11.2 IRAs, Roth IRAs, and Required Minimum Distributions

Individual Retirement Arrangements (IRAs)

An Individual Retirement Arrangement (IRA) is a personal, employer-independent retirement account. Anyone with earned income (wages, salary, self-employment income — not interest, dividends, or rental income) may contribute. The exam focuses on two flavors: the Traditional IRA and the Roth IRA.

The core contrast is when you get the tax break. A Traditional IRA may be deductible going in and is taxed coming out. A Roth IRA is funded with after-tax dollars going in and comes out tax-free when rules are met.

Traditional vs. Roth at a Glance

Exam trap: there is no income limit to contribute to a Traditional IRA, but high earners covered by a workplace plan may lose the deduction. Roth IRAs flip this — the income limit applies to the ability to contribute at all.

Contribution Mechanics and Penalties

• A single annual dollar limit applies across all of a person's IRAs combined — you cannot contribute the maximum to both a Traditional and a Roth.
• A catch-up contribution is allowed for those age 50 and older.
• Excess contributions are penalized 6% per year until corrected.
• Early distributions before age 59½ generally trigger a 10% penalty plus ordinary income tax on the taxable portion.

Exceptions to the 10% early-withdrawal penalty (still taxable, but penalty waived) include death, total disability, qualified first-home purchase (up to $10,000), qualified higher-education expenses, and medical expenses above the deductible threshold.

Required Minimum Distributions (RMDs)

A Required Minimum Distribution (RMD) is the amount a Traditional IRA owner must withdraw each year starting at age 73 (the required beginning date is April 1 of the year after turning 73). RMDs force the deferred tax to finally be paid. Roth IRAs have no RMDs while the owner is alive.

The annual RMD is computed by dividing the prior-year-end account balance by an IRS life-expectancy factor:

RMD = Prior-year-end balance ÷ Life-expectancy factor

Worked example: George's Traditional IRA was worth $500,000 on December 31 and his IRS factor is 25.0. His RMD is $500,000 ÷ 25.0 = $20,000 for the year.

The RMD Excess-Accumulation Penalty

If an owner fails to take the full RMD, the IRS imposes an excess accumulation penalty of 25% of the amount that should have been withdrawn (reduced to 10% if corrected promptly within the allowed window).

Scenario: Helen's calculated RMD was $20,000 but she withdrew only $12,000. The shortfall is $8,000. At the 25% rate the penalty is $8,000 × 0.25 = $2,000. Note the penalty is on the shortfall, not the whole RMD — a frequent distractor on the exam offers 25% of $20,000 ($5,000), which is wrong.

Rollovers and Transfers

Money can move between retirement accounts without triggering tax if it is handled correctly. A direct transfer (trustee-to-trustee) moves funds straight from one custodian to another and is the safest method — the owner never touches the money and there is no withholding.

An indirect (60-day) rollover pays the owner first; the owner then has 60 days to redeposit the full amount into another qualified account. Two traps appear constantly: (1) only one indirect IRA rollover is allowed per 12 months, and (2) if the owner misses the 60-day window, the distribution becomes fully taxable and, if under 59½, also incurs the 10% penalty. Direct transfers have no such limits.

Roth Conversions and the Saver's Logic

An owner may convert a Traditional IRA to a Roth IRA by paying ordinary income tax on the converted amount now, in exchange for tax-free qualified withdrawals later. Conversions are popular when the owner expects to be in a higher tax bracket in retirement, because the tax bill is settled at today's lower rate.

The broad exam principle ties this section together: a Traditional IRA bets that your retirement tax rate will be lower than today's, while a Roth bets it will be higher. The same logic explains why Roth accounts have no lifetime RMDs — the government has already collected its tax, so it does not need to force withdrawals to capture revenue.

Funding Limits, Spousal IRAs, and Beneficiaries

A few extra mechanics round out IRA questions. A nonworking spouse may fund a spousal IRA based on the working spouse's earned income, provided the couple files a joint return — a tested exception to the earned-income rule. The total contribution to both spouses' IRAs still cannot exceed the family's earned income.

At death, an IRA passes to the named beneficiary outside the will. A surviving spouse beneficiary may roll the account into their own IRA and defer RMDs, while most non-spouse beneficiaries must empty an inherited IRA within 10 years. Naming a beneficiary matters: without one, the account may default to the estate and lose the stretch advantages, a common exam trap that turns a tax-efficient transfer into a lump-sum taxable event.