The Basics of Individual Retirement Accounts (IRAs)
Retirement Accounts Offer a Tax-Deferred Advantage
In a taxable account, the investor is taxed on interest, dividends and capital gains, which eats away at the compounding potential of that account. However, in a tax-deferred account, these payouts and gains are not taxed until the individual takes a distribution. Retirement accounts offer this tax-deferred advantage and help to explain why so many individuals participate in at least one retirement plan.
Earned Income and Retirement Plans
Some retirement plans are started by individuals, while others are offered through an employer. An individual with earned income can open a retirement account. Earned income refers to income earned through employment or actively participating in a business. It does not include passive income, such as rental income from apartment buildings that you are not actively managing or from portfolio income.
Individual Retirement Accounts (IRAs)-The Traditional IRA
An IRA is an individual retirement plan that includes the Traditional IRA. Individuals below 70 ½ years old with earned income for that year can make a contribution to a Traditional IRA account with a contribution limit being the lesser of earned income for that year or $6,000 for 2019. Assuming you’ve generated enough earned income, you can add an extra $1,000 catch-up contribution if you’re 50 or older.
If you over-fund an IRA, you get a 6% penalty on the amount above the maximum contribution allowed during the year and any earnings associated with it. If during tax-time, you realize that you’ve over-funded your IRA, you can either remove the excess contribution or recharacterize it to next year’s contribution and you won’t be penalized if you do this before the tax-filing deadline.
The Front End-IRA Withdrawals
Money withdrawn from a Traditional IRA is taxable as ordinary income. If you take the money out before age 59 ½, you’ll have to pay a 10% penalty on top of the taxes on that withdrawal. While all income that is withdrawn is taxable, there are qualifying exemptions from the 10% penalty. These include 1) Death; 2) Permanent Disability; 3) Medical Expenses; 4) First Residential Home Purchases; 5) Higher Education Expenses.
IRS Rule 72(t)
According to IRS rule 72(t), you can receive a qualifying exemption prior to age 59 ½ if you withdraw funds in substantially equal period payments (SEPP). In this scenario, funds are placed into a SEPP plan that pays the individual annual distributions for five years or until age 59 ½, whichever comes later. The annual payments are based upon three-IRS approved methods used to calculate SEPP and you should employ the method most suited to your financial situation. Note that SEPP should not be used to game the system to prematurely access retirement funds without a penalty. The minimum five-year annual distribution can adversely impact your financial funding status in the future. Hence, rule 72(t) should be considered as a last resort alternative.
The Death Exemption
If the IRA owner dies and a named beneficiary receives the account balance, the beneficiary will not be penalized as long as the required minimum distribution (RMD) is met. The IRS rules can give you some alternative scenarios for your specific distribution requirements, depending on your age and relationship with respect to the previous IRA owner.
The Back End – IRA Withdrawals
On the back end, you are required to take a required minimum distribution (RMD) by April 1st following the year you reach age 70 ½. If you don’t, the IRS will impose a 50% insufficient distribution penalty, meaning that 50% of the minimum you should have withdrawn will go to Uncle Sam. Keep in mind that if you choose to take your distribution on April 1st following the year you reach 70 ½, you will need to take two distributions that year, which could push you into a higher tax bracket. So, try to be savvy in taking those initially required minimum distributions. No contributions can be made to a Traditional IRA after age 70 ½.
Individual Retirement Accounts (IRAs)-The Roth IRA
Roth IRAs are funded with non-deductible contributions. However, the withdrawals are tax-free if you are 59 ½ and have owned the account for at least five years. This is one of the major advantages of a Roth IRA. Additionally, for a Roth IRA, there is no required minimum distribution by age 70 ½. Furthermore, as long as you have earned income, you can continue to contribute to your Roth IRA, even after you reach age 70 ½. Neither of these options is available for the Traditional IRA. Why does the Roth IRA account holder get such special treatment? The IRS has already collected its taxes (contributions are non-deductible and withdrawals are tax-free). Thus, the if and when of withdrawals and contributions don’t concern the IRS anymore.
Contribute to your Roth IRA While You are Still Young
For 2019, If your adjusted gross income (AGI) is above $137,00 (or $203,000 if you are married and filing jointly) you cannot make a contribution to your Roth IRA. Additionally, you can only make partial contributions if your AGI is between $122,000 and $137,00 (or $193,000 and $203,000 if you are married and filing jointly). Hence, make those contributions early in your career, while you are young and not yet a high earner. The compounding effect of the time value of your investments will reward you over the decades even if you exceed your AGI during mid-career. There are no income limits to Traditional IRA contributions. However, there are limits for tax-deductible contributions.
As with a Traditional IRA, the contribution limit to a Roth IRA account is the lesser of earned income for that year or $6,000 for 2019. Assuming you’ve generated enough earned income, you can add an extra $1,000 catch-up contribution if you’re 50 or older. Note that if you have both a Traditional and a Roth IRA, the total combined contribution limit is still $6,000 (or $7,000 if you’re 50 or older) for 2019. For example, if you are 51 years old and you contribute $4,000 to your Traditional IRA and $3,000 to your Roth IRA, you have reached your contribution limit for the year.
Transfers and Rollovers-The Direct Transfer
Assume you want to move an IRA from one custodian to another (say, for example, you wanted to move your IRA from Charles Schwab to TD Ameritrade or vice versa). You can do this by direct transfer, where one custodian can directly transfer the funds to the new custodian. This allows the IRA owner to transfer between custodians without incurring penalties and tax implications.
Transfers and Rollovers-The Rollover
In a Rollover, the custodian cuts a check to the IRA owner, who must cash it and then send those funds to the new custodian. A rollover can only be done once per year and the funds must be sent to the new custodian within 60 days to avoid tax implications. Additionally, any shortfall will be taxed and incur a 10% penalty. Hence, the safest movement of an IRA from one custodian to another is by direct transfer.
This covers the basics of Individual Retirement Accounts (IRAs). Next time, I’ll talk about employer-sponsored plans. Please let me know if you have any questions.