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Individual Retirement Accounts (IRAs)
The Internal Revenue Code is one of the largest ways our government incentivizes certain behaviors of its citizens. Knowing these incentives (i.e. giving charitably, owning a home, long-term investing) can make a large impact on your lifetime tax bill. One of the largest incentives in the Code is saving for retirement via different Congressionally created vehicles such as the Individual Retirement Account (IRA).
Before we dive deep into IRAs let’s zoom out and make sure we provide context in the scope of your entire financial plan. Each financial plan and individual circumstance is unique but from a broad perspective, my hierarchy of savings (adapted from Michael Kitces) places the IRA 5th in line as seen below.
- Initial Emergency Fund and Debt Payoff Planning
- Fully funded Emergency Fund
- Health Savings Account (HSA)
- Employer Retirement Plans – 401(k)s and 403(b)s
- Individual Retirement Accounts (IRAs) & 529 College Savings Plans
- Taxable Brokerage Accounts
Any individual who has earned income can contribute to an IRA. The 2020 contribution limits are $6,000 per person or $7,000 for individuals over age 50. Thanks to the recently passed SECURE Act there is no age limit on who can make an IRA contribution. The “I” in IRA stands for individual and means there is no such thing as a joint IRA regardless of your marital status. That being said, you may use your spouses earned income to qualify to make an IRA contribution.
Bill and Sally are both 52 years old. Bill earns a salary of $165,000 and Sally is a stay at home mother. Bill may contribute $7,000 to his IRA. Although Sally does not have any earned income, she can still contribute $7,000 to her own IRA as Bill has enough earned income (greater than $14,000) to support both of their maximum contributions.
The typical deadline to contribute to an IRA is April 15th of the following year. Meaning a 2020 IRA contribution can be made as late as April 15, 2021. The postponement of the 2019 tax filing deadline from April 15, 2020 to July 15, 2020 due to the COVID-19 pandemic also postponed the 2019 IRA contribution deadline to July 15, 2020.
Types of IRAs
There are two types of IRAs (Traditional IRAs and ROTH IRAs) but we are going to think of three different buckets of IRAs for purposes of our analysis.
- Pre-tax Traditional IRAs allow for a current year deduction. When distributions are taken from pre-tax Traditional IRAs in retirement the distribution will be fully taxable at ordinary income rates. This is most likely what you think of when you hear IRA.
- After-tax Traditional IRAs are also referred to as non-deductible Traditional IRAs. After-tax (non-deductible) Traditional IRA contributions occur when an individual is not allowed a tax deduction for their contribution due to their income exceeding the applicable thresholds discussed later. Distributions from Traditional IRAs with only after-tax (non-deductible) contributions will be partially taxable. The portion of the distribution related to previous non-deductible contributions will be tax free and the portion of the distributions related to growth and earnings will be fully taxable at ordinary income rates.
- ROTH IRAs provide no deduction upon contribution but all distributions after age 59 ½ at least five years from the individual’s first ROTH contribution are completely tax free.
You might be asking, “why would anyone want the #2 after-tax (non-deductible) IRA?” The short answer is that you simply wouldn’t when compared to #1 and #3 above. The after-tax (non-deductible) #2 IRA only provides asset protection and tax deferral (same as the other two IRAs) and there is no deduction up front but earnings are still taxable upon distribution. Asset protection and tax deferral are great benefits, but it falls short when compared with pre-tax Traditional IRAs and ROTH IRAs.
In reality, the deductible traditional IRA contributions (#1) and the after-tax (non-deductible traditional IRA contributions (#2) exist in the same IRA account. These are not separate accounts but have such different treatment and outcomes it is helpful to frame the different types of contributions as different accounts.
As with most incentives in the Internal Revenue Code, the best benefits are phased out for high income earners. Individuals covered by a retirement plan at work are fully phased out from making a deductible Traditional IRA contribution (#1) once adjusted gross income (AGI) exceeds $75,000 or in the case of married couples $124,000. If neither you nor your spouse is covered by a retirement plan at work, there is no level of income that will prevent you from deducting an IRA contribution to a Traditional IRA (#1).
ROTH IRA (#3) contributions are fully disallowed for single individuals with AGI in excess of $139,000 and married couples with AGI over $206,000. The ROTH contributions limits are irrespective of whether the individual is covered by a workplace retirement plan.
After-tax (non-deductible) IRA (#2) contributions (the least desirable) can be made by anyone at any income level as long as they have sufficient earned income.
Traditional Deductible IRA (#1) vs. ROTH IRA (#3)
For individuals and couples who qualify for both deductible Traditional IRA contributions (#1) and ROTH IRA contributions (#3) which should they choose? There are a few nuanced considerations such as state estate taxes and the impact of required minimum distributions, but for the most part this decision comes down to two factors: tax rates and flexibility.
The most meaningful difference between the deductible Traditional IRA and the ROTH IRA comes down to tax rate arbitrage. Your goal is to maximize after tax value over your lifetime. If your tax rate is higher today than it will be in retirement, then the Traditional IRA will be more advantageous. If the reverse is true and your expected tax rate is retirement will be higher than it is today whether due to more projected taxable income or expected legislative changes, the ROTH IRA becomes more valuable because the distributions (in the higher tax environment) are tax free.
Second, flexibility is an often-overlooked difference between the two accounts. Traditional IRA distributions are subject to an early withdraw 10% penalty unless the individual is over age 59 ½ or meets a list of limited exceptions. ROTH IRAs are much more flexible allowing distributions up to the amount of previous contributions to be distributed tax and penalty free at any time. This flexibility enables individuals to contribute to ROTH IRAs with less fear of needing the dollars before 59 ½ and being unable to access them without triggering penalties.
What if My Income is Too High?
Individuals with AGI in excess of the above thresholds disallowing deductible contributions to a Traditional IRA or a contribution to a ROTH IRA are left to either forfeit using IRAs or analyze whether they can benefit from a “back-door” ROTH IRA. We will discuss this strategy, its significant impact, and a few pitfalls in the next post which will release on June 16th, 2020.
In summary, any individual can contribute to an IRA as long as they or their spouse have adequate earned income. These contributions are allowed regardless of age or income level. Certain aspects of IRAs are not available to high income earners such as deductible IRA contributions when there is a workplace retirement plan available and direct contributions to ROTH IRAs however, “back-door” ROTH IRA contributions may still be available. The Traditional IRA versus ROTH IRA decision is largely dependent upon your tax rate today versus your tax rate upon distribution from the account as well as your need for flexibility to take early withdrawals. Do not overlook the extreme impact the double tax benefits of IRAs will have on long-term growth and be sure to careful consider these variables with your advisor before choosing an account.