Common Cents: Understand IRAs before April 15 deadline

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An individual retirement account (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. For Perry and Dallas county residents contributing to a 401(k) or other plan at work, you might also consider investing in an IRA.

The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $6,000 in 2019 — up from $5,500 in 2018. You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA even if he or she has little or no taxable compensation, as long as your combined compensation is at least equal to your total contributions.

The law also allows taxpayers age 50 and older to make additional “catch-up” contributions. These folks can contribute up to $7,000 in 2019 — up from $6,500 in 2018.

Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that’s best for you.

Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under the age of 70 years and 6 months.

You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.

Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pre-tax) contributions lower your taxable income for the year, saving you money in taxes.

If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual IRA contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income or MAGI) and your income tax filing status.

For 2019, if you are covered by a retirement plan at work, and:

  • Your filing status is single or head of household, and your MAGI is $64,000 or less, your traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $64,000 and less than $74,000, and you can’t deduct your contribution at all if your MAGI is $74,000 or more.
  • Your filing status is married filing jointly or qualifying widow(er), and your MAGI is $103,000 or less, your traditional IRA contribution is fully deductible. Your deduction is reduced if your MAGI is more than $103,000 and less than $123,000, and you can’t deduct your contribution at all if your MAGI is $123,000 or more.
  • Your filing status is married filing separately, your traditional IRA deduction is reduced if your MAGI is less than $10,000, and you can’t deduct your contribution at all if your MAGI is $10,000 or more.

For 2019, if you are not covered by a retirement plan at work but your spouse is, and if you file a joint tax return, then your traditional IRA contribution is fully deductible if your MAGI is $193,000 or less. Your deduction is reduced if your MAGI is more than $193,000 and less than $203,000, and you can’t deduct your contribution at all if your MAGI is $203,000 or more.

What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either.

Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent withdrawal penalty if you’re under age 59 years and 6 months, unless you meet one of the exceptions.

You must aggregate all of your traditional IRAs — other than inherited IRAs — when calculating the tax consequences of a distribution.

If you wish to defer taxes, you can leave your funds in the traditional IRA but only until April 1 of the year following the year you reach age 70 years and 6 months. That’s when you have to take your first required minimum distribution from the IRA.

After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you’re required to in any year.

However, if you withdraw less, you’ll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdraw.

The rules for Roth IRAs differ in significant ways. Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation in 2019 is at least $6,000, you may be able to contribute the full amount.

But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status:

  • If your filing status is single or head of household, and your MAGI for 2019 is $122,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $122,000 and less than $137,000, and you can’t contribute to a Roth IRA at all if your MAGI is $137,000 or more.
  • If your filing status is married filing jointly or qualifying widow(er), and your MAGI for 2019 is $193,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $193,000 and less than $203,000, and you can’t contribute to a Roth IRA at all if your MAGI is $203,000 or more.
  • If your filing status is married filing separately, your Roth IRA contribution is reduced if your MAGI is less than $10,000, and you can’t contribute to a Roth IRA at all if your MAGI is $10,000 or more.

Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings.

To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:

  • You have reached age 59 years and 6 months by the time of the withdrawal.
  • The withdrawal is made because of disability.
  • The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit).
  • The withdrawal is made by your beneficiary or estate after your death.

Qualified distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA.

And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.

You must aggregate all of your Roth IRAs — other than inherited Roth IRAs — when calculating the tax consequences of a distribution.

Another advantage of the Roth IRA is that there are no required distributions after age 70 years and 6 months or at any time during your life. You can put off taking distributions until you really need the income. Or you can leave the entire balance to your beneficiary without ever taking a single distribution.

Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70 years and 6 months.

Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult.

The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working — and are probably in a higher tax bracket than you’ll be in after you retire.

A financial professional or tax advisor can help you pick the right type of IRA for you. Note that you can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $6,000 for 2019 and $7,000 if you’re age 50 or older.

You can move funds from an IRA to the same type of IRA with a different institution, that is, traditional to traditional or Roth to Roth. No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee.

The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You’ll still avoid taxes and the penalty as long as you complete the rollover within 60 days from the date you receive the funds.

You may also be able to convert funds from a traditional IRA to a Roth IRA. This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.

Note that the U.S. Internal Revenue Service has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.

Vince Sturm is an accredited wealth management advisor at Generations Wealth Advisors in Perry. Vince can be reached at 515-465-9843 or at vince@genwealthadvisors.com.

Registered Representative of and securities offered through Berthel Fisher and Co. Financial Services Inc. (BFCFS). Member FINRA/SIPC. Investment advisory services offered through BFC Planning Inc. Generations Wealth Adivsors, BFCFS and BFC Planning Inc. are independent entities. Our firm does not provide legal or tax advice. Be sure to consult with your own legal and tax advisors before taking any action that may have tax implications.

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