Retirement is one of the realities of life. But why talk about retirement when you’re just starting your career or at its most productive stage? Retirement planning is important at all ages. A well-thought-out decision now can save you from tons of regrets later.
Even people with a roller-coaster career or those having to undergo various employment positions need to consider their investment options so they can secure a steady income after retirement. One of the more popular plans recommended by most investment advisors is an Individual Retirement Account (IRA).
An IRA is a tax-advantaged account that individuals and married couples can use to invest and save for retirement. The tax strategy takes many forms, each with different rules concerning taxation, eligibility, and withdrawals. Most individual taxpayers often opt for either Traditional IRAs or Roth IRAs.
Planning for retirement is a major step, a decision that’s not to be taken lightly. The popularity of IRAs among people although well-known doesn’t necessarily mean it’s the right choice for you. At best the content here is an attempt to shed light on this complex topic.
Individual requirements differ and any investment into an IRA or any other retirement plan is advisable only after a thorough consultation with your tax professional and financial advisor.
What are traditional IRAs? How do Roth IRAs differ from traditional IRAs? Let’s find out answers to these questions and more about IRAs.
What Is a Traditional IRA and What Are Its Rules?
The taxable income reduces by investing in traditional IRAs. Suppose a contribution of $6,000 which is the full amount permissible ($7,000 if the filer is 50 years or older) is invested, the individual can deduct this amount before calculating his or her taxable income. But traditional IRAs aren’t completely tax-free. Withdrawals made from the IRAs after retirement are taxed at the rate prevalent at the time.
As stated earlier, the total contribution to traditional IRAs per year should not be more than $6,000. The contribution should not exceed $7,000 in the case of individuals aged 50 or over.
Not everyone contributing to traditional IRAs is entitled to a full tax deduction. It depends on several factors including the annual income of the individual or couple.
Some limits apply to IRA contributions and deductions when people are already covered by a qualified retirement plan through their employer. Individuals or the head of a household can claim full deduction on the contribution if the MAGI (Modified Adjusted Gross Income) is $60,000 or less. The deductions you can claim goes down as your income goes up. A partial deduction is allowed if the annual income is between $60,000 and $76,000. If the income exceeds $76,000, no deduction can be claimed by the individual or head of the household.
The deduction limits change for married couples filling joint and separately who are covered by a qualified retirement plan. To claim the full deduction, the couple must have a 2021 MAGI of $105,000 or less; a joint MAGI between $105,000 and $125,000 will entitle the couple to a partial deduction and no deduction if the income exceeds $125,000. The limits on contributions aren’t applied if the individual or couple aren’t covered by a qualified plan.
Another notable feature of the traditional IRAs is the Required Minimum Distribution (RMD). RMD is the amount that must be withdrawn by the individuals after they qualify for retirement. Until 2020, the compulsory age at which you must begin withdrawals was set as 70 ½ years. The age limit was increased to 72 years in 2020 after the SECURE Act was promulgated.
Under the same law, the age restriction placed on IRA contributions was removed. Previously individuals aged above 70 ½ years old were barred from contributing to IRAs. Now, a person of any age with earned income can invest annually in IRAs.
What Is a Roth IRA and How Is It Different From a Traditional IRA?
In a sense, a Roth IRA is the reverse of the traditional format. In this tax strategy, the qualified distributions after retirement are not taxable, whereas the contributions fall within the taxable income. You don’t have to pay income tax on the money withdrawn after you become eligible to take money from the IRA.
In addition, individuals investing in Roth IRAs are not bound by the RMD rules. Contribution to a Roth IRA is allowed as long as the individual earns income during the year.
In a Roth IRA, similar to the traditional IRA, the maximum contribution limit stands at $6,000 and $7,000 if the person is 50 years old or above. If covered by a qualified plan, to become eligible to contribute, single filers or the head of the household must have an annual income of $125,000 or less under 2021 MAGI. Only a reduced amount can be invested if the MAGI is between $125,000 and $140,000. Individuals earning an annual income of $140,000 or above can’t contribute to Roth IRAs.
Contributions to Roth IRA are subject to certain conditions:
- Contributions to a Roth IRA are based on earned income. Income, wages, bonuses, tips, commissions, earnings from a business, etc. are earned income. Money from a rented property, social security, child support, securities, etc. is unearned income.
- You can’t contribute to Roth IRA if you don’t have earned income during the year.
- Even if you have a qualified retirement plan such as a 401(k) plan you can invest in Roth IRA.
- Investing more than the permissible limit will invite a penalty, which can be escaped by withdrawing the excess amount and any related earnings within six months.
Can I Contribute to a Traditional and a Roth IRAs at the Same Time?
Contributions to both traditional and Roth IRAs are acceptable. Sometimes CPAs and investment advisors encourage investment in both to avail the benefits of both strategies. Also, if you’re not sure about your tax status in the future and not willing to increase your taxable income at present then you can invest in both.
People currently using only traditional IRAs can convert part of their retirement investment into Roth IRAs. But remember the total annual contribution to IRAs should not exceed $6,000 (or $7,000 for people above 50 years of age).
Can I Withdraw From my IRAs Early and What’ll Happen If I Do?
IRAs are a long-term investment option meant to provide the owner with a source of money after retirement. Hence, withdrawals before the retirement age will be subjected to a penalty.
Money withdrawn from IRAs (both traditional and Roth) before the age of 59 ½ generally will incur a penalty of 10%. In addition, the individual is also liable to pay tax on the withdrawn amount from a Traditional IRA and the earnings from a Roth IRA.
Withdrawal before an individual becomes eligible is permitted without penalty under certain circumstances. There are several early-withdrawal exceptions, some of them are related to unemployed individuals paying health insurance premiums, out-of-pocket medical expenses (unreimbursed expenses), qualified education expenses, permanent disability, investment in a home (to build, rebuild, or buy), and to pay for unpaid federal taxes.
The list of exceptions isn’t exhaustive. Consult a tax professional to learn who can and cannot withdraw without incurring a penalty. But the premature withdrawal amount will be taxed at a rate prevailing at that time.
IRAs can’t be used to avail loans from lending institutions. Any attempt to get a loan on IRAs will invite taxes and penalties. In addition, the account will no longer be considered an IRA.
Where Can I Open an IRA and What Investments Can I Hold in the Account?
To open an account you can approach any institution that’s permitted to operate such accounts by the Internal Revenue Service (IRS). Such institutions include federally insured credit unions, brokerage companies, savings and loan associations, and of course banks. Individuals can even approach certain brokerage firms to open IRAs.
A wide array of assets can be invested in IRAs. These assets include but are in no way restricted to cash, ETFs, mutual funds, bonds, and stocks. Gold and certain other precious metals can be used as an investment if they fulfill certain conditions.
Investors are not allowed to contribute alcoholic beverages, gems, antiques, art collections, and certain types of coins to their IRAs.
Who Gets the IRA Asset After the Death of the Filer?
While opening an account the filer must name a beneficiary. The IRA will be handed over to the beneficiary in case the assets in the account aren’t fully drawn out.
In the case of married couples, the surviving spouse automatically becomes the beneficiary. A third person can be named as the beneficiary after the express agreement of the spouse.
The same rules on withdrawal and distribution that applied to the filer will also apply to the beneficiary if that person is under the age of retirement.
Why Should I Pick a Roth IRA Over a Traditional IRA?
Let’s start with the most noticeable difference between the two. In Roth IRA, the contributions are from your post-tax income. In contrast, the contributions to traditional IRA are made from your pre-tax income.
A Roth IRA should be the first choice for those who intend to save as much as possible post-retirement. This type of account is ideal for people who expect to find themselves in a higher tax bracket during retirement. Choosing a Roth IRA will result in a smaller bill because you pay the tax upfront.
Secondly, no RMD conditions are currently tied to a Roth IRA. With this tax strategy, you have no obligation to withdraw funds from the account after your 72nd birthday.
A Roth IRA also serves as a source of money for purposes other than your needs during retirement. It’s a lot easier to withdraw funds from Roth IRA for educational expenses, medical requirements, and certain emergencies. The withdrawals in such situations are penalty-free and tax-free. IRA holders are also permitted to use contributions and invested assets up to $10,000 to fund their first home purchase.
Convenience and versatility may make a Roth IRA a better option than traditional IRA. A Roth IRA should be your obvious choice if you’re years or decades away from retirement. Bear in mind that Roth IRA must be operational for at least 5 years before you can withdraw post-retirement. Any attempt to withdraw before the 5 years, even if you’re past 59 ½ years, will attract taxes and an early withdrawal penalty.
When Is a Traditional IRA Better Than a Roth IRA?
There are three instances where traditional IRA is either the only option or better than Roth IRA.
- You’re not eligible to invest in Roth IRA. Investment in Roth IRA is prohibited if your annual income is more than $140,000 (2021 MAGI) or $139,000 (2020 MAGI). This is for individuals and the head of household filers. For married couples filing together the upper-income limit is $208,000 (2021 MAGI) or $206,000 (2020 MAGI).
- Investing in a traditional IRA is preferred if the investor needs tax deduction now as opposed to years later.
- People who think they’ll be in a lower tax bracket post their 60th birthday can opt for traditional IRAs.
What’s the 10-Year Rule and How Are the Beneficiaries Affected by It?
Just before the pandemic, changes were made to the rules governing distributions from inherited IRAs. A clear understanding of these changes will allow account holders to plan their IRAs so that the account can be inherited by the beneficiaries in the most tax-efficient way.
According to the new rules, beneficiaries of the IRA must withdraw the funds fully within 10 years. Plus, the distributions from the account will be taxable at the rate prevailing at the time of withdrawal. Beneficiaries of the IRAs are not required to withdraw funds every year. That said the account must be emptied before the end of the 10 years. The 10-year rule only applies to non Eligible Designated Beneficiaries (EDBs).
The EDB list includes people 10 years younger than the account holder, minor children of the filer, chronically ill beneficiaries, disabled beneficiaries, and spouses of the account holder.
Noncompliance with the 10-year rule will result in a penalty of 50% of the funds remaining in the IRA. The distributions from the IRA account are taxable. Plus, there is a good chance that the withdrawn funds would push the beneficiary to a higher tax bracket. Changes in the tax status might also affect the beneficiary’s medical premiums, educational loan eligibility, and more.
To reduce the impact of the 10-year rule on the beneficiary the IRA holder can take many steps.
- You can invest in Roth IRAs. Although the 10-year rule also applies to Roth IRA the distributions won’t be taxed.
- IRA account holders can name someone in the lower income tax bracket.
- Someone who falls under the EDB list can be chosen by the account holder.
Is a Roth IRA Suitable for Everyone?
Roth IRA is an attractive investment opportunity for all people irrespective of age, income, or career status.
Most experts suggest investing in Roth IRAs if you’re a millennial or Gen Z. People who are just starting their career would be in a lower tax bracket. Hence, the absence of tax breaks in Roth IRA will have the least impact on young people.
Gen Z or millennial people who make too much money and are ineligible to invest in the regular Roth IRA can still do so through a backdoor Roth IRA strategy allowed by the IRS. Investing in Roth IRA also makes the filer eligible for a $2,000 Saver’s Tax Credit.
Roth IRA is also an attractive choice for new business owners. In the initial years, when the investment is high and the returns are low or non-existent, contributing to Roth IRA will cost very little in terms of taxes.
A person who is retired can still invest in Roth IRAs. The person can continue to fund until there is a regular inflow of income money. Any fee, salary, wages, etc. can be used to fund the IRA. But, social security benefits or similar sources are not considered as income. Plus, all the rules governing eligibility, taxation, and distribution of Roth IRA will also apply for senior citizens still investing in the account.
How Can I Convert My Traditional IRA Into a Roth IRA?
Consult a tax professional and financial planner before you think of converting your traditional IRA into Roth IRA. There are three ways to execute this conversion.
Same-trustee Transfer: Requesting the institution holding your traditional IRA to transfer money into the Roth account in the same establishment.
Trustee-to-Trustee Transfer: The filer instructs the institution holding traditional IRA to transfer to a Roth account held in another financial establishment.
Rollover Transfer: Involves the transfer of distribution from traditional to Roth account using check or deposit within 60 days.
In rollover transfer, failing to deposit money into the Roth account within 60 days will invite a 10% penalty on the distributions. The penalty is in addition to taxes to be paid as the result of the conversion.
The 10% penalty is not imposed if the account holder is over the age of 59 ½.
During conversion, the individual owes taxes on the money held in the traditional IRA.
Conversion of a traditional to Roth IRA should be reported to the IRS. While filing your taxes for the year, use Form 8606 to report the conversion to the IRS.
Final Thoughts
Planning for your retirement need not be a complex affair. Plus, it should not be ignored regardless of your age. Understanding the options available to you, assessing your current situation, and running a projection on your prospects at the time of retirement will help narrow down the choice.
We would like to remind you again. Every situation is different and a decision on an IRA, its contributions and distributions, is to be taken only after a thorough consultation with your tax professional and financial advisor.
How you use the IRA has major implications for your and that of your beneficiaries’ future. We hope the article has cleared your doubts on IRAs. If not, feel free to comment or contact us. We’re here to help.