Individual retirement accounts (IRAs)

Individual retirement accounts (IRAs) allow investors to save for their 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 that contributes $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. No contribution can be made if an investor has no reportable earned income. If they make less than the contribution limit, they can only contribute up to that amount. If Jane earns $3,000 from her part-time job throughout the year, she can only contribute a maximum of $3,000 to her 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 (the IRA contribution limit 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 provides an avenue for working spouses to contribute to a non-working spouse’s IRA. For example, assume Jane works and is married to John, who is unemployed. Jane can contribute to John’s IRA, although he has no reportable income. This is referred to as a 'spousal IRA contribution.

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 provides an opportunity for investors that 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 has access to 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 does not have 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.

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.

Roth IRAs

Roth IRAs are a newer retirement account created in the 1990s. Named after Senator William Roth (who proposed these types of accounts), 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).

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, which is a standard rule for retirement plans (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 to take 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 5 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 in the previous chapter that most retirement plans have 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.