Individual Retirement Accounts (IRA) are one of the few instruments allowed by the Puerto Rico Internal Revenue Code that provide a tax benefit to individuals.
In addition, it is an excellent vehicle to create a retirement fund. What is the taxable benefit? The benefit is to take a deduction in the income tax return for every dollar of contribution made to an IRA account.
But in addition, both, the contribution and the account growth, are deferred from the income tax payment until you request a distribution of the funds. Therefore, appropriate planning with respect to the use of IRAs consists of depositing contributions while you are in the production stage and expecting to request distributions from the account when you are in the retirement stage. The reason behind this strategy is that your tax rate should be lower when you are not working and receiving income for which you paid contribution at a lower tax rate.
Let us explain this with a simple example: A taxpayer works as an employee for a private company and at the time of preparing their income tax return for the taxable year 2018, resulted with a taxable income of $42,000, which means that their income will be taxed at an effective rate of 25% according to the tables used for the calculation of the corresponding tax contribution. They decided to consult a CPA for advice regarding options to reduce the tax obligation.
The CPA very wisely indicated to the taxpayer that one option is to open and deposit funds into an IRA and at the same time they will be creating a retirement savings for themselves rather than pay taxes to the Treasury Department.
The taxpayer requested the CPA to explain how this works and what they would be savings in taxes. The CPA explained that by contributing to an IRA account, you can get a triple benefit which consists of the following:
1) You will be taking a deduction in the income tax return for every dollar that is contributed to the account which will reduce your tax obligation. To give you an example, if you deposit $5,000 into your account, which is the maximum allowed by the code, you can take a deduction in your income tax return for the same amount ($5,000) which means a saving in taxes of $1,250 (computed based on the deposit of $5,000 multiplied by the effective tax rate of 25%, previously determined).
But, more significant still, is the effect that this contribution will have on the taxpayer’s effective tax rate, as $5,000 deposit to the IRA will reduce the taxable income to $37,000 because the effective tax rate will be reduced to 14% rather than 25%, according with the tax contribution tables. Anyone with a clear mind would prefer to pay a 14% tax contribution rather than 25%. This exercise is extremely important and is more effective when computing the income tax obligation for a taxpayer who is very close to the margin of a lower tax rate.
2) Both, the contribution and the growth of the account are tax deferred until the funds are received, which generally occurs at a retirement age when your tax rate should be less.
3) Depositing the funds in an account that, if well managed and kept growing with subsequent contributions, should provide you with peace of mind when you retire.
The Code stipulates that both the amount contributed to the IRA account and corresponding growth, as result of the interests or dividends paid to the account, must be taxed as ordinary income in the year in which distributions are received.
Therefore, if you withdrew funds from your IRA account during the taxable year 2018, you should receive an informative return (Form 480.7) with the breakdown of the distribution made by the financial institution in which you had the account.
Remember that you had already taken a deduction in your income tax return for the amount contributed to the IRA account, for the taxable year that actually made the deposit obtaining a tax benefit by such deduction, as previously explained. Similarly, interest or growth on the account through the years that remained within the account were not declared as income and therefore, they are taxable when you withdraw funds from the IRA account.
Something very important to keep in mind for this year’s tax return is if you requested a distribution from your IRA account to cover expenses incurred or damages suffered by the passage of Hurricane María, the first $10,000 received for this concept shall be exempt from income tax payment.
To be eligible for this unique benefit, you must have been a resident of Puerto Rico at the time of requesting the distribution of funds and should have continued to be a resident until the end of the taxable year 2018, and should have presented an affidavit requesting the distribution of the account.
For those taxpayers who requested more than $10,000, the excess over that amount may be taxed at a special tax rate of 10% up to the amount of $100,000 received under these special circumstances. These distributions from IRA accounts due to the passage of Hurricane María, were not subject to the penalty of 10% imposed by the code due to distributions before retirement age (60 years).
Therefore, we suggest to carefully verify the informative return (Form 480.7) that you received from your financial institution so that you properly report these distributions related to your IRA aounts for 2018 taxable year.
If you have doubts on your income tax return, consult your certified public accountant, before taking any decision. For more details you may visit the “tax orientation” section on our website.