Taxes, investing and retirement represent a trifecta of thorny topics for many people, and IRAs combine all three subjects in one package. Naturally, there are many questions about IRAs.
Bankrate queried finance professionals to find out which questions come up most often. It turns out that literally all aspects of IRAs are potentially confusing. Once savers figure out the tax benefits and the rules of contributing, retirement comes along and new rules apply.
Beginner IRA questions
What does an IRA earn? And aren’t IRAs aggressive investments?
An IRA is a type of account. Specifically, it’s a tax-advantaged “wrapper” around cash or securities. CD accounts, money market accounts, savings accounts and brokerage accounts can be IRAs.
“So many people don’t understand. An IRA is just a trust established with certain tax-favored rules. They think the IRA is the actual investment,” says Jim Saulnier, CFP professional, founder of Jim Saulnier & Associates in Fort Collins, Colorado.
“Many times I must explain that an IRA is just an empty vessel, and the return of the account is dependent on what you put into the account,” he says.
It’s easy to see why consumers find it confusing. In their ads, many financial institutions encourage consumers to “invest in an IRA.”
Why open a Roth? There’s no tax deduction.
Want to decrease your taxable income today? Contribute to a traditional IRA and take a deduction for the current tax year. Want to enjoy boundless tax-free growth and compounding? Put already-taxed money into a Roth.
“When you take the money out later — that is where the (Roth offers a) big benefit,” says Mark Steber, chief tax officer at the tax preparation firm Jackson Hewitt.
The Roth has other perks, as well. Contributions can be withdrawn at any time, tax- and penalty-free. To get the earnings out tax- and penalty-free, the account owner must have had the account for five years and be at least age 59 1/2. But even then, there are some exceptions.
Intermediate IRA questions
I have a 401(k), my spouse has a 401(k) and we make deductible contributions. Can I contribute to an IRA?
Many people covered by a workplace retirement account can make deductible contributions to an IRA. But not everyone can; it depends on household income.
“Clients don’t know the rules surrounding tax deductibility of IRA contributions relating to adjusted gross income, or AGI, and participation in a qualified retirement plan,” says Joshua Duvall, CFP professional and financial adviser at Cordasco Financial Network in Philadelphia.
“Depending on the status of the client and their spouse, they may not be able to make tax-deductible contributions to their traditional IRAs, in which case a Roth IRA may be more appropriate,” he says. (Income limits for Roth contributions are substantially higher.)
For instance, in 2015, a single taxpayer covered by a retirement plan at work who earns less than $61,000 can deduct the full IRA contribution. If he earns $71,000 or more? No deduction for him.
To add to the confusion, the income limits are different for a married person whose spouse is covered by a retirement plan. Here’s how the IRS breaks it all down .
I only work part time. Can I contribute to an IRA?
Yes! You can contribute to an IRA even if you’ve officially retired from your full-time career or if you’re a kid working a summer job. As long as you have earned income, you can invest as much as you earn up to the contribution limit.
The contribution limit for 2014 and 2015 is $5,500, plus $1,000 in catch-up contributions for those 50 years old and up.
“In order to contribute, you have to earn it. You can contribute up to age 70 1/2. You can do a Roth after 70 1/2 as long as you have earned income,” says David S. Richmond, president and founder of Richmond Brothers in Jackson, Michigan.
“A lot of times, clients think that any income is earned income. They say, ‘Hey listen, I have $40,000 per year in Social Security and pension; can I contribute?'” he says.
Nope. Only taxable income earned from employment — self or otherwise — counts. Taxable alimony payments or nontaxable combat pay are included.
Advanced IRA questions
Why do I have to take a required minimum distribution?
That answer is simple. “I tell them, ‘Uncle Sam is tired of waiting for his taxes. It’s time to pay the piper,'” Saulnier says.
The IRS mandates that distributions begin by April 1 the year after the IRA owner turns 70 1/2 years old. Every year after the first RMD, the distribution must be taken by Dec. 31.
“It takes three days for trades to settle, so we sell things about a week before actually sending it. So, if somebody calls on Dec. 31 and says, ‘Oh my gosh, I forgot my RMD!’ Well, it’s a little late,” says Heather Banks, CFP professional and wealth adviser at First Bank Wealth Management.
Plan ahead for RMDs, and don’t wait for the last day of the year. The penalty for not taking an RMD on time is 50 percent of the amount you should have taken.
How is the RMD calculated?
“It’s the ending balance of all IRAs on Dec. 31st of the previous year divided by the IRS life expectancy divisor,” Duvall says.
The IRS has tables that provide that information, depending on your circumstances. One is called joint life and last survivor expectancy and another is uniform lifetime.
“Most people use the uniform lifetime table, probably 90 percent,” says Saulnier.
He cautions that IRA owners who rely on their financial institution to calculate the RMD should double-check the table used. IRA owners married to someone more than 10 years younger should use the joint life table, which reduces the amount of the required distribution.
What happens if I don’t take the RMD?
Not to put too fine a point on it, but very bad things happen if you don’t take the required distribution from a traditional IRA.
“(Investors) don’t understand the harsh penalties for failing to complete an RMD. It’s up to 50 percent of the undistributed balance,” says Duvall.
The penalty may be waived if you can convince the IRS that you made a reasonable error and are taking steps to fix it. As with all tax-related issues, doing it right the first time is much easier.