Some financial terms have become so ingrained in the vernacular that people are embarrassed to ask about them.
It’s as if everyone else is speaking a language you feel you should know, but don’t really. Such is the case with IRAs. When clients come to us to discuss their finances, they often reveal they aren’t clear on some of the IRA basics. Below I address some basic terms and concepts about IRAs.
What is an IRA? An IRA is an Individual Retirement Account. When you contribute to an IRA, you are putting money aside for your future so you will have some money when you retire. Think of an IRA as a type of savings account where you can invest in many different types of things but you will not withdraw from it until later. You can use the money you deposit into your IRA to invest in CDs, government bonds, mutual funds, stocks, and almost any other type of financial investment you can think of. What is the benefit of an IRA? Funds that you deposit inside of an IRA have tax advantages over funds that you deposit in a regular bank or investment account. Where does one open an IRA account? You can open an IRA account at a bank, brokerage firm, mutual fund company, insurance company and various other types of financial institutions. What are the different types of IRA accounts? The two main types of IRAs are Traditional IRAs and Roth IRAs. The tax rules associated with each type are the key distinctions to these two categories of IRAs. Then there are subcategories within both Traditional IRAs and Roth IRAs. Within Traditional IRAs, there are non-deductibles, spousal IRA contributions, SEP IRAs and SIMPLE IRAs. Within Roth IRAs, there are Roth spousal IRA contributions, and a Roth 401(k) option called a Designated Roth account. What are the specifics of a Traditional IRA? Traditional IRAs were introduced by Congress in 1974 to induce people to save for retirement by offering special tax treatment for these funds. Contributions to a Traditional IRA are tax-deductible if you meet certain eligibility requirements. If you are not eligible to make a tax-deductible IRA contribution, you may still make a non-deductible IRA contribution. Funds inside of an IRA grow tax-deferred. Tax-deferred means you do not pay income taxes on interest, dividends and capital gains until you take a withdrawal. Tax-deferral is a tremendous benefit. Keep in mind, the government wants you to keep funds in your IRA accounts until you are retirement age, so there are penalties if you withdraw them before age 59½. And then once you reach 70½, you must start making required minimum distributions , at which time the government begins collecting taxes on those amounts. Is there a maximum amount you can contribute to an IRA each year? The maximum amount you can contribute to a Traditional IRA and/or Roth IRA in 2017 and 2018 is $5,500 if you’re under age 50 and $6,500 if you’re 50 or older. You cannot contribute the full amount to both a Traditional and a Roth IRA, but you can split the amount between the two. You have until April 15, 2018, and April 15, 2019, respectively, to contribute for the year prior. Keep in mind, there are income limits, based on your modified adjusted gross income, to being allowed to contribute to a Roth IRA. For example, if a married couple earns more than $196,000, they cannot contribute to a Roth IRA. However, if either has access to a Roth 401(k) through their employer, they can contribute to that. What are the specifics of a Roth IRA? The basic difference between a Roth IRA and a Traditional IRA is that contributions to a Roth IRA are not tax deductible. However, the interest earned on funds in a Roth IRA account are never taxed. This means you will never pay income taxes on interest, dividends and capital gains on funds that accumulate inside of a Roth IRA as long as you follow the Roth IRA withdrawal rules . For example, one of the rules is that you must be at least 59½ to withdraw any interest or gains without being taxed. Why doesn’t everyone contribute to an IRA? You must have earned income to contribute to any type of IRA. The only exception is if you are married, and your spouse does not have earned income, you can contribute to a spousal IRA on their behalf. What is an IRA rollover and why would you want to do one? A rollover is simply the process of moving your retirement savings from your retirement plan at work (from a 401(k), profit-sharing plan, etc.) into an IRA. You typically do this when you leave the company. What are the benefits to rolling over into an IRA, as compared to leaving funds in a company-sponsored plan? IRAs typically provide more investment choices, and, you may be able to find investment choices with lower fees than the funds in your company plan. What is the 60-day rule? When you move funds from one IRA or company plan to a new IRA, funds must be deposited in the new IRA account no later than 60 days from the time they were withdrawn from the old one. If you do not do this, the funds will be taxed. (There are exceptions in which case you can apply for a waiver.) Can I move funds into an IRA from a company retirement plan while I’m still working? Most company retirement plans do not allow an employee to do this. I advise clients to call their plan sponsor and ask if they allow “in-service distributions.” What should I do with my company-sponsored plan if I leave that employer? Depending on your own situation, it could make sense to rollover funds into an IRA. Read the documents from your plan’s sponsor carefully. To avoid tax withholding, choose a direct IRA rollover with a check made payable to the new financial institution. If you do not do a direct IRA rollover, 20% of the amount will be withheld for federal taxes. Although most people think of an IRA rollover as moving funds from a 401(k) to an IRA, there is also a reverse rollover where you move IRA money back into a 401(k) plan . This could be a wise option if your employer offers good fund choices with low fees. What is the difference between an IRA rollover and an IRA transfer? An IRA transfer occurs when you move IRA funds from one financial institution directly to another. As long as there is no distribution payable to you, then the transfer is tax-free. A rollover is when you move funds from a company plan, such as a 401(k) or 403(b) to an IRA. What if I have a financial emergency and have to access funds in an IRA? You are allowed, within any 12-month period, to withdraw funds but you must redeposit these funds within 60 days to avoid being taxed and penalized (if you are under age 59½). What happens if I inherit an IRA? IRAs inherited from spouses can be moved into your own IRA, or you can keep it as an inherited IRA, but funds from IRAs inherited from non-spouses must be withdrawn within a specified amount of time (and will be taxed). What is the most common IRA Rollover/IRA Transfer mistake? In addition to not executing rollovers within 60 days, sometimes we see mistakes in how the transactions are reported to the IRS. We counsel clients to pay close attention to documentation regarding rollovers. Occasionally, plan custodians incorrectly report the transaction on the 1099-R form. To ensure you aren’t taxed on an IRA rollover or transfer, carefully explain any IRA rollover or transfer transactions to your tax preparer.
Related: The Four Primary Ways to Construct Your Retirement Portfolio
These are some of the ins-and-outs related to IRAs. I’m sure you’ll agree that there are a lot of details. There is no shame in not knowing, and its always better to ask questions ahead of time before making a mistake that can hurt your future finances.
