Back to Basics: Individual Retirement Arrangements (IRAs)

Back to Basics: Individual Retirement Arrangements (IRAs)

Happy New Year and welcome to 2019!

Did “saving money,” “budgeting,” or “planning for the future” make your resolution list? Maybe you’ve even resolved to make your financial plan and are using it to get on your personal path to success in the new year. No matter which facet of funds you’re focusing on, have you considered starting or adding to an Individual Retirement Arrangement (IRA) account for 2019?

Whether you’ve been contributing for years or are just beginning to learn about IRAs, it’s nice to take a fresh look at their benefits, differences between the two types, as well as IRS changes now and again. That’s because topic of an IRA can be a very detailed one with nearly infinite circumstances and possibilities — enough that CPAs and attorneys base entire practices on the subject.

We’ll start with IRA fundamentals:

  • IRA types
  • How IRAs work
  • How you can use an IRA

One thing I want to stress here because I see this in practice from time to time: An IRA is an account type; it’s not an investment. No specific rate of return is tied to a certain type of IRA. The return on your investment within an IRA is dependent on what you invest in within the IRA.

Now for the details.

Types of IRAs and how each works

Two basic types of IRAs exist: Traditional IRAs and Roth IRAs.

Traditional IRA

A Traditional IRA, in its essential form, is a tax-deductible tax-deferred account type.

  • Tax-deductible means that when you add, aka contribute, money to a Traditional IRA, you receive a tax deduction, aka a reduction in your taxable income, for doing so.
  • Tax-deferred means that, as your Traditional IRA account earns interest, dividends, and/or capital gains, you do not need to pay taxes on those earnings in the year you earn them.

With the tax breaks come several restrictions. The first is that there are rules that govern your ability to deduct the amount of your contribution from your income. If you are a participant in an employer-sponsored retirement plan, you may not be able to deduct IRA contributions. It’s dependent on your — and, if applicable, your spouse’s — income.

Another restriction concerns distributions from your IRA. The “normal” distribution age for a Traditional IRA is 59.5. If you take money from your IRA at age 59.5 or later, the amount of the distribution is fully taxable to you as income. If you take a distribution prior to 59.5, in most cases, you will also pay a premature distribution penalty tax in addition to income tax.

Finally, at age 70.5, the rules require you to begin distributions from your IRA. These distributions, known as required minimum distributions (RMDs), are based on your life expectancy and the value of your Traditional IRA at the end of the preceding calendar year. RMDs, as the name implies, set a minimum standard that you must take from your IRA — and pay taxes on — in your later life.

Roth IRA

A Roth IRA is a tax-free account type, essentially. You do not receive any upfront tax benefit for contributing money to a Roth IRA. However, once money is in a Roth IRA, it may never be taxed again.

Because contributions to a Roth IRA are not tax-deductible, the rules on contributions focus on whether or not you are able to contribute at all to a Roth IRA. It does not matter if you participate in an employer-sponsored retirement plan. But if you and, if applicable, your spouse’s income is too high, you may not be able to add any money to a Roth IRA.

Although 59.5 is still the age for “normal” distributions, overall rules governing distributions from Roth IRAs are more favorable. Because the contribution was not tax-deductible, you are allowed to access money that you’ve contributed to a Roth IRA at any age without taxes or penalties. At age 59.5, assuming your Roth IRA has been open for at least five years, you can also access the growth within your Roth IRA without taxes or penalties.

Also, because there are no tax consequences when taking normal distributions from a Roth IRA, RMDs do not apply during your lifetime. The IRS does not care if you leave money in an IRA indefinitely because there’s no revenue for them to raise from distributions.

How to start and use your IRA

For both Traditional and Roth IRAs, the maximum amount you can contribute is $5,500 in 2018. If you turn 50 or are older than 50 in 2018, you can contribute an additional $1,000. The maximum contribution is cumulative between both a Traditional and Roth IRA, so you can’t contribute the maximum to both. You have until Monday, April 15, 2019, to make a 2018 IRA contribution.

Keep in mind that the IRS increased contribution limits for the 2019 tax year. Traditional and Roth IRA contribution limits are now $6,000 — plus that extra $1,000 allowed for those aged 50 and better. You have until Wednesday, April 15, 2020, to make your 2019 contribution.

Speaking with your financial planner can help you weigh the possibilities and benefits of contributing to either with a greater understanding of your tax situation.

Want to start or contribute to your IRA — but don’t know how it would affect your tax situation or impact how quickly you could reach other financial goals? 

If you have financial planning questions, just ask! Interested in meeting with us to begin the path to your financial future? We’re accepting new clients, and you can start with a no-cost web or in-person consultation.

Jason Speciner
Jason Speciner

Jason Speciner is a CERTIFIED FINANCIAL PLANNER™ professional, an Enrolled Agent, and the founder of fee-only firm Financial Planning Fort Collins. He is also a member of the National Association of Personal Financial Advisors (NAPFA), Financial Planning Association (FPA), and XY Planning Network. Since 2004, he has served clients of all ages and backgrounds with unique experience working with members of generations X and Y. To learn more, check out Jason's blogs and see the media he's been featured in.