Tax Advantages of Saving in an IRA
Saving in an Individual Retirement Account (IRA) may provide significant tax advantages, depending on your personal situation. Assets saved within an IRA typically won’t be taxed until withdrawals are taken out from it, giving you time to accumulate tax-deferred wealth before any withdrawals need to be taxed as required by law.
Utilize code 1 when making distributions from traditional or SIMPLE IRAs where an individual has not met either the five-year waiting period requirement, or is eligible for one of the penalty tax exceptions.
Fair Market Value (FMV)
Fair Market Value (FMV) refers to the price an asset would sell for in an open and competitive market. When it comes to traditional investments like mutual funds and stocks, IRA custodians can easily determine their fair market values annually; for more complex assets like real estate or promissory notes held within self-directed IRAs however, third party valuation services may need to be utilized.
FMV valuation is particularly relevant if your IRA contains investments with no readily available FMV, such as private equity, mortgage notes or any other investment opportunity that requires extensive market analysis or opinion letter from an outside expert. FMVs are also essential when taking required minimum distributions (RMDs), since your FMV is used to determine what RMD amount to take each year; accurate valuations each year is therefore vital.
Traditional and Roth Individual Retirement Accounts provide tax incentives to encourage people to save for retirement by deducting contributions while Roth IRA contributions are after tax. But some contributions might not qualify as tax deductible; when withdrawing or converting such an account, any nondeductible funds must pay taxes, so it’s vital to track cost basis and file Form 8606 when conducting transactions involving an IRA account.
The IRS mandates that distributions from Traditional, SIMPLE IRAs (and certain Qualified Reservist Plans) include both pretax and posttax assets – also known as the ‘step-up in basis’ rule – so as not to incur unexpected tax bills from beneficiaries without adequate records or previous Form 8606 filings. Without this filing history and documentation in place, beneficiaries could face an unexpectedly large tax bill upon withdrawal of funds.
Required Minimum Distributions (RMDs)
As you near retirement age, the IRS mandates that you withdraw at least an annual minimum amount from tax-deferred retirement accounts as RMDs or Required Minimum Distributions.
The RMD calculation takes into account your year-end balance across eligible IRAs and employer plans and divides it by an age factor from the IRS Uniform Lifetime Table found in Appendix B of IRS Publication 590.
Use code S if making an early distribution from a SIMPLE IRA that does not meet any penalty tax exceptions and are under age 59 1/2, such as when rolling over Roth assets into non-Roth accounts or performing same year recharacterizations (recharacterization from Traditional to Roth and vice versa). Use N when performing same year recharacterizations from Traditional or Roth accounts into same type IRA (same year). Please do not combine N with codes 1, 2, 4, 8 or P for same year recharacterizations!
If your IRA invests in businesses that generate an income stream, you may owe unrelated business income tax (UBIT). Congress added this rule to the IRS code in 1950 to prevent charities and later IRAs from acting like full-fledged businesses and giving themselves an unfair edge over taxpaying competitors.
When IRAs receive unearned business income (UBTI), they must report it to the IRS using Form 990-T and pay taxes at trust rates, which are higher than individual tax rates. As you would expect, passive income such as interest, dividends and rent are not subject to UBTI; however if outside money – such as from nonrecourse loans – is used to leverage an investment purchase such as renting property, then any debt-financed profits and proceeds are taxed accordingly; over time this percentage of total profits will diminish and become less taxed over time.
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