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Retirement Perspectives

Here are some keys to navigating the complex world of IRAs.

The IRA, which turned 40 in 2014, has grown into the single largest component of the U.S. retirement market, with assets totaling more than $7.4 trillion at the end of 2014, representing an estimated 30% of all retirement assets, according to the Investment Company Institute. Yet, only 12% of U.S. households made IRA contributions in 2013.

Confusion surrounding who is eligible to fund an IRA may help explain why IRA annual participation has been stuck in the low double-digits of the eligible population for a number of years.

In reality, IRA eligibility is easy to satisfy: Virtually anyone with a reportable earned income is eligible to fund an IRA. IRAs have the potential to offer an array of tax benefits, including tax-deductible, tax-deferred compounding. And one type—Roth IRAs—receive tax-free treatment if certain conditions are satisfied. IRAs also offer the potential to unfettered access to the funds before age 59½ without paying the 10% early-withdrawal penalty, as long as particular IRS criteria are met.

Contrary to some misperceptions, individuals who participate in their employers’ workplace retirement plans, such as 401(k) or 403(b) plans, are not precluded from contributing to an IRA. In fact, in 2015, investors can contribute up to $18,000 to their 401(k), plus an additional $5,500 to an IRA for a total of $23,500. Investors who are older than 50, the total allowable contribution including catch-up amounts is $30,500.

The “IRA season” is generally considered to be from January 1 until April 15, when individuals can still fund their IRA for the prior tax year—making it an excellent time to review overall IRA eligibility rules. Here’s a quick guide to the key IRA options that potentially encourage your clients to save more for their retirement:

Traditional IRA
A traditional IRA is a tax-deferred savings account available to all individuals who have earned income and who are younger than 70½. Individuals who are under age 50 have an individual contribution limit of $5,500 in 2015 (same as 2014). Individuals who are age 50 or older can invest an additional $1,000 above this limit, under what’s commonly called a “catch-up” contribution. 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).

A traditional IRA can be funded with deductible (pretax) contributions and/or nondeductible (aftertax) contributions. You must satisfy certain income thresholds to receive a tax-deduction, although everyone with an earned income is eligible to make nondeductible contributions.

A number of variables apply in order to determine whether a taxpayer is eligible to make a deductible IRA, including filing status, modified adjust gross income (MAGI), and whether individuals and/or their spouses are active participants in a workplace retirement plan.

For example, unmarried people who are not covered by a workplace retirement plan may deduct their entire contributions to traditional IRAs, regardless of their income. But for married couples filing jointly, if one spouse is participating in a workplace retirement plan, nonparticipating spouses may deduct their full contributions to a traditional IRA if the couple’s joint income is $183,000 or less in 2015. A partial deduction is allowed if the couple’s income is above $183,000, but does not exceed $193,000. (See Table 1 for eligibility.)

 

Table 1. Traditional IRA Income Limits to Qualify for Tax-Deductible Contributions

Tax Filing Status

2014 income (MAGI)*

2015 income (MAGI)*

Single

Up to $70,000

Maximum of $71,000

Married filing jointly with both spouses participating in a workplace plan

Maximum of $116,000

Maximum of $118,000

Married, filing  jointly, with one spouse covered by a workplace plan

Maximum of $183,000

Maximum of $193,000

Source: IRS
* Modified adjusted gross income (MAGI) includes wages, interest, capital gains, income from retirement accounts and alimony paid received by the taxpayer adjusted downward by specific deductions, including contributions to deductible retirement accounts and alimony paid by the taxpayer; but not including standard and itemized deductions. 

 

Once a traditional IRA participant reaches age 70½, required minimum distributions (RMDs) must begin, and the amounts withdrawn are generally included as income and subject to ordinary income taxes.

Required minimum distributions must be taken from traditional IRAs (as well as SEP and SIMPLE IRAs) no later than April 1 following the year that an investor turns 70½. An RMD must be taken in each subsequent year by December 31. Failure to take the RMD results in a 50% penalty on the amount that was not distributed.

Roth IRA
A Roth IRA is a potential tax-free savings account available to all individuals and their spouses who have earned income and meet maximum income thresholds established by the IRS. (See Table 2.) In addition, contributions can be made at any age so long as the income test has been satisfied.

Similar to a traditional IRA, individuals who are under age 50 have an individual contribution limit of $5,500 in 2015. Individuals who are age 50 or older can make additional catch-up contributions of $1,000. 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).

Participation in a workplace 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 lifetime RMDs at age 70½ for either the account owner or a spouse beneficiary. 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 reaching age 59½. Earlier withdrawals may be subject to a 10% penalty. Nonspouse beneficiaries inheriting a Roth IRA generally receive proceeds tax-free.

 

Table 2. Roth IRA Eligibility

Tax Filing Status

2014 Income (MAGI)*

2015 Income (MAGI)*

Single

Up to $129,000

Up to $131,000

Married filing jointly

Up to $191,000

Up to $193,000

Married filing separately

Less than $10,000

Less than $10,000

Source: IRS
* Modified adjusted gross income (MAGI) includes wages, interest, capital gains, income from retirement accounts and alimony paid received by the taxpayer adjusted downward by specific deductions, including contributions to deductible retirement accounts and alimony paid by the taxpayer; but not including standard and itemized deductions. 

 

Roth Conversion
Almost anyone can convert pretax assets into a Roth IRA, even higher income-earning individuals, whose incomes preclude them from making Roth contributions in the first place. Investors can covert traditional IRAs, SIMPLE-IRAs, or SEP-IRAs to a Roth IRA by paying federal and (if applicable) state taxes on the amount that was converted in the year in which the conversion was completed. This may prove especially attractive to investors concerned about higher tax rates as they get older. (For a thorough discussion Roth Conversions, refer to our flyer: “Roth Conversion Frequently Asked Questions.”.)

Individuals may find a Roth conversion attractive if they:

  • believe that future tax rates will be greater than today;
  • wish to leave a potential tax-free legacy to a nonspouse beneficiary (this option may appeal particularly to investors who do not plan to use their IRAs as their primary source of retirement income);
  • have made significant nondeductible (aftertax) IRA contributions, thereby minimizing potential tax consequences; or
  • can afford to pay the taxes using non-IRA assets. Paying taxes using IRA assets can result in a 10% penalty if the individual is under age 59½ and an exception does not apply, and fewer dollars would be available to potentially grow tax-free. In addition, paying taxes using IRA assets can reduce the amount that could later be “recharacterized”7 back to a traditional IRA—a step some investors may take if the value of their IRAs fall after they convert.

Rollover IRAs
Many 401(k) plan participants do not realize that a rollover to an IRA provides great flexibility and portability. Aside from the potential to bequeath IRA assets to heirs and to control how that legacy will be allocated (e.g., “stretch” IRA option), an IRA can be moved to another institution’s IRA or another qualified plan (as 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 IRAs 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.

 

Table 3. How Traditional IRAs Compare with Roth IRAs
Source: Lord Abbett

 

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 penalty (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 age 59½ that represent deductible contributions and all earnings are taxed as ordinary income. Withdrawals of nondeductible contributions made on or after age 59½ are tax-free. Contributions to a Roth IRA are not tax-deductible, but withdrawals during retirement are generally tax-free. 

 

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. The examples presented are intended for illustrative purposes only.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

A simplified employee pension plan, commonly known as a SEP-IRA, is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP-IRA.

SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

MAGI or modified adjusted gross income is used to determine how much of an individual’s IRA contribution is tax deductible. It is determined by taking the adjusted gross income and adding back certain items, such as student loan deductions and IRA contribution deductions.

Recharacterization of an IRA involves first converting a traditional IRA to a Roth IRA and then undoing the conversion—recharacterizing—and reverting to a traditional IRA. The process must be completed within a legally prescribed period of time.

The stretch IRA uses beneficiary designation to achieve a more efficient way of passing on family assets to succeeding generations. A stretch IRA is for investors who will not need their IRA money during their own retirements. While the law does not restrict which taxpayers can select the stretch IRA option, the stretch strategy is appropriate only for those individuals who simply need and plan to receive the required minimum withdrawals, taken at the latest time the law allows without penalty, which is age 70½.

Combining a rollover and a contributory IRA may result in the loss of income averaging and capital gains treatment with respect to the rollover assets, if applicable. It also may affect the calculation you may need to perform to exempt your rollover IRA from any claims in the event of bankruptcy. You should consult your tax advisor before combining accounts. 

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