Here's a refresher course on IRAs -- how they work and how they can help you plan for retirement
If you are opening an individual retirement account (IRA) for the first time or need a refresher course on the specifics of IRA ownership, here are some facts for your consideration.
IRAs in America
IRAs continue to play an increasingly prominent role in the retirement saving strategies of Americans. According to the Investment Company Institute (ICI), more than one third of U.S. households owned IRAs in 2017. Traditional IRAs, the most common variety, are held by more than one quarter of U.S. households, followed by Roth IRAs and employer-sponsored IRAs (including SEP-IRAs, SAR-SEP IRAs, and SIMPLE IRAs).1
Contributions and Deductibility
Contribution limits. In general, the most you can contribute to an IRA for 2020 is $6,000. However, if you are age 50 or older, you can make an additional "catch-up" contribution of $1,000, which brings the maximum annual contribution to $7,000.
Eligibility. One potential area of confusion around IRAs concerns an individual's eligibility to make contributions. In general, tax rules require that you must have compensation to contribute to an IRA. Compensation includes income from wages and salaries and net self-employment income. If you are married and file a joint tax return, only one spouse needs to have the required compensation.
Regarding Roth IRAs, income may affect your ability to contribute. For tax year 2020, individuals with a modified adjusted gross income (MAGI) of $124,000 or less may make a full contribution to a Roth IRA. Married couples filing jointly with a MAGI of $196,000 or less may also contribute fully for the year. Contribution limits begin to decline, or "phase out," for individuals with MAGIs between $124,000 and $139,000 and for married couples with MAGIs between $196,000 and $206,000. If your income exceeds these upper thresholds, you may not contribute to a Roth IRA.2
The” Back-Door” Roth. In special circumstances you can do what is referred to as a “back-door” Roth. This allows you to bypass the MAGI ranges above. Due to potential tax repercussions if these are done incorrectly, work with a financial and tax advisor before doing this.
Deductibility. Whether you can deduct your traditional IRA contribution depends on your income level, marital status, and coverage by an employer-sponsored retirement plan. You can still contribute to your IRA for the year 2019 if you do so before Tax Day! See the ranges below to determine if you can still make a tax-deductible contribution:2
- If you are single and covered by an employer-sponsored retirement plan, your traditional IRA contribution for 2019 will be fully deductible if your MAGI was $64,000 or less. The amount you can deduct begins to decline if your MAGI was between $64,000 and $74,000. Your IRA contribution is not deductible if your income is equal to or more than $74,000.
- If you are married, filing jointly, and the spouse making the IRA contribution is covered by an employer-sponsored retirement plan, your 2019 IRA contribution will be fully deductible if your combined MAGI is $103,000 or less. The amount you can deduct begins to phase out if your combined MAGI is between $103,000 and $123,000. You may not claim an IRA deduction if your combined income is equal to or more than $123,000.
- If you are married, filing jointly, and your spouse is covered by an employer-sponsored plan (but you are not), you may qualify for a full IRA deduction if your combined MAGI is $193,000 or less. The amount you can deduct begins to phase out for combined incomes of between $193,000 and $203,000. Your deduction is eliminated if your AGI on a joint return is $203,000 or more.
- If neither you nor your spouse is covered by an employer-sponsored retirement plan, your contribution is generally fully deductible up to the annual contribution limit or 100% of your compensation, whichever is less.
Keep in mind that contributions to a Roth IRA are not tax deductible under any circumstances.
Distributions
You may begin withdrawing money from a traditional IRA without penalty after age 59½. Generally, previously untaxed contributions and earnings are taxable at the then-current regular income tax rate. Nondeductible contributions are generally not taxable because those amounts have already been taxed. It is VERY important if you are putting deductible and non-deductible contributions into your IRA that your tax professional files a form 8606 to keep track of what is taxable and what is not during the distribution phase.
You must begin receiving minimum annual distributions from your traditional IRA no later than April 1 of the year following the year you reach age 70½ and then annually thereafter. However, the SECURE ACT recently went into effect which changes the mandatory age of distribution from your IRA to 72, as long as you were born July 1, 1949 or later. Regardless of where you fall, if you miss a required minimum distribution (RMD) you may be subject to an additional federal tax equal to 50% of the difference.
Unlike traditional IRAs, Roth IRAs do not require the account holder to take distributions during his or her lifetime. This feature can prove very attractive to those individuals who would like to use the Roth IRA as an estate planning tool.
1Investment Company Institute, "The Role of IRAs in US Households' Saving for Retirement," 2017.
2Internal Revenue Service.
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