How Much Do You Know About IRAs?

Many people seem unaware how useful IRAs can be as savings vehicles

Make no mistake about it: The IRA is America's savings vehicle of choice. In 2007, assets in such accounts totaled $4.75 trillion, more than any other type of retirement account, according to an Employee Benefit Research Institute study published Wednesday.

That's the good news.

The bad news is that most Americans still don't have a clue about IRAs, even though they've been available for more than 25 years. Most Americans -- even those who don't have access to a 401(k) plan at work -- don't contribute to an IRA.

Just 10% of eligible taxpayers contributed to IRAs each year from 2000 to 2004, according to EBRI. And much of the growth in IRAs comes from rollovers (when a worker leaves his employer and transfers his 401(k) to an IRA) rather than new contributions.

So, it would appear that Americans still have much to learn about IRAs. Here are the best features - and least-known facts -- about IRAs, according to the experts:

The Nondeductible IRA

Here's one fact many people don't realize: Everyone under the age of 70-1/2 who either has earned income or is married to someone with earned income is eligible to contribute to a traditional IRA, said Barry Picker, author of "Barry Picker's Guide to Retirement Distribution Planning" and a principal with Picker, Weinberg & Auerbach, CPAs.

"Too many people confuse inability to deduct the contribution with the perceived inability to make a contribution," he said.

There are several kinds of IRAs, including traditional, Roth and SEP. And there are two kinds of traditional IRAs: deductible and nondeductible. Taxpayers whose adjusted gross income is above certain thresholds and who have an employer-sponsored retirement plan typically can't deduct their contribution to an IRA.

"For traditional IRAs, the income limits only affect whether your contribution is deductible," said Michael Kitces, editor of the Kitces Report. "There is no upper limit on income that would prevent you from being able to make at least a nondeductible contribution to an IRA, as long as you have the minimum amount of earned income."

To be sure, nondeductible IRAs have some disadvantages. There's paperwork. Nondeductible IRA owners have to file Form 8606 every year with their tax return. And there's a bit of tax work required come distribution time. Owners of nondeductible IRAs must calculate the taxable vs. the nontaxable portion of their distributions when that time comes. Plus, there's some number crunching required. One should examine whether investing in certain securities (those that produce capital gains) inside a taxable account is better at building after-tax wealth than a non-deductible IRA.

Still, those costs don't seem to outweigh one of the chief benefits of any type of IRA. And that, according to Kitces, is the power of tax-deferred compounding over long periods of time.

Read IRS Publication 590 for the rules regarding nondeductible IRAs. Of note, those who save for retirement using a nondeductible IRA will have to file Form 8606 with their tax return each year. See Publication 590 on IRS site. See Form 8806.

Tapping IRAs

Many IRA owners assume they have to wait a long time until they can get at the money in their IRA. Not so, say Kitces.

One can start taking money out of IRAs before age 59-1/2 by using the substantially equal periodic payments (SEPP) rules or what some call the 72(t) rules. It's complicated, but IRA owners can withdraw a fixed amount of money for a minimum of five years or to age 59-1/2, whichever comes last. Owners have to pay ordinary income tax on the distribution, but they don't have to pay the early distribution penalty. Learn more about SEPP rules here.

Also, Kitces says, few Americans are aware of their ability to tap IRAs without penalty for medical and educational expenses. Yes, such distribution are only allowed under certain conditions (when medical expenses exceed 7.5% of adjusted gross income, for instance), but many savers are not aware it's even an option, he said.

Beneficiary Form Problems

For those that already own (or may soon own) an IRA, Beverly DeVeny, an IRA technical consultant with Ed Slott & Company, says beneficiary form problems rank high on her list of least-known facts. The beneficiary form details who will receive the IRA when the account owner dies. In many cases, account owners fail to change the names of their beneficiaries after a divorce, death or birth.

"Just make sure there is a form on file and that it names the beneficiary that you want to inherit the account," she said. "Without a form, the account will likely go to your estate and be taxable." Or, the account could go to an ex-spouse or some other unintended person. Also, she suggested IRA owners need to look at the distribution options that will be available to their beneficiaries and make sure that they offer the flexibility that they want for their beneficiaries.

Rollover Problems

Also, DeVeny said, IRA account owners need to follow-up diligently on any transfers they make to be sure they get into the correct accounts. "Don't rely on anyone else to do this for you," she said. Likewise, IRA account owners need to be sure that rollovers are back into an IRA account within the 60-day timeframe. And finally, they need to know that they can do only one rollover every 365 days per IRA. Although the same IRA can receive more than one rollover, once it has received a rollover it cannot then distribute funds for rollover until the 365 days have passed.

Inherited IRAs

Beneficiaries need to know that the name of the decedent must always remain in the title of an inherited account and that the funds can move only in a trustee-to-trustee transfer, DeVeny said. "It is important for beneficiaries to know this because too many advisers and companies do not know it," she said. A distribution paid to the beneficiary or transferred into an account in the beneficiary's name is taxable to the beneficiary and there is no way to undo the transaction, she said.

Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.