Retirement planning is one of the cornerstones for securing your financial future. You have to save money keeping an eye on the future when you would not have a regular, stable income to fall back on. To sail through your golden years comfortably, you need to invest in a retirement plan. The most popular retirement saving plans in the US are the 401(k) retirement plan and the Individual Retirement Account (IRA). Both these plans are tax-advantaged accounts that help you build a substantial retirement corpus for your retirement.
In this article, we will focus on IRAs. There are several kinds of IRAs available to investors that they can invest in such as traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. There are certain rules mandated by the IRS (Internal Revenue Service) that you need to adhere to. These are:
- You cannot withdraw any funds from the IRA until you reach 59.5 years of age. If you do, you will incur a penalty of 10% on the amount withdrawn.
- The IRS stipulates annual contribution limits for an IRA that are updated each year. For 2022, you can contribute a sum of $6,000 to your IRA account. If you are above 50 years of age, you can contribute an additional $1,000 bringing your total contribution to $7,000.
Keeping track of different rules when it comes to IRA contributions can be tricky as you may not have enough time to study and stay on top of changing rules and regulations. Also, you may miss the deadline for making a contribution to your IRA which can affect your savings target. If you wish to understand and know about how to open an IRA account, the different kinds of IRAs, annual contribution limits, tax limitations, and more, reach out to a professional financial advisor who can guide you on the same.
Let us discuss five things you should keep in mind while making IRA contributions:
1. Traditional IRA vs Roth IRA: Which IRA to choose?
The two most popular IRAs that investors go for are a traditional IRA and a Roth IRA. The major difference between the two lies in the timing of their tax advantages. In a traditional IRA, you deduct contributions now and pay taxes on withdrawals later whereas, in a Roth IRA, you pay taxes on contributions now to be able to make tax-free withdrawals later. Another difference between the two lies in withdrawals. If you have opted for a traditional IRA, you have to take out mandatory RMDs (Required Minimum Distributions) when you reach 72 years of age. There is no such compulsion for Roth IRAs.
To make tax-free withdrawals in a Roth IRA, you must complete a 5 year holding period and reach 59.5 years of age, whereas, for a traditional IRA, there is no such holding period that you need to adhere to. You can make penalty-free withdrawals at the age of 59.5. In addition, you need to consider the present tax rates and how high you envision the future tax rates would be when you make withdrawals. This is an important consideration since you can choose a traditional IRA if you think your present tax slab is higher and you venture a comparatively lower tax rate post-retirement. Concurrently, if you deduce that your current tax rates are lower and they may increase in the future, then a Roth IRA would be more suitable as an investment after you retire.
2. Availability of Backdoor Roth IRAs
Backdoor Roth IRAs are not a special kind of IRA; instead, they are Roth IRAs wherein you can hold funds originally contributed to a regular IRA, subsequently held in a Roth IRA after an IRA transfer or conversion. Doing so allows high earners to invest in a Roth IRA legally and circumvent income limits. If you wish to take this route, you first need to make an initial contribution to a non-deductible IRA and then later convert it to a deductible or Roth IRA. This process is termed as a backdoor entry to the Roth IRA or deductible IRA contribution. Keep in mind that if you choose to go for a backdoor Roth IRA, there would be certain tax implications that you need to consider. Moreover, the U.S. Congress is also considering legislation that would reduce the benefits of backdoor Roth IRAs after 2021.
3. Option to roll over your traditional IRA to a Roth IRA
In an IRA rollover, you can convert your traditional IRA to a Roth IRA. First, you have to withdraw funds from your traditional IRA. Once you have received your eligible rollover check, you will have 60 days to transfer those funds into your Roth IRA account. Do note that you need to pay taxes on the transferred money when switching to a Roth IRA since you can contribute only after-tax dollars to a Roth account. Some of the major benefits of rolling over to a Roth IRA are:
- You are not taxed on any earnings accrued in your Roth IRA. They are tax-free.
- You can make tax-free withdrawals as you contribute after-tax dollars when making contributions.
- You do not have to pay mandatory RMDs.
- Lastly, if you expect your future tax rate to be higher than your current rate, it is wise to switch to a Roth IRA.
4. Annual Changes in Contribution Limits
Each year the annual contribution limits are updated by the IRS. For the year 2022, the contribution limits for an IRA are as follows:
- You can contribute a sum of $6,000 to your IRA account. If you are above 50 years of age, you can contribute an additional catch-up contribution of $1,000 bringing your total contribution to $7,000.
Do note that you can hold multiple IRAs but the total contribution sum cannot exceed the stipulated amount specified by the IRS.
5. Availability of a Spousal IRA
You can also open an IRA for your spouse even if they earn little to no income. If you file taxes jointly, you can contribute the maximum annual contribution limit of up to $6,000 in 2022 ($7,000 if you are 50 years of age or older). Say, for example, the wife is earning $99,000 a year, and the husband is not working, she can contribute the maximum contribution to her own IRA but she can also contribute up to the maximum to her husband’s IRA. This will enable you to maximize your tax benefits. One thing to keep in mind here is that you must file taxes as married, filing jointly.
IRAs are an excellent retirement saving instrument wherein you can save and invest money to build a substantial retirement corpus for your golden years. Not only does it offer you future financial security but it can also serve as an effective source of tax saving for you. Regardless of what you choose, make sure that you understand the pros and cons of the different IRAs available to you. Also, before making a decision, it would be wise to reach out to a financial advisor who can help you understand the benefits and drawbacks of IRAs and which one would suit your financial needs and goals better.
If you wish to understand how an IRA can fit into a suitable retirement plan for your financial goals, use the free advisor match service to get connected to a financial advisor that may be able to help. Answer a few questions and the free match tool will help match you with 2-3 vetted advisors suited to meet your specific needs.