by Jeffery Thomas
Who wants $192,000 more? That’s the difference between account balances in an IRA versus a taxable account. Got your attention? We all know there are some qualifications and that it won’t work out this way for everyone. Let’s take a look at IRAs and their company sponsored cousins.
The SECURE Act of 2019 has made some adjustments to the rules governing IRAs. Most changes are favorable to account holders. The elimination of the Stretch IRA is not one of them. This will throw a wrinkle in many estate plans. I’ll discuss this change below.
An IRA is not a type of investment, it is a tax status of an investment or savings account. The IRA status dictates how taxes are treated but are funded with investment securities, CDs or cash savings. The account document must comply with the Internal Revenue Code including the following points:
- Individuals with earned income or alimony can establish IRAs, no joint accounts.
- If the individual participates in a retirement plan at work, they may be limited on how much they can deduct based on income.
- Deduction limits for individuals participating in a qualified plan with their employer are as follows: married filing jointly – fully deductible up to $103,000 MAGI (Modified Adjusted Gross Income), no deduction at $123,000 and a partial deduction in between the above numbers. Single filers can fully deduct their contributions up to $64,000 and phases out until no deduction at $74,000.
- Roth IRAs have contribution limits based on filing status. Individuals filing single can make a $6,000 contribution if MAGI is less than $122,000 and partially phases out until MAGI is greater than $137,000 when the individual is no longer eligible to contribute. For married filing jointly contributions are permitted when MAGI is below $193,000 and phases out to zero above $203,000.
- The 2019 tax year will be the last that individuals must be younger than 70 ½ to establish or contribute to a traditional IRA.
- The IRA is established for the benefit of individual in a custodial account or a trust.
- Contributions must be in the form of cash or check. Stocks or other assets cannot be transferred or deposited into the account.
- Contributions limits for the 2019 tax year, which can be made up until April 15, 2020, can be up to 100% of earned income or $6,000, whichever is less. Married couples can claim up to $12,000 even if only one spouse had earned income. Individuals at least age 50 during 2019 can contribute an additional $1000 catch-up.
- Funds cannot be invested in life insurance policies, art, metals or other collectibles. ETF’s that hold metals or public traded companies that engage in collectibles can be placed in an IRA, special rules apply.
- IRAs cannot be used as collateral for loans. Doing so causes the pledged amount to be treated as a distribution.
IRA vs Roth
Roth version of IRAs was established by the Taxpayer Relief Act of 1997 and named for its main sponsor William Roth. Whereas the traditional IRA is a mechanism for tax deferral, the Roth can provide actual tax free retirement income. Traditional IRA contributions are tax deductible for qualified account holders, Roth contributions are not. Traditional IRA earnings are tax deferred and taxes are paid as the money is withdrawn from the account. Roth earnings are tax deferred and actually are not taxed at all when withdrawn according to plan guidelines. Be aware of the 5 Year Rule. You cannot withdraw earnings or interest tax and penalty free until five years after your first contribution. Your five year clock starts in the tax year for which you made your first contribution regardless of the years of subsequent contributions.
Traditional IRAs as well 401(k) and 403(b) assets can be converted to a Roth IRA. With this unique feature, the converted amount is taxable in the year of conversion but the 10% penalty does not apply. The earnings after conversion grow tax-deferred and can be withdrawn tax-free.
A Roth can conversion can also be recharacterized. An account holder can change the Roth back to a Traditional provided it is done by the tax filing time including extensions of the tax year in which the conversion was done. This may be useful if there was a large drop in value after conversion, the future tax outlook has changed or tax payer does not have the funds available to pay the tax due on conversion.
First, IRA account holders who are over age 50 can contribute $1000.00 per year above the stated limits. This is called a “catch-up” contribution designed to help people nearer to retirement catch-up on their savings.
Secondly, lower income IRA contributors actually get a tax credit for making contributions. A credit differs from a deduction. A deduction reduces taxable income. A credit reduces actual taxes due. For the IRA “Savers Credit” a married person making $39,000 or less can get a 50% tax credit for their contribution. In other words, if they contribute $2000, not only do they get any deduction due prior to calculating what taxes are owed they also get a $1000 reduction in taxes owed by applying the tax credit.
Distributions from an IRA
Generally age 59 ½ is the key number for distributions without penalties. Distributions from Traditional IRAs are included as regular income so tax planning comes into play here. Money not withdrawn remains tax-deferred. Account holders do not have to take distributions at this age. Actually, money can remain tax-deferred until age 72 when Required Minimum Distributions (RMD) must begin. This is a change by the SECURE Act. Prior to 2020 the age was 70 ½. The IRS has established RMD tables of what must be withdrawn based on account value. The objective is that through RMDs the account value should reach zero at the end of life expectancy. There are provisions for a beneficiary IRA should the account holder pass away with an account value.
This is where things get tricky for estate planning. Prior to SECURE the beneficiary could stretch the inherited traditional IRA based on their life expectancy. Now the traditional IRA must be depleted by year 10 after the inheritance. There are exclusions. A spouse can still base withdrawals on life expectancy. As can certain other beneficiaries with special circumstances involving disabilities or a minor.
The problems begin in estate plan strategies when the traditional IRA beneficiary is a trust set up by the parent for a spendthrift adult child. Let’s say that under the trust, the payout to the trust beneficiary is to be based on life expectancy. At the time of the parent’s death let’s say the child is age 40. Incremental amounts would drip out annually. But SECURE requires that it be depleted in year 10 meaning that a disproportionate amount would be distributed at age 50 skyrocketing their income and potentially pushing them into a higher tax bracket. Contact your estate planning attorney for their professional opinion before taking action.
Roth IRAs do not have RMDs. For qualified distributions the account holder must have satisfied the five year holding period and attained age 59 ½. Contributions, since they have been taxed can be withdrawn prior to 59 ½ without a penalty.
The penalty for premature distribution of either traditional or Roth is 10% of the withdrawn amount above any taxes due. There are provisions whereby money can be withdrawn penalty free prior to age 59 ½ from a Roth IRA; the disability or death of the account owner and up to $10,000 for the down payment on a primary residence for a first time home buyer.
Traditional IRAs have more provisions. In addition to the exclusions for a Roth, Traditional IRA provisions include medical expenses exceeding 10% of AGI, payment of medical insurance premiums during 12 weeks of continuous unemployment, qualified post-secondary education expenses, 72(t) distributions which are a series of equal periodic payments according to IRS Rule 72(t) and for National Guardsmen during deployment.
Company Sponsored Versions
IRAs have two cousins that are sponsored by businesses. These are designed for small businesses where a 401(k) or pension plan would be cost prohibitive. They are the SIMPLE IRA (Savings Incentive Match Plan for Employees Individual Retirement Account) and the SEP (Simplified Employee Pension). Both are for employers with 100 or fewer employees and neither requires cumbersome annual reporting. Both may exclude employees who are union members.
Make It SIMPLE
This is an attractive low cost way to allow employees to set aside tax deferred earnings. Employers can allow employees to choose their own financial institution by establishing the plan with IRS Form 5304-SIMPLE or the employer can choose the institution with IRS Form 5305-SIMPLE. Plans must be established by October 1. Once established, employees complete an adoption agreement. Employers can elect a 2% minimum contribution or a 3% matching contribution.
Employees may make contributions up to $13,500 in 2020 and an additional $3000 catch up if they are 50 or older.
Make It Simplified
The Simplified Employee Pension (SEP) is another attractive low cost method of setting aside money tax deferred. Contributions are made only by the employer. These plans must be established by tax filing time, usually April 15 or in the case of an extension October 15. SEPs are treated like traditional IRAs for tax purposes and are often referred to as SEP IRAs. Employees must establish a traditional IRA to participate.
SEPs have higher contribution limits than IRAs and SIMPLEs. Business owners and the self-employed can put away 25% of pay up to $56,000 for the 2019 tax year and $57,000 in 2020. Not all business can participate. Sole proprietors, for example, with incomes above $280,000 in 2019 and $285,000 in 2020 would not be eligible.
As with any financial matter consult your financial and tax advisors.