There are opportunities and pitfalls for individual retirement account (IRA) owners. While you don’t want to get caught up in a pitfall, you may want to take advantage of the tax tips and opportunities.
Individual Retirement Account Varieties - Traditional and Roth
IRAs come in two varieties: traditional and Roth. The traditional generally provides a tax deduction for a contribution and tax-deferred accumulation, with distributions being taxable. On the other hand, there is no tax deduction for making a Roth contribution, but the distributions are tax-free.
It leaves taxpayers with a significant decision, with long-term consequences of whether to contribute to a traditional or Roth IRA. If you can afford to make the contributions without a tax deduction, then the Roth IRA is probably the better choice in most circumstances. However, some high-income restrictions limit the deductibility of a traditional IRA and the ability to contribute to a Roth IRA.
Potential Pitfalls that can be encountered with IRAs
Here are some of the pitfalls that can be encountered with IRAs:
- Early withdrawals – IRAs were designed by the government to be retirement resources, and to deter individuals from tapping these accounts before retirement they added what is called an early withdrawal penalty of 10% of the taxable amount of the IRA distribution. The penalty generally applies for distributions made before reaching age 59-½, but there are some exceptions to the penalty.
- Excess contributions – The tax code sets the maximum amount that can be contributed to an IRA annually. Contributions in excess of those limits are subject to a nondeductible excise tax penalty, which is currently 6%. That penalty continues to apply each year until the over-contribution is corrected.
- Multiple rollovers – A rollover is where you take possession of the IRA funds for a period of time (up to 60 days) and then redeposit the funds into the same or another IRA. Only one IRA rollover is allowed in a 12-month period and all IRAs are treated as one for purposes of this rule. If more than one rollover is made in a 12-month period, the additional distributions are treated as taxable distributions and the rollover is treated as an excess contribution, with both causing significant tax and penalties. Rollovers can be avoided by directly transferring assets between IRA trustees.
- No Traditional IRA contributions in the year reaching age 70-½ – Individuals cannot make a Traditional IRA contribution in the year they reach the age 70½ or any year thereafter. This rule doesn’t apply to Roth IRAs. Contributions to a traditional IRA made in the year you turn 70½ (and for subsequent years) are treated as excess contributions and are subject to the nondeductible 6% excise tax penalty until corrected.
- Failing to take a required minimum distribution (RMD) – Individuals who have traditional IRA accounts must begin taking RMDs in the year they turn 70-½ and in each year thereafter. However, the distribution for the year when an individual reaches age 70-½ can be delayed to the next year without penalty if the distribution is made by April 1 of the next year. Failing to take a distribution is subject to a penalty equal to 50% of the RMD. The IRS will generally waive the penalty for non-willful failures to take the RMD, provided the individual has a valid excuse and the under-distribution is corrected. The RMD rules don’t apply to Roth IRAs while the owner is alive.
- Late contributions – If you forgot to make an IRA contribution or just decided to do so for the prior year, the tax law allows you to make a retroactive contribution in the subsequent year, provided you do so before the unextended April filing due date. As an example, you can make an IRA contribution for 2018 through April 15, 2019. This is also a benefit for taxpayers who were not previously sure they could afford to make a contribution.
- Switch the type of IRA – If you make an IRA contribution for a year, tax law allows you to switch the designation of that contribution from a traditional IRA to a Roth IRA or vice versa, provided you do so before the unextended April filing due date.
- Backdoor Roth IRA– Contributing to a Roth IRA is not allowed if the individual’s modified adjusted gross income (AGI) exceeds a specified amount based on filing status. To contribute to a Roth IRA, single tax filers must have a modified adjusted gross income (MAGI) of less than $144,000 in 2022 or less than $153,000 in 2023. If married and filing jointly, your joint MAGI must be under $214,000 in 2022 or $228,000 in 2023. If a high-income taxpayer would like to contribute to a Roth IRA but cannot because of the income limitation, there is a workaround that will allow the high-income individual to fund a Roth IRA.
Backdoor Roth IRA
Here is how that backdoor Roth IRA works:
- A contribution is made to a traditional IRA. For higher-income taxpayers who participate in an employer-sponsored retirement plan, a traditional IRA is allowed but is not deductible. Even if all or some portion is deductible, the contribution can be designated as not deductible.
- Since the law allows an individual to convert a traditional IRA to a Roth IRA without any income limitations, the non-deductible traditional IRA can be converted to a Roth IRA. Since the traditional IRA was non-deductible, the only tax related to the conversion would be on any appreciation in the value of the traditional IRA before the conversion is completed. One potential pitfall to the backdoor Roth IRA is often overlooked by investment counselors and taxpayers alike which could result in an unexpected taxable event upon conversion. For distribution or conversion purposes, all of your IRAs (except Roth IRAs) are considered one account, and any distribution or converted amounts are deemed taken ratably from the deductible and non-deductible portions of the traditional IRA, and the portion that comes from the deductible contributions would be taxable. The conversion tax implications should be considered before employing the backdoor Roth strategy.
Alimony as Compensation
In order to contribute to an IRA, an individual must receive “compensation.” For IRA purposes, compensation includes taxable alimony received. Thus, for purposes of determining IRA contribution and deduction limits, individuals who receive taxable alimony and separate maintenance payments may treat the alimony as compensation, for purposes of making either a traditional or a Roth contribution, allowing alimony recipients to save for their retirement.
One frequently overlooked tax benefit is the “spousal IRA.” Generally, IRA contributions are only allowed for taxpayers who have compensation (the term “compensation” includes wages, tips, bonuses, professional fees, commissions, taxable alimony received, and net income from self-employment). Spousal IRAs are the exception to that rule and allow a non-working or low-earning spouse to contribute to his or her own IRA, otherwise known as a spousal IRA, based upon his or her spouse’s compensation (as long as it is enough to support the contribution).
The saver’s credit, for low- to moderate-income taxpayers, helps offset part of the first $2,000 an individual voluntarily contributes to an IRA or other retirement plans. The saver’s credit is available in addition to any other tax savings resulting from contributing to an IRA or retirement plan. Like other tax credits, the saver’s credit can increase a taxpayer’s refund or reduce the tax owed. The maximum saver’s credit is $1,000 ($2,000 for married couples if both spouses contribute to a plan). The application of this credit is very limited. Please call for additional details.
IRA-to-Charity Direct Transfers
Individuals aged 70½ or over must withdraw annual RMDs from their IRAs. These folks can take advantage of a tax provision allowing taxpayers to transfer up to $100,000 annually from their IRAs to qualified charities. This provision may provide significant tax benefits, especially if you would be making a large donation (although it also works for small amounts) to a charity anyway.
Here is how this provision, if utilized, plays out on a tax return:
- The IRA distribution is excluded from income;
- The distribution counts toward the taxpayer’s RMD for the year, and;
- The distribution does NOT count as a charitable contribution.
At first glance, this may not appear to provide a tax benefit. However, by excluding the distribution, a taxpayer with itemized deductions will lower his or her AGI, which will help with other tax breaks (or punishments) that are pegged at AGI levels, such as medical expenses, passive losses, and taxable Social Security income. In addition, non-itemizers essentially receive the benefit of a charitable contribution to offset the IRA distribution.
IRA Planning Help
Please call us for further details or to schedule an appointment for some IRA planning unique to your circumstances.