Understanding IRAs
Presented by Greg Patterson
An individual retirement arrangement (IRA) is a personal
savings plan that offers specific tax benefits. IRAs are one of the
most powerful retirement savings tools available to you. Even if you
are contributing to a 401(k) or other plan at work, you might also
consider investing in an IRA.
What types of IRAs are available? The two major types of IRAs are traditional
IRAs and Roth IRAs. Both allow you to contribute as much as $5,500 in 2018
(unchanged from 2017). You must have at least as much taxable compensation as the
amount of your IRA contribution. But if you are married filing jointly, your spouse
can also contribute to an IRA, even if he or she has little or no taxable compensation,
as long as your combined compensation is at least equal to your total contributions.
The law also allows taxpayers age 50 and older to make additional “catch-up”
contributions. These folks can contribute up to $6,500 in 2018 (unchanged from
2017).
Both traditional and Roth IRAs feature tax-sheltered growth of earnings, and
both give you a wide range of investment choices. However, there are important
differences between these two types of IRAs. You must understand these differences
before you can choose the type of IRA that’s best for you.
Learn the rules for traditional IRAs. Practically anyone can open and contribute
to a traditional IRA. The only requirements are that you must have taxable
compensation and be under age 7014. You can contribute the maximum allowed
each year as long as your taxable compensation for the year is at least that amount. If
your taxable compensation for the year is below the maximum contribution allowed,
you can contribute only up to the amount that you earned.
Your contributions to a traditional IRA may be tax deductible on your federal
income tax return. This is important because tax-deductible (pre-tax) contributions
lower your taxable income for the year, saving you money in taxes. If neither you
nor your spouse is covered by a 401(k) or other employer-sponsored plan, you
can generally deduct the full amount of your annual contribution. If one of you is
covered by such a plan, your ability to deduct your contributions depends on your
annual income (modified adjusted gross income, or MAGI) and your income tax
filing status:
For 2018, if you are covered by a retirement plan at work, and;
• Your filing status is single or head of household, and your MAGI is $63,000
or less, your traditional IRA contribution is fully deductible. Your deduction
is reduced if your MAGI is more than $63,000 and less than $73,000, and you
can’t deduct your contribution at all if your MAGI is $73,000 or more.
• Your filing status is married filing jointly or qualifying widow(er), and your
MAGI is $101,000 or less, your traditional IRA contribution is fully deductible.
Your deduction is reduced if your MAGI is more than $101,000 and less
than $121,000, and you can’t deduct your contribution at all if your MAGI is
$121,000 or more.
• Your filing status is married filing separately, your traditional IRA deduction
is reduced if your MAGI is less than $10,000, and you can’t deduct your
contribution at all if your MAGI is $10,000 or more.
For 2018, if you are not covered by a retirement plan at work, but your spouse is,
and you file a joint tax return, your traditional IRA contribution is fully deductible
if your MAGI is $189,000 or less. Your deduction is reduced if your MAGI is more
than $189,000 and less than $199,000, and you can’t deduct your contribution at all
if your MAGI is $199,000 or more.
What happens when you start taking money from your traditional IRA? Any
portion of a distribution that represents deductible contributions and/or investment
earnings is subject to income tax because those contributions were not taxed
when you made them. In addition to income tax, you may have to pay a 10% early
withdrawal penalty if you are under age 5914, unless you meet one of the exceptions.
You must aggregate all of your traditional IRAs (other than inherited IRAs) when
calculating the tax consequences of a distribution.
If you wish to defer taxes, you can leave your funds in the traditional IRA, but only
until April 1 of the year following the year you reach age 7014. That’s when you have
to take your first required minimum distribution from the IRA. After that, you must
take a distribution by the end of every calendar year until you die or your funds are
exhausted. The annual distribution amounts are based on a standard life expectancy
table. You can always withdraw more than you are required to in any year; however,
if you withdraw less, you will be hit with a 50% penalty on the difference between the
required minimum and the amount you actually withdrew.
Learn the rules for Roth IRAs. Not everyone can set up a Roth IRA. Even if you
can, you may not qualify to take full advantage of it. The first requirement is that you
must have taxable compensation. If your taxable compensation in 2018 is at least
$5,500, you may be able to contribute the full amount. But it gets more complicated.
Your ability to contribute to a Roth IRA in any year depends on your MAGI and your
income tax filing status:
• If your filing status is single or head of household, and your MAGI for 2018
is $120,000 or less, you can make a full contribution to your Roth IRA. Your
Roth IRA contribution is reduced if your MAGI is more than $120,000 and less
than $135,000, and you can’t contribute to a Roth IRA at all if your MAGI is
$135,000 or more.
• If your filing status is married filing jointly or qualifying widow(er), and your
MAGI for 2018 is $189,000 or less, you can make a full contribution to your
Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than
$189,000 and less than $199,000, and you can’t contribute to a Roth IRA at all if
your MAGI is $199,000 or more.
• If your filing status is married filing separately, your Roth IRA contribution is
reduced if your MAGI is less than $10,000, and you can’t contribute to a Roth
IRA at all if your MAGI is $10,000 or more.
Your contributions to a Roth IRA are not tax deductible. You can invest only
after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions,
your withdrawals from a Roth IRA wiU be completely income tax free, including
both contributions and investment earnings. To be eligible for these qualifying
distributions, you must meet a five-year holding period requirement.
In addition, one of the following must apply;
• You have reached age 5934 by the time of the withdrawal
• The withdrawal is made because of disability
• The withdrawal is made to pay first-time home-buyer expenses ($10,000
lifetime limit)
• The withdrawal is made by your beneficiary or estate after your death
Qualified distributions will also avoid the 10% early withdrawal penalty. This
ability to withdraw your funds with no taxes or penalties is a key strength of the Roth
IRA. And, remember, even nonqualified distributions will be taxed (and possibly
penalized) only on the investment earnings portion of the distribution, and then only
to the extent that your distribution exceeds the total amount of all contributions that
you have made. You must aggregate all of your Roth IRAs (other than inherited Roth
IRAs) when calculating the tax consequences of a distribution.
Another advantage of the Roth IRA is that there are no required distributions
after age 7034 or at any time during your life. You can put off taking distributions
until you really need the income. Or, you can leave the entire balance to your
beneficiary without ever taking a single distribution. Also, as long as you have taxable
compensation and qualify, you can keep contributing to a Roth IRA after age 7034.
Choose the right IRA for you. Assuming you qualify to use both, which type
of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably
be a more effective tool if you don’t qualify for tax-deductible contributions to a
traditional IRA. However, if you can deduct your traditional IRA contributions, the
choice is more difficult. The Roth IRA may very well make more sense if you want
to minimize taxes during retirement and preserve assets for your beneficiaries. But a
traditional deductible IRA may be a better tool if you want to lower your yearly tax
bill while you re stiU working (and probably in a higher tax bracket than you 11 be in
after you retire). A financial professional or tax advisor can help you pick the right
type ofIRA for you.
(Continued on page 5)
The Shoreline I July 2018