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The Basics of IRAs
When I get asked by clients about the best tax savings options, retirement planning options are at the top of the list. In this series, I am going to break down Individual Retirement Arrangements (IRAs). These are personal savings accounts for retirement. A future post will discuss employer retirement options.
There are two different types of IRAs:
- Traditional IRAs
- Roth IRAs
Let’s start with the Traditional IRA.In a traditional IRA, the individual may receive a tax-deductible contribution when the contribution is made. But when the money is withdrawn, it’s taxed. This is called a deductible IRA. So there is a current tax deduction (benefit now), but the withdrawals are taxable. The ability to have the tax deduction depends on whether or not the individual (or their spouse) participates in an employer retirement plan. There are also income limitations (based on modified Adjusted Gross Income (AGI)).
For 2020, for single taxpayers who are covered at work, the deduction phases out for modified AGI between $65,000 – $75,000. There is no deduction if the modified AGI is greater than $75,000.
For 2020, for married filing joint taxpayers who are covered at work, the deduction phases out for modified AGI between $104,000 – $124,000. There is no deduction if the modified AGI is greater than $124,000.
For 2020, for married filing joint taxpayers who are notcovered at work, the deduction amount depends on whether or not the spouse is covered by a plan at work. If the spouse is not covered, there are no modified AGI threshold phaseouts for the deduction. If the spouse is covered at work, the deduction phases out for modified AGI between $196,000 – $206,000. There is no deduction if the modified AGI is greater than $206,000.
For individuals who exceed the income limitations, they can still contribute to a Traditional IRA, but do so as a nondeductible IRA. These individuals do not receive a current tax deduction, but also will have basis in their traditional IRA. This means that when money is withdrawn in the future, it will not all be taxed.
For an individual to qualify to contribute to a Traditional IRA, they (or their spouse) must have earned income and be under age 70 ½ at the end of the year.
Traditional IRAs have annual required minimum distributions (RMDs) once the individual turns 72. This means that they must start taking a required amount out of the account each year, based on their life expectancy. Note for 2020, all RMDs are waived. This means that taking out the RMD is optional for the year 2020, due to the COVID-19 epidemic. Additionally, when there are RMDs, keep in mind that there are some tax planning options related to these RMDs, such as donating your RMD directly to a charity.
The second IRA option is the Roth IRA. In a Roth IRA, the individual does not receive a tax deduction up front. However, when the money is withdrawn, it is not taxable (benefit later). There are income limitations based on modified Adjusted Gross Income.
For 2020, for single taxpayers, the allowed contribution to a Roth IRA phases out for modified AGI between $124,000 – $139,000.
For 2020, for married filing joint taxpayers, the allowed contribution to a Roth IRA phases out for modified AGI between $196,000 – $206,000.
For an individual to qualify to contribute to a Roth IRA, they (or their spouse) must have earned income. But, unlike the Traditional IRA, there is no age requirement to contribute to a Roth IRA.
Unlike a Traditional IRA, there are no required minimum distribution requirements for Roth IRAs. Distributions are required only after the death of the Roth IRA owner. This can make them an attractive estate planning tool as well.
The maximum amounts that can be contributed to either a Traditional IRA or a Roth IRA are the lesser of:
- $6,000 (plus an additional $1,000 if age 50 or older at the end of the year) or
Compensation includes wages, salary, bonuses, commissions, self-employment income, and certain taxable alimony payments. Compensation does NOT include investment income (interest or dividends), pensions or annuities, social security benefits, rental income, or other partnership or S-corporation income that is not subject to self-employment tax.
Additionally, spouses with little or no earned income may also qualify based on their spouse’s earned income.
Contributions must be made by the due date of the return (not including extensions). So for 2020, contributions must be made by April 15, 2021.
Note that there are penalties on excess contributions. There are also penalties on early (pre-age 59 ½ ) withdrawals that do not meet a penalty exception.
So, if you meet the income restrictions, is it better to do a Traditional IRA or a Roth IRA? The answer is “It Depends.”
As mentioned earlier, Roth IRAs can also provide an estate planning vehicle since there are no required minimum distributions. In addition, Roth IRAs can be extremely attractive to younger individuals that have much more time for the contributions to grow (ultimately tax free). If the individual’s tax rate is expected to rise over the years (i.e. they are in a much lower bracket now than they will be in when they withdrawal the money), contributing to a Roth is the way to go.
But, at a certain point, the benefit of the tax deduction in the current year may exceed the later benefit that may result from a Roth contribution. To put it another way, as an individual’s tax rate increases, it may make more sense to do a Traditional IRA contribution as opposed to a Roth IRA contribution. Either option is also subject to the income thresholds.
One final item to mention is the ability for younger individuals to contribute early to IRAs. So long as a young individual has compensation, they are eligible to contribute to an IRA. Given that most will likely be in the lower brackets (i.e. they are still students), contributing to a Roth IRA is a great savings option that will continue to benefit them in future years. Consider having your teenage children contribute to a Roth IRA, using some of their summer job income. There will be even more years for the contribution to grow tax-free, and you are instilling the retirement savings lesson in them at an early age!
Maximizing retirement contributions (whether through IRAs or employer-sponsored plans) is one of the top tax-planning strategies to consider. As with all tax advice, please consult your own tax and investment advisors for what makes sense for your specific situation.