Many of the posts on this blog have revolved around the Roth IRA account. With great reason, since it's one of, if not, the best saving tool created for retirement planning. As good as opening a Roth account is, the Traditional IRA still has its place. To explain some of the rules of the Traditional IRA Account, I have solicited the expertise of JoeTaxpayer who authors the self titled blog. Here's what Joe had to say….
For all the talk about 401(k) accounts, and Roth IRA conversions, etc, the traditional IRA (individual retirement arrangement) shouldn’t be overlooked. If you are fortunate to work at a company that offers a match on your 401(k) deposits, don’t walk away from that free money. I would suggest, however that for money beyond the match, an IRA may be the better choice.
1. Contribution Limits for 2010-2011
If you are under the age of 50, the maximum amount of money you are allowed to contribute to a Traditional IRA in 2010 is $5,000 (which is the same level as 2009). You can contribute this amount regardless of whether you are eligible to claim a deduction for using a Traditional IRA. But if you are over the age of 50, the IRS allows an additional contribution, often referred to as a “catch-up contribution,” up to $1,000. So if you already celebrated the big “5-0”, you can contribute a total of $6,000 to a Traditional IRA.
Update: The Traditional IRA Limits have remained at $5,000 and $6,000 for the 2011 tax year.
|Contribution Year||Age 49 and Below||Age 50 and Above (Catch UP)|
2. Traditional IRA Account Phaseout Limits
Now, let’s review the traditional IRA phaseout limits, the income levels at which you are allowed to take the deduction for an IRA. Note these limits kick in only if you have a retirement plan (401(k), 403(b), etc, but not a defined benefit plan) at work, whether or not you actually contribute to it. If you are single, the 2009 phaseout is $55,000-$65,000, for married filing joint, $89,000-$109,000. Below the lower figure in that range, you may deduct the full amount $5,000 if you are under 50, $6000 if you turned 50 in or before 2009. The amount you may deduct decreases linearly until the higher number of that range is reached. If you find you are just beyond these ranges, you’ll qualify to put money you can’t deduct into a Roth, instead of just putting after-tax money into the traditional IRA.
Editor's note: I've included a few charts that will help you with the computations. Please note that in Chart 2 that the limits do increase.
Next, I’ll discuss the potential advantages and disadvantages of using the IRA in favor of the (non-matched) 401(k).
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3. 401k vs. Traditional IRA
The 401(k) can excel in two regards. If you separate from the company at 55 or older, you can take withdrawals penalty-free. Of course, taxes are still due, but no penalty, as with an early IRA withdrawal. The 401(k) also offers the ability to borrow from the account. This can be a mixed blessing, and potentially risky move, but an option nonetheless.
IRA advantages start with low cost and flexibility. The costs within a 401(k) account are often tough to understand and often multi-layered, a potential combination of management fees as well as expenses for the underlying investment. For small plans, fees can easily run above 1.5% and even over 2%. Considering that your goal is to save money pre-tax at one rate and upon withdrawal, pay taxes at a lower rate. This advantage can disappear altogether in a decade with fees approaching 2% per year. With few limitations on what you may invest in within an IRA, you are free to choose from investments with very low expenses, many index based investments offer fees as low as .10%, a fraction of the average 401(k) expense.
A traditional IRA offers a penalty-free, but not tax-free withdrawal of up to $10,000 per person for the first time purchase of a new home. ‘New’ to the IRS just means that you didn’t own your principal residence during the prior two years, not that you never owned a home. You can also use this penalty-free withdrawal to help a child, grandchild, or parent.
A similar penalty-free withdrawal is also allowed for qualified higher education expenses for you, your children or grandchildren. Expenses include tuition, fees, room and board, books and supplies.
There is also an exception for withdrawal made to cover medical expenses exceeding 7.5% of your adjusted gross income.
If you are fortunate enough to be able to retire before age 59-1/2, you have an option called a Section 72(t) withdrawal. You are permitted to take withdrawals from your IRA that follows a “series of substantially equal periodic payments (SOSEPP)”. Once you begin this process, you must continue this exact withdrawal amount for 5 years or until age 59-1/2, whichever comes later. The choices for calculating that periodic payment are minimum distribution, amortization, and annuitization. Further details on this is available at the IRS web site.
4. Beneficiary Check
When opening up an IRA, or if you already have one, be sure to specify your beneficiaries. An IRA that doesn’t not have a designated beneficiary will become part of your estate and regardless of who inherits it, has limited options to continue its tax-deferred status. By specifying a beneficiary, and ideally a contingent beneficiary, your heir(s) can take withdrawals over their remaining lifetimes.
The IRA has been around since 1974 and with good reason, it deserves a place in your finance as the core of your long term retirement planning.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
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Photo by Jason York Photography