Saving for retirement isn’t a “one size fits all” deal. Individual needs, capabilities and preferences widely vary and there’s a retirement plan out there to fit just about any of these combinations. For those without an employer sponsored 401(k) or that just want to add another future income stream for their retirement, an individual retirement account (IRA) may be a good option. Some might feel that IRAs "can be confusing” but they really aren’t when examined properly. Below we will break down and simplify all the things you need to know about IRAs. Of course, don’t hesitate to ask your CPA or tax or financial advisor for assistance determining which option might be best for you.
Two Basic Types
There are two basic types of IRAs – traditional and Roth. All other IRAs are essentially variations of these two:
Traditional IRA: May allow for an income tax deduction (reducing your current income tax) based on the contributions you make. Your money then grows tax-deferred, meaning you don’t pay taxes on the earnings or your contribution until you begin receiving distributions in retirement. For example, if your $1,000 traditional IRA contribution grows to $100,000, you do not pay income tax until you start withdrawing the $100,000 during retirement.
Roth IRA: There are no income tax deductions for your contributions as after-tax money is used to fund the account. However, your money grows tax-free; you will not be required to pay income taxes on it upon withdrawal in retirement if you satisfy all requirements. This means that if, for example, your $1,000 Roth IRA contribution grows to $100,000, you can receive retirement distributions of the $100,000 income tax free.
As a baseline, you must have earned income in a given year to be eligible to contribute to an IRA. Earned income is income from wages, salary, bonuses, commissions, professional fees and self-employment income. If your only income is from unearned sources, such as investments (e.g., interest, dividends, rents, pensions, gain from the sale of property), then you cannot contribute to an IRA. For 2022, the contribution limit is up to $6,000 each year ($7,000 if you’re 50+). If your earned income is less than $6,000, or $7,000 if you’re over age 50, your maximum allowable contribution is the amount of the earned income. For example, if your earned income is $3,000, your maximum allowable contribution is $3,000 even though “maximum” IRA contributions limit is $6,000.
Your income also determines whether and what amount you are able to contribute to a Roth IRA. With Roth IRAs, your ability to contribute is phased out when your modified adjusted gross income (MAGI) reaches a certain level. For 2022, phase-out starts at $129,000 and ineligibility after $144,000 for single filers; for those that are married and jointly filing, phase-out starts at $204,000 and ineligibility after $214,000. This is higher than 2021 where single filers phased-out at $125,000 and ineligibility at $140,000, and for married filers phase-out started at $198,000 and ineligibility at $208,000.
Traditional IRA contributions are not limited by annual income; however, if you (or your spouse) are covered by a retirement plan at work (e.g., a 401(k) or 403(b) plan), then income comes into play again. Your deduction for a contribution to a traditional IRA may be limited if you are covered by a retirement plan and your income exceeds certain levels. For 2022, phase-out of deductions starts at $68,000 and ineligibility after $78,000 for single filers; for married filing jointly filers, phase-out starts at $109,000 and ineligibility after $129,000. This is higher than 2021 where for single filers, phase-out started at $66,000 and ineligibility at $76,000, and for married filers phase-out started at $105,000 and ineligibility at $125,000.
If your income levels exceed the above eligibility requirements for either type of IRA, you still have another way to invest via a nondeductible (traditional) IRA.
Nondeductible IRAs are individual retirement accounts funded with “after-tax dollars” because there is no deduction for the contributions (similar to a Roth IRA). Upon withdrawal in retirement, contributions are not taxed, but, unlike a Roth IRA, any earnings are taxable. While not as attractive as the other IRA options, this tax-advantaged growth could still make a substantial difference if accumulated over a long period of time.
Once you have determined which IRA is right for you, based on your preferences and eligibility, the next big decision is choosing the right custodian for your IRA. Many institutions offer IRAs and the main difference comes down to the types of investments offered. IRAs can only typically be invested in stocks (listed on major exchanges), bonds, mutual funds and/or CDs. For investors who want more diversification and control over their investments, there is yet another IRA option to meet their needs - Self-directed IRAs (SDIRAs). SDIRAs are held by specialized custodians that allow transactions to be directed by you as the investor or by the custodian. The flexibility of SDIRA accounts allows investors to place money into any asset permitted by the IRS, including alternative investments. They allow the investor to acquire alternative assets not accepted within traditional accounts, such as real estate, gold, commodities, options, futures and non-listed real estate investment trusts, while maintaining the benefits of tax-free or tax-deferred growth.
To Wrap It Up
The wide variety for IRA types and subsets allows each individual investor to find his or her “perfect fit.” Whether you choose to go the traditional, Roth, nondeductible or self-directed IRA route, keep in mind that each one brings its own benefits and drawbacks that can affect your financial situation in retirement. Consult with your tax advisor to help “measure and fit you” for your IRA.
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