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The Forbes Guide to Individual Retirement Accounts (IRAs)

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Tuesday, September 28, 2021 | views Last Updated 2021-09-28T18:46:40Z
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Saving for retirement is one of the biggest financial commitments an individual will make. As employers have shifted away from traditional pensions, most of the responsibility for saving for retirement now falls on ordinary workers.


According to the Center for Retirement Research, nearly half of households are “at risk” of not having enough money to maintain their current living standards in retirement. And while the numbers are worrisome, Congress has created plans to encourage retirement saving and reward those who do save with tax breaks. The individual retirement account (IRA) is one of those plans.


In this guide, we’ll cover the following:

• What is an IRA

• Different Types of IRAs

• Traditional IRA

• Roth IRA

• Niche IRAs

• Backdoor Roth IRA

• Spousal IRA

• SIMPLE IRA

• SEP IRA

• Self-Directed IRA

• Inherited IRA

• The Benefits of IRAs

• Early Withdrawals

• Rollovers

What is an IRA?

An IRA is a tax-deferred (and in some cases tax-free) retirement account that allows individuals to save for retirement. Traditional IRAs were birthed in the Employee Retirement Income Security Act (ERISA) of 1974, whose focus was regulating employer provided pension plans and other benefits.


With President Ronald Reagan’s tax cut of 1981 and the bipartisan tax reform of 1986, IRAs went through drastic changes. While IRAs were originally only for individuals who did not have employer-sponsored retirement plans, the 1981 tax cut allowed any worker to contribute up to $2,000 to their own IRA and $250 for a nonworking spouse and take a tax deduction. Then the 1986 tax reform eliminated IRA deductions for higher-income taxpayers who were also eligible for an employer’s retirement plan. (Read more about the history of the IRA.)


Not surprisingly, Congress wasn’t finished tinkering. A decade later, it increased the deduction for nonworking spouses. The next year, it made even wider changes, including the creation of the Roth IRA. Since then, lawmakers have repeatedly expanded who can contribute to an IRA and how much can be contributed.

Today, an IRA can be opened by almost anyone, though eligibility to claim a current income tax deduction is still limited by income for those who have access to a workplace plan. When used correctly, IRAs are a potent tool to build retirement savings.


Different types of IRAs

There are two main types of IRAs: A traditional IRA and a Roth IRA. From there, these two retirement accounts have multiple variations that apply to different individuals.

Traditional IRA

Who it’s for: Anyone looking to save for retirement in a tax deferred fashion. There are no limits on how many IRAs an individual can have, but the total contributions to all accounts (including both traditional and Roth IRAs) cannot exceed the annual contribution limit. An IRA can be opened even if an individual has access to an employer-sponsored retirement plan such as a 401(k). There are no income limits for account holders.


How it works: Unlike a 401(k) or other workplace retirement account, an IRA is not tied to an employer. Instead, individuals open and contribute to an IRA on their own. Subject to fairly significant income-based limitations (see below), a traditional IRA contribution can be deducted from current taxable income. Almost all distributions from an IRA are treated as ordinary income for tax purposes (the exception being distributions attributable to nondeductible contributions.) Loans from traditional IRAs are not permitted.


Tax Deduction: Whether contributions to a traditional IRA are deductible depends on several factors. These factors include whether the account holder or their spouse has a workplace retirement account available to them, their tax filing status, and their income. If the account holder (and their spouse if they are married filing jointly) does not have a workplace retirement account available to them, traditional IRA contributions are deductible regardless of income. Otherwise, the deductibility of contributions phased out at certain income levels. In 2019, the deduction for singles and heads of household who have modified adjusted gross incomes (AGI) between $64,000 and $74,000. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $103,000 to $123,000 for 2019.


Maximum contribution amount for 2019: $6,000 per year, or $7,000 for individuals who will be 50 or older by the end of 2019.


Age limits: Individuals can contribute to a traditional IRA until they are 70 ½, provided they have earned income of at least the amount contributed.

Possible penalties: Making withdrawals before age 59 ½ might result in a 10% penalty on top of ordinary taxes, although there are some exceptions, including withdrawals to pay college or graduate school tuition and up to $10,000 for a down payment by a first-time home buyer. Traditional IRAs are also subject to required minimum distributions once the account holder reaches age 70 ½. If these RMDs are not taken, the account will be subject to a penalty tax.


Roth IRA

Who it’s for: Anyone looking to save for retirement who might not benefit significantly from the deduction available from a traditional IRA. Because contributions are not deductible, a Roth IRA is ideal for those whose income places them in the lower to middle tax brackets.

Eligibility: Unlike a traditional IRA, a Roth IRA is only available to those who make less than certain income limits set each year by the IRS. For tax year 2019, single individuals and heads of household must have an AGI of less than $122,000 to make the maximum allowed Roth IRA contributions. However, individuals who make more than that, but less than $137,000, are allowed to make partial contributions. For married couples filing jointly, the eligibility phase-out range is $193,000 to $203,000. These income limits are adjusted upward yearly for inflation.


Those whose income exceeds these limits may be able to use what’s called a backdoor Roth IRA (see below).


How it works: Contributions to a Roth IRA are made with after-tax dollars; they are not tax deductible. That means contributing to a Roth IRA doesn’t reduce your current taxable income. In return, you won’t pay taxes on qualified distributions (see below) in retirement. In other words, investments held in a Roth IRA grow tax free.


Maximum contribution amount for 2019: $6,000 per year, or $7,000 for individuals who will be 50 by the end of the year.


Withdrawing contributions: One frequently cited benefit of a Roth IRA is that contributions can be withdrawn at any time tax and penalty free. The logic behind this rule is simple: Because Roth IRA contributions are on an after-tax basis, the account holder has already paid any income tax owed on contributions.

 
It’s for this reason that some suggest a Roth IRA can be used as an emergency fund. For those taking this approach, it’s important to keep track of total contributions over the years. Taking out more than you’ve contributed could result in both penalties and taxes (see below) on earnings within the account.

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  • The Forbes Guide to Individual Retirement Accounts (IRAs)

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