Top 7 Traditional IRA Hacks
Over 55 million US households own at least one IRA.
Like most tax-advantaged retirement plans, IRAs come with a litany of IRS rules and regulations that mostly limit their flexibility, but some of these quirky rules can actually be used for our benefit.
Here are seven traditional IRA strategies you should remember to make the most of these accounts.
1) Understand Your Taxes (use instead of Roth or vice versa)
First, you should attempt to understand your tax situation now versus when you retire and begin removing funds from the account.
You’ll want to do this because having the ability to choose between contributing to a Roth IRA and a Traditional IRA gives you an opportunity to arbitrage your income taxes by choosing when you pay them.
With a Roth, your contributions won’t get a tax deduction, but all of your withdrawals can be made completely tax-free.
On the other hand, Traditional IRA contributions receive a tax deduction while withdrawals are taxed as regular income.
Ideally, you’ll want to pay taxes when you’re in a lower tax bracket. So, if you have a low income currently and think you may be in a higher bracket in retirement, the Roth is for you.
However, if your income is relatively high at the moment, you may prefer to take a deduction now by contributing to a Traditional IRA instead.
By understanding your tax situation, you could benefit from a generous “tax discount” with a little thoughtful planning.
2) Use it as a Backdoor
Below we have the maximum income restrictions for making Roth IRA contributions in 2024.
If your income is too high, you won’t be able to contribute.
However, there is a strategy you can use called a Backdoor Roth IRA to fund your Roth anyway.
Here’s how it works.
Instead of contributing to a Roth IRA directly, make your contributions to a Traditional IRA on an after-tax or non-deductible basis.
Once the contribution is in the account, simply contact your custodian and have them convert it to a Roth and you have a perfectly legal Roth IRA contribution.
Any earnings or appreciation your contribution receives after you make the contribution will be subject to tax, so consider moving it into the Roth quickly or leave it in cash until you complete the conversion.
3) Convert it to Roth
We already discussed how you can use Roth or Traditional IRAs to engage in tax arbitrage and produce the best tax outcome for yourself.
One way to do that even after you’ve made a Traditional contribution is to convert those assets to a Roth IRA in a year where your income taxes are low.
Of course, that conversion will be subject to income taxes, so you’ll also need to have enough cash reserves to fund the conversion while also experiencing low income.
However, if you have a year where maybe business isn’t great or you’ve even been unemployed for a time and your taxable income is in low brackets, this could provide a great opportunity to move your IRA money into a Roth and drop any future tax liability completely.
4) Tap it Early (72t or Conversion Ladder)
You must be at least 59.5 years old to begin making qualified distributions from an IRA.
However, there are a couple of ways to access your IRA money early without paying early withdrawal penalties.
The first one is a Roth Conversion Ladder. This method takes advantage of IRS rules that allow conversions to be withdrawn from a Roth IRA once they’ve been in the account for five years.
To use this strategy, you’ll begin by converting a chosen amount of funds from your Traditional IRA to your Roth IRA. This conversion is subject to income tax.
Next, leave the conversion in the Roth IRA for at least five years. After the 5th year, you can withdraw the conversion tax and penalty-free, no matter your age.
Now, I should point out that your conversion clock starts on January 1st of the tax year in which you completed the conversion.
So, if you make a conversion on December 15th, 2023, you’ll receive credit in the IRS’ eyes for making the conversion on January 1st, 2023. This means your 5-year clock could be as short as 4 years and a day if you want to cut it that close.
The second method for accessing your IRA early is a 72T Distribution or SEPP (Series of Equal Periodic Payments).
A 72T or SEPP allows you to begin making withdrawals from an IRA for a period of five years or until you turn 59.5, whichever occurs later.
So, if you start your 72T when you’re 52, you’ll have to keep it up until you turn 59.5. If you start at age 57, you’ll have to keep going until you turn 62.
There are three methods for calculating your 72T: the annuitization method, the amortization method, and the minimum distribution method.
These formulas can be complicated and if you mess them up you could face penalties and taxes for making a non-qualified distribution. We recommend hiring a tax expert for help with this.
5) Watch Out for RMDs (convert to Roth, use QCDs)
When you turn 73 or 75 (beginning in 2033) you will be required to make annual distributions from your Traditional IRA based on end-of-year account balance and your life expectancy.
These are called required minimum distributions or RMDs.
To calculate the RMD amount, simply take the account balance on December 31st of the previous year and divide it by the distribution period listed on the IRS’ Uniform Lifetime Table.
For example, if you had a $200,000 IRA balance at the end of 2022 and you turned 75 in 2023, you’d divide $200,000 by 24.6 for an RMD amount of $8,130.08 which must be taken in 2023.
Forgetting to take an RMD will earn you a 25% penalty for each year you fail to take the distribution.
In many cases, retirees don’t need the money they are required to remove as an RMD.
With advanced planning, you could reduce your Traditional IRA balance through Roth Conversions, thus reducing the amount of your RMD, or you could use Qualified Charitable Distributions (QCDs) instead.
QCDs allow you to divert your RMD directly to a charity of your choice which reduces or eliminates your RMD on a dollar-for-dollar basis for the tax year of the QCD.
You won’t receive a tax deduction for the gift because it is coming from an account that has never been taxed, but you can use this tool to limit the amount of income you realize for the year which could reduce your tax liability, limit your exposure to the Medicare surtax, and improve the tax impact on your social security benefits.
6) Think Conservative
Since withdrawals from Traditional IRAs are taxed as regular income, it’s wise to arrange your assets so that the more conservative and slower-growing investments are in your Traditional accounts.
Don’t adjust your asset allocation strategy to accommodate this, just start by directing your fixed-income assets to the Traditional accounts first.
For example, if you desire a 60/40 stocks-to-bonds asset allocation, begin purchasing the bonds in your Traditional IRA until you either purchase 40% of your portfolio’s value in bonds or run out of money in the IRA.
If you still haven’t reached 40% in bonds when you use up your available cash, by the remainder somewhere else in your portfolio so you keep your 60/40 allocation.
Also, don’t buy municipal bonds or MUNIs in a Traditional IRA. They receive special tax consideration no matter where they are owned, but you can’t double dip the tax-deferred benefit with the tax-free yield from the bonds.
MUNIs are better held in a fully taxable space.
7) Spousal IRA
Finally, you may know that you must have earned income to contribute to an IRA.
The lone exception to this rule is that non-working spouses may contribute to an IRA based on the income of their working partner.
The couple must file their taxes as married, filing jointly and as a couple they cannot contribute more than the modified adjusted gross income of the working spouse for the year.
However, this is a great benefit for households in which one spouse doesn’t work. If you are running out of places to save but are eligible for a spousal IRA you should take advantage.
Conclusion
Hopefully, some or all of these IRAs hacks will be helpful to you as you work toward financial independence.
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Thanks for reading!
