With all of the new changes that have recently gone into effect for IRAs, I thought it would make good sense to go over some of the most important aspects of these accounts. Most all of us have at least one IRA account, and often we have a couple of accounts, including a Roth IRA and the traditional IRA (or “trad” IRA).
The rules for these accounts can become quite complex, especially as we begin drawing funds out of the accounts or considering what will happen with the account at our demise, but we shouldn’t let the complexities keep us from using these accounts. The benefits from using IRAs can be huge – and you should use the rules of the IRAs to your advantage in order to wring every bit of value from the accounts. In this issue, I bring out three of these important factors for your consideration.
I. START EARLY. As with every other facet of financial planning, time is a huge factor in the favor of building up your net worth. I often recommend that parents begin encouraging their children to contribute to an IRA as soon as they begin earning money. Keep in mind the limits to the accounts, though: your contributions are limited to the lesser of $4,000 ($5,000 if you’re over age 50), or your Adjusted Gross Income for the year. In other words, if your teenager had a part-time job that paid her $2,231 over the year, her contribution to her Roth IRA for the year would be limited to $2,231.
II. CHOOSE BETWEEN A ROTH IRA AND A TRADITIONAL IRA FOR ANNUAL CONTRIBUTIONS. This topic alone could cover many pages, but the gist of it is this: if you are able to deduct the IRA from your income and your marginal tax rate is above the minimum, you should first consider contributing to a Trad IRA. This is because of the tax-deductible nature of these accounts. In nearly every other case, it makes more sense to make your annual contributions to a Roth IRA.
There are three very good reasons for choosing the Roth IRA over the non-deductible IRA (or a deductible IRA with a low income):
1. Roth IRA proceeds (when you are eligible to withdraw them, post age 59 ½) are tax free. That’s right, there is no tax on the contributions you put into the account and no tax on the earnings of the account. You paid tax on the contributions when you earned them, so in actuality there is no additional tax on these monies.
2. There is no Required Minimum Distribution (RMD) rule for the Roth IRA. With the Trad IRA, at age 70 ½, you must begin withdrawing funds from the account, whether you need them or not. For some folks, this is probably the biggest benefit of all with the Roth IRA.
3. Funds contributed to your Roth IRA may be withdrawn at any time, for any reason, with no tax or penalty. Note that this only applies to annual contributions, not converted funds, and not the earnings on the funds. But the point is that you have access to your contributions as a sort of “emergency fund of last resort”. While this benefit could work against your long-term goals, it may come in handy at some point in the future.
III. CHOOSE THE RIGHT BENEFICIARY OPTION. By utilizing the beneficiary option as a part of your overall estate plan, you and your heirs can effectively stretch out the benefits of your IRA for significant periods of time. Since taxes are not due on the account’s holdings until they are withdrawn, delaying that even for the longest period of time makes a great deal of sense. There are many complicated nuances to assigning beneficiaries to your IRAs, but in general it makes sense first to consider your spouse as the primary beneficiary.
Your spouse will be able to treat your IRA as their own and use their own life as the determining factor in RMD calculations. In the case where the surviving spouse is significantly younger, this can have a dramatic positive affect.
If you choose instead to direct your IRA proceeds to your children, it often makes the most sense to ensure that each child is designated as the primary, sole beneficiary on a separate IRA. Otherwise, all of the children will be forced to begin RMD during the year in which your oldest heir turns age 70 ½. In addition, make sure that your heirs understand the impact of inheriting an IRA. Without proper knowledge, an unwitting heir might trigger a huge tax and penalty to utilize an IRA on today’s wants, rather than tomorrow’s needs.
IV. PLAN WHICH INVESTMENTS TO HOLD IN YOUR IRA. Given the tax deferred nature of Trad IRAs and the tax-free nature of Roth IRAs, it makes good sense to place specific components of your overall portfolio into these accounts. This is mostly true when you have non-tax-deferred holdings in addition to your IRAs and qualified retirement plans, such as a 401(k) or deferred compensation plan.
Income-generating assets such as bonds or dividend-paying mutual funds should be placed in these deferred accounts, deferring (or avoiding) taxation to a later date. Appreciating assets, like most growth stock funds, should be placed in taxable accounts, since the capital gains taxes are lower than the income tax rates at this time.