“Them are the facts after tax_
You can dream about vacation in the sun
You can dream but you can't never have you one…”
Sure, Johnny Cash may have been onto something. Taxes may be one of the only two certainties (we won’t get into the other one). But there are some silver linings. Wait, we can’t promise you an all-expenses-paid “vacation in the sun,” but we can help you unravel the intricacies of a good ol’ vehicle called an individual retirement account (IRA), one way to make the most of your finances within the prevailing tax framework.
No matter where you fall on the spectrum between, say, “savvy saver” and “retirement planning rookie,” chances are you’ve heard of IRAs, 401(k)s, etc. In this blog post, we will delve into IRA rules, discussing the main types of IRAs, contributions limits, withdrawal rules, and everything in between.
An IRA, or an individual retirement account, is a financial vehicle that offers a way for you to save for your retirement while benefiting from certain tax advantages. Introduced in 1974, this long-term savings vehicle was meant to help those without pension plans save for their retirement.
You can open IRAs through financial institutions like investment companies, banks, brokerage companies, or even personal brokers.
Technically, babies upward, anyone can have an IRA (Yes, Roth IRAs for kids exist!). But the more accurate answer is that anyone with earned income can contribute to an IRA. What is earned income? Earned income means income from employment.
Earned income: Wages, tips, salaries, net earnings from self-employment, and other taxable employee compensation
Interestingly, the earned income rule has one exception: spousal IRAs. This type of IRA is just a traditional or Roth IRA (more on that in a bit!) designed for married couples. Here, an earning spouse can contribute on behalf of a spouse who is either earning low wages or not earning at all.
IRAs allow you to invest in a wider range of financial products than 401(k)s and 403(b) plans do. You can invest in mutual funds, bonds, stocks, exchange-traded funds (ETFs), real estate, etc.
When you contribute to a traditional IRA, your contribution is usually tax deductible (subject to certain conditions, which we will talk about next). This means it will not form part of your taxable income for the year in which you make the contribution. So, your contribution grows in a tax-deferred way.
What’s tax deferral, you ask? Tax deferral involves postponing the payment of taxes and could be advantageous because:
- You could fall under a lower tax bracket during the years you make the contributions.
- Your income is invested and grows until your retirement.
- You could fall under a lower tax bracket when the time comes to withdraw from your IRA.
Before you go thinking this is too good to be true, you should know you can’t use IRAs to stash away large portions of your income. The Internal Revenue Service (the IRS) limits how much you can contribute annually to your IRA. If you have multiple IRAs, your total contribution to all of them cannot exceed these limits.
For 2022, this limit is $6,000. However, individuals above 50 years of age enjoy the right to make what is called a catch-up contribution - they can contribute $1,000 (in addition to $6,000), so their limit is $7,000. For 2023, the limit for individuals under 50 is $6,500, while for those above 50, it is $7,500.
|Age||Contribution Limit 2022||Contribution Limit 2023|
Roth IRAs come with a twist - your contributions are taxed. So, your contributions to a Roth IRA are _after-tax _dollars. But since you pay taxes on your IRA contributions, withdrawals from Roth IRAs are tax free.
The contribution limits that apply to traditional IRAs for 2022 and 2023 apply to Roth IRAs too. But remember IRA history? IRAs were introduced to give workers without pension plans a way to save for their retirement, not to help the rich save their money from taxes. So, there are some income limits on Roth IRA contributions.
This means that your MAGI - or your modified adjusted gross income - determines whether and how much you can contribute to your Roth IRA (up to the contribution limit).
Broadly speaking, when it comes to single filers, the phase-out range is $129,000 to $144,000 for 2022, while it is $138,000 to $153,000 for 2023. For married couples filing joint taxes, it is $204,000 to $214,000 in 2022; in 2023, this is $218,000 to $228,000.
Note: In (very) simple terms, your AGI is your adjusted gross income - the income you report minus any “adjustments” to your income. Your MAGI is your AGI with some deductions or adjustments added back to it.
Suppose John is a 45-year-old single filer. In 2023, if John’s MAGI is $138,000 or less, John can contribute a sum of $6,500 (the contribution limit) toward his Roth IRA.
If it falls between $138,000 and $153,000, John’s contribution will be reduced or be “phased-out” proportionately with the increase in his income.
If John’s MAGI exceeds $153,000, he will not be eligible to contribute to a Roth IRA.
|Your Filing Status||Your MAGI for 2022||Your MAGI for 2023||Permissible Contribution|
|Single filer/head of household||Less than $129,000||Less than $138,000||Up to the limit|
|More than $129,000 but less than $144,000||More than $138,000 but less than $153,000||A reduced amount|
|More than $144,000||More than $153,000||Zero|
|Married filing jointly or qualifying widow/widower||Less than $204,000||Less than $218,000||Up to the limit|
|More than $204,000 but less than $214,000||More than $218,000 but less than $228,000||A reduced amount|
|More than $214,000||More than $228,000||Zero|
|Married filing separately||Less than $10,000||Less than $10,000||A reduced amount|
|$10,000 or more||$10,000 or more||Zero|
A savings incentive match plan for employees, or a SIMPLE IRA, is a traditional IRA that startups/small businesses (think 100 or fewer employees) can opt for. By doing so, they can secure their employees’ retirement without taking on the set up and operating costs of sponsoring a full-blown employer-sponsored retirement plan.
Both employees and employers can contribute to these IRAs.
The contribution limits on SIMPLE IRAs are higher than those on traditional IRAs.
|Age||Employee Contribution Limit 2022||Employee Contribution Limit 2023|
SEP or SEP-IRA stands for simplified employee pension plans. Businesses of any size can opt for this type of plan as can self-employed individuals. Employers that choose this plan can get a tax deduction on their contributions (which they can decide on).
There’s a catch though: Employees cannot contribute to SEP-IRAs. But they do have complete ownership of all the money in their SEP-IRA, meaning they are fully vested in it from the start.
For 2022, contributions to a SEP-IRA are capped at 25% of compensation or $61,000, whichever is less. For 2023, the maximum contribution is capped at $66,000.
Well, that depends. But before we get into it, it’s important to distinguish between a contribution and a deduction. While a contribution is how much you invest in an IRA, a deduction is how much of that can be removed from your gross taxable income.
If you’re not covered by an employer-sponsored retirement plan, such as a 401(k) or 403(b), your contribution is fully deductible up to the stipulated limit (woohoo!). Suppose you contribute $6,000; this amount will be deductible from your taxable income for the year.
On the flip side, if you (or your spouse) are covered by an employer-sponsored retirement plan, the deductibility of your contribution will depend on your MAGI.
What does this mean for you if you’re covered by an employer retirement plan?
For 2022, your contribution to your IRA will be fully deductible if your MAGI falls below $68,000. If your MAGI falls between $68,000 and $78,000, it is partially deductible. If it is above $78,000, however, your contribution will not be deductible.
For 2023, your MAGI must be below $73,000 for your contribution to be fully deductible. Between $73,000 and $83,000, it is partially deductible. Above $83,000, your contribution will not be tax deductible.
For married couples filing jointly, in 2022, this phase-out range is between $109,000 and $129,000. In 2023, it is $116,000 to $136,000.
The income phase-out range applicable to you is between $204,000 and $214,000 in 2022. In 2023, this range is $218,000 to $228,000.
Now if you’re a married individual who files a separate tax return and has a retirement plan through their workplace, the phase-out range for certain tax benefits does not change each year based on the cost of living. Instead, it stays fixed between $0 and $10,000.
You pay taxes on your Roth IRA contributions. While you don't receive an immediate tax deduction for your contributions, the benefit lies in tax-free growth and tax-free withdrawals during retirement.
Employer contributions to a SIMPLE IRA are tax deductible, whereas employee contributions are not.
At the employer’s end, contributions made to a SEP-IRA are tax-deductible. This means that if you're self-employed or a small business owner, you can deduct your contributions to a SEP-IRA.
We’ll level with you: An IRA is intended to be a long-term savings instrument. So, if you make withdrawals before the age of 59½, your withdrawals (which would ordinarily be taxed as per your income slab) may also be subject to a 10% early-withdrawal penalty and even some state tax penalties, unless you can claim an exception.
These exceptions include qualified higher education expenses, health insurance premiums paid while unemployed (for 12 weeks or more), total and permanent disability of the IRA owner, etc.
These rules apply to SEP-IRAs as well.
Roth IRA withdrawal rules differ from those concerning traditional IRAs. Since Roth IRA contributions consist of post-tax dollars, holders enjoy more flexibility than traditional IRA holders do when it comes to withdrawals.
But it is important to distinguish between the withdrawal of your contributions and that of your returns (i.e., what the contributions generate). The withdrawal of your_ contributions _is _tax free and penalty free_.
However, under certain circumstances, withdrawals of your earnings may entail income tax and a 10% early withdrawal penalty (with exceptions) based on your age and for how long you’ve held the account.
Let’s break this down.
Ideally, you can escape paying taxes and penalties on your withdrawal once you reach the age of 59½ and have maintained the account for a minimum of five years. But what if you do not meet one or both of these conditions?
If your account has not been maintained for a minimum of five years, your earnings may be subject to taxes and the early-withdrawal penalty of 10%. But hey, don't lose hope just yet! There are some exceptions where you might be able to dodge that 10% penalty. Check these out:
- If you opt for a series of substantially equal distributions
- If your unreimbursed medical expenses exceed 7.5% of your adjusted gross income (AGI)
- If you're paying medical insurance premiums after losing your job
- If the distribution is a result of an IRS levy
- If you're taking qualified reservist distributions
- If you need the funds for qualified disaster recovery
- If you're using the distribution to cover qualified education expenses
- If you're using the money to cover childbirth or adoption expenses, up to a maximum of $5,000
If your account has been maintained for five years, your earnings may not be subject to taxes or the penalty if you meet one of the following conditions:
- Your income is used to (up to a $10,000 lifetime maximum) to buy, build, or rebuild your first home
- You make the withdrawal because you have a permanent disability
- After your death, the distribution is made to a beneficiary/your estate
If you’ve not held the account for five years, your earnings will be subject to taxes, but no penalty will apply.
If your account has been maintained for five years, you can withdraw your earnings penalty free and tax free!
Generally speaking, the withdrawal rules that apply to traditional IRAs apply to SIMPLE IRAs as well. In certain cases, however, the early-withdrawal penalty of 10% _may be increased to 25%. _This happens if you make a non-qualified (i.e., those that do not fall within any exception) withdrawal within 2 years of participating in your employer's SIMPLE IRA plan.
An inherited IRA is an account that is opened when the original owner of an IRA dies and their beneficiary inherits their account. This account comes into existence to hold the inherited funds.
The inherited IRA rules that will apply to you if you’re a beneficiary depend on whether you’re a spouse or non-spouse beneficiary. Spouse beneficiaries enjoy more flexibility. For instance, they can:
- Roll over the IRA funds into their accounts
- Create a new inherited IRA account
Among other limitations, a non-spouse beneficiary cannot:
- Treat an IRA as their own
- Make additional contributions to the account
They are required to create a new inherited IRA unless they opt for a lump-sum payment. Also, it’s important to note that, barring some exceptions, non-spouse beneficiaries who inherit accounts after December 31, 2019, must withdraw the funds within a 10-year period following the original owner's death.
If you hold a traditional IRA or 401(k), once you reach a certain age, you're required to withdraw a minimum amount of money from these accounts each year. These withdrawals are called required minimum distributions (RMDs).
From January 1, 2023, onward, the age at which this requirement kicks in is 73 years. Do note that this rule does not apply to Roth IRAs.
This is to be calculated based on your account balance and your life expectancy. You can calculate this based on the worksheets the IRS provides. It's crucial to take the minimum required withdrawal because if you don't, you'll face a substantial tax penalty (nobody wants that!).
In 2023, the penalty is 25% of your account balance, which is lower than before but still quite a heavy penalty. However, prompt action to resolve the situation could help you reduce this penalty to 10% in some cases.
- An individual retirement account (IRA) is a tax-advantaged means of saving for one’s retirement.
- If a person has earned income, they can contribute to an IRA.
- There are different types of IRAs, such as traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEP-IRAs, each with its own contribution limits and tax implications.
- Withdrawals from IRAs are subject to rules and penalties. Also, inherited IRA contribution and distribution rules differ between spouse beneficiaries and non-spouse beneficiaries.
- Since IRAs are long-term savings plans, money held in them usually cannot be withdrawn before the holder turns 59½ years old. Such a withdrawal usually entails a penalty.
Navigating IRA rules can be a wild ride, but by staying informed, you can fine-tune your retirement strategy and set yourself up for a secure financial future through better financial and tax planning. Happy planning!
Fincent: Your Business's Personal Financial Wizard - From Bookkeeping to Tax Filing