When it comes to financial advice, investing in an IRA is often recommended but rarely understood. We’re going to solve that problem today by exploring two of the most common IRA’s: a Traditional IRA and a Roth IRA. We’ll delve into what the benefits of each are, their respective rules, and what can and cannot be done in them. By the end of this article, I hope you’ll have a better understanding of what an IRA is. After reading, if you feel an IRA might be right for you, I’ll invite you to reach out and we can get you started down the right path. So let’s get started by answering the most common question: What is an IRA?
What is an IRA?
An IRA, or Individual Retirement Account, is a type of investment account that allows individuals to save money for retirement in a tax-advantaged way. There are several different types of IRAs, but the two most common are the Traditional IRA and the Roth IRA.
What is a Traditional IRA?
The Traditional IRA was created by the Employee Retirement Income Security Act (ERISA) of 1974 as a way to provide individuals with a tax-advantaged savings vehicle for retirement. Prior to the creation of the Traditional IRA, most retirement savings plans were only available through an employer.
The main advantage of the Traditional IRA is the tax deductibility of contributions. When you contribute, the amount is excluded from your income for the contribution tax year. The income tax is deferred on these contributions until you decide to take it out of the IRA. When you do take it out, it will be added to the taxable income in the year of the distribution.
This tax deferment can allow for a greater growth rate over the deferment period, as you have more capital to invest with. Additionally, if the taxpayer’s effective tax rate is lower in the distribution year than in the contribution year, this can lead to tax savings.
Can I contribute to a Traditional IRA?
Everyone can contribute. However, not everyone is eligible for the tax deductibility of those contributions. The deduction phases out for certain high AGI levels. These levels are based on the taxpayer’s filing status and whether they (or their spouse) were covered under a workplace plan at any point during the year or not. These values also change from year to year.
If you make a contribution that is not tax deductible, you will file Form 8606 to keep track of the contributions that you’ve already paid income tax on. Since you have already paid income tax on these contributions, you will not pay income tax on these amounts when you withdraw funds later on. What’s important to note is that anytime you make a withdrawal from your IRA, some of those funds are considered to be these non-taxable contributions. These non-taxable contributions are withdrawn equally over time until the entire IRA has been withdrawn.
You will report these non-deductible contributions on Form 8606 in the year of the non-deductible contribution. You do not have to file Form 8606 every year, but should keep all previously filed Form 8606’s on file or a running count of your non-deductible contributions so that you are not taxed twice when you make a withdrawal from your IRA. Sometimes plan administrator’s keep track of these amounts for you, sometimes they do not, so it’s always best to keep a record yourself.
The amount that you are able to contribute to your Traditional IRA is calculated as follows for each individual with a filing status of single, head of household, qualifying widower, or married filing separately:
- 100% of your compensation (see definition below) for the tax year.
- $6,500 (Add an additional $1,000 if you are 50 or older at year end), minus the following:
- Any other IRA contributions made on your behalf for the tax year.
For taxpayers filing as married filing jointly, they can use both their compensation and the compensation of their spouse, thanks to the Kay Bailey Hutchison Spousal IRA Act. That means their contribution can be the lesser of:
- 100% of both spouses combined compensation (see definition below) for the tax year.
- $6,500 (Add an additional $1,000 if you are 50 or older at year end), minus the following:
- Any amounts contributed by your spouse to any of their own IRA accounts.
- Any other IRA contributions made on your behalf for the tax year
It’s important to note that each spouse’s contribution limit is separate, meaning that they can each contribute up to the annual IRA contribution limit for the year, regardless of how much the other spouse contributes. Both IRA’s can be funded by compensation from one spouse, but the spousal IRA must be in the name of the spouse.
As an example, if one spouse has earned income of $20,000 and the other spouse has no earned income, the working spouse can contribute up to $6,500 to their own IRA and up to an additional $6,500 to a spousal IRA for the non-working spouse, for a total contribution of $13,000 for the year.
Keep in mind that those rules apply over all of your IRA’s. So if you contribute the max amount to your Traditional IRA, you cannot contribute any additional funds to your Roth IRA for the year. The contributions can be apportioned to each if you desire. For example, you can make a $3,250 contribution to your Traditional IRA, and a $3,250 contribution to your Roth IRA.
If you contribute over the limit for a tax year, you will be assessed a 6% penalty on the excess for that tax year. The amount will have to be withdrawn in order to avoid the penalty for the current tax year. You will also be assessed 6% for every future tax year where the excess remains.
If you decide not to withdraw the excess, you can stop the 6% penalty in a future year by contributing less than your maximum allowed amount and crediting the excess amount to that future tax year. However, in that situation, you would still be assessed the 6% penalty for the excess in that original contribution tax year.
When can I withdraw from my Traditional IRA?
You are able to withdraw at any point, but you will be assessed a 10% penalty if the distribution is made before the date you reach age 59 and a half, unless certain exemptions apply, such as withdrawal due to medical expenses, death, disability, or higher education expenses, among other.
Additionally, any contributions that were tax-deferred at the date of contribution, and a portion of earnings that are attributable to those contributions, will be subject to income tax in the year of distribution. Any contributions that were non-deductible are not subject to income tax, but are still subject to the 10% penalty.
Will I ever be required to withdraw from my Traditional IRA? If so, when?
Yes, you must start taking distributions by April 1st of the year after you turn 73 years old (72 if you reached that age before January 1, 2023). Note that the age was increased from 72 to 73 beginning in 2023 due to the SECURE 2.0 Act that was signed into law in December 2022.
This required distribution amount is termed the Required Minimum Distribution (“RMD”). The amount is calculated using IRS tables based on your age and life expectancy. Your IRA plan administrator is required by law to send you a statement by January 31 informing you of your RMD amount for the year.
Should you fail to withdraw an amount equal to or greater than the RMD amount, you will be assessed a penalty on the amount of required distributions that were not taken out. Up until 2022, the penalty was 50% on the missed amount. Beginning in 2023, the penalty is reduced to 25% on the missed amount. Further, beginning in 2023, the penalty will be reduced from 25% to 10% if it is withdrawn by the end of the year immediately after the missed tax year.
For example, if your 2023 RMD was $12,000, but you only withdrew $10,000 by December 31, 2023, you would be assessed a penalty of $500 ($2,000 * 25%) on the 2023 return. In 2024, your RMD was $13,000. If the taxpayer withdrew $15,000 by December 31, 2024, the IRS would refund $300 of the previously paid penalty ($2,000 * (25% – 10%)) on your 2024 return.
What is a Roth IRA?
The Roth IRA (Individual Retirement Account) was established in the United States as part of the Taxpayer Relief Act of 1997. It was named after William V. Roth Jr., a former U.S. Senator from Delaware who was instrumental in its creation.
One of the key advantages of a Roth IRA is that, as long as the contribution meets the two rules outlined below, the earnings that come from the contribution are tax-free.
There are two rules that must be met:
- 5-Year Rule: The funds must be in the account for a 5-year period. The clock begins on January 1 of the year in which the contribution is made for, regardless of what date the contribution is actually made on. If contributions are made over multiple years, each contribution has their own separate 5-year window.
- Situation Rule: Any one of the following rules must be met:
- The withdrawal must be on or after the date you turn 59 and a half years old.
- You are classified as disabled and the withdrawal is due to your disability.
- The withdrawal is made to a beneficiary after the owner’s death.
- The withdrawal is for a first-time home purchase (see below for definition).
Here is an examples to help highlight how the 5-year rule works:
Example: A calendar-year taxpayer filing as single makes a $6,000 conversion contribution on February 25, 2021, and makes a separate $6,000 regular contribution for tax year 2020 on the same date. In this example, the 5-year period for the conversion begins January 1, 2021, while the 5-year period for the regular contribution begins on January 1, 2020.
Note that in the above example, the conversion contribution is credited to the 2021 tax year, and the “regular contribution” is credited to the 2020 tax year. This is possible because a taxpayer has until the 2020 income tax return due date of April 15, 2021 to make a 2020 tax year contribution. Because the time period to make a 2021 contribution begins January 1, 2021, this provides an overlap period every year beginning from January 1 to the original tax return due date (around April 15) where the taxpayer can make a contribution for both the current year and prior year.
As noted in the example, the 5-Year period begins at different dates for each:
- For the 2020 tax year contribution, the 5-year clock begins January 1, 2020, and ends on December 31, 2024. This means that the taxpayer will have to wait until January 1, 2025 to make a tax-free withdrawal of any earnings that result from the contribution.
- For the 2021 tax year contribution, the 5-year clock begins January 1, 2021, and ends on December 31, 2025. This means that the taxpayer will have to wait until January 1, 2026 to make a tax-free withdrawal of any earnings that result from the contribution.
How much can I contribute to my Roth IRA?
Unlike the Traditional, not everyone is eligible to contribute to a Roth IRA. Certain high-income earners are not allowed to make a contribution. The exact figures are based on your filing status and change from year to year.
If you are eligible to make a contribution, then the formula for calculating how much you can contribute is the same as the Traditional IRA.
Remember that the maximum limit applies over all of your IRA’s combined. So, if you contribute the max amount to your Traditional IRA, you cannot contribute any additional funds to your Roth IRA for that specified tax year. The contributions can be apportioned to each if you desire. For example, you can make a $3,250 contribution to your Traditional IRA, and a $3,250 contribution to your Roth IRA.
When can I withdraw from my Roth IRA?
You are able to withdraw at any point, but if the withdrawal occurs before the 5-year period is reached, you will have to pay income tax on any earnings. Additionally, you will have to pay a 10% penalty on the earnings, unless you meet one of the following exemptions:
- The withdrawal is on or after the date you turn age 59 and a half.
- You are classified as disabled and the withdrawal is due to your disability.
- The withdrawal is made to a beneficiary after the owner’s death.
- The withdrawal is for a first-time home purchase.
How do I determine the earnings portion?
For Traditional IRA’s, there is no need to determine the earnings portion, as both the deductible contributions and the earnings are treated the same upon withdrawal. It is only necessary to keep track of your non-deducted contributions.
For Roth IRA’s, you would determine the earnings portion by adding up all of your net contributions to the IRA, and then subtracting it from the Fair Market Value of the account. The plan administrator may keep track of your contribution amount for you, but it is also a good idea for you to keep track of it separately. This net contribution total may sometimes be referred to as a taxpayer’s “basis”. This basis is drawn down first when you withdraw from the IRA, meaning that earnings are considered to be withdrawn at the very end. When your basis reaches zero, everything withdrawn afterwards will be considered earnings.
Will I ever be required to withdraw from my Roth IRA? If so, when?
Withdrawals from a Roth IRA are not required unless you inherit the Roth IRA from a non-spouse. You can freely choose to take money out or leave it in at your discretion.
When can I make a contribution to an IRA?
You generally can make a contribution at any time, but if you want to make a contribution for a specific tax year, it must be done from a period beginning on the first day of the tax year and ending on the original tax return due date (not including extensions) for that tax year. For example, to make a contribution for 2022, the period contribution period begins on January 1, 2022 and ends on April 18, 2023. Any contributions made before or after that date cannot be credited to the 2022 tax year. This applies to both Traditional and Roth IRA’s.
Can my child open up an IRA?
Only if they have a custodian who is 18 or older on the account. A custodian means an adult who would have control over the account until the child reached the age of maturity.
What is compensation?
Compensation includes wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. It also includes commissions, self-employment income, nontaxable combat pay, military differential pay, and taxable alimony and separate maintenance payments.
It does not include interest, dividend, pensions, annuity, deferred compensation, income from certain partnerships, or any other amount you exclude from income.
Who is a first-time homebuyer?
Generally, you are a first-time homebuyer if you had no present interest in a main home during the 2-year period ending on the date of acquisition (see below) of the home which the distribution is being used to buy, build, or rebuild. If you are married, your spouse must also meet this no-ownership requirement.
What is the date of acquisition?
This is the earlier of either:
- The date you enter into a binding contract for the home, or
- Construction on the home begins.
Are there limits to an IRA?
Yes, an IRA has rules on what is allowed and what is prohibited. Some of the more notable ones are:
- Contributions must be made in cash.
- Funds cannot be used to purchase collectibles, except for gold, silver, platinum, or palladium.
- Assets held in an IRA cannot be used for personal benefit or gain of the IRA holder. This means you cannot use the assets as collateral for a loan or use them to purchase personal property. As highlighted above though, you can withdraw from the IRA at anytime, subject to possible tax and penalties.
Note that for the third bullet point, this prevents using a margin loan from the broker or selling short in the stock market.
Are these figures up-to-date?
In recent years, Congress has begun updating the tax code to provide for inflation adjustments to most figures on an annual basis. These figures are likely to change from year-to-year and may not reflect the most current figure.
How do I get started?
Because of the significant impact an IRA can have on your tax return, it is highly recommended to start by contacting us for a thorough review of your specific situation. You can contact us here to get the process started.
You can find us at our home website at MageeTax.com
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