An Individual Retirement Account (IRA) is a great savings tool to prepare for your future and retirement. There are some common misconceptions about who can contribute to an IRA and when you can make distributions from an IRA. I am going to address these questions and hopefully give you a clear understanding of this important retirement tool.
Let’s start with the basic information about an IRA.
- An individual may contribute the lessor of $5,500 or 100% of their includible compensation annually. For the purposes of this blog, we are going to assume an individual is contributing the max of $5,500.
- If you are over the age of 50 during the tax year, you may contribute an additional $1,000 to an IRA bringing the total to $6,500 for the year.
- You must make the contribution by the tax return due date (April 15th) for the previous year.
- An additional $5,500 may be contributed for a non-working spouse if your filing status is Married Filing Joint (MFJ).
- Excessive contributions may be subject to a 6% excise tax.
- You may start taking distribution at age 59 ½ without incurring a penalty.
- You are required to start taking Required Minimum Distributions (RMDs) by April 1st of the year after you turn 70 ½.
Now let’s get into the specific Myths and Facts of an IRA.
My employer offers a 401k plan so I can’t contribute to an IRA.
If your employer offers a 401k plan but you choose not to participate and your employer does not contribute to the plan, you are not considered “covered” by an employer sponsored retirement plan, and you may contribute to an IRA and take a deduction on your 1040.
I work but my spouse stays home; therefore, they cannot contribute to an IRA because they don’t have earned income.
An additional $5,500 can be contributed to an IRA for a non-working spouse. You must file a MFJ return, and the combined contribution for both spouses cannot exceed their total includible compensation (i.e. earned income).
I already contribute to a 401k at work, so I cannot contribute to an IRA as well.
You can always contribute to an IRA, but depending on your marital status and income levels, that contribution may not be deductible on your tax return. (Amount for single taxpayers differs)
- The contribution is fully deductible if you are covered by a plan at work, you file MFJ, and your income is $98,000 or less.
- The phase out for the deduction for an individual who is covered by a plan at work and files MFJ begins with modified Adjusted Gross Income (AGI) from $98,000 to $118,000.
- If your income is over $118,00, then you lose the full deduction.
My wife contributes to a 401k at work but I do not. That means we are both “covered” under an employer sponsored retirement plan since we are married.
An individual is not considered an active plan participant just because their spouse participates at work. The individual who is not covered by a plan can contribute the full $5,500. However, if one spouse does have a 401k at work and the other does not, then the non-covered individual’s deduction can be phased out. (Amount for single taxpayer differs)
- You are filing MFJ and your spouse is not covered at work: you can take a full deduction for your IRA contribution
- You are filing MFJ and your spouse is covered at work:
- If your income is $183,000 or less, then your contribution is fully deductible
- If your income is between $183,000 and $193,000, your deduction is phased out and limited.
- If your income is over $193,000, then you will lose the full deduction on your contribution for the year
I can’t make a distribution of any kind before 59 ½ without paying a 10% penalty.
The IRS does allow for a penalty-free distribution from an IRA for any of the following reasons:
- Distributions used to pay medical expenses in excess of 10% of AGI.
- Example: Your income is $100,000 per year x 10% = $10,000
- Medical expenses total $12,000
- $12,000 – $10,000 = $2,000
- You can make an IRA distribution of $2,000 to cover these medical expenses in excess of 10% over AGI.
- A penalty-free distribution of up to $10,000 may be used for qualified first-time home buying expenses.
- Distributions used to pay for “Qualified Higher Education Expenses” for the individual, or for their lineal relatives are not subject to the 10% penalty tax.
Tax planning plays a vital role in the deductibility of IRA’s. Also, take advantage of the extended amount of time given to contribute to an IRA. This will allow you to run various scenarios with your tax return, especially if you owe the IRS. By contacting a CPA and utilizing some tax planning, you may be able to defer some income.