Traditional IRA:
What is it?
- A personal retirement vehicle for individuals that shelters earned income from taxation and defers taxes until funds are withdrawn.
Who is it meant for?
- Individuals who want a portion of their earned income sheltered and deferred until it is withdrawn from the account (tax-deferred growth).
- Individuals that need a supplement or alternative to a qualified company-sponsored plan.
- For 2021, eligible individuals may contribute up to $6,000 to an IRA and deduct this amount from their current taxable income, subject to phaseout rules. Individuals age 50 or older can make an additional “catch-up contribution” of $1,000.
- Any individual at any age may contribute to an IRA, provided he or she has earned income, or is the spouse of someone with enough earned income to cover the contribution.
What other important facts should I know?
- Loans are not permitted.
- Joint accounts are not permitted.
- Prohibited investments include life insurance and antiques/collectibles.
- Withdrawals will be subject to a 10% penalty if withdrawn before age 59 ½, unless the distribution is related to:
- a death,
- substantially equal payments,
- disability,
- first home expenses up to $10k,
- qualified education expenses, or
- medical expenses greater than 10% of Adjusted Gross Income (“AGI”).
- All withdrawals/distributions from IRAs are taxed as ordinary income in the year received.
- Required Minimum Distributions (“RMDs”) from the account are required by April 1 of the year following the year the individual turns age 72. An excise tax penalty can apply if RMDs are not taken, which can cost the taxpayer 50% of any RMD shortfall. For example, if a taxpayer’s RMD is $15,000 but only $10,000 is withdrawn by the deadline, then an excise tax of $2,500 can apply ($5,000 shortfall x 0.50 tax penalty).
- Excess contributions result in a penalty of 6% excise tax each year the excess amount is not withdrawn.
- The contribution due date is generally the tax filing deadline of April 15.
- Know the term “active participant”.
- An individual who participates in a qualified company-sponsored retirement plan, 403(b) plan, Simplified Employee Pension (“SEP”) plan, or Savings Incentive Match Plan for Employees (“SIMPLE”) IRA is considered an active participant. Federal, state, and local government plans are also taken into account, but not 457 plans.
- When Single taxpayers and both Married-Filing-Jointly (“MFJ”) spouses are not active participants, Traditional IRA contributions are fully deductible, regardless of the taxpayer’s Modified Adjusted Gross Income (“MAGI”).
- For taxpayers who are active participants, the deduction for Traditional IRA contributions is limited (or eliminated) when a taxpayer’s MAGI reach phaseout levels of $66,000–$76,000 for Single, and $105,000–$125,000 for MFJ in 2021.
- When a MFJ couple only has one spouse who is an active participant, the nonparticipant spouse will have the deduction phased out at MAGI levels between $198,000–$208,000 in 2021. The participant spouse will have the deduction phased out at MAGI levels between $105,000–$125,000 in 2021.
- Know the term “earned income”.
- It does NOT include the following:
- Earnings and profits from property such as rental income, interest income, dividend income, and investment income.
- Pension or annuity income.
- Compensation payments postponed from a previous year.
- Foreign earned income.
- Housing cost amounts, or any other amounts, that are excluded from income.
- Know the “aggregation rule”.
- The IRS requires that all deductible and nondeductible Traditional IRAs be aggregated together, therefore treated as one Traditional IRA for the purpose of calculating the cost basis of a distribution.
- Even if the nondeductible Traditional IRA contributions are separated in different IRAs from the deductible traditional IRA contributions, the aggregation rule still applies for both accounts, because they will be treated as one.
- When calculating the nontaxable portion of the distributions made during a given tax year, all distributions in that year are also aggregated as though there was only one distribution in the year.
- It does NOT include the following:
Roth IRA:
What is it?
- A personal retirement vehicle that does NOT shelter earned income from being taxed but allows investment earnings to grow tax-free, assuming distributions are qualified.
Who is it meant for?
Only taxpayers with income below certain thresholds may contribute to a Roth IRA. In 2021, contributions are phased out between MAGI of $198,000–$208,000 for MFJ, $125,000–140,000 for Single, and $0–$10,000 for Married Filing Separately (“MFS”).
- There are no age restrictions on contributions to a Roth IRA.
- For 2020, the nondeductible contribution can be up to $6,000 per individual. Individuals age 50 or older can make an additional “catch-up contribution” of $1,000.
- Contributions to Roth IRAs cannot exceed earned income.
- The contribution due date is generally the tax filing deadline of April 15.
What other important facts should I know?
- Please download “My Guide For Individual Retirement Accounts” to continue reading this helpful information!
In addition, if you feel ready and are serious about fine-tuning your retirement and wealth management plan, please click the “Learn More” button for an in-depth look at Palm Capital Management’s approach. Our office is located in Calabasas, California, and we work with Clients both in-person and remotely depending on your preference.
