If you own an IRA, then you should be as familiar as possible with the rules that govern your account.
Individual retirement accounts (IRAs) are one of the most common assets people rely on to save and invest for retirement. In fact, more than a third of households in America own an IRA. If you’re thinking of opening an IRA for the first time, it’s a good idea to review the rules. Even if you have had an IRA for years, note that laws change.
The Different Types
There are two main types of IRA accounts to choose from: traditional and Roth. The timing of the tax advantages is the main difference between the two. For a traditional IRA, contributions are tax deductible and tax is paid upon withdrawal. Roth IRA contributions are taxed in the year they are made, and qualified withdrawals are tax-free. Both types are almost equally popular:
- 36% of American households have Roth IRAs
- 35% of American households have traditional IRAs
- 26% of American households contribute to both
There are also employer-sponsored IRAs. These may fall into either of the two categories.
The IRS set a 2020 annual limit of $6,000 for people under 50 years old. People who are 50 years and older can make a total contribution of $7,000. What some breadwinners do to maximize contributions is to file joint tax returns and open a second account for their spouses. They then make additional contributions to this account. The IRS states that the combined contribution cannot exceed the lesser of the couple’s taxable income or the contributor’s individual limit times two.
The IRS considers net income from self-employment, gross wages and gross salaries as qualifying income. Too much income, however, and IRA contributions can get reduced or prohibited altogether:
- Qualifying Widower or Married Filing Jointly: The regular contribution rules apply up to $196,000. From $196,000 to $206,000, the IRS reduces the contribution limit. No contributions are allowed after $206,000.
- Single, Married Filing Separately (did not live together) or Head-of-household: Filers who earn less than $124,000 follow the usual contribution rules. More than this up to $139,000, the IRS reduces the contribution limit and after $139,000, contributing is not allowed.
- Married Filing Separately (lived together): The IRS reduces the contribution amount for less than $10,000 and prohibits contributions for $10,000 in income or more.
How much income you make determines how much of your total contribution you can deduct from your taxable income and whether or not you contribute to an employer sponsored retirement plan:
- Qualifying Widower or Married Filing Jointly: Filers who make $104,000 or less can take tax deductions up to the full contribution limit. More than this up to less than $124,000, people can get a partial deduction. Beyond this, there is no deduction.
- Single or Head-of-household: For total incomes of $65,000 or less, the individual can take the full deduction. More than this up to less than $75,000, there is only a partial deduction. Beyond $75,000, there is no deduction.
- Married Filing Separately: There is a partial deduction for income up to $10,000. After $10,000, there is no deduction.
Like any retirement account, you do not need to wait until retirement to claim your distributions. Here’s what you need to know:
- There is no penalty for traditional IRA withdrawals after reaching age 59 and a half.
- Traditional IRA distributions get taxed at the rate that is current at the time of withdrawal.
- Roth withdrawals are not taxed because taxes were already paid upfront.
- Roth IRAs do not have mandatory withdrawal rules, but traditional IRAs require distributions by April 1st of the year you turn 72 or there are considerable tax penalties.
There is no one-size-fits-all solution when it comes to choosing and funding a specific type of IRA account. This is why speaking directly with a financial professional at LPL Financial is so important. Contact us today.