Understanding retirement accounts and using them the right way can make the difference between having a secure future or just scraping by, after you stop working.
The benefits of using retirement accounts are powerful. You get to skip taxes on either the money you contribute on the front end or on the withdrawals you take out in retirement, depending on whether you use a traditional or a Roth account.
Problem is, these accounts come with a lot of rules that can be confusing, which may be keeping you from using them. No matter if you’re employed, self-employed, or in some cases, unemployed, you can use an IRA to your advantage to accumulate more money and build wealth faster.
In this article, I’ll answer four questions about IRAs to shed light on who’s eligible to use them, how to do rollovers, and tips to retire early.
Free Resource: Retirement Account Comparison Chart (PDF) - a handy one-page download that explains the differences between the main types of retirement accounts.
IRA Question #1
Chris P. says, “I make about $72,000 a year, but if I qualify for a sales bonus I may earn more. I want to open an IRA, but don’t know if I’m eligible based on my income. If not, where should I invest?”
Answer:
Thanks for your question, Chris! Here’s a quick review of the eligibility requirements for traditional and Roth IRAs:
- A traditional IRA is available to anyone with any amount of earned income. You can make contributions to a traditional IRA no matter if you earn $5,000 or $5 million a year. So, Chris can have a traditional IRA if he likes. You contribute to a traditional IRA on a pre-tax basis, which cuts your tax bill in the current year. Then you take withdrawals of contributions and earnings and pay income tax on them in retirement.
- A Roth IRA is only available to those who earn less than an annual income limit. For 2017, you’re allowed to make contributions to a Roth IRA only when your modified adjusted gross income is less than the following thresholds:
o Married filing jointly: $196,000
o Qualifying widow(er): $196,000
o Single: $133,000
o Head of household: $133,000
o Married filing separately and not living together: $133,000
o Married filing separately and living together: $10,000
See also: Which is Best: A Roth or Traditional Retirement Account?
If Chris is a single taxpayer and his 2017 income doesn’t exceed $133,000, he’s qualified for a Roth IRA. But what if Chris has a great year at work and makes a big sales bonus that makes him ineligible for a Roth IRA?
This is a terrific problem that I hope Chris will have! If you contribute too much to a Roth IRA or become ineligible, it’s easy to fix. So, don’t let that concern keep you from making contributions.
Any time you over-contribute to an IRA, contact the administrator of your account as soon as possible to discuss your options. It’s a common situation that custodians are used to dealing with and helping investors resolve.
Any time you over-contribute to an IRA, contact the administrator of your account as soon as possible to discuss your options. It’s a common situation that custodians are used to dealing with and helping investors resolve. If you make a correction before certain deadlines, you may have no penalty or just a small one.
There are typically four ways to correct excess IRA contributions:
1. Recharacterization – involves transferring excess contributions from one IRA to another type of IRA. You could move all or any excess Roth IRA contributions into a traditional IRA, up to the annual limit. This is the best option because you’re still investing money for retirement.
2. Timely removal – allows you to withdraw any excess or unwanted contributions, plus any investment gains or minus any losses. The deadline is Tax Day, plus a 6-month extension, which is generally October 15. You will owe taxes plus a 10% penalty on any earnings generated by your excess contribution, but not on the contribution itself.
3. Late removal – allows you to remove excess contributions after October 15 of the following year. However, you will owe a 6% penalty for every year the excess remains in the account.
4. Carry forward – allows you to offset any excess contributions by subtracting them from your limit for the following year, as long as you qualify to make a contribution. This could correct a situation when you accidentally contribute too much to either a traditional or a Roth IRA. The downside is that you still owe a 6% penalty on excess amounts for every year that an overage isn’t corrected.
For 2017, the most you can contribute to either a traditional IRA, a Roth IRA, or a combination of both is $5,500, or $6,500 if you’re over age 50. You can split contributions into any proportion you like, such as $1,000 in a traditional IRA and $4,500 in a Roth IRA.
Chris didn’t mention if his company offers a 401k retirement plan. If so, that’s the first place he should invest. I love employer plans because they come with multiple benefits.
For instance, contributions are automatically deducted from your paycheck before you ever see the money. In addition, you get high contribution limits, legal protection from creditors, complimentary access to financial advisors, and you may receive free matching funds.
For 2017, you can contribute up to $18,000, or $24,000 if you’re over age 50, to most workplace retirement plans. Make a goal to contribute a minimum of 10% to 15% of your income to a plan at work—such as a 401k, 403b, or 457—before using other types of retirement accounts.
Increase your contribution each year until you max it out. If you do that and still have more money to invest, you can max out both a workplace plan and an IRA in the same year.
However, the tax benefits of using both a workplace plan and an IRA depend which type of IRA you have. To learn more about using multiple retirement accounts, read or listen to podcast episode #492, Can You Contribute to a 401k and an IRA in the Same Year?.
IRA Question #2
Jeff W., says, “If my wife decides to quit a job with a 401k and stay home for a few years after we start a family, what options does she have to continue saving for retirement?”
Answer:
Jeff, I’m glad you’re thinking ahead! IRA rules allow the breadwinner in a marriage to fund an account for a non-working partner in any year you file taxes jointly. It doesn’t matter why one spouse isn’t earning income. He or she could be a stay-at-home parent, unemployed, or even working to get a business off the ground.
IRA rules allow the breadwinner in a marriage to fund an account for a non-working partner in any year you file taxes jointly.
Depending on your income, you can choose to contribute to either a traditional IRA, a Roth IRA, or a combination of both, for you or your spouse. But as I’ve mentioned, if you have a workplace plan, max it out first.
Again, the income threshold to qualify for a Roth IRA in 2017 is $196,000 when you’re married and file a joint return. So, if you earn more, both of you would only be eligible for a traditional IRA.
See also: The Rules for Using a Spousal IRA
IRA Question #3
Molly from Chicago says, “I’m 29 years old, make about $70,000 a year, and have no debt. After listening to your podcast, I’ve saved about $15,000 in a high interest savings account and have been investing in an IRA and the stock market. My job offers a 401k with no matching, so I haven’t enrolled in that plan.
I was born with a chronic heart condition and doctors say that I may live to be 70, but probably not long after that. I have good insurance that allows me to pay for the expensive medical care I need.
Because life is short, I’d love to retire in my 40s or 50s. But I’m stumped on how to save for retirement because I’m concerned about having to pay early withdrawal penalties. Would it be better for me to put more in my savings instead of contributing to a retirement account? I know you have to prepare for the unexpected, but I also want to enjoy what I have while I still can.”
Answer:
Molly, I really appreciate you sending in this question. There are a couple of solutions to avoid early withdrawal penalties from retirement accounts when you’re younger than 59½. First, let’s cover the benefits you get with a Roth IRA.
With a Roth, your contributions are not tax-deductible, which means you make them on an after-tax basis. Because you pay tax upfront on Roth contributions, you’re allowed to withdraw them at any time for any reason. You don’t owe the IRS additional tax or penalties on the amount of your original contributions, if you’ve owned the account for five years.
However, the earnings or investment growth that your contributions create would be subject to a 10% early withdrawal penalty. For instance, if you opened a Roth IRA in 2010 and have contributions that total $30,000 and earnings of $3,000, your account is now worth $33,000.
If you’re younger than 59½, you could tap up to $30,000 from the account with no restrictions, tax liability, or penalties. But you’d owe income tax, plus an additional 10% early withdrawal penalty on $3,000—unless you qualify for an exemption.
To learn more details about the exemptions that apply, read or listen to podcast #494, 4 Penalty-Free Ways to Use a Roth IRA Before Retirement. The beauty of using a Roth IRA is that your money is restricted, but not completely locked away. Of all retirement accounts, a Roth gives you the most spending flexibility.
There’s also a little-known rule you can use to completely avoid the 10% early withdrawal penalty from any type of retirement account if you need or want to tap it early. It goes by a few different names including a 72(t) plan, a 72(t) distribution, substantially equal periodic payments, and a SEPP plan.
The 72(t) rule allows you to set up a plan to take equal monthly or annual distributions from an IRA or a workplace plan, if you no longer work for your employer.
The 72(t) rule allows you to set up a plan to take equal monthly or annual distributions from an IRA or a workplace plan, if you no longer work for your employer. It’s not to be used lightly because it comes with restrictions and financial consequences if you don’t use it the right way.
The amount you can withdraw using a 72(t) plan is calculated using one of three accounting methods approved by the IRS. I won’t go into the details, but some of the factors include your account balance, age, and life expectancy.
Payments you receive from a 72(t) plan that weren’t previous taxed, such as for a traditional IRA or 401k, would be subject to income tax. And once you begin taking these distributions early, you can’t stop taking them for a certain amount of time.
Once you start a series of substantially equal periodic payments, you must continue the withdrawals for a minimum of 5 years or until you reach age 59½, whichever is longer. Then you can take retirement distributions any way you like. Most traditional accounts force you to take annual required minimum distributions once you reach age 70½, whether you used a 72(t) plan or not.
Another rule you must follow once you begin a 72(t) plan is that you can’t make any new contributions or add any rollover funds. The account is basically frozen while a distribution plan is in place.
So, creating a SEPP can be fantastic if you have plenty of money in your retirement account and are ready to tap it before reaching the official age of 59½. It’s a penalty-free way to start spending your retirement funds early on anything you like, such as medical expenses or travel.
If you decide to begin a 72(t) plan, be sure to get help from a tax professional who has experience setting them up. Taking too little, too much, or missing a distribution deadline can trigger expensive income tax and penalties from the original date you made an error.
See also: Investing FAQs: How to Get Higher Returns, Retire Early, and Do Rollovers (Podcast #495)
IRA Question #4
Allison S. says, “I’m a big fan of the show and listen every chance I get. I love the format of your podcast and the topics you cover. My husband contributes 10% of his income to a 401k with matching. He also has an annuity through a trade association and we’re wondering if he can roll it over into either his 401k or a new IRA. What are the rollover rules we should know? Also, can you contribute the maximum amounts to both a traditional IRA and a Roth IRA in the same year, or is it an aggregate limit?”
Answer:
Thanks for your kind words and great questions! Both retirement accounts and annuities can be rolled over into other types of accounts without triggering taxes or penalties—if they have the same tax status. For instance, you can roll over a traditional 401k or a SEP IRA into a traditional IRA because they’re all tax-deferred accounts.
But if you own an annuity outside of an IRA or workplace retirement plan, it can only be rolled over to another qualified annuity using a rule called a 1035 exchange. This allows you to move the money to a different annuity contract without paying taxes or penalties (however, an annuity surrender fee may apply).
So, unless your husband’s annuity is owned inside of a retirement plan, you can’t do a rollover to another retirement plan. Distributions from an annuity or from a retirement plan before age 59½ get taxed as ordinary income, plus an additional 10% early withdrawal penalty.
As I previously mentioned, you’re allowed to split the annual contribution limit between a traditional IRA and a Roth IRA in the same year in any proportion you like. For instance, you could send $3,000 to a traditional IRA and $2,500 to a Roth IRA. But I’d encourage your husband to max out his workplace plan first before investing in other types of retirement accounts.
See also: 7 Pros and Cons of Investing in a 401k at Work
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