The Importance of Proper Retirement Account Funding Strategies by Jeff Boettcher
If you’re someone who may need to rely heavily on Social Security for your future retirement income, you may want to consider alternative saving methods.
Even if you are one of the lucky few, who are eligible for a Pension from your employer and regardless of how much you will receive from Social Security it is almost always advisable to have additional personal savings in place to secure a comfortable retirement. Although Social Security was created as a financial ‘safety-net,’ today’s reality is that most Americans see Social Security as one of their primary retirement vehicles and therefore have a substantial need to grow their own personal savings to fill in the future income “gaps” that are likely to exist.
One way to increase your future financial comfort and possibly take advantage of either tax-deferred or tax-free savings options is to open an Individual Retirement Account (IRA). By having an IRA, you may be able to defer your contributions from taxation. Any taxes owed on the growth that take place within of these types of accounts can also be put off until the future – or you may even be able to withdraw your funds tax-free depending on the type of IRA you choose.
Having a good overall understanding of the different types of IRA accounts that are available can make a big difference when choose the plan that is best for you, as well as when you make your contributions and you begin to make your withdrawals from the account.
Types of IRA Accounts
There are basically three different types of Individual Retirement Accounts. These include the deductible and the non-deductible Traditional IRAs, and the Roth IRA. While there are a number of similarities among these accounts, there are also several key differences, which may deem one or the other as more beneficial for various investors – depending on their situation, investment time frame, and goals.
The Traditional IRA has been in existence since 1974. For many years, this was the only type of IRA that was available. Today, the Traditional IRA can essentially be divided between a deductible and a non-deductible version.
In order to be eligible to contribute to a Traditional deductible IRA account you have to have at least some amount of earned income. If so, there are a number of nice advantages to taking part in this type of account, including:
- Tax deductibility of plan contributions (in full or in part, depending on how much annual income you earn, and whether or not you participate in an employer-sponsored retirement plan);
- Tax deferral of investment earnings.
For the years 2015 and 2016, those who are single tax filers are able to fully fund a deductible Traditional IRA account, provided that their income does not exceed $61,000 per year. If their income is between $61,000 and $71,000 per year, these individuals may partially fund this type of an IRA account. And, if they earn in excess of $71,000, then they will be unable to contribute at all.
If an individual is a married tax filer, and his or her spouse is also a participant in a retirement plan through their employer, then they are eligible to fully fund a deductible Traditional IRA account, provided that their annual income is under $98,000. This type of IRA can be partially funded if their income is between $98,000 and $118,000. However, if their income exceeds, the $118,000 threshold, then the deductible Traditional IRA cannot be funded.
For an individual who is a joint tax filer and whose spouse is not involved in an employer-sponsored retirement plan, a deductible Traditional IRA account can be fully funded if their annual income is below $183,000. This type of IRA can be partially funded if their income is between $183,000 and $194,000, but cannot be funded at all if their income is more than $194,000 per year.
- RMD Requirements^ – Based on the Required Minimum Distribution, or RMD, rules, those who own Traditional IRAs will be required to start withdrawing at least a certain amount from their accounts, beginning the years in which they turn age 70 1/2. If you do not comply with the RMD requirements, you could be penalized
- No Additional Contributions^ – When you turn age 70 1/2, you will also no longer be allowed to make any further contributions into your Traditional IRA account.
In addition, with the deductible version of the Traditional IRA, because your contributions have not yet been taxed, and the earnings inside of the account are tax-deferred, all of the withdrawals will be considered to be taxable income. With that in mind, the actual amount of money that is netted out of each withdrawal will depend upon your tax bracket at the time.
Side Note^: Distributions from your Tax-Deductible IRAs can increase the tax rate you pay on your Social Security Income. Therefore, although IRAs can be a great way of saving for retirement they can also have drawbacks and paying higher tax rates on your Social Security could be one of them.
In 1997, investors were introduced to the Roth IRA. This plan, while it has some similarities to the Traditional IRA account, also has several key differences. First, with the Roth IRA, contributions enter the account after they’ve been taxed. Therefore, there is no tax deduction of deposits.
Another key difference with the Roth IRA is that the funds that are inside of the account grow tax-free^. The money can also, in most cases, be withdrawn on a tax-free basis. This can make a substantial difference in the amount of money that is netted out to the retiree / investor.
Unlike the Traditional IRA, there is also no RMD requirement. Therefore, the account holder will not be required to begin withdrawing funds from the account at age 70 1/2 – or at any age. Nor must they stop making deposits into the account at a certain age.
It is important to note that with a Roth IRA account, there is still a 10% IRS early withdrawal penalty by removing funds from the account prior to reaching age 59 1/2. However, if the funds that are withdrawn are the investor’s initial contributions, there will be no IRS penalty – regardless of the age of the investor as long as the deposits have met certain IRS limitations.
There are also income limits in terms of how much you can actually contribute to a Roth IRA. For example, the table below shows whether your Roth contribution will be impacted by the amount of your modified adjusted gross income:
|If your filing status is:||And your modified AGI is:||You can contribute:|
|Married filing jointly or qualifying widow(er)||< $184,000||Up to the limit|
|Married filing jointly or qualifying widow(er)||>/= $184,000 but < $194,000||A reduced amount|
|Married filing jointly or qualifying widow(er)||>/= $194,000||$0|
|Married filing separately and you lived with your spouse at any time during the year||< $10,000||A reduced amount|
|Married filing separately and you lived with your spouse at any time during the year||>/= $10,000||$0|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year||< $117,000||Up to the limit|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year||>/= $117,000 but < $132,000||A reduced amount|
|Single, head of household, or married filing separately and you did not live with your spouse at any time during the year||>/= $132,000||$0|
In addition, just like with a Traditional IRA account, Roth IRAs have annual maximum contribution limits. In 2016, these are also $5,500 for investors who are age 49 and younger, and an additional $1,000 for those who are age 50 and over.
For those who own both a Traditional and a Roth IRA, this does not mean that they are allowed to contribute these dollar figures into each of the accounts, but rather the total dollar amount – regardless of how the figure is allocated between the two.
Things to Keep in Mind
When considering the investment into an IRA, it’s important to keep in mind that you can make your prior year’s contribution through April 15th of the following year. In other words, if you have not yet made your 2015 IRA deposit, you can still do so through April 15th of 2016. And, by combining your 2015 and 2016 contributions, means that you could essentially put as much as $11,000 ($5,500 for 2015 and $5,500 for 2016) to work if you are age 49 or younger, or up to $13,000 ($6,500 + $6,500) if you are age 50 or over.
Putting all of the pieces of the retirement planning puzzle together can be difficult. That’s why it is important to work with someone who is not only knowledgeable about retirement, but also someone who is well versed in your specific retirement circumstances. For Federal Employees that means someone who has a background in your very complex retirement package and for small business owners it means someone who knows how IRS rules apply, not just IRAs but to other small business related retirement accounts as well. That way, you can be more assured that the options that you choose will work together in moving you towards your ultimate retirement goals.