Individual retirement accounts

Individual retirement accounts (IRAs) allow investors to save for retirement outside of employer-sponsored plans. We’ll discuss these two types in this chapter:

• Traditional IRAs
• Roth IRAs

Traditional IRAs

Traditional IRAs are non-qualified retirement plans because they’re not workplace-sponsored, although they function similarly to qualified plans. Like most qualified plans, contributions are deductible against earned income. For example, an investor making $50,000 contributing $4,000 to a traditional IRA is only taxed on $46,000 of earned income. Distributions are typically fully taxable as ordinary income.

Contribution limit

The contribution limit for IRAs in 2024 is the lesser of $7,000 or the amount of earned income during the year. To contribute, investors must have earned income. A contribution cannot be made if an investor has no reportable earned income. For example, a person unemployed throughout the year is ineligible to make an IRA contribution. If they make less than the contribution limit, they can only contribute up to that amount. For example, a person earning $3,000 from a part-time job throughout the year can only contribute a maximum of $3,000 to their IRA.

Investors may make IRA contributions annually up to the contribution limit. Additionally, investors may contribute towards a specific year’s contribution limit until the tax-filing deadline the following year (typically April 15th). For example, an investor can contribute towards 2023’s contribution limit until April 15th, 2024. Contributions made between January 1st, 2024 and April 15th, 2024 must be specifically assigned* to 2023 or 2024.

*Assume an investor makes their first-ever IRA contribution on February 1st, 2024. They must determine if the contribution will count towards 2023’s $6,500 limit or 2024’s $7,000 limit (contribution limits increased by $500 in 2024). In most circumstances, it’s better to contribute to the previous year’s limit until it is reached.

Spousal IRAs

As discussed above, only individuals with earned income may contribute to IRAs. However, the IRS allows working spouses to contribute to a non-working spouse’s IRA. For example, assume Jane works and is married to John, who is unemployed. Although he has no reportable income, Jane can contribute to John’s IRA on his behalf. This is referred to as a 'spousal IRA contribution. Regardless of the name, the accounts are separate - there is no such thing as a joint IRA.

Catch-up provision

Investors age 50 or older are eligible for a “catch-up” provision, which allows an additional contribution of $1,000 per year. It allows investors who missed contributions in their younger years to build their retirement accounts up faster. In 2024, a person age 50 or older may contribute up to $8,000 ($7,000 + $1,000 catch-up).

Deductibility of contributions

Traditional IRA contributions are not always deductible. Three potential situations determine the tax status of a contribution:

Investor is not covered by a qualified workplace plan

• Contributions are always deductible

Investor is covered by a qualified workplace plan and low income

• Contributions are always deductible

Investor is covered by a qualified workplace plan and high income

• Contributions are partially deductible or not deductible

Covered by a qualified workplace plan means the investor can access a qualified retirement plan through their work. For example, an investor working at a corporation that can contribute to a 401(k) is covered by a qualified plan.

As you can see, if an investor has no access to a qualified workplace plan like a 401(k), they can always deduct their contributions. If they have access to a qualified workplace plan, the tax status of their deduction depends on their income level. The higher the income, the less likely the customer can deduct their contributions. You won’t need to know specific numbers, but you may encounter test questions on the general concept.

Sidenote

Traditional IRA phaseouts

Sometimes it’s helpful to be exposed to the actual numbers to build context for what test writers consider low & high income. Although there are more than just two tax statuses, we’ll only discuss the numbers for those filing single and married filing jointly. Again, you do not need to memorize the numbers below.

Taxpayers filing single (2024)

Income	Result
< $77,000	Full deduction
$77,000 - $87,000	Phaseout range
> $87,000	No deduction

Investors filing single can make a fully tax-deductible contribution if making less than $77,000 annually. A phaseout begins between $77,000 and $87,000, which means the investor may only deduct part of their contribution. Above $87,000, none of their contributions are tax-deductible.

Married taxpayers filing jointly (2024)

Income	Result
< $123,000	Full deduction
$123,000 - $143,000	Phaseout range
> $143,000	No deduction

Investors filing jointly can make a fully tax-deductible contribution if making less than $123,000 annually. A phaseout begins between $123,000 and $143,000, which means the investor may only deduct part of their contribution. Above $143,000, contributions are not tax-deductible.

Investors making non-deductible contributions to a traditional IRA are only taxed on the growth when a distribution (withdrawal) is taken. The basis (amount contributed) returns to the investor tax-free upon withdrawal.

When retiring or quitting a job with a qualified plan, many investors roll their retirement plan assets into IRAs. When money is rolled from one retirement plan to another, it is not a tax-reportable event (no taxes due). Moving retirement assets to an IRA allows the investor to keep their assets tax-sheltered and provides additional investment options. Most qualified plans place limitations on the types of investments they allow. IRAs are only prohibited from short sales, margin, and some option strategies*.

*In particular, an investor cannot sell uncovered (naked) options due to the significant risk involved.

Roth IRAs

Roth IRAs are a newer retirement account created in the 1990s. Named after Senator William Roth, this type of IRA provides a “reverse” tax status when compared to typical retirement plans.

Contributions

Contributions are made after-tax, which means they are not deductible. Roth IRA assets grow tax-sheltered and can be withdrawn in retirement tax-free if meeting specific requirements.

Although contributions are not deductible, there are contribution limits. The same traditional IRA contribution limit of $7,000 per year applies to Roth IRAs. Also, the contribution limit is for both IRA types combined. If an investor contributes $3,000 to their traditional IRA, they may only contribute $4,000 to their Roth IRA. If the account owner was age 50 or older, they could contribute an additional $1,000.

Not all investors are eligible to contribute to Roth IRAs. In particular, investors with high incomes cannot contribute. You won’t need to know the specific numbers for the exam, but we’ll disclose them below (if you’re curious).

Sidenote

Roth IRA phaseouts

These are the phaseout limits for being eligible to contribute to a Roth IRA:

Taxpayers filing single (2024)

Income	Result
< $146,000	Full contribution
$146,000 - $161,000	Phaseout range
> $161,000	No contribution

Investors filing single can make a full Roth contribution if earning less than $146,000 annually. A phaseout begins between $146,000 and $161,000, which means the investor may only make a partial contribution (of the $7,000 limit, or $8,000 if age 50 or above). Above $161,000, no Roth contributions may be made.

Married taxpayers filing jointly (2024)

Income	Result
< $230,000	Full contribution
$230,000 - $240,000	Phaseout range
> $240,000	No contribution

Investors filing jointly can make a full Roth contribution if earning less than $230,000 annually. A phaseout begins between $230,000 and $240,000, which means the investor may only make a partial contribution (of the $7,000 limit, or $8,000 if age 50 or above). Above $240,000, no Roth contributions may be made.

Distributions

Roth IRA owners taking distributions must meet two requirements to avoid taxes. First, the account owner must be at least 59 ½ years old, a standard retirement plan rule (otherwise, a 10% early withdrawal penalty is assessed). Second, the account must be open for at least five years. An investor opening their first Roth IRA at age 60 must wait until age 65 for tax-free withdrawals. The five year aging period* for Roth IRAs starts on the day of the first contribution.

*Investors taking distributions above age 59 1/2 but haven’t reached the five year aging period are subject to ordinary income taxes on the gains above basis, but not the 10% penalty. For example, assume a 60 year old opens their first Roth IRA and contributes $5,000. Two years later the account is worth $8,000, and the investor requests a full withdrawal. They will pay ordinary income taxes on the $3,000 of growth, but no additional 10% penalty.

We learned earlier that most retirement plans are subject to required minimum distributions (RMDs) when the account owner turns 73. Roth IRAs are not subject to RMDs. Taxes are not assessed when distributions occur; therefore, the IRS isn’t concerned about forcing investors to take distributions.

Sidenote

Roth 401(k)s

Similar to Roth IRAs, Roth 401(k)s offer many of the same tax benefits. Contributions are after-tax (non-deductible), the assets grow on a tax-sheltered basis, distributions are tax-free in retirement if meeting specific requirements, and RMDs are not required. The same rules apply for qualified withdrawals - the investor must be 59 1/2, and the account must pass the five year aging requirement. Unlike Roth IRAs, Roth 401(k)s are qualified workplace plans that are governed by the Employee Retirement Income Security Act (ERISA).

Sidenote

Divorce & retirement plans

Divorce is a fairly common event, with roughly 50% of all marriages ending in separation in the United States. One of divorcing couples’ biggest challenges is splitting their jointly owned assets, and retirement plans are considered in these proceedings. In this sidenote, we’ll cover the general process of splitting up retirement plans due to divorce.

Qualified plans are split up through qualified domestic relations orders (QDRO). If the two parties agree on the amount to be split (e.g., two former spouses agree to split both their 401(k) plans 50/50), the agreement is made in divorce court and the presiding judge signs off the QDRO. If there is no agreement in place, the proceedings in divorce court will determine how the retirement plan(s) will be split (and then signed off by the judge). Regardless of any agreement or disagreement, the QDRO must comply with ERISA.

Non-qualified plans like traditional and Roth IRAs are divided through transfer incident to divorce orders. This process is very similar to the QDRO process, but the order is not required to comply with ERISA.

When a retirement plan is split, a distribution occurs. Good news for the parties involved - the IRS does not tax the distribution. The original account owner is not assessed any taxes (ordinary income or penalties), and the new owner (former spouse receiving the assets) is not taxed as long as the funds are rolled over into a similar retirement plan. For example, Former Spouse 1 distributes 50% of their 403(b) to Former Spouse 2, who deposits the funds into their traditional IRA.

If the receiving former spouse does not deposit funds into a similar retirement plan (e.g. transferring funds from a pre-tax 403(b) to an after-tax Roth IRA) or simply takes the distribution in cash, they will pay ordinary income taxes on the amount received. For example, Former Spouse 1 distributes retirement assets to Former Spouse 2, who places the funds into their (non-retirement) checking account. Additionally, Former Spouse 2 may be subject to the 10% early withdrawal penalty if below age 59 1/2. The penalty would apply if the distribution was made by order through a transfer incident to divorce. If it were QDRO instead, no early withdrawal penalty would apply.

Inherited IRAs

Many Americans die (hopefully at an old age) with balances in their IRAs. When this occurs, beneficiaries (those who inherit these accounts) must follow specific distribution protocols. Unfortunately, the Internal Revenue Service (IRS) does not allow assets to remain in tax-sheltered accounts forever.

Distribution rules are divided into two different categories depending on the beneficiary:

• Spousal beneficiary
• Non-spouse beneficiary

Spousal beneficiary

There are many benefits to being married. One is the added flexibility when inheriting IRA assets from a spouse. This type of beneficiary has these options:

Claim the IRA as their own
This option allows the spousal beneficiary to roll the inherited assets into their own IRA. If the spousal beneficiary is below age 73, they are not required to take distributions. However, they may face the 10% early withdrawal penalty if they take a distribution before age 59 1/2.

Claim the assets into an inherited IRA
If the spousal beneficiary is below the age 59 1/2 and plans to take a distribution, claiming the assets into an inherited IRA is likely their best choice. The only downside is that inherited IRAs require distributions to take place. In particular, the spousal beneficiary can elect to take annual RMDs or distribute all assets within 10 years.

Non-spouse beneficiary

There are two types of non-spouse beneficiaries - eligible designated beneficiaries and designated beneficiaries. An eligible designated beneficiary is a minor child of the decedent (deceased IRA owner), a permanently disabled person, a chronically ill person, or a person not more than 10 years younger than the decedent. A designated beneficiary is anyone not meeting one of the previously mentioned attributes. This is the primary option for non-spousal beneficiaries, although distribution methods may vary depending on the type of beneficiary:

Claim the assets into an inherited IRA
This option is the same as we discussed above for spousal beneficiaries. Distributions are not subject to the 10% early withdrawal penalty, but distributions are required. Eligible designated beneficiaries can elect to take annual RMDs over their lifetime. Otherwise, either type of non-spouse beneficiary can elect to distribute all assets within 10 years.

Key points

Traditional IRAs

• Potentially deductible contributions
• 100% taxable distributions

Traditional IRA contributions

• 2024 contribution limit is lesser of:
  • $7,000
  • Annual earned income
• Age 50+ can contribute $1,000 more
• Spousal IRA allows non-working spouse contribution

Deductible traditional IRA contributions

• Always allowed if not covered by a qualified plan
• If covered by a qualified plan:
  • Deductible if low-mid income
  • Non-deductible if high income

Roth IRAs

• Non-deductible contributions
• 100% tax-free distributions if:
  • Age 59 1/2 or older
  • Roth IRA is aged 5 years

Roth IRA contributions

• 2024 contribution limit is lesser of:
  • $7,000
  • Annual earned income
• Contribution limits apply to both Roth and traditional IRAs combined
• Cannot contribute if high income

Roth 401(k)s

• Qualified workplace plan
• Similar tax structure to a Roth IRA

Qualified domestic relations order (QDRO)

• Orders qualified retirement assets to be split
• Typically utilized during divorce proceedings
• Distribution not taxable
• Receipt of funds may be taxable
  • Not taxable if placed into a similar retirement plan
  • Taxable as ordinary income if not placed into a similar retirement plan
  • No early withdrawal penalty

Transfer incident to divorce

• Orders non-qualified retirement assets to be split
• Utilized during divorce proceedings
• Distribution not taxable
• Receipt of funds may be taxable
  • Not taxable if placed into a similar retirement plan
  • Taxable as ordinary income if not placed into a similar retirement plan
  • Early withdrawal penalty applies if receiver below age 59 1/2

Spousal IRA beneficiary choices

• Claim IRA as their own
• Claim assets into inherited IRA, and
  • Take RMDs annually, or
  • Distribute all assets within 10 years

Non-spouse eligible designated beneficiary choices

• Claim assets into inherited IRA, and
  • Take RMDs annually, or
  • Distribute all assets within 10 years

Non-spouse designated beneficiary choices

• Claim assets into inherited IRA, and
  • Distribute all assets within 10 years