Individual Retirement Accounts (IRAs) are a crucial part of a long-term investing strategy. Although I have written separately that HSAs may be even better, many people cannot contribute to a HSA compared to a Traditional or Roth IRA.
Let’s start with some of the basics. There are two types of IRAs, Traditional and Roth. Traditional IRA contributions are generally tax-deductible, and they grow tax free, but when you pull the money out of the account, you have to pay taxes on both the contributions and the growth at ordinary income tax rates. Roth IRA deductions are not deductible, but when you pull the money out of the account, you do not pay taxes on the contributions or the growth. With both Traditional and Roth IRAs, you can start withdrawing the money without penalty at age 59.5; however, with Traditional IRAs you have to start taking certain distributions out at age 70.5, whereas you are never required to withdraw the money from your Roth IRA. Also, you can no longer contribute to a Traditional IRA starting at age 70.5, but you can still contribute to a Roth IRA after that age.
The deadline for a contribution for any given year is April 15 of the following year, meaning that the deadline for 2016 is April 15, 2017. If you are under 50, you can contribute up to $5,500 per year into your combined IRA accounts. If you are 50 or over, then the amount becomes $6,500 per year. These limits are lower if you do not have that much earned income for the year. Spouses can often rely on the other spouse’s earned income if it is greater than the spouses’ combined IRA contributions.
If you have access to a retirement plan at work, the ability to deduct the Traditional IRA contribution can start to phase out for a married person filing jointly at $98,000 of adjusted gross income (AGI) in 2016. That amount goes up to $183,000 if you do not have a retirement plan at work but your spouse does. If neither spouse has a retirement plan at work, then there is no income limit to be able to deduct the contribution. If you exceed the income limits in a year, then you can still make a Traditional IRA contribution, but you cannot deduct it. For Roth IRAs, if a married filing jointly person’s AGI exceeds $184,000, then their ability to make any contribution to a Roth IRA becomes limited, and it disappears entirely at $194,000.
The IRA rules create some interesting opportunities. One is a custodial IRA for a child. For example, if your child gets a summer job and earns $4,000, then he or she could put that $4,000 into a Roth IRA (a Traditional IRA doesn’t make as much sense because the deduction usually isn’t beneficial) and let it grow tax free for an incredible period of time. You could even make the contribution for the child so that the child can keep his or her hard earned money. Just make sure that there is proof that the income is earned, ideally with a W-2 or 1099, or in the worst case with receipts or other contemporaneous paperwork showing that it was earned and not just a gift or allowance.
Another opportunity is that you can convert a Traditional IRA into a Roth IRA regardless of your income. You just have to pay the tax on the amount of money that you convert at your ordinary income tax rate. In most cases, it will not make sense to voluntarily pay tax now on the conversion, because you only benefit from paying the tax now if your tax rate will be higher when you withdraw the money in the future. However, if for whatever reason you have a year with an uncommonly low tax rate, such as if you quit your job to go back to grad school, or if you take a sabbatical between jobs, then that may be a good year to take the tax hit of a conversion.
Importantly, if you never took a deduction on your Traditional IRA contribution, then you do not have to pay tax on converting to a Roth. This rule essentially enables a “backdoor” Roth IRA contribution whereby you contribute to a Traditional IRA without taking a deduction and then quickly convert it to a Roth. So long as you have no other Traditional IRAs with money in them, then the conversion does not result in tax. On the other hand, if you have some money in Traditional IRA that you previously deducted, then you have to pay tax on the conversion based on the ratio of your previously-deducted Traditional IRA balance to the total balance of your Traditional IRA accounts. This rule operates based on the account balances at the end of the year, so you cannot get around this problem by making a backdoor Roth IRA contribution and then later rolling an old 401(k) into a Traditional IRA during the same calendar year.
Finally, the IRS recently issued some rules about rollovers, which occur when you personally take a check as a distribution from a IRA and then put that money back into another IRA within the 60 day limit. In turns out that people were abusing this to basically take multiple 60 day interest-free loans of their IRA balances each year and the IRS didn’t like it. As a result, you can only make one such rollover within any one year period (not calendar year based), regardless of how many IRA accounts you have. These rules do not apply to a direct transfer of IRA balances, since you never receive that money in hand, but rather one IRA trustee or broker sends the money directly to another.
IRAs create many opportunities to build wealth, and the fact that you are limited in how much and when you can contribute money into those tax-advantaged accounts means that you should not let another year pass you by if possible. In another article, I will go into some more in depth strategies for handling a IRA to Roth IRA conversion in a tax efficient manner.