Today, I thought I’d talk a bit about types of IRAs; limitations on contributions, and how you can make contributions.
First and foremost, you need earned income to make an IRA contribution. Wages, salaries, tips, and income from a business you own would all be examples of earned income.
Unfortunately, income from investments, pensions and Social Security cannot be used to contribute to an IRA.
So, if you’ve got earned income, the next step would be to figure out the most appropriate type of IRA – which is going to be dependent on your income and age, but also on your employment situation.
How Employment Affects Your IRA
People who are employed and receiving a W-2 show their earned wages each year. A traditional IRA or Roth IRA works best for these folks, but there are income limitations.
Roth IRA contributions are done after-tax, which means you don’t take a tax deduction when you make a contribution. Typically, Roth IRAs generally make sense for younger investors who are in relatively low tax brackets with higher-earning years ahead of them.
If you file single, your modified adjusted gross income cannot exceed $140,000. If you’re married and filing jointly, your household income cannot exceed $208,000. If it does, you cannot make a Roth contribution.
One of the biggest perks of contributing to a traditional IRA is the ability to take a tax deduction off the amount you contribute, since traditional IRAs are before-tax. If your employer offers a 401(k) retirement plan, the government expects you to take advantage of that plan and do most of your retirement savings within it.
However, you can still open an IRA and contribute to it as well. They just limit your ability to make deductible contributions. In this case, your modified adjusted gross income can’t be more than $76,000 if you’re single or $125,000 if you’re married.
If you don’t have a retirement plan available from your employer there is no income limitation on making deductible contributions to a traditional IRA, unless your spouse is a participant in an employer plan. Then, your household income cannot exceed $208,000.
Those numbers I just quoted you for traditional IRAs—the income limitations in order to make contributions—apply to deductible contributions only. Anyone can make non-deductible contributions to a traditional IRA, regardless of income. However, we often discourage doing so because it creates a bit of a tax-filing nightmare. A traditional IRA is really meant to be pre-tax money. If you add a contribution that cannot be deducted, you are adding after-tax money. You might hear the phrase, “cream-in-the-coffee” in relation to this. That is to say that once you’ve mixed after-tax contributions—the cream—to a pre-tax IRA—the coffee—you can’t separate the two.
All future distributions from now until the IRA has been depleted will contain a taxable portion and a portion that is not. It is your responsibility (or your accountant’s) to keep track of that and note it on future tax returns. It can certainly become time-consuming and might result in a higher tax return preparation bill because of the additional workload.
Before I move on to IRAs for self-employed savers, I should mention that the maximum IRA or Roth contribution cannot exceed $6,000 per year unless you are over 50. If so, you can contribute an additional $1,000 for a total of $7,000. If your earned income is less than the maximum, you can only contribute what you earned.
Also, there are lower limits to those income figures I quoted earlier that begin phasing out your ability to make contributions. For example, a married couple that has access to 401(k)s through their employers can’t make deductible IRA contributions once their income reached $125,000. However, they aren’t permitted to make the maximum contribution if their income exceeds $105,000. Between $105,000 and $125,000, the deductible contribution phases out until it is zero.
Now, for those who are self-employed, you know a traditional IRA or Roth is acceptable for saving. But most self-employed folks want the ability to save more than the $6,000 or $7,000 a year permitted by IRAs. This is where SEP IRAs and SIMPLE Plans come in. SEPs allow for contributions of up to $58,000 per year, or 25% of total compensation, whichever is less. SIMPLEs allow for $13,500 in contributions with an additional $3,000 permitted for people 50 and over.
Small business owners who want to provide a retirement plan for a small group of employees often use SIMPLEs. By doing so, it allows employees to make salary deferrals into the plan similar to how 401(k)s do. The employer can also make contributions by matching employee contributions or as a non-elective deferral. A non-elective deferral is when a business owner decides to contribute to their employees’ SIMPLEs regardless of the employee’s decision to make contributions.
SEP IRAs are used most by self-employed individuals or employers who have only a handful of employees and want the flexibility to contribute based on cash flow. It does not allow for employee salary deferrals, only for employer contributions. Because a business or a self-employed individual utilizes SEPS and SIMPLEs, there aren’t any income limitations on making pre-tax contributions to them.
So, let’s say you’ve decided on the best vehicle for you—be it an IRA, a Roth, a SEP or a SIMPLE—and you’ve determined that you can and will contribute. The final order of business is to make the contribution. All contributions must be done in cash. Some of you may be familiar with IRA distributions in which we pick up shares inside your IRA and move them to your brokerage account without selling them.
The reverse does not work, as all contributions must be in cash. However, the cash can come from anywhere—your bank account, salary deferral from your paycheck if your employer will allow it, or from your brokerage account here.