What is an Individual Retirement Account (IRA)?

Individual retirement accounts (IRAs) are domestic trusts or custodial accounts that are established by an employee or self-employed person and to which contributions are made and deducted subject to certain restrictions. The three general types of IRAs that are available to an individual are:

• deductible IRAs,

• nondeductible IRAs, and

• Roth IRAs.

Deductibility. For 2009, an individual's contribution to an IRA may not exceed $5,000 per year, or, if less, 100 percent of compensation. Those who are 50 and over can contribute an additional $1,000. The ability to make deductible contributions is subject to income phase-out limits, which are indexed for inflation. However, unlike ordinary IRAs, Roth IRAs are funded with after-tax contributions and therefore are not tax deductible.

Tax upon distribution. Generally, amounts in an ordinary IRA are taxed upon distribution. However, with Roth IRAs, qualified distributions are not included in the individual's gross income upon distribution. To be a qualified distribution from a Roth IRA, the distribution must satisfy a five-year holding period and must meet several requirements.

Can an ordinary IRA be converted to a Roth IRA? Yes, an amount in a traditional IRA may be converted to a Roth IRA if two conditions are satisfied:

1. The modified AGI of the IRA owner may not exceed $100,000 for a taxable year. If married, a joint return must be filed and the couple's combined income is subject to the $100,000 AGI limit.

2. The amount contributed to the Roth IRA must satisfy the definition of a qualified rollover.

In this case, the 10-percent early withdrawal tax does not apply.

For taxable years beginning after December 31, 2009, all taxpayers, regardless of income, may convert their traditional IRAs to Roth IRAs (Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222, May 17, 2006, 120 Stat. 345). Taxpayers who convert their IRAs in 2010 would have two years to pay the resulting tax; taxpayers who convert their IRAs in 2011 and beyond would have one year to pay the resulting tax.

Can amounts from other retirement plans be converted to a Roth IRA?

Amounts in another IRA can be converted to a Roth IRA. Also, effective for distributions after December 31, 2007, amounts from a qualified retirement plan, tax-sheltered annuity, or 457 plan may be directly rolled over to a Roth IRA (Code Sec. 408A(e), as amended by the Pension Protection Act of 2006). The transaction is treated as a Roth conversion if all other conversion qualifications (e.g., income below the $100,000 level before 2010) are met.

Military personnel. Members of the armed forces serving in Iraq, Afghanistan and other combat-designated localities may count tax-free combat pay as earned income in determining the contribution amount to a traditional or Roth IRA beginning in 2004 . The Heroes Earned Retirement Opportunities (HERO ) Act (P.L. 109-27), signed into law by President Bush on May 29, 2006, allows tax-free combat pay to be included as earned income for determining the contribution amount for traditional and Roth IRAs. Prior to this change, a military member whose earnings consisted only of tax-free combat pay was barred from contributing to either type of IRA.

Employer involvement. Ordinarily, an individual establishes his or her own IRA with a bank, savings and loan, brokerage firm, or insurance company. However, employers (including self-employed persons, labor unions, and other employee associations) can establish IRAs for the exclusive benefit of their employees or members and their beneficiaries. These sponsors can also establish IRAs for the nonemployed spouse of an employee or member.

Payroll deduction. Rather than sponsoring IRAs, employers may instead set up a payroll deduction IRA program for their employees. In this situation, an employer collects employee IRA contributions by deducting amounts from paychecks of participating employees and by transferring withheld funds to the IRA sponsor.

A payroll-deduction IRA is not considered a pension plan subject to ERISA as long as the employer does not endorse the program. The employer will not be considered to have endorsed the program and will be free of ERISA responsibilities if all of the following conditions are met:

1. Materials distributed to the employees, either by the employer or by the IRA sponsor, clearly say that:

   • The program is completely voluntary;

   • The employer is not endorsing the sponsor or its investment program;

   • There are other IRA investments available to employees outside the payroll-deduction program;

   • An IRA may not be appropriate for everyone; and

   • The tax consequences are the same whether or not payroll deductions are used to make the IRA contributions.

2. The employer is not the IRA sponsor or an affiliate of the sponsor.

3. No significant investments will be made in securities of the employer.

4. If the payroll-deduction IRA is the result of a collective bargaining agreement, no investments designed to provide more jobs, loans or similar direct benefits to union members are permitted.

In addition, the employer must promptly transfer the funds it deducts from its employees' paychecks to the IRA sponsor or it risks the imposition of some ERISA responsibilities.

SIMPLE plan. Employers with 100 or fewer employees who received at least $5,000 in compensation from the employer in the preceding year may adopt a Savings Incentive Match Plan for Employees (SIMPLE plan), if they do not currently maintain another qualified plan [see ¶47,720 ].