If someone ever tells you they know everything about IRA’s, they are either flat out lying or they are ignorant of many of the rules. As I started to write this piece this week on traditional IRA’s, my goal was to sum it up in less than a page. However, I quickly realized that would not be possible. There are so many rules! I will do my best to keep this to the point.
The IRA, or Individual Retirement Arrangement, was established by the Employee Retirement Act of 1974, aka ERISA. The IRA is a personal account (hence the I for Individual) that is held at an institution such as a bank or brokerage. You can start them through Schwab, TD Ameritrade, etc…
Once the account is open, you have to fund it. This can be done in a number of ways. The easiest way is to make a contribution, which can be done by simply writing a check or moving money from a checking or savings account. Other options include rolling over money from another account, such as an IRA, 401K, or other qualified plan.
There are limits to how much money can go into a Traditional IRA per year. For 2015, the limit is $5500 if you are under age 50, and $6500 if you are 50 up until age 70.5. After age 70.5, you can no longer contribute to a traditional IRA, and must start taking RMD’s, which I will explain later. The rules of an IRA state that you can only contribute earned income, so if your income is less than the limits, you can only contribute up to what you and your spouse combined make. For instance, if your earned income in 2015 is $4000, that is the maximum that you can contribute. Each spouse can contribute up to the limit in their own IRA if their combined earned income is high enough.
If you meet the criteria I have described, you can contribute to an IRA. Whether or not you can deduct your contribution from your taxable income depends on if you and your spouse are covered by a retirement plan at your jobs. If neither of you are covered by a plan at work, you are not restricted. If you are both covered, then you can deduct your contribution if your MAGI falls below $98,000 ($61,000 if single). From a MAGI of $98,000 to $118,000 (or $61,000 to $71,000 if single), the deduction is phased out, meaning only some of your contributions will be deductible. Over $118,000 ($71,000 if single) you cannot deduct your contributions. However, the rules change again if you are not covered by a plan at work, but your spouse is. Then you can fully deduct your contribution if your combined MAGI is $183,000 or less, and it phases out up to $193,000. Confused yet?
The benefit of making a tax deductible contribution is that all of the money in the account, while it remains in the account, is tax deferred until you take it out. Ideally, you will have a lower tax bracket in retirement, and therefore you not only delay taxation, but lower it as well. Even if you can’t deduct your contribution, there is still a benefit of putting money in after tax (I will caution that you may want to look at a Roth instead if you are eligible). The money that goes into your IRA after tax is still allowed to grow tax deferred until you withdraw it. All of those capital gains and dividends that would have been taxed annually stay in the account without taxation until you take it out. The other great thing about a non-deductible IRA is that you can use it to make what is called a back-door Roth IRA contribution when you are not eligible for a Roth. More about this next week when I discuss Roth IRA’s.
Once you fund the IRA, you can start investing the money in anything that the custodian allows. Typically, this will be investments like stocks, etf’s, mutual funds, CD’s, money market accounts, etc… However, there are exceptions to this rule. Some custodians (who typically charge higher fees) will allow you to purchase alternative investments such as real estate (but not collectibles) in your IRA. This can be very complicated and expensive, so be sure to consult your CFP before attempting this.
Money that is in an IRA is always available to withdraw. However, there are rules about withdrawing, and they are not favorable until you are 59.5. If you take money out before 59.5, you will pay an 10% penalty in addition to any taxes you may owe on that withdrawal. There are a few situations where this can be avoided, such as if the withdrawal is for unreimbursed medical expenses over 10% of AGI, in certain situations to pay medical insurance, if you are disabled, die, use the substantially equal payments program (SEPP), for qualified education expenses, to purchase a first home ($10,000 limit), or to pay the IRS (shocking). If you withdraw the contributions you made to a non-deductible IRA, there is no penalty.
In the year you turn 70.5, you must begin taking what are known as required minimum distributions, or RMD’s. The IRS has a formula on how to calculate RMD’s, but most custodians will do that calculation for you. If you fail to take an RMD, there is a 50% penalty on the amount not taken.
When it comes to the traditional IRA, this is just a brief overview. For more information, see the IRS website, or talk to your fee-only financial planner. The traditional IRA is an excellent retirement savings tool, but it may not be the best tool for you. Educate yourself before you decide how to invest, ans it will pay you back over time!