We often find when we ask the question – do you contribute to an IRA, people often say, yes, it is deducted out of my paycheck. I thought this might be a good time to explain the different types of retirement accounts.
The types of work-related accounts include:
- 401(k)
- 403(b)
- 457
- Simple IRA
- SEP IRA
- Profit-sharing
- Keogh plan
IRA accounts are accounts that you do on your own – independent of your employer. These are accounts you set up through a financial planner, a bank, or a self-managed account.
To make contributions to an IRA account, you must have earned income. Earned income comes from wages or self-employment income. You cannot count pension, Social Security, interest, or dividend income as earned income. You can contribute up to the amount of your earnings and/or the maximum dollar amount.
If you are under the age of 50, you can contribute $6,000 a year. Over the age of 50, you get to add an additional $1,000 per year. Again, there is the limitation of earnings. If you only earned $4,000 this year, that is the maximum that you can contribute to an IRA.
As a spouse – you can count your spouse’s earnings as your own for determining IRA contributions. If your spouse earned $10,000, you are eligible to contribute a maximum of $10,000 between yours and your spouse’s IRAs.
The registration of an IRA is going to be either Traditional or Roth.
Roth IRAs means you have put in after-tax money. Both your contributions and the income from those contributions will grow tax-free. If you wait five years from the opening of the account and are age 59 ½ when the distributions are taken, you avoid taxes and penalties on the total distributions.
If you put $6,000 in each year for 10 years, you will have put a total of $60,000 into the account. The account grows with earnings to a total value of $165,000. When you remove the funds from the account, there will be no taxes required to be paid.
Traditional IRAs can be deductible or nondeductible contributions. To be able to make deductible contributions, you must be below the adjusted gross income limits. Deductible contributions mean that in the current year, you would get a deduction on your tax return. When you begin to take distributions out of the investment, the distribution will be 100% taxable.
If you are above the adjusted gross income limits, you would have to make nondeductible IRA contributions. This gives you a basis in your IRA. When you begin to take distributions out, they will be partially taxable and partially tax-free. Put that same $60,000 in over the ten years and let it grow to $165,000. If you were to take the entire amount out in one year, you would have a taxable income of $105,000. Form 8606 will determine the taxable portion and the non-taxable portion if you take the distributions over time.
The critical difference between the Roth IRA and the nondeductible Traditional IRA is the taxability of the earnings. With the Roth IRAs, the earnings grow tax-free. Within the nondeductible Traditional IRA, the earnings growing are taxable earnings.
IRAs – you do on your own. You can do all Traditional, all Roth, or a combination of the two for your maximum annual contributions. The registration will be either Traditional or Roth. The investments can be mutual funds, individual stocks, bonds, alternative investments, or CDs in the bank. When people ask how much an IRA will earn, we cannot tell them. The registration type is an IRA – either Roth or Traditional. The investment choices will determine what the account earns and what the performance numbers are.
If you inherit an IRA, it becomes a beneficiary IRA. The beneficiary account will retain the same taxability – it will either be a beneficiary Roth IRA or a beneficiary Traditional IRA. The rules in effect for any death that occurred on or after January 1, 2020, require the entire account to be distributed within 10 years. Before 2020, the distribution rules allow them to occur over a lifetime.
Which work-related account do you have? 401(k)s are used in for-profit companies. Non-profit organizations and educational institutions use 403(b) contributions. Municipalities use 457 plans. They all have similar rules and regulations. For those under age 50, an individual can contribute $19,500. Those over the age of 50 can contribute an additional $6,500.
Most plans were initially written with the option of making pre-tax contributions. If the company or governmental entity has re-written its plan, it may now allow for Roth contributions.
The remaining four employer plans – SIMPLE and SEP IRAs, profit sharing, and Keogh each have different income and contribution limits. While SIMPLE and SEPs are called IRAs, they are entirely separate from a Roth and Traditional IRA. SIMPLE IRAs allow for both employee and employer contributions. SEPs, profit-sharing and Keogh account types only allow for employer contributions.
Many of the distribution rules are similar for all these retirement accounts. Penalty-free distributions can begin at age 59 ½. There are other exceptions to allow for early distribution penalties. They are different depending on the type of account. Some of the most popular exceptions include distributions for death, disability, educational expenses, health insurance premiums for the unemployed, and first-time home purchases.
Another exception only for employer-related retirement plans is the separation of service at age 55. If you leave your job after the age of 55, you can take distributions from your 401(k), 403(b), and 457 and obtain an exception to the penalty. This is not true of IRA distributions.
All employer-related plans have a maximum age before distributions are required. The old rules, before January 2020, required distributions to start by age 70 ½. The current rules starting in 2020 are that distributions are now required to start by age 72. This is true even of Roth’s employer-plan contributions.
The one exception to the mandatory distribution rules is for Roth IRAs. There is no requirement to take funds out of a Roth IRA at any age.
Note that there is currently a bill before Congress to raise the required minimum distribution (RMD) age to 75 for all retirement plans with an RMD requirement.
RMDs are simply the minimum that you are required to take out at your RMD age. You can always take more than the RMD amount. You can begin taking distributions earlier if funds are needed.
Rules and regulations regarding contributions and distributions from retirement accounts can be confusing, with so many differences among the plans. If we at Planning with Purpose can assist you in understanding the requirements of your work-related plan or are interested in learning more about IRAs, please do not hesitate to contact us.