In this post, I want to explore IRA accounts as a beginner. It is worth noting that I am not an expert. In fact, this post is where I am solidifying my understanding about them after some research. If I make I mistake, please feel free to let me know in the comments.
Additionally, I am doing my best to showcase the main differences between traditional vs Roth IRAs.
Disclaimers
I’m not a tax advisor or investment advisor. The information in this post is just to share some information so that you are aware of some options and do your own research. I may be wrong in my interpretations of the tax code. On top of that, I am referring to the US tax code specifically.
What Are IRA Accounts?
An IRA is a type of investment account for retirement. IRA stands for Individual Retirement Arrangement, according to IRS wording. I will only talk about the following two main types: traditional IRAs and Roth IRAs.
Contribution Limits
The IRS limits the amount that a person can contribute to his or her IRA accounts. Right now, the limit is set at $6,000 per year ($7,000 if you are 50 years or older).
One important detail to keep in mind is that the contribution limit is across all your IRA accounts. I know someone, definitely not me, who had the misunderstanding that you can contribute $6,000 to a traditional IRA and another $6,000 to a Roth IRA. It turns out that the combined contribution cannot exceed $6,000 (or $7,000) for all of them, as mentioned above.
If you happen to contribute more than what you were supposed to, the IRS imposes a penalty of up to 6% on the excess amount. Here is a quote from their page:
Tax on excess IRA contributions
An excess IRA contribution occurs if you:
* Contribute more than the contribution limit.
* Make a regular IRA contribution for 2019, or earlier, to a traditional IRA at age 70½ or older.
* Make an improper rollover contribution to an IRA.
Excess contributions are taxed at 6% per year for each year the excess amounts remain in the IRA. The tax can’t be more than 6% of the combined value of all your IRAs as of the end of the tax year.
To avoid the 6% tax on excess contributions, you must withdraw:
* the excess contributions from your IRA by the due date of your individual income tax return (including extensions); and
* any income earned on the excess contribution.
As you can see, if you happen to contribute too much, you might be able to avoid the penalty provided you withdraw the excess before the tax deadline.
Read more about contribution limits directly from the IRS here.
Contribution Deadline
Did you know that you can still contribute to your IRA accounts for last year? I recently realized that the IRS allows taxpayers to contribute to their IRA accounts for the prior year up to the tax filing deadline. Furthermore, were you aware that you can contribute to your spouse’s IRA accounts?
That means that even if we are in 2022, you can still contribute to your accounts for 2021 if you have not maxed them out yet.
Traditional IRA
A traditional IRA is similar to a 401(k) in that your contributions are tax-deductible if you meet certain requirements. You can contribute up to $6,000 per year into your traditional IRA (or $7,000 for certain people), but make sure to check the section above on contribution limits.
Since this is a retirement account, the IRS may impose penalties if you withdraw before you reach the age of 591/2.
The IRS puts some restrictions on how much you can deduct in taxes from your contributions. It will depend on whether you (or your spouse) are covered by a retirement plan at work, such as a 401k. Keep in mind that this restriction seems to apply whether or not you actually participate in your employer’s retirement plan. Just the fact that you have the option means the restriction applies to you.
Your deduction limits will be based on your Modified Adjusted Gross Income or MAGI (sometimes it’s written as “modified AGI”).
It is worth noting that you can contribute to a traditional IRA regardless of how high your income is. However, you will only be able to claim tax deductions for your contributions based on where your MAGI falls.
Let’s take a look at the deduction limits based on MAGI.
2021 Deduction Limits
1. People Covered By A Work Plan
Here is a table directly from the IRS website for the year 2021 for people covered by an employer’s plan:
|
If Your Filing Status Is… |
Then You Can Take… | |
|---|---|---|
| single or head of household |
$66,000 or less |
a full deduction up to the amount of your contribution limit. |
|
more than $66,000 but less than $76,000 |
a partial deduction. |
|
|
$76,000 or more |
no deduction. |
|
| married filing jointly or qualifying widow(er) |
$105,000 or less |
a full deduction up to the amount of your contribution limit. |
|
more than $105,000 but less than $125,000 |
a partial deduction. |
|
|
$125,000 or more |
no deduction. |
|
| married filing separately |
less than $10,000 |
a partial deduction. |
|
$10,000 or more |
no deduction. |
|
| If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status. | ||
2. People NOT Covered by a Work Plan
You can find the table below at this link.
|
If Your Filing Status Is… |
Then You Can Take… | |
|---|---|---|
| single, head of household, or qualifying widow(er) |
any amount |
a full deduction up to the amount of your contribution limit. |
| married filing jointly or separately with a spouse who is not covered by a plan at work |
any amount |
a full deduction up to the amount of your contribution limit. |
| married filing jointly with a spouse who is covered by a plan at work |
$198,000 or less |
a full deduction up to the amount of your contribution limit. |
|
more than $198,000 but less than $208,000 |
a partial deduction. |
|
|
$208,000 or more |
no deduction. |
|
| married filing separately with a spouse who is covered by a plan at work |
less than $10,000 |
a partial deduction. |
|
$10,000 or more |
no deduction. |
|
| If you file separately and did not live with your spouse at any time during the year, your IRA deduction is determined under the “Single” filing status. | ||
2022 Deduction Limits
You can check the new deduction limits for 2022 from the IRS itself at this link.
Roth IRA
A Roth IRA is another popular retirement account. However, unlike a traditional IRA, contributions to a Roth are not tax-deductible.
In a Roth IRA, you contribute after-tax money. The benefit you get is that now your money will grow tax-free. You can withdraw all of your contributions and earnings when you are 591/2 years old without paying any tax on those distributions. Even better, those withdrawals won’t be considered income.
Your contributions are limited to $6,000 per year (read the contribution limits section above).
Here is a table with the different income limits to contribute to a Roth IRA for the year 2021.
| If your filing status is… | ||
| married filing jointly or qualifying widow(er) |
< $198,000 |
up to the limit |
|
> $198,000 but < $208,000 |
a reduced amount |
|
|
> $208,000 |
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 |
< $125,000 |
up to the limit |
|
> $125,000 but < $140,000 |
a reduced amount |
|
|
> $140,000 |
zero |
Check here for 2022 contribution limits.
Who Is It For?
This type of account is probably well suited for young people who are not earning too much yet. They can contribute cheap after-tax money since their tax bracket is likely low. If they keep increasing their income, they might not be able to contribute directly anymore.
Withdrawal Rules
Another great characteristic of Roth IRAs is that you can withdraw your contributions tax-free and penalty-free at any time. This is the case because you already paid taxes on that money.
To withdraw your earnings tax and penalty-free however, you will need to wait until your account is at least 5 years old and you are at least 591/2 years old. There are a few exceptions where you can avoid paying taxes on earnings and the 10% penalty. I think this topic is well explained in this post by the Motley Fool.
Additionally, you can convert your traditional IRA into a Roth IRA through something called a “Backdoor Roth conversion”. This move can help you avoid income limitations for contributing directly to a Roth IRA account. However, you will have to pay taxes on the un-taxed portion of the traditional IRA you are converting. Each conversion into a Roth will have its own 5-year wait period until you can withdraw that money penalty-free.
To be honest, there are many complicated rules about withdrawing money from a Roth IRA, so you might want to consult a professional about it.
Spousal IRA
A spousal IRA is technically not a different type of account from the two mentioned above. It is basically a way to fund a Roth or traditional IRA for your spouse when he or she does not earn income or not a lot.
The IRS allows the working spouse to contribute towards the Roth or traditional IRA of the non-working partner. Of course, as is often the case, you have to make sure your total household income qualifies for this.
You can help your spouse grow his/her retirement account when they are not able to. This is especially useful considering that you can only contribute $6000 a year to your IRA accounts. You do not want to miss a chance to max out those accounts if you can (in my personal opinion).
Which Broker To Use?
There are several brokers who offer retirement accounts to their customers. With that said, the ones my wife and I have experience with are Fidelity, Charles Schwab, and Wealthfront.
Previously, I mentioned that my main broker of choice is Robinhood, but it does not offer any retirement accounts. Therefore, it is disqualified from this list.
fidelity
Overall, the one I like the most is Fidelity because it allows me to buy fractional shares of any stocks and ETFs. It is also commission-free so I can maximize my investment.
charles schwab
Charles Schwab has a more modern feel but their fractional share offering is rather limited. You can only buy partial shares of stocks in the S&P 500. If you want to purchase any other company or ETF, you have to buy full shares.
To me, this is annoying since I want to balance my portfolios based on their dollar weight without having to worry about the number of shares that I need to buy. They may be expanding this option in the future, but as of today, the option does not exist. I should point out that Charles Schwab is also a commission-free broker, at least for stock trades.
wealthfront (robo-advisor)
For those of you that don’t want to take the time to invest by yourself, a robo-advisor like Wealthfront might be what you are looking for. Wealthfront is a broker that uses AI to automate your investments based on your risk profile. Your Wealthfront portfolio will be mainly composed of ETFs in a variety of sectors.
One thing I like about Wealthfront is that they do tax-harvesting. That means that before the tax year is over, they will re-balance your portfolio by selling some losing assets so the capital losses can offset some of your gains, hence saving you money come tax season.
Wealthfront charges a 0.25% management fee for the services they provide. At first, it might not seem like much, but keep in mind that each ETF has its own management fee on top of what Wealthfront charges. Just for the record, currently, the management fee for VOO (Vanguard’s S&P 500 ETF) is about 0.03%.
Personally, I prefer to manually control my investments, so Fidelity is perfect for me in that sense.
Final Thoughts
I’m not even close to being an expert in this topic, but nonetheless, I wanted to share some information about IRAs that some readers may not have known about.
To recap:
- You have until this year’s tax return deadline to contribute to IRA accounts for the previous year
- Traditional and Roth IRAs both offer their own tax advantages. Analyze which one is better for you
- You can contribute to your spouse’s IRA accounts (with requirements)
Let me know in the comments if I missed something or something needs to be clarified. And if you have a particular strategy with your retirement accounts or investment in general, I would love to hear it in the comments.