Individual Retirement Accounts (IRAs) play an important role in many investors’ portfolios. The more you understand about the rules, the better your chances are to use them to your advantage.

Traditional IRAs

Deductible Contributions
If you are eligible to contribute to a traditional IRA, you get to take a deduction on your tax return. To be eligible, you must meet the following requirements:

  • In general, you must have earned income. You can’t contribute more than you get in earned income. The exception is for a spouse who is not working outside the home. In that case, he or she may make a contribution even without income of their own as long as the working spouse’s income can cover both contributions.
  • The maximum contribution is $6,000 for 2020. If you are over age 50, you can contribute another $1,000. These extra allowances for people over age 50 are called “catch-up contributions.”
  • Contributions can be made in the year the income is earned or up to the filing deadline of your tax return (April 15th in most cases), not including extensions.
  • If you don’t participate in a company retirement plan (and neither does your spouse), you can contribute up to your earned income or the maximum contribution, whichever is greater subject to some phase-outs if you file Married Filing Joint (MFJ).
    • If you file MFJ and neither spouse is covered at work, the complete phase out for a deductible contribution starts at $206,000.
    • If you are single and not covered by a company retirement plan, you can take the greater of your earned income or the maximum contribution, whichever is greater. For example, if you earn $3,000 a year, and the maximum you can contribute is $6,000, you can contribute $3,000. If your earned income was $10,000, you could contribute $6,000.
  • If you do participate in a company retirement plan (like 401(k)s, 403(b)s, SEPs, SIMPLEs, etc.) and your modified AGI (Adjusted Gross Income) is too high, you may be phased out of a deductible traditional IRA contribution.
    • Deductions will be completely phased out for singles with modified AGI more than $75,000 and married filing joint at $124,000 (at least one spouse covered at work).
    • Modified AGI takes your AGI from your tax return and adds back deductions like half of self-employment taxes, IRA contributions and Social Security, qualified tuition expenses, among others.
  • You can contribute as long as you have earned income. But unlike a 401(k), even if you are still contributing you still need to start required minimum distributions (RMDs) at age 72. Which means you may be contributing and withdrawing at the same time.

Non-Deductible Traditional IRA Contributions
Just because you can’t deduct a traditional IRA contribution doesn’t mean you shouldn’t do it. Anyone can contribute up to $6,000 ($7,000 if over age 50) to a traditional IRA (assuming you have that much earned income). You won’t get a deduction on your tax return, but you will get tax-deferred growth on the earnings.

You will need to file a Form 8606 when you make non-deductible traditional IRA contributions. The form lets the IRS know that the money you contribute has already been taxed. Then later when you take a distribution, you won’t have to pay tax on your non-deductible contributions. You will owe tax on any earnings when you take a distribution. If you’ve made non-deductible traditional IRA contributions in the past and have not filed Form 8606, you may want to amend your prior returns and attach completed Form 8606s.

Multiple Accounts
You can have as many different IRA accounts as you’d like. You just can’t contribute more than $6,000 ($7,000 if over age 50) in one year. Once RMDs start, you can calculate your distributions on the total IRA balance, but take the money from only one (or more) IRA account.

Moving Money from One Retirement Account to Another
You can do as many “direct” rollovers as you’d like to in any year. A “direct” rollover just means that the institutions sending and receiving your IRA do it directly. That can mean by wire transfer or by check (assuming the check is made out to the new custodian and not you). A direct rollover is a reportable event, so you’ll get a Form 1099-R at tax time. If you did a full rollover, you won’t owe taxes, but be sure to talk to your CPA so this is coded correctly.

A distinction you may need to be aware of is a direct transfer from one like account to another (like an IRA at one custodian to an IRA at another custodian). That is not a reportable event and there won’t be any IRS forms issued.

If you get a check payable to you (not the new custodial firm) from a company retirement plan (an indirect rollover), you may have tax issues. In these cases, the issuing company must deduct 20% for taxes. You have to make up that amount if you want to do a full rollover and not get hit with taxes, and potentially, an early distribution penalty. Then you have to wait until the following tax filing to get your 20% back.

If you do an indirect IRA-to-IRA transfer (where you take custody of the assets), including SEP IRAs and SIMPLE IRAs, you don’t have to meet that 20% withholding requirement, but you do need to deposit the funds in the new IRA within 60 days. If you miss the 60 day deadline, it may be fully taxable. There are some exceptions (“self certified corrective procedures”) that may get you off the hook for penalties (things like mistakes by the financial institutions, death in family, incarceration!, illness—there are  eleven of these). You are limited to doing an indirect rollover once every 365 days.

Regardless if you are doing a direct or indirect rollover, if you have after-tax contributions to your company retirement plan, you can roll those over to a traditional IRA. You’ll need to file Form 8606 to let the IRS know that you’ve already paid tax on those dollars. Once again, coordinate with your CPA so everyone is clear what has already been taxed.

IRA Distributions
When you withdraw money from a traditional IRA, distributions are taxable at ordinary income tax rates. (If you have non-deductible contributions made with after-tax money, your withdrawals will only be taxable on the earnings and pre-tax contributions.)

At age 72, you are required to take RMDs from traditional IRAs. The SECURE Act gives you until April 1st of the year following the year you turn age 72 to take your first distribution. But if you do that, you may have to take two distributions in that year. Still might be worth it if you have higher income in the prior year.

If you turned 70 ½ before 2020, you need to follow the old rules that say you start RMDs at age 70 ½. You can’t stop and then start again at age 72. A little quirk in the SECURE Act rules.

Here’s another quirk: You can still start making Qualified Charitable Distributions (QCDs) from your IRA at age 70 ½ even if you don’t have to start RMDs until age 72. QCDs allow you to gift up to $100,000 from an IRA to charity (but not your Donor Advised Fund). The charitable contributions before age 72 would just be tax-free distributions from an IRA to charity without a deduction (because you avoid tax on the distribution). After age 72, QCDs reduce the amount of taxable RMDs you have to take up to $100,000. If you are still working past age 70 ½, your QCD may be reduced by contributions made after 70 ½.

You can use RMDs as part of your rebalancing process. Use the after-tax distributions to replenish cash reserves you’ll need for expenses. Once you’ve brought the cash reserves back up to your target, invest the rest in underweighted asset classes to avoid selling something and generating capital gains.

IRA Tax Penalties
The IRS is going to get you if you try to take money out of your traditional IRA too early or too late. If you try to take a distribution before age 59 ½, you’ll have to pay a 10% early withdrawal penalty. If you try to delay taking a distribution past age 72, you’ll have to pay a 50% penalty on what you should have withdrawn but didn’t.

There are a few ways around the 10% early distribution penalty. The exceptions to this rule are: 1) death, 2) disability, 3) divorce decree, 4) certain medical expenses, 5) qualified higher education expenses, 6) up to $10,000 for first home, 7) distributions that are substantially equal periodic payments (72(t)) and 8) up to $5,000 withdrawal for qualified birth or adoption (apparently per child).

Roth IRAs

A Roth IRA allows you to put away after-tax money and let it, and any earnings, grow tax-free, assuming you meet certain criteria. You do not get a tax deduction as you do with a traditional IRA.

Contributions can be made in the year the income is earned or up to the filing deadline of your tax return (April 15th in most cases), not including extensions.

You can contribute past age 72 as long as you have earned income and are otherwise eligible. You never need to take RMDs from Roth IRAs during your life expectancy. Heirs can stretch out distributions over ten years and there is no tax due. In these cases, heirs may want to wait until the tenth year to take a distribution to allow the balance to continue to grow tax-free. If the original owner died before the five-year period was complete, there may be tax due for the heir.

Eligibility to Make Contributions
The contribution maximum is the same for Roth IRAs as it is for traditional IRAs ($6,000 or $7,000 for investors over age 50).

The income thresholds for eligibility to contribute to a Roth, however, are somewhat different than they are for traditional IRAs. Singles may contribute to a Roth IRA until modified AGI is more than $139,000. Married couples filing jointly may contribute as long as their modified AGI is below $206,000. Remember, you don’t get to deduct Roth contributions, so these thresholds are just to determine eligibility.

Spousal contributions are allowed for non-working spouses as long as the working spouse’s income can cover both contributions and they meet the income eligibility requirements.

Roth IRA Conversions
To convert a traditional IRA to a Roth IRA, you pay the tax on the traditional IRA up front with money from a separate account. If you have to use money in your traditional IRA to pay the tax on the conversion, it will be considered an early withdrawal (assuming you are under age 59½), and you will owe a 10% penalty on it.

Always file a Form 8606 on Roth conversions. You may need to tell your CPA that you’ve done this as the 1099-Rs only show a distribution has been made.

Converting to a Roth doesn’t have to be an all-or-nothing proposition. You can convert part of your traditional IRA. This can be part of a tax diversification strategy. Keeping both traditional and Roth IRAs can hedge your bets with whatever happens in the future with tax legislation or government regulations.

If you used non-deductible contributions to your traditional IRA, you may not owe much tax at all when you convert. You only pay tax on the earnings or the portion that hasn’t been taxed when you convert.

Beware pro-rata rules when converting. When converting to a Roth IRA, all your traditional IRAs are considered as one big combined IRA (including SEP and SIMPLE IRAs). So you can’t segregate the after-tax contributions. The pro-rata rule says you have to take a portion of both pre-tax and after-tax money when you convert. So if you have 10% after-tax contributions across all IRA accounts, only 10% is not taxed in a conversion or partial conversion.

Watch the timing of IRA rollovers in the same year as a Roth conversion. The pro-rata rules apply as on the end of the year of the conversion. If you roll over a plan in the same year, that counts as part of the total IRA even if the conversion happens before you do the rollover.

A word of caution regarding the SECURE Act: Don’t just convert to avoid the loss of the lifetime stretch-out. Paying tax now at high rates is not necessarily better than your heirs paying tax over a ten year period.

Who Should Not Convert
There are clearly some situations where you’ll end up paying more in taxes, penalties, or both by choosing to convert to a Roth IRA versus leaving your money in a traditional IRA. Let’s take a closer look at these situations.

  • If you expect to consume your IRA assets in retirement and you expect your tax rate to be lower after retirement, you should not convert. But consider this: Tax rates today are near historical lows. Do you think taxes could go up when you retire?
  • If you know you will need the money within five years of converting, don’t convert. If you pull money out of your Roth less than five years after converting, you will have to pay taxes (and penalties if you are under age 59 1/2) on any appreciation above your original contribution.
  • If you would have to sell IRA assets to pay the tax, think carefully about converting. You will end up paying taxes and perhaps penalties on assets withdrawn from your IRA. Will your investment time horizon be long enough that compounding will make up for this loss in your nest egg?
  • If you would pay more in tax now by converting versus having your heirs pay the tax over ten years after they inherit.

Who Should Consider Converting
You might want to convert if:

  • You plan to retire early and spend at least as much money as you did during your working years. Many more people are choosing to spend 100% of their current income in retirement. They have no intention of living on less; in fact, the opposite may be true. If you retire early and are still active, it is possible your income needs will go up. And that could also mean you will pay more in taxes in retirement.
  • Asset prices are depressed. If your IRA is smaller, you’ll pay less in tax.
  • You have enough money in an outside account to pay the tax due on a Roth conversion. In effect, this “grosses up” the value of the Roth IRA. You are converting assets that generate taxable income to assets that generate tax-free income.
  • You don’t want to take minimum withdrawals from your IRA. Converting to a Roth will allow you to eliminate those required minimum distributions that start at age 72. By postponing distributions (perhaps indefinitely), your money can continue to grow untouched for many years.
  • You think tax rates may go up in the future, and you would rather lock in lower tax rates now.
  • You may not need the Roth IRA money during retirement and would like to pass it on to your kids or grandkids. Your heirs can take out the money over a ten year period once they inherit and will not owe tax.

Special Considerations with Company Stock
Any stock grant itself (or participation in an ESPP) has no immediate impact on income that would affect Roth IRA contribution limits. However, compensation income generated from stock option exercises or restricted stock/RSU vesting can affect overall income that might make a Roth conversion less attractive.

The effect of stock grants on the income threshold depends on the type of grant. The spread from ISO (incentive stock option) exercises is not included in AGI. Therefore, after you exercise ISOs and hold the stock, the potential resulting alternative minimum income (AMTI) will not push up ordinary income or affect eligibility for Roth contributions. Should you trigger AMT, you may want to consider doing a Roth conversion up to the point where your regular income tax equals or slightly exceeds your AMT income, thus avoiding AMT tax.

But if the ISO is disqualified (e.g. by a same-day sale or a sale in the same year of exercise) and becomes an NSO (non-qualified stock option), the income is classified as ordinary income and affects AGI.

NSOs always generate ordinary income at exercise. Restricted stock/RSUs generate ordinary income at vesting. If you want to do a Roth IRA conversion, you may choose to delay NSO income until the next year, when possible, unless your options are about to expire.

The more income you have in the future, the more it makes sense to convert in the current year, when tax rates are potentially lower than they will be in the future. Don’t forget to consider future sources of income like pensions, retirement plan distributions, stock options or restricted stock that continue to vest after retirement. Higher income can affect how much you pay in Medicare surtaxes and premiums or how much tax you pay on Social Security benefits.

Tax Penalties on Roth IRAs
There are less potential penalties for a Roth IRA. Since you are not required to take RMDs, you won’t run into that nasty 50% penalty (for traditional IRA minimum distributions not taken on time). You may, however, bump into the 10% early distribution penalty.

You can always withdraw the amount of contributions you made to the Roth IRA without penalty. If you withdraw earnings, there are some exceptions to the 10% penalty. If you’ve held the Roth for at least five years, the exceptions are:

  • Age 59 ½ or older
  • Disabled
  • IRA beneficiary
  • First-time homeowner (up to $10,000)

If you’ve held the Roth IRA for less than five years, there are a few more ways to avoid the 10% penalty:

  • Significant unreimbursed medical expenses
  • Paying for medical premiums after losing a job
  • Qualified higher education expenses
  • Substantially equal periodic penalties (same rules as under traditional IRA)

Two Five-Year Rules
We just mentioned one five-year rule as an exception to the 10% penalty on Roth IRA distributions: if you’ve held the Roth IRA for five years and you are 59 1/2, there is no penalty. If you’ve created multiple Roth IRAs, this five year rule starts with the first Roth you set up. You start the clock on January 1 of the year you made that first contribution.

Not so on Roth IRA conversions. The five-year rule starts every time you convert a traditional IRA to a Roth. Partial conversions too. The clock starts January 1 of each year you did a Roth conversion. If you die before the five years are up, your heirs may owe tax on their distributions.

So you need to keep track of when you do the first Roth contribution and any Roth conversions over the years. You did file those 8606s for conversions, right? That would tell you when each of those Roth conversion clocks started running. If you mess up and pull out money before the end of the five-year period, you just owe tax and a 10% penalty on the earnings. You never owe tax on your contributions to a Roth IRA (except when the money goes in initially).

SEP IRAs

SEPs are retirement plans that use an IRA as a funding vehicle. They are established by self-employed individuals or by companies looking for a simple way to fund a retirement account. Either the employer or the employee can open an account with a fund company, brokerage, bank, or other financial institution.

You have until the due date of your tax return (including extensions) to set up the accounts.

The employer can contribute up to 25% of an employee’s salary (up to $285,000 in compensation) or $57,000 whichever is less. (The employer’s contribution is limited to 20% of up to $285,000.) That’s a huge difference from the traditional and Roth IRA contribution limits of $6,000 (or $7,000 if over 50).

The employee can also contribute subject to the regular rules regarding IRAs. (So if your employer contributes less than $6,000 ($7,000 with the catch-up), you can make up the difference.) The employer is not required to make a contribution every year. When the employer does make a contribution, it can’t discriminate in favor of highly compensated employees.

SEPs are easy and cost-efficient to set up and maintain. Annual employer contributions are discretionary. There is no annual IRS form to file. Contributions can be made after plan year-end (up until tax-filing deadline). Employees have investment responsibility for his or her own account. SEPs must cover all employees, even part-time. No loans are allowed.

SIMPLE IRAs

A SIMPLE plan is a retirement plan available to employers with 100 or fewer employees. Employees contribute using salary deferral. Employers must contribute a match for all eligible employees.

Employees can contribute up to 100% of compensation up to a maximum of $13,500. Employees can also make catch-up contributions of $3,000 per year. Employers must match contributions from 1% to 3% of compensation.

Inherited IRAs

The rules for inherited IRAs vary depending on whether you are the spouse of the deceased or someone else. The spouse is allowed to rollover the deceased’s IRA into their own IRA. Then the normal rules apply to the spouse’s IRA.

Everyone other than the spouse treats the inherited traditional IRA as a beneficiary IRA. You cannot make any new contributions to the account and you must take minimum required distributions over the ten years after the year the owner died. These distributions can be taken every year for ten years or any time within the ten years as long as the account is emptied by the end of ten years. The “ten-year rule” only applies to deaths in or after 2020 (part of the SECURE Act). If the owner died before 2020, distributions can generally be made over the life of the beneficiary. There are some exceptions to the new SECURE Act rule, so be sure to touch base with your financial advisor, CPA or attorney.

If you inherit a Roth IRA as a non-spouse, you have to take distributions over a ten year period. There is no tax due, but you have to deplete the account at the end of the tenth year following the year the owner died (so in some cases, that’s more like eleven years). Some beneficiaries may want to wait until the last year to withdraw from Roth IRAs to continue the tax-free growth.

Confused?
I’d be surprised if you weren’t confused at this point. The IRS rules are really tricky and seem to change frequently (ala the SECURE Act most recently.) All the more reason to find a financial advisor or tax professional (or both) that can act as your seeing-eye dog through the twists and turns in the world of IRAs.

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Disclosures
The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.