Investment accounts are distinguished by their tax-related characteristics. Eligibility, contribution limits, required withdrawals, conversions, and tax implications for these accounts can get confusing. Consult a licensed accountant to ensure the best decisions are made.
In addition to, or instead of, qualified accounts sponsored by your employer, you can set up your own Individual Retirement Arrangements or IRAs. (Over the years it's become overwhelmingly common to assume IRA stands for Individual Retirement Account. In order to avoid confusion I embrace the common use hereafter).
IRAs are technically non-qualified but do provide tax advantages. They may be sponsored by an employer or by you as an individual. These plans include the Traditional Individual Retirement Account (Traditional IRA) and the Roth IRA.
IRA limits for 2020 and 2021 are $6,000. If you are over the age of 50, you’re allowed a catch-up contribution of $1,000. Your annual compensation must be at least as high as the amount of direct contributions made in a given tax year to IRA accounts.
Any funds you withdraw from a Traditional IRA prior to age 59.5 are subject to a 10% penalty, on top of the taxes payable on the amount withdrawn. Once you reach age 72 you must begin to take distributions out of your account.
While annual contribution limits for IRAs are lower than for 401(k)s, there’s usually far greater investment flexibility in IRAs. You may be able to buy any of thousands of stocks, bonds, mutual funds or exchange traded funds. This makes it easier to diversify your investments, and also gives you the flexibility to select investment funds that have very low management fees.
In a Traditional IRA, contributions you make in a given year are made pretax, allowing you to reduce your income tax bill in the year the contribution is made. Your investments in an IRA grow tax-deferred—no taxes until you begin to take money out.
In a Roth IRA, your contributions are made after (or post-) tax. That is, you don’t get to lower your taxes in the contribution year. Any gains are tax-deferred, but most importantly, you pay no taxes when you take the money out. Needless to say, not having to pay any taxes on gains is very appealing. It’s so appealing that everyone wants to do it. But the government limits eligibility for Roth IRA contributions by income. In 2020, if you are single and have an adjusted gross income (AGI) of less than $124,000 ($125,000 in 2021), you can contribute the maximum to a Roth IRA. The permitted contribution gradually phases out, so that once your AGI reaches $139,000 ($140,000 in 2021), you are likely no longer eligible to contribute to a Roth IRA at all. If you are married filing jointly, for 2020 your permitted contribution begins to phase out at a combined AGI of $196,000 ($198,000 in 2021), and eligibility ends at $206,000 ($208,000 in 2021).
Check the IRS website for the latest updates.
Your contributions to a Roth can be withdrawn at any time without tax implications, because they were made post-tax, but any gains are taxed if withdrawn before age 59.5. There is a caveat that withdrawn funds have to have been in the account for at least five years. Otherwise, you could owe taxes and the 10% penalty.
It is possible to convert a Traditional IRA to a Roth, but that generally triggers taxes since the contributions to the Traditional account benefited from tax deductibility in the years they were made and the government wants its share of your income.
If you participate in a qualified retirement account offered by your employer (e.g., 401(k) or 403(b)) you may also be able to contribute to a Traditional or Roth IRA. I recommend confirming with your accountant whether you are eligible. If you’re not eligible to contribute and still have some money you’d like to put away tax-deferred you can contribute to a Non-deductible IRA. As the name implies, you are unable to deduct contributions from your income but the funds grow within the account on a tax-deferred basis. When withdrawn in later years you pay taxes on the gains but not on your original, non-deductible contributions.
It’s important to discuss non-deductible IRA contributions with your accountant as she may need to document the precise dates and amounts of your contributions in order to properly calculate taxable gains in future, in particular if you decide to convert some of the non-deductible Traditional IRA funds into Roth IRA (see Backdoor Roth IRA).
In 2020, if you are single or a head of household covered by a workplace retirement plan, and you seek to make contributions to a traditional IRA, your ability to deduct contributions from taxable income begins to phase out at a modified adjusted gross income (AGI) of $65,000. The allowance phases out completely at a modified AGI of $75,000. In 2021 those numbers are $66,000 and $76,000, respectively.
For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the modified AGI phase-out range is $104,000 to $124,000 in 2020. In 2021 those numbers are $105,000 and $125,000, respectively.
For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s modified AGI for 2020 is between $196,000 and $206,000. In 2021 those limits are $198,000 and $208,000.
If you are "phased out" because your earnings are too high, you may still be able to contribute to a non-deductible IRA. With a non-deductible IRA you still get to invest tax-deferred, but you don't get to deduct contributions from each year's taxable income.
The SECURE Act
The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act made some significant changes to intergenerational IRA transfers. It is still possible for a spouse to inherit an IRA account and roll it over into her own name. Subsequently, it’s as though she has been the owner of the account all along, and she can elect how she would like to receive the proceeds, subject to rules specifying required minimum distributions. By very gradually taking required distributions over her remaining lifetime she can minimize the taxes payable on those account withdrawals.
It used to be the case that an IRA owner could also pass an account to a child, who could then stretch out required distributions over their expected lifetimes. The younger the children, the smaller their required annual distributions. This approach was commonly referred to as a “Stretch IRA.” Note that this was a strategy—not a formal IRA type.
The Stretch IRA allowed the child to extend RMDs over many more years than the parent, allowing more of the balance to remain invested where it could grow further on a tax-deferred basis. Furthermore, the child’s tax bill could be much more favorable than the parent’s, due to a lower likelihood that the (smaller) additional income would push the earnings to a higher tax bracket. The strategy could also be used with grandchildren. The original IRA owner could name a grandchild as beneficiary, and that youngster could stretch required distributions out over many decades.
The SECURE Act took away the Stretch allowance for most non-spouse beneficiaries. There are some exceptions, for example, in the case of siblings who are close in age to the original owner or children with disabilities, but most inter-generational inheritors must now empty the inherited account within ten years. This rule has been dubbed the “drain in ten” rule.
Acceleration of distributions is much more likely to force recipients into higher marginal tax brackets and deprives them of the tax-deferred growth they could have realized over many more years. Any funds remaining in the account are subject to heavy penalties, which could reach 50% of the amount not distributed as required.
Another negative consequence of this rule change is that distributions received by the beneficiary are no longer in a tax-deferred account, so any subsequent interest, dividends, or capital gains on those distributions are subject to tax.
For decades, estate planners drafted Trust documents using wording consistent with the now expired Stretch IRA regime. Many of those documents must now be updated. If you or a parent has any such documents, have them reviewed to ensure the language still holds unambiguously.
There are other ways to approach intergenerational tax planning challenges, including naming a Trust as the beneficiary of a retirement account. Due to potential complexities of Trust law, it’s highly advisable to review all these decisions and structures with a competent and specialized attorney and or tax accountant.
Traditional vs. Roth Accounts
It’s commonly assumed that Roth accounts are more advantageous than Traditional IRA accounts. For the most part this is correct. Most people assume this is correct because it’s great to receive money in future without having to pay taxes. But if that was the only consideration, the decision between the two would hinge only on whether you believe marginal tax rates will be higher or lower when you retire. If you believe you’d pay higher marginal tax rates in your retirement years, then the Roth strategy makes more sense because you pay low taxes now and avoid higher ones in future. If you believe marginal tax rates will be lower in retirement, you’d be better off with a Traditional IRA because you’ll avoid higher taxes now and pay lower taxes later. See Bogleheads.org for a derivation proving my point above regarding marginal tax rate comparisons.
The "superiority" of the Roth IRA comes from its flexibility. In particular, Roth IRAs don’t force us to take required minimum distributions, while Traditional IRAs are subject to RMDs, which trigger taxes. Having control over the timing of withdrawals without penalty is very useful. It is also easier to initiate early withdrawals from Roth IRAs by taking your own contributions out since they were made post-tax. Early withdrawal from Traditional IRAs may trigger 10% penalties on top of taxes. It is generally inadvisable to withdraw early from Roth accounts, but the flexibility to do so as needed is useful.
Roth IRAs used to have the additional advantage that you could continue to make contributions at any age, while Traditional IRAs did not allow contributions after age 70.5. But that difference was removed by the SECURE Act which now allows Traditional IRA contributions beyond age 70.5.
We don’t know whether our taxes will be higher or lower in retirement. Forecasting taxes decades into the future is an impossible task and not worth the effort. A further complication is that in addition to uncertainty about future tax rates, we don’t know whether future legislation will tax Roth IRAs or undermine any of the other existing retirement account types. If that happens, existing account holders may be grandfathered under the old rules but there are no guarantees. The only response to these unknowns is a tax diversification strategy of purposely holding both pre-and post-tax accounts in case tax laws change.