Individual Retirement Accounts: Understanding Your Choices for Tax Advantaged Savings

Individual Retirement Accounts: Understanding Your Choices For Tax Advantaged Savings

 understanding your choices for tax advantaged savings

Individual Retirement Accounts: Understanding Your Choices For Tax Advantaged Savings

Have you funded your IRA this year? Are you eligible? How often have you heard these questions? In 1974, Congress passed legislation that created Individual Retirement Accounts (IRAs) to encourage individuals to save for retirement. Life expectancies were expanding, traditional pension plans were going by the wayside and it was clear that Social Security would one day be insufficient to support people in retirement. The idea of an IRA is to encourage savings today to be used later in life. The benefits of IRAs have now proven themselves for over a generation, but too often we still do a poor job explaining how these accounts work, and the incredible ad-vantages that these types of accounts provide. The different names can be confusing and the advantages of each can vary. Here, we will look at the three most common types of Individual Retirement Accounts including the Traditional IRA, the Roth IRA and the Rollover IRA.

Individual Retirement Accounts: Understanding Your Choices For Tax Advantaged Savings

What is an IRA?

Before we look at the differences in each of these types of accounts, it’s important to understand what’s so special about retirement accounts in the first place. It all centers around one word – taxes. In a regular investment account, as your money grows, you are required to pay taxes each time you make a sale, earn interest or receive a dividend. These taxes reduce the value of your gains, and can lower your account balance when you pay. But in an IRA, as long as the assets stay in the account, they grow tax-deferred or even tax-free! For assets in these accounts there are no taxes paid on sales, dividends or interest. This tax-free nature is the incentive Congress baked into IRAs with the hope of enticing everyone to save more. These accounts give you a chance to build up everything you earn until you need it for retirement.

But, as with all things tax related, each of these accounts are federally regulated, reviewed annually and subject to Congress changing them at any time. So it is important to always check the latest rules and opportunities with your financial advisor, accountant or the IRS website.

Traditional IRAs

This is the basic IRA that you open as a new stand-alone account to save for your retirement. You can open a traditional IRA at any bank or brokerage firm, and you can invest the money in the account in a wide range of acceptable investments, including most all publicly traded securities. There is an annual limit to how much can be contributed to an IRA, and the IRS updates this amount annually.

What’s unique about a Traditional IRA?
In addition to the assets growing tax-free as long as they’re in the account, your annual contributions might be tax-deductible. In the year you make the contribution, you may be able to sub-tract that amount of your contribution from your taxable income depending on your annual income, filing status, and whether you or your spouse have a retirement plan at work. For example, in 2016, if you are single and make less than $61,000 this year in modified adjusted gross income, you can deduct your full $5,500 contribution from your taxable earnings.

Do I qualify?
In 2016, anyone who is younger than 70.5 years old, and has earned income, can contribute up to $5,500 a year. If you’re 50 or older, you’re also allowed to contribute an additional $1,000 as a “catch-up.”

When can I start using the money?
You can start withdrawing from the account penalty-free at 59.5, and you must start withdrawing soon after you reach 70.5. Starting at age 70.5, you are required to make annual withdrawals from your IRA. These are called Required Minimum Distributions or RMDs. Your RMD is calculated each year based on the year-end value of your IRA and a factor table established by the IRS. For example, in the year you turn 70.5, you are required to withdrawal last year’s December 31 value dividend by 27.4.

How are withdrawals taxed?
All withdrawals from a Traditional IRA are subject to your regular income tax rate. Along the way, you have deferred capital gains, and taxes on your dividends and interest. When you take money out, your entire withdrawal is subject to ordinary income taxes. There is one exception to these taxes. If your contributions did NOT qualify for a tax deduction, each year you can reduce the amount of the withdrawal that is taxable by a pro-rata portion of your contributions over the years. Talk to your accountant about how this applies in your situation.

What are the penalties I should be concerned about?
If you withdraw from your IRA before you’re 59.5 you will need to pay not only taxes on the withdrawal, but an additional penalty of 10%. That’s in addition to a state tax penalty that may also apply.

Are there any exceptions?
There are a few situations in which you can withdraw from these accounts without paying a penalty. These are generally considered hardship situations and include things such as qualified first-time home purchases (up to $10,000), and qualified education or medical expenses.

Is a Traditional IRA best for me?
When IRAs were created, the thinking was that you would most likely be in a lower income tax bracket once you retire and start withdrawing from your IRA. So, even though you will be paying ordinary taxes on the full amount, it was expected that you would be in a low enough tax bracket to make this attractive. Today, we see this is true for some people, but not all.

Traditional IRAs are the best choice for people who qualify for and need the annual tax deduction. If you believe that you will be in a much lower tax bracket in retirement than you are now, contributing to a Traditional IRA is the right choice. If you don’t, you might want to consider a Roth IRA instead.

Roth IRAs

Roth IRAs are the relative new kid on the block, having been established in the Taxpayer Relief Act of 1997. They are named after Senator William Roth, one of the congressmen who’s credited with establishing them. Roth IRAs were meant to provide even more encouragement to save for retirement.

What’s unique about a Roth IRA?
Like a traditional IRA, any contribution you make into a Roth IRA grows tax-free, reinvesting year after year. Unlike a traditional IRA, no one is eligible to receive a tax deduction when they contribute to these accounts. Instead, you get a far more valuable long-term benefit; as long as certain requirements are met, you won’t pay any taxes when you make a withdrawal. And if you never need the money, you’re never forced to make a withdrawal or take an RMD.

Do I qualify?
Unlike a traditional IRA, only certain people are eligible to contribute to a Roth IRA. In 2016, you must make less than $132,000 (if you’re single) or $194,000 (if you’re married filing jointly) to contribute. If you qualify, you can contribute up to $5,500 a year, with an additional $1,000 “catch-up” if you’re 50 or older. The allowable contribution is proportionally reduced starting at incomes of $117,000 if you single and $184,000 if you are married filing jointly.

If you make more than these income limits, there is still a way that you can take advantage of a Roth IRA. As long as you have no other IRA accounts, you can use a strategy called an immediate “Roth Conversion.” You contribute each year to a Traditional IRA and immediately convert the full amount into a Roth IRA while the funds are still in cash. If you have any other IRA accounts, this strategy will not work as Roth Conversions generally involve paying ordinary income taxes on the pretax contributions and investment gains within all traditional IRAs that exist.

When can I start using the money?
You can withdraw what you’ve contributed at anytime both tax and penalty-free. After you turn 59.5, and if the account has been opened for 5 years, you can withdraw both your contributions and all earnings tax and penalty-free as well. And like we discussed above, there is no mandatory age when you must start withdrawing from these accounts.

What are the penalties I should be concerned about?
With Roth IRAs, because contributions are always penalty and tax-free, income taxes and the possible 10% early withdraw penalty is only accessed on the earnings. There are two requirements you need to be concerned with using these accounts. Like Traditional IRAs, you have to be over 59.5 to avoid an early withdraw penalty. In addition, Roth IRAs also have a special “Five Year Rule.” This rule means that even if you’re over 59.5, you have to have your account open for five years before you start withdrawing earnings to avoid a penalty or income taxes on your earnings.

Are there any exceptions?
There are some exemptions to these rules when withdraws are used for, including among other things qualified first-time home purchases (up to $10,000) and qualified education or medical expenses. The details can be confusing, so it’s important that you work closely with your accountant or investment advisor to understand the rules.

Is a Roth IRA best for me?
Those that benefit most from Roth IRAs are the exact opposite of those that benefit from a Traditional IRAs. If you believe that you might be in the same or a higher tax bracket in retirement than you are now, Roth’s might be best for you. Also, if you want to set aside assets for retirement, but don’t want to have any restrictions on when you must access them, Roth IRAs might be the right fit for you. Finally, if you might have future generations to consider in your estate planning, you might want a Roth IRA.

Should I consider both kinds of IRAs?
You are able to contribute to both a Traditional and Roth IRA in the same year. However, you can’t contribute more than a total of $5,500 (or $6,500 if you’re eligible for “catch-up”) between the two accounts. So if you can’t predict your taxes and financial success twenty years from now, it might be a good choice to contribute partially to both kinds of IRAs each year.

Rollover IRAs

These days, people are constantly on the move and jumping from job to job. All of this job-hopping can leave a trail of abandoned retirement accounts behind. A rollover IRA is a traditional IRA that is funded by all of these possibly forgotten accounts, consolidating them into one place.

What’s unique about a Rollover IRA?
Rollover IRAs are a little different from Traditional and Roth IRAs. They can’t be contributed to directly. Instead, they’re used to consolidate retirement accounts. If you were to leave your job and decided to “cash out” of your company retirement plan before retirement age, your money would be subject to taxes and early withdraw fees. By utilizing a Rollover IRA, you can “roll-over” the account directly into an IRA without incurring any early withdraw penalties, and the as-sets remain invested tax-deferred until distribution.

Do I qualify?
Rollover IRAs are used by those who have changed jobs or retired and have assets accumulated in their employer-sponsored retirement plans, such as a 401(k) or 403(b) for example. IRA rollovers can occur from a retirement account such as a 401(k) into an IRA, or from one IRA to another if you are consolidating IRA accounts.

When can I start using the money?
Rollover IRAs are treated exactly like Traditional IRAs. You can start withdrawing from the account penalty-free at 59.5, and RMDs are required once you reach 70.5. When you start withdrawing from these accounts, you pay your regular income tax rate on the distributions.

What are the penalties I should be concerned about?
When initiating a rollover, there are two ways you can do it. The recommended way is to utilize a “trustee-to-trustee” rollover, where the trustee of the retirement plan sends the proceeds from your work retirement account directly to the trustee of your new Rollover IRA. It’s a clean and easy way to transfer the money without being subject to any penalties.

The other way to initiate the rollover is much more complicated. You can have the distribution from the company retirement plan sent directly to you by check. You then have 60 days to deposit these proceeds into your Rollover IRA. However, when distributions are sent by check, there is often a 20% withholding penalty taken out of the distribution. When you deposit the check into your new Rollover IRA, you have to replace the 20% that was withheld with your own savings. Otherwise, this 20% will be considered a completed distribution and will be subject to regular income taxes and an early withdraw penalty of 10% if you’re under 59.5. If you follow the rules, the 20% that was withheld is credited from your Federal Income tax liability when you file your tax return.

It’s also important to note that you’re only allowed to do one IRA to IRA rollover by check, each year. The one-year calendar running from the time the distribution is made. If more than one rollover is done in a calendar year, the entire amount is subject to your regular income tax rate as well as a 10% early withdraw penalty.

Is a Rollover IRA best for me?
There are many reasons someone might want to use a Rollover IRA. Consolidating work retirement accounts into a single Rollover IRA can make it easier to allocate and monitor your assets. Many company retirement plans charge rather large fees, both in administrative fees to maintain the account as well as in the mutual funds management fees that are available in the plan. Consolidating in a Rollover IRA also allows you to decide how to invest your assets, especially if you have limited options available in the work retirement plan.

Conclusion

So have you contributed to your IRA yet? Actually you have until April 15th of the following year to make your tax year IRA contribution. You will get the most tax-deferred investment advantage, though, by contributing early in January and letting your funds grow all year. Even if you have a qualified plan at work, an after-tax Traditional IRA or Roth IRA can be a great way to supplement your long-term savings, and these opportunities should be funded before your taxable investment account.

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