The book Become Loaded for Life! describes how to build multiple portfolios for financial freedom and retiring early. In addition to tax deferred retirement accounts like 401(k)s, covered here in a separate post, you can augment your savings strategies by using individual retirement accounts or IRAs. The different types of IRAs are explained below to help you advance your retirement goals.
Traditional Individual Retirement Account
A Traditional IRA is a tax deferred account, having some of the same characteristics of a 401(k) although they provide the account owner with more control over how the funds are invested and are not limited to employer provided options. You can contribute up to $6,000 for 2019 to a Traditional IRA, so the amount that can be invested is lower than a 401(k). There is also a $1,000 catch-up provision for individuals aged 50 or older, bringing the total to $7,000. Traditional IRA accounts also have the same 10% early withdrawal penalty for taking distributions before the age of 59½.
Tax Deductible IRA Contributions
Your Traditional IRA contribution may be tax deductible depending on 1) if your adjusted gross income is below a certain threshold and 2) if you or your spouse is covered by an employer retirement plan like a 401(k). Essentially, as your income increases only some or none of your Traditional IRA contribution will be tax deductible. If your income is above the threshold you may still contribute to a Traditional IRA, but the contribution will not be tax deductible. See the chart below for eligibility.
Traditional IRA example: Eric makes $59,000 in income for the year and he is covered under his employers’ 401(k) plan. Eric is able to contribute $19,000 to his 401(k) plan reducing his taxable income to $40,000. He is also eligible to contribute $6,000 to a Traditional IRA bringing his taxable income down to $34,000. Additional tax deductions, like the standard deduction of $12,000, would help Eric lower his taxable income even further. Remember, a person may have both a 401(k) account and a Traditional IRA in the same year.
Early Withdrawal Options for Traditional IRAs
Traditional IRAs benefit from some of the same waivers as 401(k) accounts described in the post on 401(k) accounts. These include:
The Rule 55 distributions option;
Rule 72(t) Substantially Equal Periodic Payment or SEPP exemption;
The option to pay medical expenses that are greater than 10% of your adjusted gross income for the year. In addition, a person is able to use Traditional IRA funds to pay health insurance premiums for a period in which they are unemployed to be able to continue their health insurance coverage.
If an account owner dies or suffers total and permanent disability the account can be accessed without penalty.
The qualified military reservist called to active duty option;
There are two additional options for accessing Traditional IRA account funds. The first is the ability to access $10,000 for the purchase of first home as a primary residence under section 72(t)(2)(F) and the second is to pay for certain qualified higher education expenses under section 72(t)(2)(E).
Roth Individual Retirement Account (Non-Tax Deferred Account)
A Roth IRA appears similar to a Traditional IRA, but with one key difference, it is not a taxed deferred retirement account. Roth IRA contributions are not tax deductible and your contributions are made with after tax dollars. However, one benefit of a Roth IRA is that future distributions are not taxed. If you invest $50,000 in a Roth IRA over several years and it grows to $150,000 you will not pay any income tax on the money you withdraw at retirement, at least currently. I have some concerns about the future of the tax-free status of Roth IRA accounts that are covered in the book Become Loaded for Life! available on this website.
A Roth IRA allows you to contribute up to $6,000 for 2019 with the additional $1,000 catch up provision for those aged 50 and older. Distributions taken before the age of 59½ are subject to the 10% penalty, but again as shown with the previous exemptions above there are ways to avoid these penalties.
Another benefit of Roth IRAs is that they are not subject to required minimum distributions when you reach the age of 70½. Required minimum distributions are mandatory withdrawals based on a percentage of the total account value, this is a way for the IRS to make sure it can collect some taxes on all that tax deferred money stashed in your 401(k). Roth IRAs do not require withdrawals until after the death of the owner because no tax is owed on the distributions, so you are not forced to withdraw any of the money during your lifetime. If you wish, you could leave it all to your heirs.
Roth IRA Eligibility
Not everyone is eligible to contribute to a Roth IRA; it is designed for people who are not high income earners. If a taxpayer’s adjusted growth income on their federal taxes is above a certain threshold they can't contribute to a Roth IRA, see the chart below.
Another important consideration regarding IRA contributions, either a Traditional IRA or a Roth IRA, is that the contributions don't have to be made by the end of the tax (calendar) year. The contributions may be made until the federal tax filing deadline which usually falls on April 15 of the following year. This provides a little extra time to save and make those contributions for the year.
Backdoor Roth IRA Strategy
As explained above, a person with a higher income may not be eligible to contribute to a Roth IRA. However, there is a way to still contribute to a Roth IRA and we will use Tina as an example. Tina is single with an adjusted gross income of $140,000 per year so she is not eligible for a Roth IRA; but she will take advantage of the backdoor Roth IRA strategy.
First, Tina opens a Traditional IRA account and deposits her contribution. Soon after opening this account and before Tina makes any investments with these funds, she completes the paperwork with her brokerage account company to convert the account to a Roth IRA, this process of converting is frequently called a rollover. Usually if you rollover a Traditional IRA to a Roth IRA you have to pay taxes on any gains you have made in the account. Since Tina rolled over the account right away and has not invested these funds, she does not have any gains, so there are no taxes to be paid. Tina now has a Roth IRA account. It is that simple.
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