not force withdrawals to start. This lets a Roth grow tax-free indefinitely and pass to heirs efficiently — a favorite exam contrast point. Also remember: Roth contributions (not earnings) can be withdrawn at any time tax- and penalty-free because they were already taxed.

Required Minimum Distributions (RMDs)

A Required Minimum Distribution (RMD) is the minimum amount the IRS requires a Traditional IRA (and most qualified plan) owner to withdraw each year starting at age 73. The purpose is to force eventual taxation of the deferred money. The annual RMD is calculated by dividing the prior year-end account balance by a life-expectancy factor from the IRS Uniform Lifetime Table.

• Formula: RMD = Prior year-end balance ÷ life-expectancy factor
• Missing or shortchanging an RMD historically triggered a steep excise tax on the shortfall (reduced under recent law but still significant).

Worked RMD Example

Worked example: Maria turns 73 this year. Her Traditional IRA balance on December 31 of last year was $500,000. Her IRS life-expectancy factor for age 73 is 26.5.

RMD = $500,000 ÷ 26.5 = $18,868 (rounded).

Maria must withdraw at least $18,868 this year and pay ordinary income tax on it. If she withdraws only $10,000, the $8,868 shortfall is exposed to the IRS excise tax. Note: a younger owner has a larger factor, producing a smaller required percentage; the factor shrinks with age, raising the required withdrawal over time.

IRA Funding Vehicles and Prohibited Investments

An IRA is a tax structure, not an investment — it can hold bank deposits, mutual funds, securities, or an individual annuity. Producers must know the prohibited holdings: an IRA may not invest in life insurance or in most collectibles (art, antiques, gems, most coins). A frequent exam point is that funding an IRA with a fixed or variable annuity is permitted but offers no extra tax shelter, since the IRA already provides tax deferral. The contribution deadline is the tax-filing date (generally April 15) of the following year.

Rollovers vs. Transfers

Moving retirement money is tested precisely. A direct transfer (trustee-to-trustee) moves funds between custodians without the owner touching them and has no tax or frequency limit. A 60-day rollover pays the money to the owner, who must redeposit it within 60 days to avoid tax and the 10% penalty; only one such rollover per 12 months is allowed across all IRAs. If a distribution from an employer plan is paid to the employee, a mandatory 20% federal withholding applies — a reason the direct trustee-to-trustee route is usually preferred.