No, it’s not your grandfather’s childhood friend. An IRA (individual retirement account) is a tax advantaged way of saving for retirement.
No, it’s not your grandfather’s childhood friend. An IRA (individual retirement account) is a tax advantaged way of saving for retirement. There are a few different types of IRA, but the two types of IRAs that individuals can fund to take advantage of tax sheltered savings: a Traditional IRA and a Roth IRA. The other two are for self- employed individuals or small businesses.
Depending on your income, contributions to traditional IRAs are tax-deductible (“pre-tax”) in the year the contributions are made. So if you contributed $6,000 to an IRA one year, your taxable income for that year decreases by $6,000. When you withdraw that money in retirement, the withdrawals are taxed at ordinary income tax rates.
In 2021, the annual contribution limit to an IRA is $6,000. If you are 50 or older, you can contribute up to $7,000. If you earned income less than the contribution limit, you can contribute an amount equal to your earned income. As of 2021, there is no maximum age at which you can contribute to an IRA as long as you earn income equal to how much you contribute.
If you have an employer-sponsored retirement plan (401k), there are income limits at which deductions on your contribution phase out. Below are the limits if you have a retirement plan through your employer.
You can begin taking withdrawals from a traditional IRA at age 59 ½. At age 72, traditional IRA holders must start taking required minimum distributions (RMDs). These distributions are determined by dividing the retirement account’s prior year-end fair market value (FMV) by the applicable distribution period or life expectancy. The IRS has published a copy of the RMD worksheet to help you determine the amount you need to withdraw. Your IRA custodian can help you with this as well. It is vitally important that you take RMDs. If you don’t, the amount not withdrawn is taxed at 50%!
Roth IRA contributions, on the other hand, are not tax deductible and are therefore “post-tax” money. However, when you withdraw those funds in retirement, the withdrawals are tax free, subject to the five-year rule. The five-year rule requires you to wait five years before making withdrawals from your Roth IRA. Roth IRAs are not subject to RMDs in the holder’s lifetime and the yearly contribution limits are the same as traditional IRAs.
There are income limitations for individuals wishing to contribute to a Roth IRA, however. The table below shows the income limits by filing status for 2021.
As stated above, Roth IRA holders do not have to take RMDs in their lifetime, beneficiaries (other than a surviving spouse) must take RMDs or face the 50% penalty. There are different rules depending on whether the beneficiary is a spouse or someone else.
Because of the different tax treatment of traditional and Roth IRAs, the key issue is whether or not your income tax rate is higher now than it will be in retirement. Impossible to know, Magic 8-ball or not, I know. You can only make an educated guess. For younger workers just entering the workforce, a Roth IRA could suit you since you haven’t yet reached your earning potential, i.e. paying less income tax now than later in life. You also have time on your side for those contributions to grow tax free for a significant amount of time. The downside is of course that you are contributing and paying taxes on your contributions when you are making less money, meaning less money to live off of.
However, if you are in your peak earning years and are in one of the higher tax brackets (but within the income limits), the only place for your income tax liability in retirement to go is down.
Here are a few additional tips to consider.
Tip #1: By building up a balance of both Traditional retirement assets and Roth retirement assets, you will provide flexibility for yourself during retirement years. When you are pulling from your retirement portfolio to cover living expenses, you will have the option of pulling from assets that will be taxable upon distribution (Traditional pre-tax IRA account) as well as assets that are non-taxable upon distribution (Roth). Since the tax rates are tiered, one could use a strategy of pulling from taxable assets to bring their income up to the top of a targeted tax bracket, then switching to assets from non-taxable accounts and therefore keeping themselves in a target tax bracket each year and reduce the average income tax rate for all taxable distributions over their lifetime.
Tip #2: If you’ve maxed out your 401k contributions and still wish to save additional funds in tax-advantaged savings but you’re over the income limits for deductible IRA contributions as mentioned above, you could do an alternative planning strategy: Non-deductible IRA contributions followed by Roth conversions.
Tip #3: Money put into a Roth IRA can be pulled out at any time for emergencies or to pay for college tax and penalty free. Note, that this is only the contributions that are allowed to be removed without penalty and any growth on those contributions would be taxed and penalized. While we don’t usually recommend this because we want you to focus on saving for retirement, it’s important to note it's an option.
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