Posted by Fletcher Accounting and Tax Service Inc.

IRA Terms Explained

IRA Terms Explained

If you already have an IRA, or you are thinking of opening one, pat yourself on the back. An IRA is an excellent resource for retirement, which offers the benefits of capital savings and tax increases through accumulation. But the language of finance at times complicates simple concepts.

First, we describe the two main terms of the IRA: the traditional IRA and the Roth IRA, before addressing the other concepts.

Traditional IRA: Depending on your earnings, you may be able to deduct contributions to traditional IRAs. You can still give to a traditional IRA if your earnings are too high, but your contribution will not be deductible. When the time comes to remove money from a traditional IRA, you only pay taxes on amounts that have not been taxed yet.

Roth IRA: Unlike a conventional IRA, you can never deduct contributions to a Roth IRA. Also, if your earnings exceed certain limits, you will not be able to contribute to a Roth. The Roth IRA accounts have a unique rule, called the five-year rule, which states that your contributions must be in your account for five years before you can withdraw income tax and penalty-free. Also, you must be at least 59 years of age to withdraw income tax and penalty-tax.

Additional IRA Terminology

Money going in, money going out. What is deductible and taxable for the IRA? And what about the transfer of funds from one type of account to another? We will answer these questions in our explanation of the IAR terminology below.

IRA Terms: money entered or removed from your account

Contribution: This is the money you deposit in an IRA account. There are annual limits to the amounts you can contribute to IRA accounts. The limits are the same for traditional accounts and Roth IRAs.

For 2019, contributions are limited to the smallest of these:

  • Your remuneration (salary and net income from self-employment)
  • $ 6,000 (or $ 7,000 if 50 and over)

Deductible Contribution: The deductible means that it is possible to deduct the return contribution. Any deductible contribution reduces taxable income. Deductible contributions are always fully taxed at the time of the distribution. Deductible IRA contributions apply only to traditional IRAs and not to Roth IRAs; therefore, you may hear the term "deductible IRA" used to describe a traditional IRA.

Non-deductible contribution: A non-deductible contribution does not affect the taxes of the year in which you contribute, provided it is not an excess contribution. Non-deductible contributions are made with after-tax funds. Therefore, when you make a distribution, the initial amount of the contribution will not be taxed.

Distribution: This is the money you withdraw from an IRA account. Another terminology of the IRA that you can hear is "withdrawal." This includes any value converted or rolled over. You will receive a 1099-R certificate from the IRA custodian (the financial institution to which the money belongs) that indicates this amount. 

IRA Terms: Transfer money from one type of account to another

Conversion: This means in particular that we go from a traditional IRA to a Roth IRA. When you contribute to a traditional IRA, you have the option to transfer your contributions to a Roth IRA. You can do it if your income is too high to contribute directly to a Roth IRA. This is sometimes called the IRA backdoor.

If your traditional IRA is a deductible IRA, the conversion will be taxable. If it is a non-deductible IRA (no deduction has been made), converted contributions aren't taxed. However, any converted earnings will be taxed.

Re-characterization: Modification of conversion fees from a traditional IRA to a Roth IRA contribution (or vice versa). If you re-characterize a conversion contribution, the IRS treats it as if you had made the initial contribution in the latest version of the IRA. Under the 2017 Income Tax Reduction and Reduction Act, it is not possible to re-characterize a conversion from a Roth IRA to a traditional IRA from January 1, 2018, to December 31, 2025.

Rollover: This is the tax-free transfer of funds from one pension plan to another. For example, if you leave a job, you can withdraw money from 401(k) and deposit it into an IRA. It's like you're doing distribution and a contribution at the same time.

There are two ways to transfer money from the pension plan:

  • A transfer may be a direct transfer from the custodian of one plan to the custodian of the other, usually by Electronic Funds Transfer (EFT). The first custodian can also send a check to another to make the transfer.
  • You can withdraw funds from the previous plan by check or with an EFT to one of your bank accounts. You must deposit the money in the new plan within a window of 60 days.

The second method, also called indirect reinvestment, has drawbacks. The tax is likely to be subject to a withholding tax of 20%. Therefore, to make this a tax-free rollover, you must deposit 80% of the remaining funds, as well as an amount of equity sufficient to offset the amount withheld. If you deposit only 80%, a 20% withholding tax will apply. If you are under 59, an additional penalty of 10% will be used for early withdrawal.

You can make a rollover back to the same IRA account from which you withdraw funds.

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