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What is This IRA You Talk Of?

| October 12, 2015
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10.12.2015 Written by: Jim Eutsler, Retirement and Financial Planning, P&G Retirement Planning 

This article explores the components of IRAs - both traditional and Roth.

If you asked the average savings-oriented person what are the top three retirement savings vehicles they think of, I’m willing to bet a 401(k) and an IRA typically make the list.  What I hope to do in this article is provide you with some generalities (and a few specifics) on IRAs and once you have a good feel for that, the next couple of articles will delve into specific IRAs.  For purposes of this tutorial, my IRA universe consists of the two most common – the Traditional IRA and the Roth IRA.

An IRA, or Individual Retirement Account, is a retirement plan that allows individuals to direct income, pre-tax or post-tax depending on the IRA type, up to specific annual limits, towards investments that can grow tax-free or tax-deferred, which may require a distribution later in life. 
Let’s break down some of the components of that definition:

Income: You cannot make regular (non-rollover) IRA contributions unless you or your spouse have qualifying income.  While there are other rules (i.e. age, income limitations, etc.) which may limit the amount you can contribute to an IRA, the idea is that you must earn money to make money.  The ‘or your spouse’ component of that definition is important because if your spouse does not work, or is a stay-at-home parent, they can still open an IRA by using contribution money from the working spouse.

Pre-tax or post-tax – Two options that fall into one of three camps: 
  • A traditional IRA is a pre-tax deduction if your work (or your spouse’s work) offers no retirement plan.  If you/spouse’s work offer a retirement plan, you may still get a pre-tax deduction if your income is below certain thresholds.  
  • A Roth IRA is where post-tax contributions come into play.  With a Roth, you contribute money to the fund using cash that has already been taxed (your net paycheck).  
  • The third camp is contributing to a traditional IRA with post-tax money because you want the tax-deferred growth advantage of a traditional IRA, however, you exceed the income limits allowing for deductibility of the contribution.
Specific Annual Limits – The 2015 contribution limit of an IRA, whether a Roth or a traditional, is $5,500.  If you are age 50 or older, you are allowed an additional $1,000 catch-up contribution.  That number is well below the $18,000 401(k) yearly limit, but hey, it’s still a good chunk of money.
Tax-Free or Tax-Deferred – Tax-free refers to the fact that you use after tax money to fund the IRA and years later, when you take money out, you pay absolutely nothing on the investment gains.  Tax-free is applicable to a Roth IRA only.  Tax-Deferred is where you fund the IRA with pre-tax money and therefore get an immediate tax deduction on the contribution (pending income limitations); however, the full balance of the account is taxable upon distribution.  You are effectively ‘deferring’ any taxes on that contribution (if applicable) and those investment gains and this tax treatment is applied to a traditional IRA.
Distributions Later in Life – These are called Required Minimum Distributions (RMDs) and the idea of ‘later in life’ is rather specific here, and that is age 70 ½.  Technically speaking, you have to take a distribution from a traditional IRA by April 1st of the year following the calendar year in which you reach age 70 ½.  There is a formula driven schedule, based on life expectancy, published by the IRS that one must follow in taking these distributions and the penalties are steep (50% of what is left to meet the RMD) if you do not take your RMD.  Note this is for a traditional IRA only, as Roth IRAs have no required distribution.
As you can see, IRAs have many moving parts.  The IRS spells out exactly how to comply with each nuance and failure to follow those rules can prove costly.
If you want to walk through this together, feel free to reach out to me at jim@hengeholdcapital.comNext up will be ‘IRAs – Who is a Roth?’.

Retirement and financial planning services at the Cincinnati firm Hengehold Capital Management.

Content in this article is not intended to be financial advice. Instead, we think of it as educational, and financial education is important to us.

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