What is an IRA?
Individual Retirement Accounts (IRAs) are a type of tax-advantaged retirement savings vehicle that can be established by individuals outside of an employer sponsored plan and come with certain tax incentives designed to encourage people to save for retirement.
We briefly cover IRAs in Milestone 5 of the Next Dollar Roadmap. This is a more detailed post about these retirement savings accounts.
IRAs are tax-advantaged retirement savings accounts that are owned and managed by an account owner/beneficiary.
In 1974 congress passed the Employee Retirement Income Security Act (ERISA) which paved the way for the first IRAs. Originally, IRAs were designed for small business owners who did not have access to employer pension plans (this preceded 401(k)s).
Anyone with earned income can set up and contribute to an IRA. There are thousands of banks, investment houses, and brokers who would all be happy to help set up your account.
Within the account itself, owners may choose from all sorts of investment options like stocks, bonds, ETFs, mutual funds, and even real estate in certain types of IRAs.
Eligibility
Anyone with earned income can set up an IRA, but SIMPLE and SEP IRAs (see below) are for self-employed individuals and small business owners.
You are only allowed to contribute up to the amount of earned income you realize in a given tax year. So, if you realized $3,000 of earned income in a tax year, you’d only be eligible to contribute up to that amount into an IRA.
Limiting the contributions to earned income means if your only sources of income are dividends, capital gains, or other passive means, you can’t contribute to an IRA.
You can also contribute to an IRA even if you already participate in another retirement plan such as a 401(k), 457, or 403(b).
In 2023, annual IRA contribution limits are $6,500 per individual or $7,500 if you are 50 or older.
There are limitations on how much one can contribute and/or deduct from their taxes for contributions to an IRA based on their modified adjusted gross income or MAGI. We’ll cover those limits as we discuss each IRA type.
Traditional IRAs
Traditional IRAs allow savers to deposit funds on a pre-tax basis into the accounts.
This means any money put into the account is not taxed upon deposit, but contributions and growth of the investments are taxed as ordinary income when withdrawn in retirement.
As an account owner, one would make contributions into the account and take a deduction for those contributions when they file their taxes at the end of the year.
If you do not have access to an employer sponsored retirement plan (like a 401(k), 403(b), or 457) then traditional IRA contributions are fully deductible.
If you or your spouse has access to an employer sponsored plan, your deductible contributions are limited according to your MAGI as follows:
2023 MAGI | Deduction Amount | |
Single/Head of Household | $73,000 or less | Full Deduction |
$73,000 to $83,000 | Partial Deduction | |
More than $83,000 | No Deduction | |
Married Filing Jointly | $116,000 or less | Full Deduction |
$116,000 to $136,000 | Partial Deduction | |
More than $136,000 | No Deduction | |
Married Filing Separately | $10,000 or less | Partial Deduction |
More than $10,000 | No Deduction |
To be clear, you can still contribute to a Traditional IRA no matter what your income is, you just start losing access to a tax deduction at a certain point.
We’ll talk more about why you might want to do this anyway when we get to Backdoor Roth IRAs.
There are also penalties for withdrawals made from a traditional IRA before age 59.5. We will cover this in more detail below as well.
Roth IRAs
Unlike Traditional IRAs, Roth IRAs require account holders to use funds that have already been taxed before being deposited into the account.
However, in this case, the entire account balance, including the growth of the assets, can be withdrawn completely tax-free in retirement.
Another difference of Roth IRAs as compared to Traditional IRAs is that they do not come with required minimum distributions as the account holder ages. We’ll cover RMDs below.
Since Roth IRA contributions are made after tax, withdrawals of the contributions can be made without penalty. This means the Roth IRA can serve as a sort of emergency savings account, though you’d probably be better off leaving any contributions in the account as long as possible.
While any growth from investments in the account is unavailable for penalty-free withdrawal, there are a few exceptions.
If you become disabled or use a Roth IRA to fund the purchase of your first home or pay for college, those withdrawals can be made penalty-free.
Like other IRAs, you must be 59.5 to begin making penalty-free distributions of growth in the account. There is also a five-year rule in effect that must be satisfied before penalty-free withdrawals can begin.
Finally, not everyone can contribute to a Roth IRA. You must have modified adjusted gross income that falls in or below the following limits:
2023 MAGI | Contribution Amount | |
Single/Head of Household | $138,000 or less | Up to Annual Limit |
$138,000 to $153,000 | Partial Contribution | |
More than $153,000 | No Contribution | |
Married Filing Jointly | $218,000 or less | Up to Annual Limit |
$218,000 to $228,000 | Partial Contribution | |
More than $228,000 | No Contribution | |
Married Filing Separately | $10,000 or less | Partial Contribution |
More than $10,000 | No Contribution |
But, if you find yourself excluded from participating in a Roth IRA due to having a high income, fear not, there’s a back door…
The Back Door Roth IRA
Many high-income individuals still contribute to Traditional IRAs on an after-tax basis because they can convert contributions to a Roth IRA and reap the benefits of tax-free growth.
This method is known as the Backdoor Roth IRA.
It’s basically a loophole in the tax code that the IRS and congress have seen fit to leave open for years now. By adding a step, savers with high incomes who would normally be excluded from making qualified IRA contributions can still gain the benefits of contributing to Roth IRAs.
To execute this strategy, contributions are made to a traditional IRA on an after-tax basis (meaning no tax deduction is taken for the deposit). Next, after a period, those funds are converted to a Roth IRA where they can grow tax-free.
There is one potential tax hurdle to this strategy known as the pro rata rule.
The IRS sees all of one’s IRAs as one account, even if you have accounts with multiple institutions.
Since conversions from a Traditional IRA to a Roth IRA are taxable, the IRS taxes all traditional IRA balances on a pro rata or proportional basis to the amount converted.
For example, let’s assume Backdoor Ben has a traditional IRA worth $20,000 that’s several years old. Ben wants to put $5,000 in a Roth IRA, but Ben’s income is now too high to make contributions to the Roth IRA directly.
Undeterred, Ben decides to try the backdoor method. He quickly makes his $5,000 deposit and subsequent conversion.
Since Ben had a $25,000 Traditional IRA balance when he completed his conversion, he will have to pay income tax on 80% ($20k untaxed/$25k total) of the converted amount. In this case, $4,000 of the conversion is subject to income tax.
It’s not necessarily the end of the world, but if you have a large IRA balance don’t let this potential tax surprise catch you off guard.
One other comment about the Backdoor Roth IRA.
Some people are enamored with this approach because they feel like they’re pulling one over on the IRS and executing some highly technical scheme that only the big boys know about.
Don’t let a desire to do some fancy tax avoidance tap dance take your eye off the ball. In many cases, you can just contribute to a Roth 401(k) at work instead and get the same benefit.
The IRS is very, very aware of the backdoor and it’s been left open since 2010. Use it if it makes sense, but try not to flatter yourself too much about it.
For further information about Roth vs Traditional savings, please read this post.
Self-Directed IRA
For more seasoned investors who don’t feel that equities available from the typical investment company are able to fully meet their investment needs, there’s the self-directed IRA (SD IRA).
SD IRAs are available as either Traditional or Roth IRAs and are administered by a custodian of some sort. SD IRA custodians are typically well versed in these accounts and understand the potential plusses and pitfalls they come with.
Like other IRAs, SD IRAs are subject to contribution limitations, income restrictions, early withdrawal penalties, RMDs, and qualified distributions must be made after age 59.5.
The key difference is an SD IRA allows the owner to invest in less commonly purchased assets like real estate, precious metals and commodities, private enterprises, tax liens, and limited partnerships.
For example, if our friend Backdoor Ben later decides he wants to own a rental property but wants to keep it inside his Roth IRA, he can do that with an SD IRA.
The growth in value of the asset and any revenue it produces would have the same tax treatment as any other asset in a normal IRA.
The problem is there are a lot of land mines that come with SD IRAs. As the account owner, you are not allowed to receive ANY material benefit from any of the assets until age 59.5.
So, if Ben is between tenants and decides to spend the weekend at the rental house owned by his IRA, he would trigger a huge tax liability by doing so.
SD IRAs are not for everyone so be thoughtful if you choose to go this route.
SEP IRA
Simplified Employee Pension (SEP) IRAs are for self-employed individuals like contractors or small business owners.
Withdrawal restrictions for SEP IRAs are just like those for Traditional IRAs. For 2023, SEP account holders can contribute up to 25% of their income or $66,000, whichever is less.
Business owners can set up SEP IRAs for their employees, but the employees can’t make contributions to the account. Contributions by the employer are tax deductible.
Simple IRA
Savings Incentive Match Plan for Employees or SIMPLE IRAs are similar to SEP IRAs with the key exception being that employees are allowed to make deposits into their own accounts.
Employers are also required to make contributions, which are also tax deductible.
For 2023, employees are allowed to contribute up to $15,500 annually or an additional $3,500 if 50 or older.
IRA Withdrawal Restrictions
We’ve already touched on the most significant restriction to bear in mind as one uses an IRA to save for retirement.
Any unqualified withdrawals made before age 59.5 are subject to a 10% penalty.
There are a few hardship exceptions to this rule, so if you become disabled or have other significant medical expenses you could look into it.
Additionally, for Roth IRAs, withdrawals are subject to the five-year rule(s) which you can read more about here. It stipulates that withdrawals cannot be made until five years have elapsed since the first Roth IRA account was established for the account holder.
So, if you don’t have the cash to fully fund a Roth IRA, but think you may want to start funding it soon AND withdraw from the account all within five years, open an account and put a dollar in it to start your clock.
Required Minimum Distributions
Since IRA contributions are made on a tax-deferred basis (Roths excluded), Uncle Sam puts a time limit on how long those assets can sit before he begins collecting his share.
After all, in many cases inherited assets receive a new tax basis when they are transferred from the estate of the deceased to their chosen beneficiary. If IRA owners were allowed to bequeath their untaxed assets after their death, that earned income could potentially go completely untaxed forever.
It would also make IRAs an exceptionally attractive estate planning tool.
However, Uncle Sam is wise to this, so he has put in place an age (currently 72) at which account owners must begin taking required minimum distributions (RMDs) and pay taxes on the withdrawn portions of their IRA account balances.
The RMD amount is calculated using a life expectancy table provided by the IRS. The older you get, the higher percentage you are required to remove from the account.
If you die before the account balance is exhausted, your beneficiaries will have to continue taking RMDs until the account is exhausted, but they must empty the account within 10 years unless the recipient is a spouse or an eligible designated beneficiary.
This makes perfect sense, but it can also be significantly inconvenient if you don’t need the money.
In many cases, people find they have enough income from other sources like pensions and social security to cover their spending needs. An RMD that forces them to realize even more income unnecessarily while also triggering a higher tax bill can be tough to stomach.
To avoid this, many recommend converting Traditional IRA assets into Roth IRA assets in the years before turning 72 when RMDs begin.
If you are charitably inclined, Qualified Charitable Distributions are also a fine option for reducing exposure to RMDs.
