Individual retirement accounts play a vital role in the retirement plans of many Americans. In fact, according to the latest figures from the Employee Benefits Research Institute, nearly 25 percent of all retirement plan assets in the nation reside in IRAs. While many of these accounts may have originated in 401(k) plans, an increased number of taxpayers add funds to IRA accounts each year. Despite the fact that IRAs have been around since 1974, there continues to be a significant amount of confusion on how best to leverage this retirement planning tool. The tips below may help you to leverage IRA accounts for this tax year.
While many employees have access to retirement accounts at work, the fact is there are still workers without access to a traditional qualified plan like a 401(k). Unfortunately, contribution limits on IRAs are significantly lower than the $18,000 limit ($24,000 for those over age 50) on qualified plans. For tax years 2015 & 2016, maximum contributions to an IRA are $5,500 for those under age 50. Taxpayers over age 50 are allowed a catch-up contribution of $1,000 for a total of $6,500.
Traditional IRA - Deducting your contribution
A Traditional IRA may allow you to deduct your contribution from taxable income which can be an effective way to reduce your tax liability. However, Traditional IRAs that are funded with pre-tax dollars are fully taxable at retirement once the funds are withdrawn. Remember, you cannot access your accounts without penalty until after age 59 ½ and the IRS requires that you start taking required minimum distributions at age 70 ½. While funding your IRA with pre-tax dollars can be a powerful approach to reducing your tax liability, there are certain stipulations that must be met.
If you or your spouse (if married) are not covered by a retirement plan at work, there are no income limits to get in the way of deducting your Traditional IRA contribution. However, taxpayers that are covered by a retirement plan at work and would also like to deduct an IRA contribution will be subject to income limits. In that case, deductions are available for single filers with modified adjusted gross income (MAGI) of less than $61,000 - deductions phase-out from $61,000 to $71,000 for 2015. Married taxpayers that are filing jointly where both spouses have access to a retirement plans at work can deduct their contributions if MAGI is less than $98,000. Deductions phase-out for income between $98,000 and $118,000 with no deduction available with income greater than $118,000. For example, a married couple has MAGI of $95,000 and both spouses are contributing to their 401(k) plan at work. Since they are both covered by a retirement plan at work but their MAGI is less than $98,000, they both can contribute and deduct $5,500. If they were over age 50, they could deduct $6,500.
The good news is that IRA contributions may be available to a non-working spouse, providing a boost to retirement savings. If the working spouse is not covered by a retirement plan at work but earns income greater than or equal to the IRA contributions they are planning to make, both the working and non-working spouse can make a tax-deductible IRA contribution without any income limit. If the working spouse is covered by a retirement plan at work, contributing to a spousal IRA can be complicated.
First, the working spouse’s IRA contribution is phased-out when MAGI is between $98,000 to $118,000 when they are already covered by a qualified plan at work. However, in a case where the working spouse is covered by a plan, deducting a non-working spouse’s contribution is phased-out for couples with income between $183,000 and $193,000. For example, a married couple has MAGI of $165,000 with all of the income earned by one spouse. The working spouse is also covered by a retirement plan at work. Since their MAGI is greater than $118,000, the working spouse cannot make a deductible contribution to their IRA in addition to their 401(k) contribution. However, because their MAGI is less than $183,000, the non-working spouse can still make a $5,500 deductible contribution to their IRA. Spousal IRAs can be a powerful tool for increasing pre-tax retirement contributions.
After-tax Roth contributions
In contrast to the pre-tax Traditional IRA, the Roth IRA is funded with after-tax dollars so no tax deduction is available. However, qualified distributions from a Roth IRA after age 59 ½ may be completely tax-free. That’s right – no tax on the earnings. The account must have been open for 5 years. Additionally, you are not forced to withdraw funds after age 70 ½ (RMDs) and there is the availability of qualified withdrawals of up to $10,000 for a first time home purchase. The Roth IRA is also a powerful tool as beneficiaries may realize tax-free income over their lifetime too.
As is the case with Traditional IRAs, Roth IRAs are also subject to MAGI contribution limits. Eligibility phases out between $116,000 and $131,000 for single filers and between $183,000 to $193,000 for joint filers. The higher eligibility phase-out can make the Roth IRA a great option for taxpayers already maxing out their 401(k) plans that earn too much to contribute to a Traditional IRA.
Deciding which IRA is most advantageous for you can be tricky as the decision is often based upon how you think your taxable income will change over time, the need for flexibility and your desire to leave tax-free income for heirs. Generally, if you believe you will be in the same or higher tax bracket at retirement, the Roth IRA may be worth extra consideration. Alternatively, if you believe you will be in the same or lower tax bracket during retirement, a tax deduction today through a Traditional IRA may be a better fit. Since everyone’s situation is unique, consider speaking to your tax and financial adviser to determine the most appropriate approach for you.
Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.