The tax code offers two types of IRAs; one is referred to as the traditional individual retirement account (IRA), so named because it was the first type of IRA available, having been created by Congress back in the 1970s. The second type is the Roth IRA, established in 1997 and named after William Roth, who was a senator from Delaware.
Traditional IRA – The tax benefit of a traditional IRA is that it 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 phase out as their adjusted gross income (AGI) increases.
| IRA Contribution Limits | ||
| Year | Under Age 50 | Age 50 and Over |
| 2013 through 2018 | $5,500 | $6,500 |
| 2019 through 2020 | $6,000 | $7,000 |
The annual contribution limits are inflation adjusted periodically and include an additional catch-up amount for taxpayers age 50 and over.
To make a contribution, an individual must have earned income (income from working, such as wages or some form of self-employment income). There are special provisions 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, who is age 65, only worked part time during 2020 and his wages were $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 $5,000 for 2020.
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 is fully phased out for unmarried filers when their AGI reaches an amount $10,000 over the threshold. For married taxpayers and certain surviving spouses, full phase-out is achieved when their AGI is $20,000 over the threshold. Those using the married separate filing status who are active participants in their employer’s qualified plan generally are not allowed a deduction once their AGI reaches $10,000.
| Phase-out Threshold for Active Participants in Qualified Pension Plans | |||
| Filing Status | 2018 | 2019 | 2020 |
| Single & Head of Household | $63,000 | $64,000 | $65,000 |
| Joint & Surviving Spouse | $101,000 | $103,000 | $104,000 |
| Married Filing Separately | Zero | Zero | Zero |
Generally, when funds are withdrawn from an IRA, the distribution is fully taxable, including 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.
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 when contributions are made. 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, including the need for earned income. However, for higher-income taxpayers, the amount they can contribute to a Roth IRA is reduced as their AGI increases above an inflation-adjusted threshold established for their filing status.
| Roth IRA Contribution Limit Phase-out Range | |||
| Year | Married Filing Joint | Married Filing Separately | All Others |
| 2018 | 189,000 – 199,000 | 0 – 9,999 | 120,000 – 135,000 |
| 2019 | 193,000 – 203,000 | 0 – 9,999 | 122,000 – 137,000 |
| 2020 | 196,000 – 206,000 | 0 – 9,999 | 124,000 – 139,000 |
Selecting the IRA Type for You – If you are going to include an IRA in your retirement planning, a decision you will have to make is whether to choose a traditional IRA or a Roth IRA. A traditional IRA provides a tax deduction for contributions and tax-deferred growth, but 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, which 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 – There is a 6% penalty on amounts contributed to an IRA in excess of the allowable contribution amount. This penalty continues to apply annually until the excess is corrected. There is also a 10% early distribution penalty on the taxable amount withdrawn from an IRA before reaching age 59½. However, some or all of the 10% penalty is waived under certain circumstances. While distributions from Roth IRAs are generally tax-free, some portion of the distribution could be taxed and subject to penalty if funds are withdrawn prior to completing the 5-year aging period. Please call this office for additional 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, but 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, such as years when their income is abnormally low or a year when their income might even be negative due to atypical deductions or business losses. Even the new higher standard deductions may offer a taxpayer 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 are made to a traditional IRA and then converted to a Roth IRA. This procedure has some tax traps, so be sure to consult with this office 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 is referred 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 and can have a big impact on your current tax situation as well as in your retirement years. Please call for assistance.
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