What Is A Traditional IRA?
A traditional IRA is any IRA that is not a Roth IRA or a SIMPLE IRA.
Who Can Set Up a Traditional IRA?
You can set up and make contributions to a traditional IRA if:
- You (or, if you file a joint return, your spouse) received taxable compensation during the year, and
- You were not age 70½ by the end of the year.
You can have a traditional IRA whether or not you are covered by any other retirement plan. However, you may not be able to deduct all of your contributions if you or your spouse is covered by an employer retirement plan. See How Much Can You Deduct, later.
Both spouses have compensation. If both you and your spouse have compensation and are under age 70½, each of you can set up an IRA. You cannot both participate in the same IRA.
What Is Compensation?
Generally, compensation is what you earn from working. For a summary of what compensation does and does not include, see Table 1-1. Compensation includes the items discussed next.
Wages, salaries, etc. Wages, salaries, tips, professional fees, bonuses, and other amounts you receive for providing personal services are compensation. The IRS treats as compensation any amount properly shown in box 1 (Wages, tips, other compensation) of Form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans). Scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.
Commissions. An amount you receive that is a percentage of profits or sales price is compensation.
Self-employment income. If you are self-employed (a sole proprietor or a partner), compensation is the net earnings from your trade or business (provided your personal services are a material income-producing factor) reduced by the total of:
- The deduction for contributions made on your behalf to retirement plans, and
- The deduction allowed for one-half of your self-employment taxes.
Compensation includes earnings from self-employment even if they are not subject to self-employment tax because of your religious beliefs.
When you have both self-employment income and salaries and wages, your compensation includes both amounts.
Self-employment loss. If you have a net loss from self-employment, do not subtract the loss from your salaries or wages when figuring your total compensation.
Alimony and separate maintenance. For IRA purposes, compensation includes any taxable alimony and separate maintenance payments you receive under a decree of divorce or separate maintenance.
Table 1-1. Compensation for Purposes of an IRA
| Includes ... |
Does not include ... |
| |
earnings and profits from property. |
| wages, salaries, etc. |
|
| |
interest and dividend income. |
| commissions. |
|
| |
pension or annuity income. |
| self-employment income. |
|
| |
deferred compensation. |
| alimony and separate maintenance. |
|
| |
income from certain partnerships. |
| |
|
| |
any amounts you exclude from income. |
What Is Not Compensation?
Compensation does not include any of the following items.
- Earnings and profits from property, such as rental income, interest income, and dividend income.
- Pension or annuity income.
- Deferred compensation received (compensation payments postponed from a past year).
- Income from a partnership for which you do not provide services that are a material income-producing factor.
- Any amounts you exclude from income, such as foreign earned income and housing costs.
When Can a Traditional IRA Be Set Up?
You can set up a traditional IRA at any time. However, the time for making contributions for any year is limited. See When Can Contributions Be Made, later.
How Can a Traditional IRA Be Set Up?
You can set up different kinds of IRAs with a variety of organizations. You can set up an IRA at a bank or other financial institution or with a mutual fund or life insurance company. You can also set up an IRA through your stockbroker. Any IRA must meet Internal Revenue Code requirements. The requirements for the various arrangements are discussed below.
Kinds of traditional IRAs. Your traditional IRA can be an individual retirement account or annuity. It can be part of either a simplified employee pension (SEP) or an employer or employee association trust account.
Individual Retirement Account
An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets all of the following requirements.
- The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.
- The trustee or custodian generally cannot accept contributions of more than $4,000 ($4,500 if you are age 50 or older). However, rollover contributions and employer contributions to a simplified employee pension (SEP) can be more than this amount.
- Contributions, except for rollover contributions, must be in cash. See Rollovers, later.
- You must have a nonforfeitable right to the amount at all times.
- Money in your account cannot be used to buy a life insurance policy.
- Assets in your account cannot be combined with other property, except in a common trust fund or common investment fund.
- You must start receiving distributions by April 1 of the year following the year in which you reach age 70½. See When Must You Withdraw Assets? (Required Minimum Distributions), later.
Individual Retirement Annuity
You can set up an individual retirement annuity by purchasing an annuity contract or an endowment contract from a life insurance company.
An individual retirement annuity must be issued in your name as the owner, and either you or your beneficiaries who survive you are the only ones who can receive the benefits or payments.
An individual retirement annuity must meet all the following requirements.
- Your entire interest in the contract must be nonforfeitable.
- The contract must provide that you cannot transfer any portion of it to any person other than the issuer.
- There must be flexible premiums so that if your compensation changes, your payment can also change. This provision applies to contracts issued after November 6, 1978.
- The contract must provide that contributions cannot be more than $4,000 ($4,500 if you are age 50 or older), and that you must use any refunded premiums to pay for future premiums or to buy more benefits before the end of the calendar year after the year in which you receive the refund. For 2006, contributions cannot be more than $4,000 ($5,000 if you are age 50 or older).
- Distributions must begin by April 1 of the year following the year in which you reach age 70½. See When Must You Withdraw Assets? (Required Minimum Distributions), later.
What's New for 2006
Traditional IRA contribution and deduction limit. The contribution limit to your traditional IRA for 2006 will be the smaller of the following amounts:
- $4,000, or
- Your taxable compensation for the year.
If you will be age 50 or older before 2007, the most that can be contributed to your traditional IRA for 2006 will be the smaller of the following amounts:
- $5,000, or
- Your taxable compensation for the year.
Modified AGI limit for traditional IRA contributions increased for a married couple filing a joint return. For 2006, if you are covered by a retirement plan at work, your deduction for contributions to a traditional IRA will be reduced (phased out) if your modified adjusted gross income (AGI) is:
- More than $75,000 but less than $85,000 for a married couple filing a joint return or a qualifying widow(er),
- More than $50,000 but less than $60,000 for a single individual or head of household, or
- Less than $10,000 for a married individual filing a separate return.
These articles are reprinted with the permission of the author.
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