Stashing money away for your retirement is a wise, even necessary, thing to do. So as you consider saving up for your golden years, you might want to take a look at retirement vehicles that offer tax advantages at the time of your contributions or at retirement.
One of the simplest ways to benefit from tax advantages while saving for retirement or in later years is to contribute to an Individual Retirement Account (IRA). However, there are different kinds of IRAs to choose from, each with different advantages, rules, and limitations.
What differentiates these retirement plans, and which one might be right for you? Let’s dive in and take a closer look.
A traditional IRA allows you to make annual tax-deductible contributions to your IRA account. Instead of paying taxes on the money you contribute now, you defer those tax payments until retirement, at which you point you pay taxes on your withdrawals.
As long as your contributions don’t exceed your annual earned income, the amount you can contribute to your traditional IRA is as follows:
- If you're under the age of 50, you can contribute as much as $5,500 each year.
- If you're 50 or older, you can benefit from the $1,000 IRA “catch-up” rule, which allows you to contribute as much as $6,500 each year.
A feature the traditional IRA shares with the Roth IRA is that you can contribute funds up until the filing deadline, which this year is April 17, 2018 (for the 2017 tax year).
Traditional IRA tax deductions can lower your tax bill, with your contribution being fully deductible if neither you nor your spouse are covered by a workplace retirement plan. If you are covered by a workplace retirement plan, than your contribution may be fully or partially deductible depending on your modified, adjusted gross income. But there are limits: IRA deductions may begin to phase out once your modified adjusted gross income exceeds a certain level. Here’s how the phaseout works:
- If you're a single filer, your phaseout range for tax year 2017 was $62,000–$72,000; for 2018, it's $63,000–$73,000.
- If you're a joint filer, your phaseout range for 2017 was $99,000–$119,000; for 2018, it’s $101,000–$121,000.
Note that there are a few more rules that apply to the phasing out of both your contribution and deductibility. To learn more, you can check out the IRS.gov page on 2017 deduction limits, the TD Ameritrade page on IRA and Roth IRA rules, or contact a tax consultant for more detailed information.
Here’s another important thing to consider: Roth versus traditional IRA. The difference? Traditional IRA contributions are tax deductible; Roth IRA contributions are not.
But here’s the kicker: although there are no Roth IRA tax deductions for the contributions you make now, all your withdrawals and earnings are tax-free once you're in retirement.
So it’s a matter of deciding whether you think it’s best to pay taxes now, at your current tax rate, or later when you're retired. Under current law, your Medicare premium is based on your taxable income. Taking money out of your Roth IRA in retirement would not increase your Medicare premium, whereas distributions from your traditional IRA might increase your premium.
Your contribution limits for a Roth IRA are the same as those for a traditional IRA. But the amount you can contribute will begin to phase out—all the way down to zero—once you reach a certain level of income. Here are the phaseout limits:
- For single filers, contributions for tax year 2017 begin phasing out at $118,000, and are ineligible at $133,00; for tax year 2018, phaseout begins at $120,000, ineligible at $135,000.
- For joint filers, contributions for 2017 begin phasing out at $186,000, ineligible at $196,000; for tax year 2018, phaseout begins at $189,000, ineligible at $199,000.
Another thing to consider: if you’ve made the transition from being employed to self-employed, or if you’ve experienced a significant drop in income, and hence a drop in tax rate, a conversion to a Roth IRA may be an advantageous move.
If you happen to be self-employed, you can use a SIMPLE IRA plan to save up for retirement. These plans are usually used by small businesses with employees, rather than by sole proprietors with no employees. The contribution limits are as follows:
- If you're under age 50, your tax-free contribution limit per year is $12,500.
- If you're age 50 or above, your annual contribution limit goes up to $15,500.
The SIMPLE IRA is an employer retirement plan, meaning that as an “employee,” your contributions are made with pre-tax dollars. But as your own “employer,” you are allowed tax deductions for your contributions into this plan.
The SIMPLE IRA also comes with an additional perk: as your own boss and employee, you can add an additional 3% “employer-matched contribution” on top of your original contribution. So if you’ve maxed out your contribution limit, this is a way to add more. And if you do not have employees, consider a SEP IRS or Solo 401(k), as these plans are usually easier to administer and more flexible than the SIMPLE IRA. There are also plenty of other retirement plans available for self-employed entrepreneurs.
Have you changed jobs this year? If so, and if you had a 401(k) at your former job, you are probably deciding what to do with it. You have several options: you can leave your assets in your employer’s plan, cash it out, roll it into your new employer’s 401(k) plan, or roll it into a personal IRA plan.
Among these options, cashing out your retirement is something you should consider with caution, as you may be subject to taxes on the full amount plus additional penalties if you’re under the age of 59 1/2. Typically, your 401(k) provider will be required to withhold 20% on the taxable amount of your distribution if you get a direct payment. If you later decide to roll over the payment, you will need to make up for that withholding or you will still have taxes and penalties on the withheld amount. Bottom line: A direct rollover of your 401(k) is a much easier option than is taking out your 401(k) and trying to deposit the cash into another tax-qualified account later.
Before the latest tax reform, if you had converted or rolled over any retirement plan into a Roth IRA, you were also able to “undo” it if you found your previous retirement plan to be more favorable (which often had to do with tax liabilities). This is called “recharacterization.” Under the new tax laws, however, recharacterization is no longer allowed.
So if you made a conversion or rollover into a Roth IRA after January 1, 2018, you're stuck with it. But if you made a Roth IRA conversion in 2017, the IRS will allow you this one time to recharacterize it as a traditional IRA contribution as long as you do it by October 15, 2018.
If you withdraw funds from a traditional IRA or 401(k) before the age of 59 1/2, you’ll be subject to a 10% early withdrawal penalty; plus, your funds will be taxed as regular income.
But there are exceptions to the rule. If you withdraw funds early to pay for higher education costs, high medical costs, health insurance costs after a period of unemployment, or if you use the funds to buy your first home, you may be able to sidestep the penalty—but you still have to pay the income tax. There is also a special rule for 401(k) withdrawals. If you're at least age 55 when you stop working for that employer, your withdrawal may still be taxable, but there will be no 10% penalty.
And finally, it’s important to be aware of required minimum distributions, or RMDs. These are steep penalties that you will incur if you fail to make the required withdrawals from your traditional IRA. How steep? Try 50% of the amount you should have withdrawn. These RMDs do not have to begin until you turn 70 1/2, though, and are based on life expectancy.
In fact, this last point is one reason why some investors decide to go with a Roth IRA plan versus a traditional IRA, as Roth IRAs don’t have required minimum distributions.
Want more detailed information about IRAs? The TD Ameritrade IRA Guide offers plenty of useful information to help you decide what’s best for your retirement goals.
TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.
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