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The Principles, Perks and Pitfalls of IRAs

Christopher Ricci, CFP®

Financial Advisor, Briggs Advisory Group

May 17, 2017

Whether you’re nearing the end of your career or just entering into the workforce, it’s imperative that you are properly investing your money in your future by saving for retirement. Unfortunately, not all Americans are putting this important principle into practice — only about one-third of workers are saving in 401(k)s or other tax-deferred retirement plans.1

Employers can offer company-sponsored retirement plans to their employees — such as 401(k)s and 403(b)s — and the most efficient and disciplined way for individuals to take advantage of these plans is through automatic payroll deductions throughout the year. Other common benefits of these plans include dollar-cost averaging and taking advantage of employer matching contributions.

However, many companies, like many workers themselves, aren’t investing enough in the future. Research from Fidelity shows that only 14 percent of employers offer retirement plans2. If an individual doesn’t have an employer-sponsored plan available or would like to contribute more than the allowable maximum amount, an individual retirement account (IRA) is often an appropriate place to do so.

Basics of IRAs
An IRA offers an ideal way for an individual to save money for life after work, as the account allows savings to grow on a tax-deferred basis. Anyone with an income can open an IRA, and you can contribute to both a 401(k) and an IRA. Though you may already have a 401(k) or other employer-sponsored retirement plan, it might not be enough to accrue the amount of savings you want or need to support your retirement lifestyle — in fact, according to the estimates of many financial experts, you might require up to 85 percent of your preretirement earnings in retirement.3

Individuals are able to opt for either traditional or ROTH IRAs. Traditional IRAs offer tax deductions for the tax years in which the contributions were made (and you pay taxes on your money only when you make withdrawals during retirement), while Roth IRAs provide individuals opportunities to invest money after taxes and then take the contributions and earnings out during retirement without tax penalties. There are income limits for Roth IRAs, though, so a traditional IRA may be the better fit if your income surpasses those limits. However, keep in mind that there are also limits on the deductibility of IRA contributions, depending on your income and whether or not you and your spouse are covered by retirement plans at work. See the IRA Deduction Limits page on the IRS site for more information.

Making Contributions
Because IRAs are tax-deferred vehicles, investment growth can compound at a higher rate than a nonretirement account. In order to maximize this powerful benefit, it’s wise to contribute as much as you are able to, up to annual government limits. For example, for 2017 contributions, an individual younger than the age of 50 was limited to a contribution of $5,500 or the total of his or her taxable compensation, whichever was less. For an individual 50 or older, he or she was able to contribute an additional $1,000, totaling up to $6,500 for the annual contribution.4

Contributions made to a Roth IRA are also limited by an individual’s income level. See the table below for the amounts you can contribute based on your filing status and your modified annual gross income.

Filing Status

Modified AGI

What You Can Contribute

Married (filing jointly) or qualifying widow(er)

< $186,000

Up to the limit

>  $186,000 but < $196,000

A reduced amount

> $196,000

Zero

Married (filing separately), and you lived with your spouse at any time during the year

< $10,000

A reduced amount

> $10,000

Zero

Single, head of household or married (filing separately), and you did not live with your spouse at any time during the year.

< $118,000

Up to the limit

> $118,000 but < $133,000

A reduced amount

> $133,000

Zero

Source: IRS

In contrast to the Roth IRA, you won’t be paying taxes on the money you put in your traditional IRA until you withdraw that retirement savings from your account, which can also add to the motivation not to touch that money until you reach retirement.

If you decide to withdraw any amount of savings from your traditional IRA prior to reaching the age of 59 1/2, you will be required to pay a penalty fee for taking that money out. The penalty is typically 10 percent, and you will also pay an additional income tax on that distribution, which will be calculated according to your tax bracket. In contrast, because you have already paid taxes on them, your contributions to a Roth IRA are able to be withdrawn at any time without taxes or penalty; however, any gains in the Roth IRA are subject to early withdrawal penalties similar to a traditional IRA.

Six Pitfalls to Avoid

To make sure you’re making the most of your investments, it’s important for you to take necessary actions in order to avoid certain pitfalls — such as those listed below — that could end up being costly in the end.

  • Neglecting to maintain accurate and updated information — Ensure your beneficiary designations are on file and updated. These must be reviewed periodically, especially after major life events.
  • Contributing to a Roth IRA when you don’t qualify — If your income is too high (see table above), making contributions to a Roth IRA is not in your best interest. If you already have a Roth IRA and either get married or have an increase in salary, resulting in a much higher income, you want to make sure you don’t put in more money than allowed into your Roth IRA. Over-contributing will result in a 6-percent excise tax on the over-contribution, so it’s best to keep the Roth IRA account open but increase the contributions you make to your work’s 401(k) (if you have one) or a traditional IRA, instead.
  • Not keeping track of nondeductible IRA contributions — Your nondeductible contribution amounts are treated as your basis. It’s important to track the basis of these contributions (money that you’ve already paid taxes on) so that you don’t end up paying taxes on them again when you withdraw them during retirement. (For a much more comprehensive understanding of nondeductible contributions, speak with your financial advisor.)
  • Not taking required minimum distributions — You must take your first required minimum distribution (RMD) either by Dec. 31 in the year in which you turn age 70 1/2 or by April of the following year. If you defer until April of the following year, you must take two RMDs that year. Failure to take your RMD will result in a tax penalty of 50 percent.
  • Not withholding taxes appropriately from IRA distributions — IRA distributions are treated as additional income for the year and are taxed based on your tax bracket. If you are younger than age 59 1/2 and do not qualify for an exception, the distribution is treated as a premature distribution, and you will pay a 10-percent penalty, in addition to regular income taxes. Failure to report the IRA distribution and pay the full amount of taxes owed will result in additional penalties.
  • Not properly executing 60-day rollovers and trustee-to-trustee transfers — Receiving a check for your IRA balance and depositing it into another IRA within 60 days is considered a 60-day rollover (or an indirect rollover). The rollover distribution is not taxable if it is deposited into the new IRA within 60 days, but you must still report it when you file your taxes. Additionally, only one 60-day rollover is allowed within a 12-month period. If you execute more than one 60-day rollover within a 12-month period, the additional rollover will not be treated as a rollover but will be treated as a taxable distribution. A trustee-to-trustee transfer (or a direct rollover) is an electronic transfer of funds from one IRA custordian to another. The funds never touch the hands of the client. Trustee-to-trustee transfers can be done as often as the client wishes, are not reportable to the IRS and are not required to be reported on your tax return.

Ensuring you are taking the proper measures to save for the retirement you desire is essential throughout your entire career. Your financial advisor can help you decide what type of account and what investments are best for you and your situation, especially when life’s unexpected changes come along.

 

1 Ben Steverman. “Two-Thirds of Americans Aren’t Putting Money in Their 401(k).” Bloomberg, Feb. 21, 2017.
2 Ibid.
3 “What Is an IRA?” Retirement Planning — Learn about IRAs. Fidelity Investments.
4 “Ultimate guide to retirement.” CNNMoney.

 

Chris Ricci, CFP®, is a financial advisor at Briggs Advisory Group, a firm that, since 2002, has provided innovative tax-optimized wealth management solutions through a process of focused execution and service excellence, working together with clients as their single trusted team of advisors. The firm’s value value is rooted in its uniquely designed and experienced team of a CPA, CERTIFIED FINANCIAL PLANNER™ professionals and financial advisors. You can learn more about Briggs Advisory Group at www.briggsadvisory.com.

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Dollar-cost averaging does not assure a profit and does not protect against loss in declining markets.

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