What Are the Rules of Section 408 for IRAs?

Section 408 of the Internal Revenue Code provides the tax rules for Individual Retirement Arrangements, or IRAs. These regulations govern an IRA’s lifecycle, from its creation and funding to the withdrawal of assets. They are designed to encourage retirement savings through tax advantages. The code defines contribution limits and the tax treatment of funds as they grow and when distributed. Compliance with these rules is necessary to receive the associated tax benefits.

Core Types of Individual Retirement Arrangements

The most common types of IRAs are the Traditional IRA and the Roth IRA, each defined by a distinct approach to taxation. A Traditional IRA allows individuals to potentially make tax-deductible contributions, which may lower your taxable income for the year. The investments within the account grow tax-deferred, meaning you do not pay taxes on interest, dividends, or capital gains each year.

The tax liability for a Traditional IRA is incurred when funds are withdrawn. Distributions in retirement are treated as ordinary income and taxed at the individual’s current income tax rate. This structure is often favored by those who anticipate being in a lower tax bracket during retirement than in their peak earning years.

In contrast, the Roth IRA operates on an opposite tax principle. Contributions are made with after-tax dollars, meaning you do not receive an upfront tax deduction. The primary benefit emerges during retirement, as all qualified distributions from a Roth IRA are completely tax-free, provided certain conditions are met.

This tax-free treatment includes both the original contributions and all investment earnings. The Roth IRA is an attractive option for individuals who believe their tax rate will be higher in retirement or who want the certainty of tax-free income. The choice between a Traditional and Roth IRA depends on an individual’s financial situation and expectation of future tax rates.

Rules for Contributing to an IRA

Federal regulations impose limits on the amount of new money an individual can contribute to their IRAs each year. For 2025, the maximum contribution is $7,500. The rules also include a catch-up provision for individuals age 50 and over, allowing them to contribute an additional $1,000, for a total of $8,500 for the year.

The deadline for making an IRA contribution for a specific tax year is the tax filing deadline, typically April 15th of the following year. This gives individuals extra time to fund their retirement account after the calendar year has ended. When making the deposit, you must designate the specific year the contribution is for.

While anyone with earned income can contribute to a Traditional IRA, the ability to deduct those contributions depends on income and whether the individual is covered by a retirement plan at work. If not covered by a workplace plan, contributions are fully deductible regardless of income. If covered, the deductibility is phased out based on Modified Adjusted Gross Income (MAGI).

For 2025, the deduction phases out for single filers with a MAGI between $81,000 and $91,000 and for those married filing jointly between $128,000 and $148,000. Individuals who contribute to a Traditional IRA but cannot deduct it make a “non-deductible” contribution. These after-tax funds must be tracked by filing IRS Form 8606 to avoid being taxed a second time upon withdrawal.

Rules for Withdrawing from an IRA

The tax treatment of withdrawals depends on the type of IRA. For a Traditional IRA, distributions are generally included in your gross income and taxed as ordinary income. If the IRA contains both pre-tax and after-tax funds, the pro-rata rule applies, meaning any distribution will consist of a proportional mix of taxable and non-taxable money.

Distributions taken from any IRA before the owner reaches age 59½ are considered early withdrawals, subject to regular income tax plus an additional 10% tax penalty. However, the tax code provides exceptions, allowing penalty-free withdrawals for the owner’s death or disability, certain medical expenses, or a first-time home purchase up to $10,000. Individuals must file IRS Form 5329 to report the penalty or claim an exception.

For Roth IRAs, qualified distributions are entirely tax-free and penalty-free. A distribution is qualified if made after the owner is 59½ and has held any Roth IRA for at least five years. To ensure accounts are used for retirement, the government mandates Required Minimum Distributions (RMDs).

IRA owners must start taking RMDs from their Traditional IRAs beginning in the year they turn 73. The RMD amount is based on the prior year-end account balance and the owner’s life expectancy. Failing to take the full RMD results in a 25% penalty on the amount that should have been withdrawn, which is reduced to 10% if the mistake is corrected in a timely manner.

Prohibited IRA Transactions

The Internal Revenue Code forbids IRA owners from engaging in prohibited transactions to prevent misuse of the account’s tax-advantaged status. A prohibited transaction is any improper use of the IRA by the account owner, their beneficiary, or any disqualified person, such as a fiduciary or certain family members.

Specific examples of prohibited transactions include borrowing money from the IRA, selling personal property to it, or using the account as collateral for a personal loan. Buying property for personal use with IRA funds, such as a vacation home, is also prohibited. These rules prevent any self-dealing between the IRA and its owner.

The consequences of a prohibited transaction are severe. The entire IRA is treated as distributed on the first day of the tax year in which the transaction occurred, making the account’s fair market value taxable income. If the owner is under age 59½, this deemed distribution is also subject to the 10% early withdrawal penalty, effectively dissolving the IRA and its tax benefits.

Moving Funds via Rollovers and Transfers

The tax code provides methods for moving retirement funds between accounts without triggering taxes or penalties. A direct rollover, or trustee-to-trustee transfer, is the simplest method. The financial institution holding the IRA sends the funds directly to the new institution, and the account owner never takes possession of the money.

An alternative is the indirect rollover, where the financial institution distributes funds to the account owner, who then has 60 days to deposit the money into another eligible retirement plan. If the 60-day deadline is missed, the entire amount is considered a taxable distribution and may be subject to early withdrawal penalties. Direct rollovers are recommended to avoid this risk.

A regulation for indirect rollovers is the one-rollover-per-year rule. An individual can only make one IRA-to-IRA indirect rollover in any 12-month period, regardless of how many IRAs they own. This limitation does not apply to direct rollovers or conversions from a Traditional IRA to a Roth IRA.

A transfer is a distinct process from a rollover, involving moving funds between two similar types of accounts, such as from one Traditional IRA to another. In a transfer, the money moves directly between institutions without the owner receiving it. Transfers are not considered rollovers and are not subject to the one-per-year limitation.