The Many Rules Surrounding IRAs

Contribution Rules with IRAs

The first rule with all IRAs is that you cannot ever contribute more to one than the amount of your earned income. Earned income is income that you are provided from employment, self-employment, or supplementary income related to employment such as disability benefits and strike pay.

Income that is not considered earned income include unemployment benefits, pension income, and income from rental property and investments. Earned income is generally active income, where non-qualifying income is of a more passive nature.

Given the current limits on IRA contributions, as of 2018, those who are employed full-time or self-employed will almost always have earned income above these thresholds, which is only $5500 per year, with an extra $1000 added for those who are over the age of 50.

In 2019, the IRS has announced it will be raising the limits to $6000 for those under 50, and $7000 per year for those over 50.

Once we retire, we may no longer have enough earned income to qualify, and often do not have any, and this is when this rule tends to come into force much more. This is one of the reasons why it’s important to take advantage of IRA contributions while in the earning phase of your life, prior to retirement.

The presumption though is that once you are retired, you should not need to use a traditional IRA, because its purpose is to defer tax until you retire, and that time has already arrived. It makes less sense to place the requirement of earned income on Roth IRAs though, because people can still take advantage of contributions well into retirement if their income allows it.

Canada’s version of the Roth IRA, the TFSA, does not come with any earned income requirements, and people do contribute to them well into retirement. For whatever reason, Roth IRAs are not set up this way, and presumably the IRS feels that people who are able to contribute to an IRA from other sources do not merit this tax benefit in their retirement.

It is true though that those who can still contribute income to an IRA after they retire are by definition fairly comfortable already, to the extent that the government may feel justified in collecting full tax rates from their investments and savings without conveying any special benefits.

Contribution limits for IRAs apply to the total contributions to one’s IRAs, whether that be with a traditional or Roth IRA. The sum total for both cannot exceed these limits and this leaves us needing to decide which one we are better off contributing to, and in some cases, what proportion of each we want to use our contribution limits on.

Traditional IRAs allow us to contribute up to age 70 ½, while Roth IRAs have no age restriction.

Tax Treatment Rules

Both traditional and Roth IRAs have their own tax benefits, but they are very different in nature. Traditional IRAs defer taxation on both the principal and earnings held within the IRA, where the idea is to wait to pay the tax until retirement, when we will be in a lower tax bracket and pay less tax.

We also get to use the amount of deferred tax to invest over this time, which can amount to a significant amount, and while this extra money earned by using what is essentially the government’s money over many years, the compounding that results can have this adding up to a lot more, especially if one’s returns are on the higher side.

Therefore, even if one does not expect to be in a lower tax bracket in retirement, in other words the tax rate can be expected to be the same, we can still benefit a lot by investing deferred tax money. There’s also the benefit of having this sum of money devalued by inflation, which over a period of many years results in the amount being paid back representing substantially less value in future dollars.

Without the tax advantages of an expected lower tax bracket, it is generally preferable to have your money in a Roth IRA though, which has its own tax advantages. Without the added benefit of paying a lesser percentage in tax, the Roth IRA’s structure has it coming out on top, especially if one expects a good return on their money or better.

Roth IRAs do not offer any tax deductions on contributions, but any earnings in the plan aren’t subject to tax, even when withdrawn. Both Roth and traditional IRAs are beneficial in themselves, but when we compare the two, we generally need the tax savings on the contributions later to keep them a competitive choice.

How Income Affects IRAs

With traditional IRAs, one can contribute up to one’s contribution limit for the year regardless of income, but in order to receive the tax deduction, in many cases, one’s income needs to be below a certain threshold. Roth IRAs have their own income threshold but it is higher, and there is a gap between them that one could contribute to either a traditional IRA without the deductions or a Roth IRA fully qualified.

The income limit for full traditional IRA deductions for those who are also covered by a retirement plan at work is $63,000 for single filers, with partial deductions available up to $73,000, and if one’s income is higher, no deduction is available, even though one still may contribute.

Couples who are covered at work have a limit of 101,000 for full deductions, with a partial deduction available up to 121,000. If you do not have a retirement plan at work but your spouse does, the limit is 189,000 for a full deduction and 199,000 for a partial one.

Those who are single and are not covered by their employer are not under any income limits, as is also the case with joint filers with neither having a work sponsored retirement plan.

Roth IRAs have their own limits, with the limit for single filers being 120,000 for full benefits and 135,000 for partial benefits, with joint filers limited to a total income of 189,000 for full tax treatment and 199,000 for partial tax benefits.

All of these income limits are based upon what is called modified adjusted gross income, which for most people is just their taxable income, although things like deductions for student related expenses, self-employed health care contributions, and a few other things that don’t affect most taxpayers.

IRA Withdrawal Rules

Both traditional and Roth IRAs are retirement plans and function to provide incentives for people to actually save for retirement, rather than just to get them to save generally. The magic age that the IRS deems to be one deemed minimally proper for retirement is 59 ½.

When you withdraw from any IRA before this age, you normally become subject to a penalty, although there are some exceptions.

With a traditional IRA, you are allowed to withdraw to help you pay for your first home, for qualified educational expenses for yourself, your spouse, your children, or your grandchildren, if you have unreimbursed medical expenses exceeding 7.5% of your income, if you are called to active duty in the military lasting over 179 days, you become totally and permanently disabled, or if you inherit an IRA from a deceased spouse.

Otherwise, a 10% early withdrawal penalty applies, in addition to needing to declare the withdrawal as income.

Once you reach the age of 70 ½, not only can you no longer contribute to a traditional IRA, you are also required to make prescribed withdrawal amounts each year until you pass or the IRA is fully withdrawn.

Roth IRAs do not have penalties attached to withdrawing the principal amount that is contributed, but withdrawing its earnings does have age restrictions. There are two main criteria that apply here to avoid a penalty, which is being over the age of 59 ½ and your holding the Roth IRA for more than 5 years.

Both need to be the case for a penalty free withdrawal, although as is the case with traditional IRAs, there are exceptions similar to those offered with traditional IRAs, with a few more included such as paying for health insurance if you are unemployed, if you owe money to the IRS, or if you choose to take an equal annual withdrawal for at least 5 years and up until age 59 ½.

The fact that contributions themselves aren’t subject to penalties does serve to make withdrawing from a Roth IRA more flexible, where substantial portions can be withdrawn prior to age 59 ½ with no special conditions or penalties, where with a traditional IRA, you need an exception to avoid paying the 10% penalty.

IRAs can provide those of average to above average income with a means to gain tax advantages while furthering their retirement goals, and the rules surrounding them are a little complicated but fairly easy to understand and take advantage of.