Responding to a series of high-profile pension collapses, Congress in 1974 enacted the ERISA act to provide some safeguards for retirees. One important component was the creation of the IRA account, encouraging workers to set aside additional retirement funds on their own. Contributions were limited to $1,500 per year and only permissible for those not covered at work.
Since then, the rules have changed more often than costumes at a Lady Gaga concert.
Today, IRA accounts come in two flavors: traditional and Roth. The main difference lies in the tax treatment of contributions and withdrawals. Generally speaking, traditional IRAs consist overwhelmingly of pre-tax contributions which grow tax-deferred and are taxed as income at the time of withdrawal. Roth accounts, introduced in 1997, are funded with after-tax money but incur no taxes at distribution.
The traditional IRA account is the workhorse of personal retirement investment, holding over $4 trillion in assets. In addition to providing a vehicle for individual contributions, this type of account also serves as the vessel into which assets of company retirement plans are rolled upon termination of employment. Yet surprisingly few people contribute additional funds; according to the Employee Benefit Research Institute, only 6 percent of holders added to their accounts in 2013.
For 2014, anyone with earned income may contribute up to $5,500, and workers over 50 may salt away $6,500. These contributions are fully tax deductible if neither you nor your spouse has access to a company retirement plan. If your spouse’s employer has a plan but you do not, your deduction phases out above a joint income of $181,000. This should be your first stop if your company provides no options.
Whether your account holds annual contributions or a rollover from a company plan, certain rules apply regarding taking the funds out. You must attain the age of 59 ½ to avoid a penalty of 10 percent for early withdrawal, and distribution of any capital or earnings not previously taxed will be included in your taxable income for the current tax year. But remember that the tax shelter allows the balance to grow larger each year than would otherwise be the case after making obeisance to the IRS.
Traditional IRAs also require that you begin the process of cashing in during the year you turn 70 ½ (legislators inexplicably love half years). From that time you must apply an actuarial formula to determine a minimum required distribution that would theoretically deplete your account over your remaining lifetime (your bank or broker will help you make the calculation).
Contrariwise, Roth accounts allow only after-tax contributions (with the same limits as traditional IRAs, subject to a joint income limit of $181,000). The beauty of the Roth account is that earnings and contributions may be withdrawn totally tax-free (after meeting certain holding requirements and attaining age 59 ½). Furthermore, there are no mandatory withdrawals, and you may pass them along to beneficiaries tax-free. This is the place to turn if you cannot deduct your payments but still want to save more for retirement. And even if your income exceeds the threshold, you can still make non-deductible IRA contributions and then convert them into your Roth account.
Next week, we discuss common mistakes made by IRA account holders and how to avoid them.
Christopher A. Hopkins, CFA, is a vice president of Barnett and Co. Advisors.