The following commonly overlooked or unknown facts about IRAs should be kept in mind by all:
1. There are different types of IRAs
There are several types of IRAs, each with their own benefits and limitations. Below is the basic information you should know about traditional, Roth, Spousal, SEP, Simple, non-deductible and Self-Directed IRAs.
The Traditional IRA
This is the most popular of the IRA accounts. The basic features of the traditional IRA include:
- For the year 2020, an upfront tax break of up to $6000, plus an extra $1000 of catch-up contribution if you are age 50 or older. There are certain stipulations attached to deductibility including your current income and tax filing status. As well as the availability of a retirement plan at you or your spouse’s job, which could lower your taxable income for the year.
- Earnings realized are not taxed as long as the money remains within the IRA account.
- Withdrawals made in retirement are taxed at your tax rate at that time. For most of us, our retirement tax rate is likely lower than our tax rate in our 40s, 50s, or 60s. This lower tax bill is an added benefit of letting your money grow undisturbed in the traditional IRA account.
The best benefits of a ROTH include:
- Withdrawals made in retirement are 100% tax free. Note however that contributions made are not deductible for tax purposes. For the 2020 tax year, the ROTH contribution limit is $6000.
- There are taxes and penalties that apply to initiating withdrawals from your ROTH prior to retirement. In Retirement however, ROTH IRA withdrawals are rather seamless and easy.
- Being eligible to contribute to a ROTH IRA according to the IRS, is all income based. With Roth IRAs, your ability to contribute is phased out when your modified adjusted gross income reaches an IRS predetermined level. For 2020, phase-out starts at $124,000 and you are ineligible after earning $139,000 for single filers. Meanwhile, for married filing jointly, phase-out starts at $196,000 and you are ineligible once you have earned up to $206,000.If you however earn too much money to contribute to a ROTH IRA, there does exist a legal way to open a ROTH IRA via a backdoor ROTH.
THE SEP IRA
This is a simplified employee pension, set up and funded for employees by their employer, who in turn gets tax benefits for putting the SEP in place.
If you are self-employed however, you are both the employer and employee. This means that you as an employer can contribute to a SEP IRA, receive a business deduction for your contributions, all for the benefit of the employee (you).
Key features of the SEP IRA include:
- Annual contribution limits are much higher that what the laws allow in other retirement accounts – the lesser of up to 25% of employee compensation or $57,000 in 2020.
- The employer must contribute equally (based on percentage of employee salary contributed) to all employee accounts, including their own.
- Contribution size may vary from year to year based on the employer’s business cash flow but must always be equal for all eligible employees.
- Employees must have worked for the employer in at least three of the last five years, and must have earned at least $600 in compensation during the year to be eligible to contribute.
- Sole proprietors can open a SEP IRA for themselves.
- There are no catch-up contributions allowed for individuals over the age of 50.
- Even if you have a full-time job as an employee (whether or not you participate in your employer’s 401(k) or another retirement plan), if you earn money on a side gig or running a small side business, you could still take advantage of creating and contributing to a SEP IRA to reduce your taxable income and save even more for retirement.
Key features of the nondeductible IRA include:
- After-tax dollars are used in contributing to this form of IRA, hence the name.
- Since the account is funded with post-tax dollars, taxes are due (in retirement) on any earnings growth you withdraw, but not on your principal.
Although the IRS stipulates that a person “must have earned income to be eligible to contribute to an IRA”, there is a loophole married taxpayers can explore.
If you or your spouse is not working, or simply brings in a very low income, you can both contribute to your very own separate IRAs, which can be either Roth or traditional.
Do however watch for phase-out and other IRS rules. Other key features include:
- You and your spouse must file a joint tax return and have taxable compensation to be eligible.
- Contribution limits are based on the limit the working spouse is allowed. For the 2020 tax year, up to $6000, or $7000 for those age 50 or older.
- The account can be funded with cash from either spouse’s earnings but must be opened in the non-working spouse’s name with his or her social security number associated with the account.
- The total amount contributed to both IRAs must be the lesser of your joint taxable income or double the annual IRA contribution limit ($7000 + $7000 for couples over 50)
THE SIMPLE IRA
Simple stands for Savings Incentive Match Plan for Employees. It is very similar to an employer-sponsored 401(k) and exists primarily for small companies and self-employed individuals. Key features include:
- Contributions limits are lower than set limits for the 401(k). $13500 in 2020 as compared to $19500 for the 401(k).
- As an employee, you are allowed to contribute to the account via salary deferral, unlike the SEP.
- Generally, employers are required to kick in up to a 3% matching contribution or a fixed contribution of 2% of each eligible employee’s salary.
- To qualify to participate in a SIMPLE IRA, an employee must have earned at least $5000 during any two years before the calendar year and expect to receive at least that amount in the current year.
- Catch-up contributions are allowed if you are age 50 or older (unlike the SEP).
- Participants are allowed to roll the money from the SIMPLE IRA into a traditional IRA after two years of participation. This is a great benefit of the SIMPLE IRA plan.
- It is highly important to note however that early withdrawals from a SIMPLE IRA within the first two years of contributing to the plan may be subject to a 25% penalty – in addition to regular taxes.
IF you do not like the investment options offered in an IRA, a self-directed IRA may be worth your looking into.
Traditional IRAs (most IRAs covered above) typically limit investments in the account to the well-known investment vehicles including stocks, Certificates of deposits, bonds and mutual funds.
In a self-directed IRA however, you are allowed to spread or broaden your spectrum of possibilities. You can include assets such as real estate, gold, commodities, options, futures, and a stake in privately held companies.
You will be getting all the tax-deferred benefits of a traditional IRA, nondeductible IRA, or Roth IRA. But, you won’t be as limited in your investment options. Key features include:
- The IRS does not allow holding items like collectibles and life insurance in the account.
- Setting up the account requires the use of a trustee or custodian who specialized in the investment vehicles of choice
2. “Catch-up” contributions can help those age 50 or older save more
If you are age 50 or older, you are eligible to save an additional $1,000 in a traditional IRA or Roth IRA each year. This means for 2020 the maximum would be $6,000 plus $1,000 catch-up.
This is a great way to make up for any lost savings periods and make sure that you are saving the maximum IRA amount allowable for retirement.
If you take advantage of this between the ages of 50 and 70, you could have as much as $40,000 or more to spend in retirement versus an individual who did not seize upon the catch-up contribution rule.
3. Even if you cannot contribute to traditional IRAs or Roth IRAs, you can still benefit from contributing to a nondeductible IRA
There is still an advantage to contributing to a nondeductible IRA, despite no tax deduction upon funding as you would normally get with a traditional IRA .
For example, you could not contribute to a traditional IRA if you’re covered by a 401(k), 403(b) or other retirement savings plan at work and you are phased-out based on income level, and/or you are ineligible to contribute to Roth IRA due to income levels.
Nondeductible IRAs are individual retirement accounts funded with “after-tax dollars” because there is no deduction for the contributions (like a Roth IRA).
However, as the funds are held in an IRA, any earnings on those funds are not taxed until withdrawal in retirement.
This tax-advantaged growth could make a substantial difference if accumulated over a long period of time.
In addition, on withdrawal, you are taxed only on the earnings withdrawn and not on the contributions you made.
4. IRS rules allow the opening of a Roth IRA for a child who has taxable earned income
The benefit of opening and funding an IRA for a child or minor — especially a Roth IRA where the earnings withdrawn in retirement will never be taxed—can be a great way to give him or her a head start on saving for retirement.
This is because the longer the timeline, the greater the benefit of tax-free earnings.
Starting to put away earnings from babysitting or doing household chores can be a great way to pave a bright future of investing for a young individual.
Gifting money to cover the contribution to a child or grandchild is another means of funding an IRA. This way, the child can keep all their earnings and still have savings for retirement.
Note however that the gift given and contributed to the IRA cannot exceed the child’s earned income (from doing chores, for example). However, be mindful to make sure that all gifts you make (including the contribution to Roth IRA) stay below the annual gift tax exclusion per person.
For 2020, the annual gift tax exclusion is $15,000.
Making the right IRA determination
A major factor in determining with IRA to proceed with is “Household Income”.
As a baseline, you must have earned income in a given year to be eligible to contribute to an IRA. Earned income is described as your salary, bonuses, commissions, professional fees, and self-employment income.
If your only income is from unearned sources such as investments (e.g., dividends, rents, pension) only, then you cannot contribute to an IRA because IRA contributions cannot exceed your earned income.
Once you know which IRA is right for you, the next step is to shop for custodians to hold your IRA. There is a wide range of banks to brokerage accounts in existence today.
The main difference will be your choice of investment offerings within your IRAS, in other words, what can the money in your IRA be invested in.
For other non-traditional investment vehicle options, see my review of Fundrise and RichUncles respectively.