One of the most important reasons to invest and save is retirement; in your lifetime, you need to accumulate enough wealth to continue supporting yourself without income, and the paltry sums which social security entitle you are just not enough to live off of. In this lesson, I will talk about one way to store and grow your money: IRAs.
There are two major types of Individual Retirement Account (IRA): the traditional IRA and the Roth IRA. Which one you can employ depends on your income. The maximum eligible income for Roth IRA depends on whether you’re married: a single person – or the head of a household – is qualified as long as his income does not exceed $122,000 (in 2019). Married couples who file jointly must earn less than $193,000 to qualify for a Roth IRA. Additionally, if as a single person, you earn more than $122,000 but less than $137,000, you qualify for partial contributions to a Roth IRA, but we will talk about what that means later on.
For traditional IRAs, the eligibility rules are more complex. In addition, to considering income, the IRS considers whether you have a workplace retirement plan option. If you are single and not covered by a workplace retirement plan, you are eligible for a Traditional IRA at any income level; however if there is a workplace retirement plan in place for you, you may only utilize traditional IRAs if your income is less than $64,000 (in 2019), and if you earn less than $10,000 more than $64,000, you qualify for partial deductions. If you are married and covered by a retirement plan, the income limit for a joint filing and full deductions is $103,000, and as long as you earn less than $123,000, you qualify for partial deductions. An entire explanation of eligibility for traditional IRAs can be found here.
Keep in mind the income which determines your eligibility for IRAs is your Modified Adjusted Gross Income (MAGI). This number will be close to your Adjusted Gross Income (AGI), as it is equal to AGI with some deductions added back. For the list of deductions go here.
In specifics, if you qualify for full contributions to a traditional IRA, you may pay up to $6,000 (in 2019) of your income every year into an account, which will be stored and managed by the bank or financial service company the account is opened with. If you are older than 50, you’ll be able to pay an additional $1,000 in “catch-up contributions.”
These contributions are almost always tax deductible. If you and your spouse are not covered by a workplace retirement plan, all contributions are fully tax deductible. Otherwise, it depends whether you qualify for full contributions. Once you pass the max limit for full deductions – $64,000 for single people and $123,000 for couples filing jointly – only part of your contribution is tax deductible. A chart of the phase-out can be found on most financial services website.
The money you put in this account grows by investing. You may choose what to invest in, or you may hand over control to a financial company, as with regular money. The benefit of using a traditional IRA, however, is that holder doesn’t pay capital gains tax on the investment.
However, withdrawals from the account are subject to several taxes, depending on the circumstances. In short, when you withdraw from a traditional IRA, you will have to pay income tax; The percentage is obviously equal to your current marginal tax bracket. Additionally, if you choose to withdraw before you reach the age of 59 ½, you will have to pay a 10% penalty, as a penalty for early withdrawal. There are exceptions for which no penalty will be charged the most common are distributions as a result of:
- the IRA owner’s death
- total and permanent disability
- qualified first-time homebuyer distributions
- payment of your qualified higher education expenses
- payment of certain medical insurance premiums paid while unemployed
- payment of unreimbursed medical expenses that are more than a certain percentage of your adjusted gross income
- an IRS levy of the IRA
This 10% tax is only on withdrawal of investment gains, which means, before you reach the age of 59 ½, you can withdraw the value of the original contribution from a traditional IRA and pay only income tax on it. Thus it is important to keep records, detailing what counts as a “contribution” and what counts as an “investment gain.”
Once you reach the age of 70 ½, the IRS will mandate a required minimum distribution (RMD); this is the value of money which you are required to withdraw from the traditional IRA. If you fail to withdraw the amount, a tax of 50% will be levied, so it is important to take your money back.
The Roth IRA is essentially the better version of the traditional IRA; You pay no income tax on withdraws or profits (early withdrawal penalties still apply), and there is no RMD. The tradeoff is that the money deposited is not tax deductible, meaning contributions are in post-tax dollars.
Additionally, contributions are capped at the same limit as the traditional IRA, and the “catch-up contributions” also allow contributions to be $1,000 more. But the phase-out works differently. For traditional IRAs, the amount which is tax deductible decreases as your income increases when you’re in the range where you qualify for partial deductions. However, for Roth IRAs, the maximum contribution decreases as your income increases. Charts for this type of phase out can be found on most financial services websites and an equation can be found here
If the owner of an IRA dies while there is still money in the account, that money can be inherited in three ways: lump sum distribution, distribution into the spouse’s IRA, or the creation of a special IRA. Lump sum distributions is a one-time payment of the entire value left in the account. This payment is subject to income tax if the account is a traditional IRA and subject to other taxes if the account is a Roth IRA and younger than 5 years. No early withdrawal penalty is applied, however.
If the beneficiary of the funds is the spouse of the original holder and the sole beneficiary, the beneficiary may choose to add the complete value of the account to his or her current respective IRA, with no extra fees or taxes. Afterward, the money is regulated according to the rules of the spouse’s IRA.
Otherwise, the money will be transferred into another account of the same type. If the original owner of the account is younger than 70 ½ and the account is a traditional IRA or if the account is a Roth IRA, the beneficiary may then choose to transfer the money into life expectancy account or a 5-year account. A life expectancy distributes the money throughout the life of the decedent, while the 5-year account distributes the entire sum as a lump sum on December 31st five years after the original owner dies. If the owner of the account is older than 70 ½ and the account is a traditional IRA, the options are restricted to a life expectancy account. Nonetheless, these accounts will follow the rules of regular accounts, meaning income tax is applied to withdrawals and there is an RMD if the account is a traditional IRA. However, as both methods move forward the time table for withdrawals, no early withdrawal penalty is imposed.
The specifications within the laws regarding IRAs can be read here
It is never too early to begin saving for retirement, and IRAs provide a great way of storing and growing money over your lifetime. IRAs, like other portfolio tools such as index funds, are incredibly easy to manage and provide an excellent source of passive income after retirement. Whether you are paying off student debt, or seeking retirement, an IRA is a trustworthy tool that one can employ to help bring about financial success and stability.