By Kristi De Rycke, Registered Assistant
Individual Retirement Accounts or IRAs can be great savings vehicles for anyone regardless of if they are employed by a large company, self-employed or a stay-at-home parent. They can be a way to grow your money with tax benefits. Not sure exactly what they are or how to use them, no problem. Here are some answers to common questions on IRA options.
What is an IRA? IRA stands for Individual Retirement Account.
Who can contribute to an IRA? Anyone who meets the earned income requirement can contribute to an IRA. This is true if you are self-employed, work for someone else or a stay-at-home parent (spousal IRA see below).
How much can you contribute to an IRA? You can contribute up to $6,000 annually and an extra $1000 if you are 50 or older as. You can only contribute this maximum if you have earned at least this amount in that year. For stay-at-home parents, your spouse must have earned enough to save in their IRA and your IRA. This can be a lump sum when you have more cash flow. It could also be taken out biweekly or monthly to time with your paycheck.
What if I start automatic contributions and then decide I can no longer contribute? You can change your contributions at any time by increasing or decreasing your contributions. The money can remain in this account even if you are not actively contributing to it. You can contribute more during good years and less during more challenging times.
Will my money be safe in an IRA? Remember that IRAs are only a vehicle for saving that offer tax benefits. Think of it as a container. You are standing looking at the shelf of Rubbermaid containers. You either pick the red rectangular option (Traditional) or the tall and skinny blue one (Roth) based on your tax and income situation. We will further discuss this below. Then, you get to decide what you want to put in it. There are different risks to different investments so choose carefully. Individual stocks are a much higher risk than say a US treasury bond. Do not be afraid to ask for help in setting this up and selecting the investments if you are not 100% certain.
What options do I have to invest into in a Traditional/Roth IRA? It really is easier to start with the things that are not allowed in the account. The only restricted options are life insurance, derivatives, collectables, and most coins. Nearly everything else can be invested in an IRA including a combination of stocks, bonds, mutual funds, ETFs, annuities and REITS (real estate investment trusts).
Can I put a mix of investments in my IRA? The easy answer is absolutely. For example, you can choose to do 40% in bond funds, 40% in stock funds and 20% in cash or any mix of options. You can have as many or as few investments as you want. You can change your investments in the Traditional or Roth IRA at any time without tax consequences.
I have an employer sponsored plan like a 401(k) or a 403(b) can I still contribute to an IRA? The amount you have in an employer sponsored plan does not affect your contribution limits on IRAs. You can still contribute up to the allowed amount of $6,000 ($7,000 if 50 or older). There are restrictions on the benefits of an IRA contribution based upon the income you earn. For example, if you want to contribute to a pre-tax Traditional IRA and have access to a 401k plan at your employer you cannot take a tax deduction if your income is over $105,000 for 2021. Consult with your tax advisor before establishing new account to see what makes the most sense.
Why would I want to contribute to an IRA if I have an employer sponsored plan? You may consider contributing enough to get your match in the employer sponsored plan and then contributing to an IRA. You typically have more flexibility with an IRA than an employer sponsored plan which we will further discuss below.
Are there income limits on IRA contributions? Yes. For the Roth, you can contribute the $6,000 ($7,000 if over 50) if you are single and your modified adjusted gross income is less than $125,000. If you are over the $125,000 but under $140,000, you can complete a partial contribution. If you are married and filing jointly you can contribute the full amount if your income is less than $198,000. You can do a partial contribution if your joint income is between $198,000 but less than $208,000. There is also a legal strategy that you can use if you are over the income limits called a backdoor Roth IRA. There are also limits to the traditional IRA if you or your spouse are offered a retirement plan at work. If you file married filing jointly and have a retirement plan at your work, you must make $105,000 or less. If you file married filing jointly and your spouse has a retirement plan at work, you must make $198,000 or less to fully fund the traditional IRA. If you are offered a 401K plan at work and single, you must make $66,000 per year or less to max the Traditional IRA.
What if I do not work, can I contribute to an IRA? You must have earned income which can be paid by someone else or self-employed. If you do not work but your spouse does, they can open a spousal IRA and contribute the same amount for you out of their income if their income covers both their and your annual contribution.
What is the youngest a person may contribute to an IRA? A person can contribute to an IRA as soon as they start having earned income even including a paper route. Sorry but allowances do not count. The amount they contribute must be equal to or less than the amount they earned and reported that year. A parent or grandparent can contribute to the IRA for them but only up to the amount that the minor had earned in that year.
Is there an upper age limit on when I can no longer contribute? There no longer is an age limit since January 2020 thanks to the SECURE Act. If you have earned income, you can contribute the maximum allowed for your age if you made and reported that much income.
What is the difference between a traditional and Roth IRA? There are 3 main differences between the two in addition to the income limit stated above. Taxes, taking early withdrawals without penalty and required distributions.
#1 Taxes: If you contribute to a Traditional IRA, your income will be reduced dollar for dollar by that amount. If you make $50,000 and you put $5000 into a Traditional IRA, your income will look more like $45,000 to Uncle Sam when it comes to tax time. This money will then grow without paying any taxes on it until you withdraw it. At that time, you will be taxed on it as ordinary income. When you contribute to the Roth IRA, you contribute after you have paid taxes on the money. However, once you have been taxed on this money, it will grow tax free and you will not be taxed upon withdrawal. This means if you take $1000 out of it, then you get $1000 free and clear. The Roth might be a better option for someone who will be in an anticipated high tax bracket in retirement. If you are not sure if your anticipated future taxes will be higher or lower, discuss this with your tax professional.
#2 Rules on Withdrawals: The rule for traditional IRAs is that you cannot withdraw money prior to age 59 ½ or you will pay a 10% penalty in addition to the taxes owed. The Roth IRA allows more flexibility in that you can withdraw before 59 ½ without having to pay the penalty in certain circumstances. These exceptions include medical expenses, health insurance if you have collected unemployment for 12 weeks, college costs, first time home purchase ($10,000 individual/ $20,000 per couple), disability, active duty over 179 days or if your IRA is set up with regular payments in an annuity. It’s important to note that you must also have the Roth account open for at least 5 years to be qualified.
#3 Required Minimum Distributions: RMDs require you to withdrawal a certain amount every year once you’ve reached the age of 72. The IRS will calculate a certain amount each year that you are required to withdraw regardless if you need it. There is a calculation based on the sum of your traditional IRA and your age. You will have no required minimum distributions on the Roth IRA.
What if I still want to contribute to an IRA for last year? The deadline for contributing for a prior year’s IRA is typically April 15th. You can contribute for the current year from January 1 of that year to April 15th of the following year. Just make sure to define that you are contributing for the prior year.
By Greg Johnson
There are a lot of moving parts to IRA accounts, but this covers a lot of the details you need to know as an investor. The biggest mistake I see people making is thinking an IRA pays you interest. As Kristi describes an IRA is just how the money is treated for tax purposes. Knowing the details of how your IRA account works is key to planning for distribution of income during your retirement years as well as knowing what kind of access you have to the money. If you are uncertain of how things work, please reach out to a qualified financial advisor who help you navigate all these details.