Recently, my friend Esmeralda pointed out that I haven’t really written about or explained IRAs. I looked back over my posts and realized she was right on the money. I often mention IRAs but I’ve never really done a Q&A about them or explained what they are.
So, what is an IRA? IRA stands for Individual Retirement Account. There are several types of IRAs, but this blog post will focus on the two most common: the traditional IRA and the Roth IRA. The IRA itself is not an investment, it’s an account and you make investments within the account. At their most basic, both IRAs share some common features; individuals can set aside personal savings from earned income ($5,500 per year as of 2018, over age 50 you are allowed an additional $1,000 called a catch-up contribution), both provide tax advantages in their own way, both allow for spousal IRAs for non-working spouses, and both may be protected from creditors in bankruptcy proceedings. But as with all things investing and governed by federal law and the US tax code, things aren’t always that simple.
With a traditional IRA, you make contributions which may be tax-deductible. I say ‘may’ because you might be in a situation where contributions to your traditional IRA are not tax deductible. More on that below. Your contributions grow tax-deferred until you make a withdrawal – a distribution. Your distribution is taxed at ordinary income tax rates provided you are age 59 1/2 or older. If you are under age 59 1/2, your distribution may be subject to a 10% penalty in addition to ordinary income tax. This penalty can be avoided if the distribution is for qualified education expenses, first-time home purchase (up to $10,000), or unreimbursed medical expenses in excess of 10% of your AGI if you are under age 65 (7.5% if over age 65).
What are those tax-deductible limits mentioned above? Well, this depends on whether you or your spouse is covered by a retirement plan through your employer and your income level.
If you are married filing jointly and YOU are covered by a retirement plan, you can take a full deduction up to $101,000 AGI. Between $101,000 and $121,000 AGI a partial deduction. Over $121,000 AGI, no deduction.
If you are married filing jointly and YOUR spouse is covered by a retirement plan, you can take a full deduction up to $189,000 AGI. Between $189,000 and $199,000 AGI a partial deduction. Over $199,000 AGI, no deduction.
Single or Head of Household? You can take a full deduction up to $63,000 AGI. Between $63,000 and $73,000 AGI a partial deduction. Over $73,000 AGI, no deduction.
Married filing separately? Not a good situation. You can take a partial deduction if your AGI is less than $10,000 AGI and you get no deduction if your AGI is $10,000 or more.
You have to take a Required Minimum Distribution (RMD) after age 70 1/2 and you can no longer make contributions to your traditional IRA – even if you are still working!
With a Roth IRA, you make post-tax contributions (i.e., no current tax deduction available). There is no RMD requirement at age 70 1/2 and you can continue saving in your Roth IRA if you have earned income. Three are, however, income limits on who can contribute.
If your tax filing status is single, you can contribute up to $5,500 if you earn less than $120,000 MAGI. You can make a partial contribution between $120,000 and $134,999 MAGI. If you earn $135,000 MAGI or more, you are ineligible. You may, however, be able to make a Backdoor Roth IRA contribution.
For married filing joint, you can contribute up to $5,500 if you earn less than $189,000 MAGI. You can make a partial contribution between $189,000 and $198,999 MAGI. If you earn $199,000 MAGI or more, you are ineligible. You may, however, be able to make a Backdoor Roth IRA contribution. Notably, you can contribute even if you or your spouse are covered by an employer retirement plan.
Your Roth IRA contributions grow tax free and if your distribution is a qualified distribution, it is tax free! If you happen to take a distribution prior to age 59 1/2 and have owned your Roth IRA less than five years you’ll owe taxes and a 10% penalty on your earnings portion of the distribution. Like the traditional IRA, this penalty can be avoided if the distribution is for qualified education expenses, first-time home purchase (up to $10,000), or unreimbursed medical expenses in excess of 10% of your AGI if you are under age 65 (7.5% if over age 65). There are a few other exceptions as well so be sure to check with your tax preparer.
If you happen to take a withdrawal prior to age 59 1/2 and have owned your Roth IRA for at least five years or more, you can avoid the income taxes and 10% penalty on your earnings portion of the distribution if you meet one of the following exceptions: first-time home purchase (up to $10,000), disability, or the distribution is paid to a beneficiary of your estate after your death.
If you are over 59 1/2 and have owned your Roth IRA for less than five years, you’ll owe income tax but no 10% penalty on your earnings.
If you are over 59 1/2 and have owned your Roth IRA for five years or more, there is no income tax or 10% penalty on your earnings.
Q. Can I have an IRA for my child?
A. Generally, yes. However, your child has to have earned income.
Q. When can I open and make my IRA contribution?
A. You can open and contribute to your IRA at any time. You do have the ability to open and contribute to an IRA for the previous year up until tax filing in April. Just make sure to open and fund your IRA prior to submitting your finalized tax return. For example, let’s say you want to fund an IRA for 2018, you may open and fund the IRA as late as your tax filing date in April 2019. For a Roth IRA in particular, this sets the five-year clock (for avoiding potential tax on distributions) starting at January 1, 2018.
Q. I had $4,300 in earned income. Can I contribute $5,500 to an IRA?
A. You can only contribute up to $4,300 (your maximum earned income).
Q. Can I contribute and have both types of IRAs (a traditional and a Roth)?
A. Yes, but your maximum combined contribution cannot exceed $5,550 (or your maximum earned income). For example, you could contribute $2,750 to each if you are otherwise eligible.
Know that all investing involves risk, and you should always seek help if you are not sure about what you are doing. As an independent Certified Financial Planner™, I can help you. No matter where you are in life, a CFP® professional can help you create a financial plan for today and tomorrow. #LetsMakeAPlan #CFPPro #talktometuesday #Hireaplanner #RothIRA #fees #IRA