IRA Basics

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

What Is An IRA?

An Individual Retirement Account (IRA) is a tax-advantaged investment tool designed to help individuals save for retirement. It offers potential tax benefits, either upfront through tax-deductible contributions (Traditional IRA) or at retirement with tax-free withdrawals (Roth IRA).

How Does An IRA Work?

An IRA works by allowing individuals to contribute a portion of their income into a dedicated account. This account can hold various investments like stocks, bonds, mutual funds, and more. The key features include:

  1. Contribution Limits: The IRS sets annual limits on how much you can contribute.
  2. Tax Advantages: Traditional IRAs offer tax-deferred growth, meaning you pay taxes upon withdrawal. Roth IRAs provide tax-free growth, with contributions made with after-tax dollars.
  3. Withdrawal Rules: In most cases, withdrawals can be made after age 59½ without penalty, but traditional IRAs require mandatory withdrawals at age 73.
Iras

Types Of IRAs

  1. Traditional IRA
    A tax-advantaged retirement account that allows you to make pre-tax contributions, reducing your taxable income for the year you contribute. Taxes on earnings are deferred until withdrawals, which are taxed as ordinary income. Withdrawals prior to age 59½ may incur a 10% penalty unless an exception applies.
  2. Roth IRA
    This account features post-tax contributions, meaning you pay taxes on the money going in, but withdrawals of both contributions and earnings are tax-free in retirement, provided certain conditions are met. There are income limits for eligibility to contribute.
  3. SEP IRA (Simplified Employee Pension)
    Designed for self-employed individuals and small business owners. Contributions are made by the employer only and are tax-deductible as a business expense. Employees do not contribute to this account.
  4. SIMPLE IRA (Savings Incentive Match Plan for Employees)
    Aimed at small businesses that do not have any other retirement plan. Both employers and employees can contribute with mandatory employer contributions. It has higher contribution limits than traditional and Roth IRAs but lower than those for SEP IRAs.
  5. Self-Directed IRA
    A variation of a Traditional or Roth IRA that allows for a broader range of investments, including real estate, precious metals, and private placements. Requires a custodian that permits these types of investments. It involves higher risk and potentially higher fees.
  6. Spousal IRA
    This is not a distinct type of IRA but a strategy for a non-working spouse to contribute to an IRA (either Traditional or Roth, depending on eligibility). The working spouse’s income must cover the contributions made to both IRAs.
  7. Inherited IRA
    Also known as a Beneficiary IRA, this is an account opened when you inherit an IRA or employer-sponsored retirement plan after the owner dies. Different rules apply for spouses and non-spouses regarding how and when the money must be withdrawn.
  8. Custodial Roth IRA This is a type of Roth IRA set up for a minor by a parent or legal guardian. The custodian manages the account until the child reaches the age of majority in their state, at which point control of the IRA transfers to the young adult. There are special rules required to open a custodial Roth IRA.
    • Rules
      • Eligibility: The child must have earned income (e.g., wages from a part-time job).
      • Contributions: Must be made with after-tax dollars and cannot exceed the minor’s earned income.
      • Tax Treatment: Contributions are not tax-deductible, but earnings grow tax-free, and withdrawals are tax-free if the rules are followed.
      • Age of Majority: Once the minor reaches the age of majority, they assume control of the account, which becomes a standard Roth IRA.

2024 IRA Contribution Limits

  1. Traditional IRA
    • Limit: $7,000 annually.
    • Catch-up Contribution (age 50 or older): Additional $1,000.
  2. Roth IRA
    • Limit: $7,000 annually.
    • Catch-up Contribution (age 50 or older): Additional $1,000.
  3. SEP IRA (Simplified Employee Pension)
    • Limit: 25% of compensation or $69,000, whichever is less.
  4. SIMPLE IRA (Savings Incentive Match Plan for Employees)
    • Limit: $16,000 annually.
    • Catch-up Contribution (age 50 or older): Additional $3,500.
  5. Self-Directed IRA
    • This follows the same contribution limits as Traditional or Roth IRAs, depending on which type the self-directed IRA is structured as:
      • Limit: $7,000 annually.
      • Catch-up Contribution (age 50 or older): Additional $1,000.
  6. Spousal IRA
    • The limits for a spousal IRA are the same as those for Traditional or Roth IRAs, depending on which type is used:
      • Limit: $7,000 annually.
      • Catch-up Contribution (age 50 or older): Additional $1,000.
  7. Inherited IRA
  8. Custodial Roth IRA
    • The limits for a custodial Roth IRA are the same as those for Roth IRAs, depending on which type is used:
      • Limit: $7,000 annually but can not exceed the minor’s earned income.
Is An Ira A Good Investment For Retirement

2024 IRA Income Limits

Here are the income limits for contributing to IRAs in 2024. These limits determine eligibility for tax deductions or contributions based on your Modified Adjusted Gross Income (MAGI):

Roth IRA Contribution Limits

  • Single Filers and Head of Household:
    • MAGI less than $146,000: Full contribution.
    • MAGI $146,000 to $161,000: Reduced contribution.
    • MAGI more than $161,000: Not allowed to contribute.
  • Married Filing Jointly:
    • MAGI less than $230,000: Full contribution.
    • MAGI $230,000 to $240,000: Reduced contribution.
    • MAGI more than $240,000: Not allowed to contribute.
  • Married Filing Separately:
    • MAGI $10,000 or less: Reduced contribution.
    • MAGI more than $10,000: Not allowed to contribute.

The reduced contribution is based on an IRS formula and depends on your MAGI for that year.

Steps for a Backdoor Roth IRA

A backdoor Roth IRA is a strategy used by high-income earners to circumvent the income limits that restrict direct contributions to a Roth IRA. Here’s how it typically works:

  1. Contribute to a Traditional IRA: You start by making a nondeductible contribution to a Traditional IRA. There are no income limits to contribute to a Traditional IRA, but there are limits on tax-deductible contributions based on income, filing status, and coverage by an employer-sponsored plan.
  2. Convert to a Roth IRA: Shortly after making the Traditional IRA contribution, you can convert it to a Roth IRA. This conversion is not restricted by your income level.
  3. Pay Taxes on the Conversion: If the contributions to the Traditional IRA were nondeductible, you only owe taxes on any earnings that occurred between the contribution and the conversion. If the conversion is done quickly after the contribution, the taxable earnings will be minimal.

Key Considerations

  • Pro Rata Rule: If you have any other IRAs that contain pre-tax contributions or earnings (from deductible contributions or earnings on the contributions), the IRS requires that the conversion consider these funds on a pro-rata basis. This could mean a higher tax bill if you convert, as you would have to include a portion of these pre-tax amounts in your taxable income for the year.
  • Step Transaction Doctrine: This strategy is technically legal, but it’s important to be cautious about the timing of the conversion. If done too simplistically or immediately after the contribution, the IRS might view it as a step transaction, essentially a direct Roth contribution, which could challenge the process under audit.
  • Tax Planning: It’s wise to consult with a tax advisor when executing a backdoor Roth IRA to understand the tax implications fully and ensure compliance with IRS rules.

Traditional IRA Deduction Limits

Unlike Roth IRAs, Traditional IRAs do not have an income limit. However, you can deduct a certain amount from your taxes.

For those covered by a workplace retirement plan:

  • Single or Head of Household:
    • $77,000 or less: Full deduction.
    • More than $77,000 but less than $87,000: Partial deduction.
    • $87,000 or more: No deduction.
  • Married Filing Jointly:
    • $123,000 or less: Full deduction.
    • More than $123,000 but less than $143,000: Partial deduction.
    • $143,000 or more: No deduction.
  • Married Filing Separately (you or your spouse are covered by a workplace retirement plan):
    • Less than $10,000: Partial deduction.
    • $10,000 or more: No deduction.

For those not covered by a workplace retirement plan but with a spouse who is:

  • Married Filing Jointly:
    • $230,000 or less: Full deduction.
    • More than $230,000 but less than $240,000: Partial deduction.
    • $240,000 or more: No deduction.

The partial deductions are based on an IRS formula and dependent on your MAGI for that year.

SEP IRA and SIMPLE IRA

  • SEP IRA: No MAGI-based limits for contributions, but contributions must be proportional for all eligible employees based on the employer’s contribution.
  • SIMPLE IRA: No MAGI-based income limits for contributions.

Self-Directed IRA, Spousal IRA, and Custodial Roth IRA

  • Follow the same income limits as Traditional or Roth IRAs, depending on the account type chosen.

Inherited IRA

  • No contributions are allowed to Inherited IRAs, thus no income limits apply.

IRA Taxation and Penalties

Here’s a detailed overview of the tax implications and potential penalties associated with different types of Individual Retirement Accounts (IRAs):

Traditional IRA

Taxation:

  • Contributions are typically made with pre-tax dollars; you get a tax deduction on your contributions based on your income and filing status.
  • Earnings grow tax-deferred.
  • Withdrawals in retirement are taxed as ordinary income.

Penalties:

  • Early withdrawal penalty of 10% if you take money out before age 59½ unless an exception applies (e.g., first-time home purchase, qualified education expenses, certain medical expenses).

Roth IRA

Taxation:

  • Contributions are made with after-tax dollars; there is no tax deduction when you contribute.
  • Earnings and withdrawals are tax-free in retirement, provided the account has been open for at least five years and withdrawals are made after age 59½.
  • Contributions (not earnings) can be withdrawn at any time without taxes or penalties.

Penalties:

  • A 10% early withdrawal penalty on earnings (not contributions) if taken out before age 59½ and before the account is five years old unless an exception applies.

SEP IRA (Simplified Employee Pension)

Taxation:

  • Contributions are made by the employer only and are tax-deductible as a business expense.
  • Earnings grow tax-deferred.
  • Withdrawals are taxed as ordinary income in retirement.

Penalties:

  • An early withdrawal penalty of 10% applies to distributions taken before age 59½, with certain exceptions similar to those for Traditional IRAs.

SIMPLE IRA (Savings Incentive Match Plan for Employees)

Taxation:

  • Contributions are pre-tax, reducing your taxable income.
  • Earnings grow tax-deferred.
  • Withdrawals are taxed as ordinary income in retirement.

Penalties:

  • Early withdrawal penalty of 10% if taken before age 59½.
  • An increased early withdrawal penalty of 25% if the withdrawal is made within the first two years of participation in the plan.

Self-Directed IRA

Taxation:

  • Follows the same tax rules as Traditional or Roth IRAs, depending on which type it is categorized under (either pre-tax or after-tax contributions).

Penalties:

  • Penalties for early withdrawal are the same as those associated with Traditional or Roth IRAs.

Spousal IRA

Taxation:

  • Taxation depends on whether the spousal IRA is a Traditional or Roth IRA, following the respective tax rules of each.

Penalties:

  • Early withdrawal penalties are the same as those for Traditional or Roth IRAs, depending on which type it is.

Inherited IRA

Taxation:

  • No contributions can be made; however, distributions are typically required and are taxed based on the original account type (Traditional or Roth).
  • For Traditional Inherited IRAs, distributions are taxed as ordinary income.
  • Distributions from Roth Inherited IRAs are tax-free, provided the IRA was opened at least five years before.

Penalties:

  • Generally, there are no penalties for withdrawals from Inherited IRAs, but required minimum distributions (RMDs) must be taken to avoid a 25% excise tax on the amount that was required to be distributed but was not.

Tax Exceptions

Traditional IRA

Penalty Exceptions:

  1. First-time Home Purchase: Up to $10,000 can be withdrawn penalty-free to buy, build, or rebuild a first home.
  2. Higher Education Expenses: Withdrawals can be made to pay for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution for you, your spouse, or your children or grandchildren.
  3. Unreimbursed Medical Expenses: Amounts more than 7.5% of adjusted gross income can be withdrawn penalty-free.
  4. Health Insurance Premiums: Withdrawals are allowed penalty-free if you are unemployed and pay for health insurance.
  5. Disability: Withdrawals are penalty-free if you are totally and permanently disabled.
  6. Substantially Equal Periodic Payments (SEPP): Under IRS Rule 72 (t), you can take at least annually scheduled withdrawals for five years or until age 59½, whichever comes later.
  7. IRS Levy: If the IRS levies the IRA for unpaid taxes.
  8. Military Reservists: Certain withdrawals are penalty-free if called to active duty for more than 179 days.
  9. Birth or Adoption: Up to $5,000 can be withdrawn penalty-free for each birth or adoption event.

Roth IRA

Penalty Exceptions (on earnings; contributions can always be withdrawn tax and penalty-free):

  1. First-time Home Purchase: Same as Traditional IRA, up to $10,000.
  2. Higher Education Expenses: Same criteria as for Traditional IRAs.
  3. Unreimbursed Medical Expenses and Health Insurance: Same conditions as Traditional IRAs.
  4. Disability and Death: Withdrawals are penalty-free upon disability or to beneficiaries after the account holder’s death.
  5. SEPP: Withdrawals under Rule 72(t) are penalty-free.
  6. Birth or Adoption: Withdrawals up to $5,000 penalty-free.

SEP IRA and SIMPLE IRA

Penalty Exceptions:

  • The exceptions are generally the same as those for Traditional IRAs since these plans follow similar taxation rules for distributions. However, SIMPLE IRAs have an additional penalty (25% instead of 10%) for withdrawals within the first two years of participation, which reverts to 10% after two years.

Self-Directed IRA

Penalty Exceptions:

  • Follows the rules of Traditional or Roth IRAs, depending on its type.

Spousal IRA

Penalty Exceptions:

  • Follows the rules of Traditional or Roth IRAs, depending on its type.

Inherited IRA

Penalty Exceptions:

  • Generally, early withdrawal penalties do not apply to Inherited IRAs.

IRA Savings Tips

  1. Start Early: The earlier you begin saving in an IRA, the more time your money has to grow through the power of compound interest. Even small, regular contributions can grow significantly over time.
  2. Maximize Contributions: Try to contribute the maximum amount allowed each year. For 2024, the limit is $7,000, with an additional $1,000 catch-up contribution if you are age 50 or older.
  3. Set Up Automatic Contributions: Automate your savings by setting up regular, automatic transfers from your checking or savings account to your IRA. This reduces the temptation to spend the money elsewhere and ensures consistent contributions.
  4. Take Advantage of Catch-Up Contributions: If you’re 50 or older, you can make additional catch-up contributions. This is an excellent way to boost your retirement savings if you have a late start or want to maximize your funds for retirement.
  5. Choose the Right Type of IRA for Your Situation: Decide between a Traditional IRA and a Roth IRA based on your current and expected future tax situation. A Roth IRA makes more sense if you expect to be in a higher tax bracket in retirement, while a Traditional IRA is beneficial if you’re currently in a higher tax bracket and anticipate being in a lower one after retiring.
  6. Invest Wisely: Your IRA’s growth depends significantly on how you invest. Diversify your investments to manage risk and maximize returns over the long term. When selecting investments, consider your age, risk tolerance, and retirement goals.
  7. Monitor and Rebalance: Regularly review your IRA’s performance and rebalance your portfolio to maintain your desired asset allocation. This helps manage risk and can improve your IRA’s performance over time.
  8. Avoid Early Withdrawals: Early withdrawals from your IRA can lead to penalties and lost growth opportunities. Only consider withdrawals for qualified exceptions, and even then, evaluate the impact on your long-term savings.
  9. Consolidate Retirement Accounts: If you have multiple retirement accounts from different employers, consider consolidating them into a single IRA. This can make managing your retirement savings easier and might reduce fees.
  10. Stay Informed About Changes in IRA Rules: Tax laws and contribution limits can change. Stay informed about any changes to IRA regulations that could affect your retirement planning. Usually, the IRS announces the contribution limits for IRAs for the upcoming year during the fall of the current year.
  11. Seek Professional Advice: Consider consulting with a financial advisor, like The Annuity Expert, who can provide personalized advice based on your individual financial situation and goals.
  12. Plan for Required Minimum Distributions (RMDs): For Traditional IRAs, plan for RMDs, which begin at age 73. Understand the amounts you will need to withdraw to avoid penalties for failing to take RMDs.
  13. Use Windfalls Wisely: If you receive a windfall, such as a bonus, tax refund, or inheritance, consider contributing a portion of it to your IRA to boost your retirement savings.

How We Can Help

At The Annuity Expert, we understand the importance of planning for a secure and comfortable retirement. With over 15 years of experience as an insurance agency, annuity broker, and retirement planner, we specialize in helping you find the best solutions at the lowest costs.

We recognize the core problem you face: uncertainty in retirement planning and the fear of outliving your savings. Symptoms of this problem include anxiety about financial stability, confusion over the best investment choices, and the challenge of navigating complex IRS rules.

Our mission is to alleviate these concerns by offering personalized, expert advice tailored to your unique needs. We stand for transparency, reliability, and the pursuit of financial security for all our clients.

What We Recommend

To achieve your retirement goals, follow these high-level steps:

  1. Initial Consultation: Schedule a free consultation with us. During this meeting, we’ll assess your financial situation and retirement goals.
    • Main Benefit: Personalized strategy tailored to your needs.
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Features and Benefits

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Common objections might include concerns about fees or the complexity of switching accounts. We address these by offering transparent pricing and handling all the paperwork for you, ensuring a smooth transition.

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Questions From Our Readers

What are the benefits of investing in an IRA through a financial institution?

Investing in an IRA through a financial institution can provide tax advantages, potential investment growth, and a diversified portfolio to help save for retirement.

What are the benefits of investing in an IRA as part of your retirement plan?

Investing in an IRA as part of your retirement plan can provide additional retirement savings, potential tax benefits, and flexibility in managing your portfolio.

Can you cash out an IRA?

If you withdraw money from an Individual Retirement Account (IRA) before turning 59 and a half, you will usually have to pay taxes and an additional penalty tax of 10%. However, this penalty has some exceptions, such as using IRA funds to pay for medical insurance if you lost your job.

Does my money grow in an IRA?

IRAs, like any other investment, can increase in value over time. You can grow your IRA through annual contributions and by appreciating your investments.

I have a Merrill Edge IRA account; how do I withdraw a large amount, and is it taxable?

To withdraw a large amount from your Merrill Edge IRA account, you would typically initiate the withdrawal online or by contacting Merrill Edge customer service. Withdrawals before age 59 1/2 may incur a 10% early withdrawal penalty in addition to income taxes. However, there are exceptions such as disability, certain medical expenses, or first-time home purchases that may waive the penalty.

I took money from my IRA to buy out my partner. I still have the money in my account that I owe the IRS, but they have not reached out, and I don’t know where to send the money. What should I do?

If you withdrew money from your IRA and owe taxes on it, it’s important to address this proactively, even if the IRS hasn’t reached out yet, to avoid penalties and accrued interest. Typically, you would report the withdrawal when filing your annual tax return and pay any associated taxes at that time. If you’re unsure about the amount or the process, it’s advisable to consult with a tax professional. They can assist in determining the exact tax liability and guide you through the process of paying it, ensuring compliance and possibly avoiding penalties or interest for late payments.

What is better to have in an IRA, a CD, or a fixed annuity?

The better choice depends on your individual financial goals, risk tolerance, and the specifics of the products available to you. Fixed annuities generally offer higher interest rates compared to CDs and may provide more liquidity options. However, annuities often come with longer commitment periods and potential penalties for early withdrawal. CDs are typically considered safer and more straightforward, with fixed terms and FDIC insurance. Annuities might be more suitable for those seeking higher returns and can commit long-term, while CDs are often preferred for their safety and simplicity.

Can I invest my IRA into a flexible-premium deferred annuity?

Absolutely! You can definitely put your IRA money into a flexible-premium deferred annuity.

If I have a 401k and an IRA, are the contribution limits separate?

Yes, 401(k) and IRA contribution limits are separate. You can contribute to both a 401(k) and an IRA in the same year, and the limits for each type of account do not affect each other. This allows individuals to maximize their retirement savings by utilizing the distinct advantages of both types of accounts.

Are all IRAs the same?

No, there are several different types of Individual Retirement Accounts (IRAs), each with unique rules and benefits.

Does money in an IRA grow tax-free?

Yesif it’s a Roth IRA. In a Roth IRA, your contributions are made with after-tax dollars, meaning you’ve already paid taxes on the money you put into it. The growth of your investments in a Roth IRA is tax-free, as are the withdrawals, provided certain conditions are met. This includes a five-year holding period and reaching the age of 59½, among other stipulations.

What are the downsides of an IRA?

Limited contribution limits, full taxability when you withdraw from a traditional IRA, and exposure to market loss, which can lead to uncertainty in growth, are some of the potential downsides of an IRA.

Do Traditional IRAs earn interest?

Yes, Traditional IRAs can earn interest, but they typically generate returns through a wider range of investments, such as stocks, bonds, mutual funds, and ETFs, not just interest income. The choice of investments determines the IRA’s growth potential.

How much interest does an IRA earn?

The average return on an IRA varies widely depending on its investment choices. Historically, IRAs invested in a mix of stocks and bonds might average returns of 5% to 8% per year.

Are IRA accounts insured?

IRA accounts are not directly insured, but the funds held within an IRA at a bank or brokerage are protected up to $250,000 by the FDIC or SIPC, respectively.

Can you lose money on a Roth IRA?

Yes, you can lose money on a Roth IRA if the investments within the account decline in value. While Roth IRAs offer tax-free growth and withdrawals, they are still subject to the risks associated with their underlying investments.

How much money do I need to open an IRA?

The minimum amount required to open an IRA varies by financial institution. Some providers allow you to open an IRA with no minimum deposit, while others may require anywhere from $100 to $1,000 or more.

How many IRAs can you have?

You can have multiple IRAs, including different types (like Traditional, Roth, SEP, and SIMPLE IRAs), but total contributions across all accounts cannot exceed the annual contribution limits set by the IRS for your age and income level.

Shawn Plummer, CRPC

Chartered Retirement Planning Counselor

Shawn Plummer is a Chartered Retirement Planning Counselor, insurance agent, and annuity broker with over 14 years of first-hand experience with annuities and insurance. Since beginning his journey in 2009, he has been pivotal in selling and educating about annuities and insurance products. Still, he has also played an instrumental role in training financial advisors for a prestigious Fortune Global 500 insurance company, Allianz. His insights and expertise have made him a sought-after voice in the industry, leading to features in renowned publications such as Time Magazine, Bloomberg, Entrepreneur, Yahoo! Finance, MSN, SmartAsset, The Simple Dollar, U.S. News and World Report, Women’s Health Magazine, and many more. Shawn’s driving ambition? To simplify retirement planning, he ensures his clients understand their choices and secure the best insurance coverage at unbeatable rates.

The Annuity Expert is an independent online insurance agency servicing consumers across the United States. The goal is to help you take the guesswork out of retirement planning and find the best insurance coverage at the cheapest rates

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