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When the Employee Retirement Income Security Act [ERISA] of 1974 was signed into law, American workers gained unprecedented flexibility to accumulate assets for their golden years. That pension reform bill created the individual retirement account (IRA)—a powerful savings tool with the potential to defer paying taxes on contributions and earnings until you start withdrawing at some later date. Individuals not covered by retirement plans at work could open a traditional IRA through private financial institutions. And retiring workers or individuals changing jobs could transfer the proceeds of their employer-sponsored retirement plans into a rollover IRA.
IRAs have grown into the single largest component of the U.S. retirement market. According to the Investment Company Institute (ICI), IRA assets totaled $5.7 trillion at the end of third-quarter 2013, or more than one out of every four retirement dollars. Yet the ICI reports that only 15% of U.S. households made IRA contributions in 2012 and that very few eligible households made “catch-up” contributions allowed by law.
Lord Abbett believes everyone should have an IRA. One reason is because all IRAs offer tax-deferred compounding, and some (e.g., Roth IRAs) may even be tax-free if certain conditions are satisfied. Another powerful reason an individual should have an IRA is potential access to the funds before age 59½ without paying the 10% penalty, as long as certain IRS exceptions apply.
But with the increasing complexity of IRA rules, an individual would be prudent to contact Lord Abbett or a financial advisor for additional details before making any IRA investment or withdrawal decisions. Here’s a quick guide to the key IRA options that can potentially help you save more for your future:
A traditional IRA is a tax-deferred savings plan available to all individuals with earned income who are under age 70½ and their spouses if the spouse is also under age 70½. Individuals who are under age 50 have an individual contribution limit of $5,500 in 2014 (see Table 1). Individuals who are age 50 or older can invest an additional $1,000 above this limit, under what’s commonly called the “catch-up” provision of IRA regulations. Contributions may be made at any time during the calendar year or by the tax filing due date for that year, not including extensions (generally April 15).
Source: Internal Revenue Service.
The deduction for contributions made to a traditional IRA depends on (1) household income and (2) whether the participant (and/or the participant’s spouse) was covered for any part of the year by an employer retirement plan. When covered by a retirement plan, the deductible amount is also affected by how much income was earned and by the tax return filing status (see Table 1).
Once a traditional IRA participant reaches age 70½, required minimum distributions must begin, and the amounts withdrawn are generally included as income. Withdrawals are typically subject to ordinary income tax. [Note: Required minimum distributions (RMDs) must be taken from traditional IRAs (as well as SEP1 and SIMPLE2 IRAs) no later than April 1 following the year that a person turns 70½. An RMD must be taken from the IRA in each subsequent year by December 31. Failure to take the RMD will result in a 50% penalty on the amount that was not distributed. Mandatory distributions of dollars that were contributed pretax and deducted from an individual’s taxable income at the time, as well as the earnings on those contributions, are taxed as ordinary income at the time of distribution. Mandatory distributions based on aftertax contributions that were not deducted from taxable income are tax-free.]
A Roth IRA is a potential tax-free savings plan available to all individuals and their spouses who meet an IRS-imposed income test (see Table 2). In addition, contributions can be made at any age so long as the income test has been satisfied.
Source: Internal Revenue Service.
Participation in a company retirement plan, other than lowering current income, does not affect Roth IRA eligibility. Contributions to a Roth plan are always made on an aftertax basis. There are no RMDs at age 70½ (for the account owner or surviving spouse). All of which provides the potential for tax-free growth and withdrawals as long as the Roth account remains open for five years and the distribution is made on or after attaining age 59½; otherwise, there is a 10% penalty. Nonspouse beneficiaries inheriting an individual’s account generally receive proceeds income tax-free.
Although you may not be eligible to make Roth contributions, everyone is eligible to convert pretax assets into a Roth account. There are no longer income requirements, which means any investor can convert a traditional IRA, SIMPLE-IRA, or SEP-IRA to a Roth IRA by paying federal and (if applicable) state taxes on the amount converted in the year of the conversion. This may prove especially attractive to investors concerned about higher tax rates as they get older.
Example: Roth IRA Conversion
Bob has a traditional IRA of $100,000, $90,000 of which reflects a combination of pretax contributions and earnings. Converting it to a Roth IRA would put him in the 39.6% tax bracket, and he is concerned about how much he would owe in taxes. Figures 1 and 2 show the difference between a full conversion and a partial conversion. (Note: Even in a partial conversion, Bob would still be able to convert additional dollars from his traditional IRA account in the future.)
(Hypothetical example; for illustrative purposes only)
(Hypothetical example; for illustrative purposes only)
* In a partial conversion of a traditional IRA, the nontaxable amount is determined by taking the amount converted and multiplying it by a fraction. The numerator of the fraction is the total aftertax dollars in all of the individual's existing non-Roth IRAs, and the denominator is the non-Roth IRA's account value at year-end plus the converted amount. The balance of the conversion is taxable.
You may find a Roth conversion attractive if you:
Many 401(k) plan participants do not realize that rollovers to IRAs provide great flexibility and portability. Aside from the potential to bequeath IRA assets to your heirs and control how that legacy will be allocated (stretch IRA8 option), an IRA can be moved to another institution’s IRA or another qualified plan (so long as the plan allows). The account can be converted into a Roth IRA, which generally will eliminate further taxation. Of course, there may be administrative fees and other costs involved with an IRA rollover.
Making the Right Choice
Which type of IRA is right for you? Your financial advisor can help you decide. You also may want to consider the benefits of consolidating your IRAs9 with one financial institution. There’s less paperwork. It’s also easier to develop a balanced strategy; assemble a diversified portfolio; monitor performance; calculate required minimum distributions; and track beneficiary options.
Source: Lord Abbett.
Whatever you choose, don’t wait until the tax deadline to fund your IRA each year. You could miss out on tax-deferred growth. The sooner you contribute to your IRA for 2014, the better your chances of boosting your retirement savings in the long run.
In summary, traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties (in addition to ordinary income tax) if withdrawn prior to age 59½, unless an exception applies. As a general rule, withdrawals both on and after 59½ that represent deductible contributions and all earnings are taxed as ordinary income. Withdrawals made on or after age 59½ based on nondeductible contributions are tax-free. Contributions to a Roth IRA are not tax-deductible, but withdrawals during retirement are generally tax-free.
A Note about Risk: Investing involves risk, including the possible loss of principal.
Please note that there may be administrative fees and other costs involved in an IRA rollover and conversion to a Roth IRA.
Diversification does not guarantee a profit or protect against loss in declining markets.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.