IRAs and Other Retirement Savings Plans
Traditional, Roth, SEP and Individual IRAs
Last month we discussed 401(k) and 403(b) plans you can contribute to as an employee. This month we’ll review some of the other retirement plan options. Even if you’re contributing the maximum allowed to your 401(k) or 403(b) plan, you can also contribute to an individual retirement account. If you’re a business owner, you have even more types of retirement plans to choose from.
Let’s begin by discussing IRAs, which come in three basic varieties: traditional deductible IRAs, traditional nondeductible IRAs and Roth IRAs. In 2008 you can contribute 100 percent of your earnings up to a maximum of $5,000 to an IRA ($6,000 if you’ll turn age 50 by Dec. 31). If you’re married, your nonworking spouse can also contribute the same amount to an IRA as long as total IRA contributions that year don’t exceed the amount of your earned income.
We think it makes sense to contribute to an IRA if your contributions are tax-deductible. But if you don’t qualify for a tax deduction, should you still contribute to an IRA? We’ll answer this question after reviewing the basic rules for each type of IRA.
Traditional Deductible IRA
If you have earned income and aren’t a participant in any other retirement plan, you can deduct IRA contributions in full regardless of your modified adjusted gross income (see footnote No. 1 on page 19).
If you participate in another retirement plan, your deduction is only partially allowed if you’re single and your modified AGI is between $53,000 and $63,000 or if you file a joint tax return and your modified AGI is between $85,000 and $95,000. You cannot deduct IRA contributions if your income is above these levels.
• Planning Tip: If you’re married and file a joint tax return, and your spouse doesn’t participate in a retirement plan, you can make a fully deductible IRA contribution in your spouse’s name based on your own earned income if your modified AGI is less than $159,000. This deduction is phased out if your modified AGI is between $159,000 and $169,000, and no deduction is allowed for the spousal IRA contribution if modified AGI is more than $169,000.
The money in your IRA will grow tax-deferred until it’s withdrawn. You cannot contribute to a traditional IRA for the year in which you reach age 70 1/2 or for any later year. At 70 1/2 you’re required to start taking minimum withdrawals at least annually. If all your IRA contributions have been deductible, all withdrawals will be taxed as ordinary income. If you withdraw money from your IRA before age 59 1/2, you’ll have to pay a 10-percent early withdrawal penalty unless you meet one of several IRS exceptions. See IRS Publication 590 for an explanation of these exceptions.
Traditional Nondeductible IRA
If you work but aren’t eligible to make a deductible IRA contribution because of the income limits previously discussed, you can still contribute the maximum to a nondeductible IRA. All other rules for this type of account are the same as for the deductible IRA except for the taxation of withdrawals. When you take a withdrawal from a nondeductible IRA, a portion of the withdrawal is considered a nontaxable return of your contributions. You’re taxed only on the withdrawal’s earnings portion.
• Planning Tip: If you have both deductible and nondeductible IRAs, the IRS requires you to treat these as one IRA for purposes of determining how your withdrawal is taxed. In other words, if you take a withdrawal only from the nondeductible account to minimize the tax impact, you won’t avoid being taxed. A portion of your withdrawal will still be tax-free, but part of it will be treated as if it came from the deductible IRA. Plan accordingly for the associated income tax liability.
This IRA has the same contribution limits as a traditional IRA, but there are some significant differences. In 2008 you can make the full contribution to a Roth IRA if modified AGI is under $101,000 (if you’re single) or $159,000 (if you’re married and filing a joint tax return), regardless of whether you participate in another retirement plan. Contributions are phased out for modified AGI in excess of these amounts, and they’re not allowed at all when modified AGI exceeds $116,000 for a single person or $169,000 for a couple filing a joint tax return.
Unlike with traditional IRAs, you can contribute to a Roth IRA after age 70 1/2, and there are no required minimum distributions during your lifetime. (The beneficiary who inherits the account will be required to take minimum withdrawals, however.) The money in your Roth IRA will grow tax-deferred, and qualified withdrawals are completely tax-free (see footnote No. 2, page 19). Thus, although you don’t get a tax deduction for your contributions, the Roth IRA offers significant tax benefits.
• Planning Tip: The earnings portion of a nonqualified withdrawal is subject to income taxes and possibly a 10-percent early withdrawal penalty, but you can withdraw your Roth IRA contributions tax-free and penalty-free at any time. We recommend you try to avoid this, since depleting the account prematurely defeats the purpose of contributing to the Roth IRA.
In all three cases, remember that you cannot contribute more than what was earned. In other words, if you want to invest the full $6,000 in each spouse’s name, the working spouse has to earn at least $12,000. Also, the amounts we mention in this article are only for 2008; the maximum contributions to IRA accounts will be periodically increased for inflation.
The Roth IRA is a good choice as long as you can hold the assets in the account at least long enough for your withdrawals to be qualified. It’s an even better choice for those who have a long time horizon (the longer the better) or for those who expect their tax bracket in retirement to be the same or higher than it is now.
The nondeductible IRA is our third choice, overall. We suggest you contribute to this type of account only if you don’t qualify for the deductible or Roth IRA. Besides the lesser tax benefits, the nondeductible IRA also requires more work in terms of tracking contribution amounts and computing the taxable portion of withdrawals.
Now let’s move on to a couple of other types of retirement plans that may be of particular interest to those who are self-employed. These are the SEP-IRA and the individual 401(k) plan.
A Simplified Employee Pension IRA can be established by a self-employed individual or by a partnership or corporation. SEP-IRAs are generally less expensive and less burdensome to administer than qualified plans, such as Keoghs or profit-sharing plans.
In 2008 an incorporated business owner can contribute 25 percent of wage income or $46,000, whichever is less. A self-employed person’s contribution on his or her own behalf is subject to a lower percentage of about 20 percent. (These contribution rates must actually be adjusted downward using an IRS formula, as described in Publication 560.) The employer isn’t obligated to contribute a fixed amount annually and, in fact, can decide on a year-by-year basis whether to make any contribution at all. All contributions are tax-deductible.
Employers contribute on their own behalf as well as for their eligible employees (if any). An eligible employee is one who’s at least 21 years old, has been employed for at least three of the last five years and received compensation of at least $500 from the employer in 2008. (You can set less-restrictive eligibility requirements, if you wish.)
Contributions can be made to a SEP-IRA after age 70 1/2, and distributions are subject to the same rules that govern traditional deductible IRA distributions. It may seem strange, but if you continue to work after age 70 1/2, you’ll have to take taxable withdrawals in the same year you make deductible contributions.
• Planning Tip: Contributions to SEP-IRAs can be made as late as the tax return’s due date, including extensions. In fact, a SEP-IRA account can actually be opened as late as the filing deadline as well, including extensions.
For business owners who have no employees (other than a spouse) and who’d like to contribute a higher amount to a retirement plan, the individual 401(k) will be of interest. This plan can be established by self-employed individuals, incorporated businesses and partnerships.
The overall maximum that can be contributed in 2008 is $46,000; the limit is $51,000 if you’ll be at least 50 years old by year-end. Contributions are figured in two parts. The first is the deferral of up to 100 percent of your earnings or $15,500 in 2008 ($20,500 if age 50 or older), whichever is less. You can also contribute 25 percent of your compensation if you’re incorporated or approxim-ately 20 percent of your net Schedule C income if self-employed. Contributions aren’t mandatory.
The plan assets will grow tax-deferred until withdrawn, and amounts withdrawn are fully taxable. Minimum distributions are required to begin at age 70 1/2. An early withdrawal penalty of 10 percent may apply if the assets are withdrawn before age 59 1/2. Plan loans are allowed, however. You’ll be required to file a Form 5500 with the IRS each year once the plan assets are worth $250,000 or more.
• Planning Tip: Although contributions can be made as late as the due date of the business’s tax return, including extensions, the plan must be established by the last day of the business’s tax year (Dec. 31 if you’re a sole proprietor). Therefore, you have to plan ahead to establish this account before the year-end deadline.
Now let’s put all the pieces together using an example. Assume Roger, age 52, and Katie, age 50, are married and file a joint tax return. Their modified AGI for 2008 is expected to be $115,000. Roger owns a small business that’s unincorporated, and Katie doesn’t currently work. Roger expects his net Schedule C self-employment income to be $75,000, and he doesn’t currently have a retirement plan for the business.
Since neither Roger nor Katie participate in a retirement plan, they could contribute $6,000 on Roger’s behalf and $6,000 on Katie’s behalf to traditional deductible IRAs for total retirement contributions of $12,000 this year. But if they want to save more, as we think they should, he’ll need to establish a retirement plan for his business.
If Roger establishes a SEP-IRA, he could contribute up to $13,940 on his own behalf for 2008. He could also contribute $6,000 to a Roth IRA or to a nondeductible IRA; we recommend the Roth. Further, even though Roger can’t deduct his own IRA contributions, he can contribute $6,000 to a traditional deductible IRA for Katie. Another choice would be to contribute to a Roth IRA on Katie’s behalf. Whichever IRA they choose for Katie, their total retirement savings for 2008 can be as high as $25,940 — equal to about 34 percent of Roger’s earnings.
If Roger establishes an individual 401(k) plan instead of a SEP-IRA, he could contribute up to $34,440 for 2008. In addition, he could contri-bute $6,000 to his own Roth IRA and $6,000 to a deductible IRA in Katie’s name. In this case, retirement savings can be as high as $46,440 — nearly 62 percent of Roger’s income. Whether Roger and Katie will want to contribute at this level depends on their income needs as well as on what other income is available to them. (Notice that the individual 401(k) contribution actually reduces adjusted gross income enough so that Roger would have the option of making either a Roth IRA contribution or a deductible traditional IRA contribution for himself.)
We hope this two-part series of articles has provided you with some valuable ideas for making the most of your retirement savings opportunities. We recommend you consult your financial adviser to determine which retirement plans are most appropriate to your situation.
1 Modified AGI = AGI plus traditional-IRA deduction, student loan interest deduction, foreign earned income exclusion, foreign housing deduction, qualified interest on U.S. savings bonds used for higher education and exclusion of employer-paid adoption expenses.
2 For a withdrawal to be qualified, you must have had the Roth for five years and one of the following must be true: You’re age 59 1/2, you’re buying a home for the first time or you’re disabled, or distributions are paid after the account owner’s death. See IRS Publication 590 for a comprehensive list of exceptions to the early withdrawal penalty.
Alexandra Armstrong is a certified financial planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment advisory firm located at 1850 M St. N.W. in Washington, D.C. Securities are offered through Commonwealth Financial Network, a member of FINRA/ SIPC. Investment advisory services are offered through Armstrong, Fleming & Moore, Inc., an SEC-registered investment adviser not affiliated with Commonwealth Financial Network.
Consult your personal financial adviser before making any decisions.
Ms. Armstrong can’t answer individual questions, but she welcomes suggestions for future article topics.
This material has been provided for general informational purposes and does not constitute either tax or legal advice. Investors should consult a tax or legal professional regarding their individual situation. The fifth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being,
co-authored by Alexandra Armstrong and Mary R. Donahue, is available on Amazon. com, Kindle and Nook.