The next tool in your investment toolbox is going to be your IRAs (Independent Retirement Accounts). While your employer based plan (these are your 401(k)s or your 403(b)s) can be extremely beneficial, due to the tax breaks and employer matching that you can take advantage of, it is important to look at all of the investment vehicles. The next obvious one is the IRA.
So what are the differences between a 401(k) and an IRA. Well the first one must be set up through your employer, while the second one can be set up on your own (hence the “individual” part). Employers cannot contribute to your IRAs and you will most likely need to set them up on your own. We will cover where and how to set up an IRA in a separate article, but first, let’s just establish what they are and if you need one.
There are two main types of IRAs that you will encounter, the Traditional and Roth IRAs. We are going to break them down separately, and then compare the two.
The Traditional IRA:
The Traditional IRA acts very much like a 401(k) in terms of how it can be taxed. Both can be deducted for state and federal tax purposes. Sometimes, there are Traditional IRAs that can connect with your employers to take pre-tax deductions from your normal paycheck, just like a 401(k). Other times, especially if you are finding your own plan out in the market, you will actually be contributing to your Traditional IRA with your after-tax money. The benefit comes whenever you file your taxes, you can deduct your contributions from your taxable income. To see whether or not your Traditional IRA plans can be connected to your employer’s payroll system, you should talk to your account provider and HR department. You can contribute pre-tax every year that you qualify, and your earnings each year can grow tax free as well. Operating just like the 401(k), your Traditional IRA will only be taxed whenever it is pulled out in retirement, as income.
The Roth IRA:
The Roth IRA acts almost exactly opposite of the Traditional. All contributions made will be with after-tax dollars. The benefit of the Roth IRA is that while you pay the tax up front, you won’t have to worry about paying taxes on the money ever again, even as it grows. This account will allow you to contribute every year that you qualify, grow off of your investments tax free, and can be pulled out in retirement tax free. The nicest thing about the Roth IRA is that once you pay the tax up front, you never have to worry about it again! Many people like to participate in a Roth IRA to diversify their tax strategies.
Can you Even Participate?
While both of these accounts can be great things to add to your investment toolbox, there are some limits as to who can participate. These were created to encourage people who don’t have an abundant amount of money to participate. With that said, there are some limits as to who can participate and how much they can contribute.
The Traditional IRA:
According to the IRS, the maximum amount that a person can contribute this year (2017) is $5,500. Just like with the 401(k), there is an extra $1,000 contribution given to individuals 50 and over. These amounts are in addition to your maximum allowance for your 401(k) contributions. Contributing to one does not affect the other in terms of contribution limits. Now anyone can contribute to a Traditional IRA, regardless of their income. There are a few limitations on how much you can contribute to a Traditional IRA.
- You cannot deduct more than you have in compensation for the year. For example, you only have $2,000 in compensation this year, but you received a $2,000 gift from a family member and want to contribute $4,000 to your Traditional IRA. You cannot contribute more than the $2,000 you have in compensation.
- There is a rule that allows you to contribute more than our compensation into an IRA if your spouse has enough compensation to cover the difference. Known as the Kay Bailey Hutchison Spousal IRA Limit, a married couple can cover a spouse if they do not work or do not make more than the full contribution limit. For example, Kris makes $3,000 in compensation and Devon makes $30,000 in compensation. Even though Kris only makes $3,000, Kris can contribute up to the full $5,500 limit since Devon has enough compensation to cover Devon’s contribution to an IRA and the difference is Kris’s compensation and the full contribution limit. ($30,000 – Devon’s $5,500 limit = $24,500. This is more than enough to cover the $2,500 that Kris needs to max out the IRA contribution.)
The catch is that not everyone can deduct their contributions to a Traditional IRA account. To determine whether or not you can deduct your contributions to a Traditional IRA, you first need to know what your modified AGI will be. Your modified AGI is different than your normal AGI that some people are used to seeing. Take a look at the chart below to figure out your Modified AGI:
Now that you know what your modified AGI is for Traditional IRA purposes, let’s see if you can deduct your contributions. The two factors that really affect a person’s ability to deduct their Traditional IRA contribution is their filing status and whether or not they, or their spouse, is covered by another type of retirement plan through work. For example, if you are married and file a joint return, then you will look at the first set of boxes. Then you need to determine if you are covered by your work for another retirement plan (like if your work participates in a 401(k), then you are covered by you work). Finally, you should find the subset of modified AGI limits to see where you fall within the chart. This should then tell you whether or not you are able to take a full, partial, or no deduction.
If you can only take a partial deduction, refer to the following chart to determine what your deduction is limited to:
The Roth IRA:
According to the IRS, the maximum amount that a person can contribute this year (2017) is $5,500. Just like with the 401(k), there is an extra $1,000 contribution given to individuals 50 and over. These amounts are in addition to your maximum allowance for your 401(k) contributions. Contributing to one does not affect the other in terms of contribution limits. However, you can only contribute a total of $5,500 to IRAs in total, whether it is all towards a Traditional, Roth, or a combination of the two. Now unlike the Traditional IRA, not everyone can participate in a Roth IRA. There are additional limitations to the Roth IRA, because of the special tax rules. While you do pay the tax on the money up front, the money grows tax free. It is also not taxed when the money is withdrawn for retirement.
For the contribution limits, there are several rules. First, the same two contributions limits for the Traditional IRA also apply to the Roth IRA. You cannot contribute more to your Roth IRA than your compensation, and the rules with your spouse apply as well, known as the Kay Bailey Hutchison Spousal IRA Limit Rule. After these circumstances, the limitations mostly have to do with income. First, you will want to identify what your modified gross income is:
Once you know your modified gross income, refer to the limitations table:
Finally, if you are limited in the amount that you can contribute, refer to the table below:
What If You Need the Money Early?
While I STRONGLY disagree ever withdrawing money that you have saved away for retirement, sometimes there are situations that happen and you need money fast. Because of this, it is important to look at the different ways that you can access your money, and they differ based on what type of IRA you have. The IRS will penalize you for a withdrawal before the age of 59 ½. Here are the things to keep in mind.
If you take any money from your Traditional IRA, the IRS will tax you on the withdrawal at that current tax rate and hit you with a 10% penalty. There are some exceptions to this rule, which I plan on covering in a follow up post. So in general, keep it in mind that you will not only have less money in your retirement account, be taxed on that amount, but you will also lose 10% of that money to the tax man.
The Roth IRA is slightly more forgiving when it comes to accessing your funds before the age limit. You are able to withdrawal the money that you actually contributed to the account, without having to pay any more tax or penalty on it. However, if you want access to the earnings on the account, the rules can be more complicated. Generally, the earnings are subject to a five year waiting period. So if you touch the earnings before your first Roth IRA contribution is five-years-old, then that withdrawal could be subject to being additionally taxed and a penalty being applied.
What is this Required Minimum Distribution Nonsense?
This is a term that basically means the IRS wants their money. Once you reach the nice age of 70 ½, the IRS has implemented some rules to make sure that you start pulling out some of that money so that they can get the tax money that you have deferred all of these years. As usual, there are differences between the Traditional and Roth IRA accounts.
The Traditional IRA is subject to RMDs. Not only are you required to start taking money out, which will be taxed by the IRS, but you can no longer contribute to this account either. To figure out how much you must withdrawal, refer to this IRS publication here.
The Roth IRA is not subject to RMDs. You are free to let your account continue to grow well into your old age. You are also free to continue to contribute to your Roth IRA well into your old age. The only time that there are RMDs to be concerned with in regards to the Roth IRA is if you have inherited one. Again, if you are concerned about needing to take out money due to an inherited Roth IRA, check out this IRS publication here.
So Which One Should I Be Using?
This is another loaded question, as it all comes down to personal preferences and circumstances. The general advice is when you think you will be making more money. If you think you are currently making more money than you will in retirement, than a Traditional IRA is more suited for your situation. The idea here is that you will be deferring paying taxes until retirement where you think you will be making less money. If you think that you are currently in a low tax bracket and will be making more money in retirement, than a Roth IRA would be the way to go. The idea being that you would pay tax now while you are in a lower tax bracket, letting the contributions grow tax free. Yet another option is to mix up your contributions into both accounts, as some people like to diversify their tax strategies. However, every situation is different and if you plan on following the financial independence path, the answer can be very different because of several FI tricks. I plan on writing another article that will focus on IRAs for people that are interested in Financial Independence and talk about the Mega Backdoor Roth strategy and the Roth IRA Conversion Ladder.
*All of the information within these tables can be found at here.