Learn the fundamentals of the traditional IRA.
Find out how the Roth IRA differs from the traditional IRA
Find out how to select the best IRA type for you.
Learn about penalties associated with both types of IRAs.
Find out more about IRA conversions.
Learn more spousal IRAs, contribution limits and deductions.
Find out more about retirement distributions, penalties and opportunities to withdraw funds tax-free.
The tax code offers two types of IRAs. The first, created by Congress in the 1970’s, we call the traditional individual retirement account (IRA). The second type, the Roth IRA, was established in 1997 and named after William Roth, a senator from Delaware. Fiducial offers retirement planning, and your representative can explain more about your options. For now, we give you a primer on the different types of IRAs, their pros and cons, and how to choose the one that’s right for you.
Traditional IRA
First up, the traditional IRA! The traditional IRA provides a tax deduction for the amount of the contribution up to the maximum allowed for the year. Higher income taxpayers that also participate in their employers’ retirement plans, such as a traditional pension plan or a 401(k) plan, can make contributions, but the deductibility of their contributions phases out as their adjusted gross income (AGI) increases.
Contributions
The annual contribution limits, with inflation adjusted periodically, include an additional catch-up amount for taxpayers age 50 and over.
To make a contribution, an individual must have earned income. This income may come from working, such as wages or some form of self-employment income. Special provisions exist in the tax law that allow taxable alimony, non-taxable military combat pay, and certain taxable fellowships and stipends to be treated as earned income for purposes of the earned-income limit. The maximum contribution is the lesser of the earned income or the IRA contribution limit amount for the year.
Example: Phil, age 65, only worked part time during 2020 and had wages of $5,000. His contribution limit is the lesser of his earned income, $5,000, or the IRA contribution limit, $7,000. Thus, Phil can contribute any amount up to $5,000 for 2020.
Tax deductions for IRA contributions
The traditional IRA deduction begins to phase-out when an individual who makes a traditional IRA contribution is also an active participant in a qualified retirement plan and their AGI has reached certain inflation-adjusted thresholds.
The deduction fully phases out for unmarried filers when their AGI reaches an amount $10,000 over the threshold. Married taxpayers and certain surviving spouses achieve full phase-out when their AGI is $20,000 over the threshold. Those using the married-separate filing status and who are active participants in their employer’s qualified plan generally are not allowed a deduction once their AGI reaches $10,000.
Usually, when an individual withdraws funds from an IRA, the distribution is fully taxable. This includes the amount contributed and the earnings. An exception applies when a taxpayer elects not to take a deduction or when the deduction has been phased out. Contributions that were not deductible are recovered tax-free proportionally to each distribution. For example, if 8% of the overall contributions to a traditional IRA were nondeductible, 8% of each distribution will be tax-free and 92% will be taxable.
Takeaways on traditional IRAs
Traditional IRAs are recommended for those that may need a tax deduction in order to afford to make a contribution or those who are contributing later in life and cannot substantially benefit from a Roth IRA’s tax-free accumulation and whose income during retirement will be in a tax bracket substantially lower than it was when they were making the contributions.
Roth IRA
The tax benefit of a Roth IRA is quite different than that of a traditional IRA. With a Roth IRA, a taxpayer gets no tax deduction for contributions. However, the taxpayer gets tax-free accumulation, and at retirement, all distributions are tax-free, including the account’s earnings (if a five-year required holding period is met).
The annual contribution limits for a Roth IRA are the same as for a traditional IRA. This includes the need for earned income. However, for higher-income taxpayers, the amount they can contribute to a Roth IRA reduces as their AGI increases above an inflation-adjusted threshold established for their filing status.
Selecting the right IRA type for you
If you want to include an IRA in your retirement planning, you will have to decide between a traditional IRA or a Roth IRA. A traditional IRA provides a tax deduction for contributions and tax-deferred growth. However, any withdrawal from the account is fully taxable except for non-deductible contributions.
On the other hand, Roth IRA contributions are not deductible, but distributions after retirement are tax-free. A Roth IRA offers tax-free accumulation, meaning the earnings build up over the life of the IRA tax-free. Making the decision involves a number of factors, and the decision may change as finances dictate.
For those currently with low income and on a limited budget with little extra income to spare for IRA contributions, the traditional IRA offers a tax deduction. This will allow them to make a larger contribution and is better than having no retirement funds at all. In addition, lower-income individuals may qualify for (and benefit from) the Saver’s Credit, which provides a tax credit that may help them afford a contribution.
For those who can afford to make a non-deductible IRA contribution without financial stress, the Roth is the go-to IRA because of its tax-free accumulation.
Even younger individuals should strongly consider investing in a Roth IRA. The longer one has a Roth IRA, the more tax-free income it can provide.
Other issues to consider
Unfortunately, like everything involving taxes, there are a number of complications and special considerations.
Penalties
The IRS charges a 6% penalty on amounts contributed to an IRA in excess of the allowable contribution amount. This penalty continues to apply annually until the contributor corrects the excess. A 10% early distribution penalty also exists on the taxable amount withdrawn from an IRA before reaching age 59½.
However, contributors may waive some or all of the 10% penalty under certain circumstances. While generally tax free, some portion of a Roth IRA distribution could be taxed. It could also be subject to penalty if funds are withdrawn prior to completing the 5-year aging period. Ask your Fiducial representative for more details.
Conversions
To take advantage of the tax-free benefits of a Roth IRA, an IRA owner can convert a traditional IRA to a Roth IRA any time. However, taxes must be paid on the amount of the taxable traditional IRA funds converted to a Roth IRA. Timing is key when making a conversion.
Many taxpayers overlook some great opportunities to make conversions. For instance, years when their income is abnormally low or a year when their income might even be negative due to atypical deductions or business losses are a great time to convert. Even the new, higher-standard deductions may offer a taxpayer benefits. One example: They have the opportunity to convert some or all of their traditional IRA to a Roth IRA without any conversion tax.
Conversion is also a way to get around the AGI limitation on making Roth IRA contributions. Often referred to as a back-door Roth IRA, non-deductible contributions get deposited to a traditional IRA and are then converted to a Roth IRA. This procedure has some tax traps. Be sure to consult with your Fiducial representative before attempting a back-door Roth IRA.
Spousal IRAs
Spouses with no or a small amount of compensation for the year may contribute to their own IRA based upon their spouse’s compensation. If the unemployed spouse chooses a traditional IRA and the working spouse participates in an employer’s plan, the contribution’s deductibility phases out between $196,000 and $206,000 (2020 inflation adjusted amounts). If a Roth IRA is chosen, the contribution limit also phases out between $196,000 and $206,000, even if the working spouse isn’t covered by an employer’s plan.
Retirement Distributions
For both traditional and Roth IRAs, distributions can begin once a taxpayer reaches age 59½ without penalty. For traditional IRA owners, once they reach age 72 (up from 70½ for those who turned 70½ before 2020), they must begin taking what we refer to as a minimum required distribution (RMD) each year.
The minimum amount is based upon current age and the value of the IRA account. Failing to take a distribution of the required minimum amount may result in a 50% penalty of the amount that should have been withdrawn. However, the IRS will waive the penalty under certain conditions.
TIP: In any post-retirement year when your income is below the taxable threshold, you have an opportunity to withdraw from the IRA tax-free. You should consider doing so even if you don’t need the income. You can put it away in a savings account until you do need it.
Roth IRAs are not subject to the RMD requirement so long as the Roth account owner is alive.
Saving for retirement is extremely important, even if it means cutting back on discretionary spending. Choosing the right IRA or retirement plan can become complicated. It can have a big impact on your current tax situation as well as in your retirement years. Need help with your retirement planning? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations. Ready to book an appointment now? Click here. Know someone who might need our services? We love referrals!
For more small business COVID-19 resources, visit Fiducial’s Coronavirus Update Center to find information on SBA loans, tax updates, the Paycheck Protection Program, paid sick and family leave, and more.