- Retirement planning using IRAs and its tax benefits
CPA Francisco Luis
Even though our island is facing a severe economic recession that has lasted more than 10 years, and priorities could have changed after the passage of hurricanes Irma and María last year, we can’t procrastinate our responsibility to properly plan for our individual future.
Various strategies may assist in this process. For example, some employers may provide retirement plans to their employees and also self-employed individuals may also use the so called “Keogh” retirement plans.
The goal should be to defer taxation in years when earnings are being taxed at higher tax brackets than those that should apply in the retirement stage.
This is one of the main reasons for the Individual Retirement Accounts (“IRAs”) continue to be one of the most useful tools for our retirement planning, an alternative available for generally any taxpayer.
However, the decision of investing in an IRA is one of no easy task. There are deductible and non-deductible IRAs, and there are different alternatives on where the funds of the IRA may be invested. To address this, the particular circumstances of the taxpayer play a crucial factor in this important decision.
As of today, the maximum amount of contribution to an IRA is $5,000, if the taxpayer is single and $10,000 in the case of married taxpayers filing jointly. The taxpayer may contribute to the IRA until age 75, as long as there is enough taxable income to absorb the allowed deduction for contributing to the IRA.
On the other hand, the taxpayer may commence withdrawing from the IRA at age 60. The taxpayer has the option of receiving the funds in a lump sum payment or in periodic annual payments. In general, withdrawals made prior to age 60 are subject to a 10 percent penalty.
Nonetheless, there are a few exceptions in which withdrawals may be allowed without the imposition of such penalty.
These exceptions are: if the funds are used for the purchase of the first residential property; for the payment of college studies for a direct dependent; for the purchase of a computer for an eligible person; to cover medical expenses related to a catastrophic disease of an immediate family member; and if the funds are to repair or reconstruct the taxpayer’s residential property affected by fire, hurricane, earthquake or fortuity cause; and in case of death, disability or unemployment.
The taxpayer will need to provide evidence of any of these circumstances to the financial institution where the IRA is invested.
Generally, any amount distributed from an IRA is taxed as ordinary income at distribution. An exception to this general rule is if the funds are used in the acquisition of the first residential property of the taxpayer in which case there is no taxation at distribution, but the tax basis of the property is reduced for the amount distributed.
Currently, as part of the disaster relief tools approved by the Puerto Rico Treasury Department, there is a window up to June 30, 2018, where the taxpayer may withdrew from the IRA without penalties and subject to a special tax rate of 10 percent.
The first $10,000 from these special distributions are exempt. There are special requirements covered in the guidance issued by the Treasury Department under the Administrative Determination #17-29 that should be carefully evaluated prior to requesting a distribution under this window.
The amount that may be included as ordinary income is the total amount of the distributed funds, reduced by any exempt income. If the distribution includes interest income from certain qualified Puerto Rico financial institutions, the taxpayer may elect to have a withholding at source of 17 percent (10 percent in the case of governmental employees). The remainder of the distribution will be taxed at the applicable ordinary income tax rates in the year of the distribution.
As mentioned before, the taxpayer has the option of opening a non-deductible IRA. The non-deductible IRA provides no deduction for the taxpayer at the moment of the contribution, but at distribution there is no taxation on the principal nor the accretion of the funds. Annual contributions to non-deductible IRAs are subject to the same limits ($5,000 single or $10,000 married filing jointly).
Contributions to IRA are required to be made on or before the due date for the tax return in which they are being made, including extensions.