By John Patrick Foley, CFP®, ChFC®
I recently attended a seminar on IRAs with a couple of my E3 colleagues and heard a surprising statistic – only 14% of eligible tax payers make a contribution to an Individual Retirement Account (or IRA) each year. That’s crazy low! Perhaps more education on IRAs is in order?
An IRA is a way for an individual to save money toward retirement. It’s not an investment itself, but rather a vehicle in which you can invest into stocks, bonds, mutual funds, and many other assets except for collectibles and life insurance.
Anyone can save into an IRA as long as you have taxable earned income for the tax year. The type of IRA you can contribute to, however, is limited based on factors such as income, age, tax filing status, and whether you or your spouse are covered by a retirement plan at work.
According to the IRS, taxable earned income includes the following: Wages, salaries, tips, and other taxable employee pay; Union strike benefits; Long-term disability benefits received prior to minimum retirement age; Net earnings from self-employment if: You own or operate a business or a farm or You are a minister or member of a religious order You are a statutory employee and have income.
The maximum amount you can contribute to an IRA is $5,500 for 2016 or the total of your taxable compensation, whichever is smaller. If you are 50 or over before the end of the year, you can contribute an additional $1,000 for a total amount of $6,500.
Once you have taxable earned income and are ready to save into an IRA, the important question now is: “Which one do I (and am I able to) contribute to?”
Deductible Traditional IRA – Your traditional IRA contribution might be tax-deductible depending on your tax filing status, your modified adjusted gross income, and whether you or your spouse, if filing jointly, are covered by a retirement plan at work. When it is time to make a withdrawal from your deductible IRA, 100% of your withdrawal is taxed as ordinary income.
Non-deductible Traditional IRA – This IRA is funded with after-tax dollars, meaning you have already paid taxes on the money you put into it. Therefore, you cannot deduct contributions on your tax return. When it is time to make a withdrawal from your non-deductible IRA, only your gains portion of your withdrawal is taxed as ordinary income.
Roth IRA – You fund a Roth IRA with after-tax dollars as well. When you make a withdrawal at retirement, you pay no taxes! Zero, zilch, nada, nothing!
As mentioned earlier, the type of IRA you can contribute to is limited based on factors such as income, age, tax filing status, and whether you or your spouse are covered by a retirement plan at work. Speak with us and/or your accountant to determine which may be most appropriate for you.
Important Deadline – Contributions to IRAs are based on tax years. Any contributions made within a tax year count toward that same tax year with an exception for contributions made between January and the tax filing deadline of April 15th – these contributions can count toward the previous tax year if you choose. So, for 2015, you can make contributions from January 1, 2015 through April 15, 2016 and it will still count toward 2015.
Other considerations – Since IRAs are designed to be for retirement, there may be a 10% penalty assessed on all or a portion of withdrawals made before you reach age 59 ½. I say “may” because there are a handful of exceptions, depending on the type of IRA, that waive can this early withdrawal penalty – such as for qualified education expenses, medical expenses, a first-time home purchase, costs due to a sudden disability, or when making substantially equal periodic payments. Again, check with us or your accountant to determine if any of these exceptions apply.
If you have a Traditional IRA, the IRS requires you to withdraw a minimum amount each year starting in the year in which you turn 70 ½. These withdrawals are known as Required Minimum Distributions, or RMDs. The amount of the RMD is based on the previous year’s IRA balance and your life expectancy, according to tables published by the IRS. You do not have to take RMDs from your Roth IRAs.
If you are a small business owner, you may also be able to make contributions to a Simplified Employee Pension (SEP) IRA or a Savings Incentive Match Plan for Employees (SIMPLE) IRA. Stayed tuned for a future post about these two, and other, retirement plans for small business owners.
As you can see, IRAs can be beneficial for most taxpayers. Talk with your advisor, accountant, or give our office a call to see which IRA may be most appropriate for your financial goals and situation.