The Forbes Guide to Individual Retirement Accounts (IRAs) – test

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.

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.

Qualified distributions: As noted above, qualified distributions are tax and penalty free. According to the IRS, a qualified distribution from a Roth IRA is any distribution that meets the following two criteria:

1. It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
2. The payment or distribution is:
   1. Made on or after the date you reach age 59½,
   2. Made because you are disabled (defined earlier),
   3. Made to a beneficiary or to your estate after your death
   4. Meets an exception that permits up to $10,000 from a Roth IRA to be used for a downpayment on a first home purchase.

The first criteria has become known as the 5-year rule. The good news is that once you satisfy the 5-year for one Roth IRA account, you’ve satisfied it for all your Roth IRA accounts (for those who have more than one). As you’ll see in a moment, there is a different 5-year rule that applies to Roth IRA conversions.

Possible penalties: Making non-qualified distributions may result in a 10% penalty plus taxes on any earnings. There are no required minimum distributions for the original account holder of a Roth IRA. A non-spousal inheritor of a Roth IRA is required to take RMDs.

Niche IRAs

On a broad level, all IRAs are the same. They are incentivized retirement savings vehicles. But on a granular level, there are variations of IRAs that make them accessible to a wider range of individuals.

Other types of IRAs include, but aren’t limited to, the following:

Backdoor Roth IRA

Individuals who make more than the income limits noted above are ineligible to contribute directly to a Roth IRA. Instead, they can take advantage of what is popularly known as the backdoor Roth IRA. This strategy, which helps high-earners save money for retirement while still receiving the tax benefits of a Roth IRA, was officially blessed by Congress in the 2017 tax law.

Here’s how it works. A high earner makes nondeductible contributions to a traditional IRA, which has no income limitations, and then immediately converts the account to a Roth IRA. While taxes would be due for any gains in the account at the time of the conversion, these gains should be few if any since the conversion happens shortly after the contribution to the traditional IRA.

There are two issues to be aware of with a backdoor Roth IRA. First, although the conversion may come from one traditional IRA account, the IRS determines the tax consequences by considering all traditional IRA accounts held by the individual. Called the aggregation rule, it prevents taxpayers from pursuing “abusive” IRA tax strategies. Taking all traditional IRA accounts into consideration, the IRS then applies a pro-rata rule to determine the tax liability flowing from the conversion. Under this rule, the IRS may deem some of the conversion to be attributable to other IRAs, whose earnings (as well as any deductible contributions previously made) are taxable. That includes any pre-tax 401(k) money from a previous employer that you have rolled into an IRA.

Second, Roth IRA conversions are subject to their own 5-year rule. In order to avoid a penalty, one must wait five tax years before distributing Roth IRA conversion amounts. Furthermore, this 5-year rule applies individually to each new Roth IRA conversion.

Individuals considering a backdoor Roth strategy should read this story–and also consult a tax advisor.

Spousal IRA

A spousal IRA helps married couples work around the income eligibility requirement for contributions to a traditional or Roth IRA. Those who wish to contribute to this retirement account must file a joint tax return with their spouse in order to be eligible. Under a spousal IRA, a working spouse with a workplace retirement plan can contribute to the non-working spouse’s IRA..The income limits to claim a deduction for that contribution are higher than for a regular IRA:; for 2019, a full deduction can be claimed if AGI is below $103,000, and the deduction is phased out from $103,000 to $123,000.

SIMPLE IRA

The Savings Incentive Match Plan for Employees, or SIMPLE IRA, is for small business owners (with 100 employees or fewer) who want to offer an employer-sponsored retirement plan but are not large enough to offer a traditional 401(k). Employers offering SIMPLE IRAs cannot offer any other type of retirement plan and are required to match contributions up to 3% of employee compensation, or provide a 2% nonelective contribution for each eligible employee. Funds in a SIMPLE IRA are fully vested immediately, making them an attractive option for workers who aren’t sure how long they may stay at a particular employer.

SEP IRA

The Simplified Employee Pension IRA, or SEP IRA, is generally used by a self-employed individuals who want to contribute more to a retirement plan than a SIMPLE IRA allows.  Employers can contribute up to 25% of the employee’s total compensation or a maximum of $56,000 in 2019, whichever is less. Because all employees must receive the same contribution, this plan is generally only used by small businesses without any or many employees. While only employers can contribute to a SEP-IRA, participants in a SEP-IRA can also contribute to a traditional IRA or a Roth IRA, but the normal income limits on deducting contributions to a traditional IRA apply.

Self-directed IRA

Most IRAs only allow account holders to invest in approved stocks, bonds, mutual funds and CDs. For investors who desire more control over where they’re investing their money, a self-directed IRA can be of help. With this type of retirement account, account holders can invest their money in other categories, such as real estate, cryptocurrency and notes . This account is a well-suited option for individuals willing to take on more risk but still who want the tax-benefits of IRAs. Be careful; rules governing self-dealing still apply to self-directed IRAs.

Inherited IRA

Individuals who inherit an IRA from a non-spouse are subject to complicated rules on how to manage the account. The IRS requires individuals who inherit an IRA to begin taking required minimum distributions beginning December 31 in the year after the death of the original IRA owner and each year after. These distributions are not subject to the 10% early penalty withdrawal.

Investing for retirement when you are young is important, thanks to the power of compounding over time. Money invested through a traditional IRA or Roth IRA grows tax deferred or tax free, respectively, which increases the value of that compounding.

Keep in mind that IRA contribution limits are much lower than 401(k) limits, which allow $19,000 in annual contributions for the 2019 tax year, or $25,000 if your will be 50 by the end of 2019.  Using an IRA in addition to a 401(k) can help individuals reach their retirement savings goals fastert. In addition, having money in both a 401(k) and a Roth IRA can offer a saver more flexibility if they need some of the money before retirement.

Workplace retirement plans  like 401(k)s can allow participants to borrow up to $50,000 or half their balance, whichever is less. Loans aren’t permitted from an IRA. Instead, individuals who wish to access their money in a traditional IRA before retirement, or age 59 ½, are forced to take an early withdrawal. This means the money taken out of the account will be taxed as ordinary income and may be subject to a 10% early withdrawal penalty.

Some situations exempt account holders from early withdrawal penalties. Individuals who choose to use IRA funds for the following scenarios may be able to avoid the 10% early withdrawal penalty:

• First-time home purchase up to $10,000 (or $20,000 for couples)
• Qualified education expenses, including tuition, fees, books, supplies and participating equipment.
• Death or disability
• Unreimbursed medical expenses
• Health insurance if you’re unemployed
• You are in the military reserve and are called to active duty
• You owe taxes to the IRS

There is also a provision that allows you to start taking money from an IRA early, without penalty, if you arrange to take substantially equal periodic payments over your life expectancy.

There is one key difference between early withdrawals from traditional IRAs and ROTH IRAs: contribution withdrawals from Roth IRAs are allowed at any time and are tax and penalty free. However, any earnings that are withdrawn from a Roth are subject to taxes and penalties, unless you meet one of the qualifying exemptions listed above.

Most 401(k) plans are restrictive in terms of how the employer sets them up. They determine the investment options and fees. If you leave an employer you are still subject to those rules, provided your money remains in the 401(k).. Rolling over a 401(k) into an IRA allows individuals to take back control over their investments — but there are strict rules to follow while completing the process.

The IRS lists three types of IRA rollovers:

1. Direct rollover: Your old provider pays your account funds directly to your new provider. No taxes are withheld from the transfer amount.
2. Trustee-to-trustee transfer: If you’re rolling funds from one IRA into a new retirement plan or IRA, the institution can make the payment directly. No taxes are withheld from the transferred amount.

60-day rollover: If you receive a check from a closed 401Ik) or IRA, you must roll over the funds into a new plan within 60 days to avoid it being taxed and facing an early withdrawal penalty. If you aren’t able to roll over the funds within 60 days due to extenuating circumstances, the IRS may waive the penalty. The IRS limits savers to one 60-day rollover per 12 month period to prevent individuals from abusing the ability to have possession of their funds directly before retirement. Beware: If you get a check directly from your workplace plan intending to do a 60-day rollover, your employer may withhold taxes, making it difficult for you to come up with all the funds to deposit in a new retirement account within 60 days.