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Jan 24 2018 37430 1
Traditional IRA Rules and Limits
ByJeff Rose on
With all the concern these days about the Roth IRA, traditional IRAs may be in danger of getting lost. But for many of the same reasons that a Roth IRA is so important, traditional IRAs continue to be valuable.
I admit it – I’m a big fan of the Roth IRA. I think everyone should have one.But there are times when a traditional IRA gets the job done.
It can be the better choice of the two if you’re currently a high tax bracket but expect to be in a much lower one when you retire. The tax savings from the current deduction can easily outweigh a lower level of tax savings in the retirement years.
So let’s give equal time to the traditional IRA. Below is everything you need to know about a traditional IRA, and how to best take advantage of the plan.
Traditional IRA Plan Eligibility
One of the biggest advantages with a traditional IRA is that almost anyone can set one up and contribute to it. The only requirement is that you must have earned income to be eligible. That’s income from salary, wages, self-employment or contract work.
Unfortunately, you can’t make contributions out of unearned income, like investment income, pensions or Social Security.
A traditional IRA is an excellent choice if you have a job and you’re not covered by an employer-sponsored plan at work. You can contribute every year, and deduct it from your income for tax purposes.
One of the biggest advantages with a traditional IRA is that it doesn’t require you to file any additional forms with the IRS. You can just show your deduction on page 1 of your federal 1040.
You can make contributions to a traditional IRA right up until you turn 70 ½. After 70 ½ you’re no longer eligible to contribute, even if you have earned income.
Now if you’re self-employed, there are other plans that will enable you to make much larger contributions. For example, you can contribute up to $55,000 per year ($61,000 if you are 50 or older) to self-employment plans, such as aSolo 401(k)or aSEP IRA. There’s even theSIMPLE IRAthat allows you to contribute up to $12,500 per year ($15,500 if you are 50 or older).
Anyone of these plans would be more appropriate if you’re self-employed. But a traditional IRA can be a good starter plan until that happens.
Traditional IRA Plan Variations
You can even set up a traditional IRA for members of your household. There are two special IRA variations allowing you to do this:
Spousal IRA. You can create an fund an IRA for your spouse, even if he or she isn’t employed outside the household.
Plan contributions must still come from earned income, but it can be your earned income as the source. It’s an excellent way for a non-working spouse to also have a tax-sheltered retirement plan.
For example, let’s say that you make an IRA contribution each year up to the maximum amount allowed – $5,500. You can also make a contribution on behalf of your spouse for up to the same amount. The only requirement is that you have sufficient earned income to fund both contributions. In this case, you could make the maximum contribution for both you and your spouse as long as your earned income is at least $11,000 per year.
Custodial IRAs for minors. Few people are aware of this type of IRA, but it opens the possibility of setting up an account for your minor children. The same rules apply to minors as they do to adults.
They can contribute to an IRA as long as they have earned income. And since so many teenagers have earned income, there are eligible to set up a custodial IRA.
It works similar to any other type of custodial account. It’s set up in the name of the parent or guardian, who owns the account and managed it. But once the minor reaches the age of majority in their state – which is either 18 or 21 – the account reverts to the minor.
Traditional IRA Contribution Limits
The maximum contribution to a traditional IRA for 2018 is $5,500 per year. If you’re age 50 or older, there’s a “catch-up contribution” of $1,000 per year. Your total contribution will be $6,500 per year. These are the limits that also pertain to both the spousal IRA and the custodial IRA for your children.
There’s an important secondary contribution limit that may apply to people who have a very generous employer-sponsored retirement plan, or even multiple plans.
It’s particularly relevant for high income taxpayers, who make larger than average retirement contributions.
The maximum contribution to all retirement plans is$55,000 for 2018, and $61,000 if you are 50 or older.
If you add up your contributions to all retirement plans, the total contributions – including employer matching contributions – cannot exceed $55,000, or $61,000 if you are 50 or older. That includes 401(k), 403(b), 457, TSP, Solo 401(k), and SEP and SIMPLE IRAs. If your contributions to one or more of these plans exceeds the limits, you will not be eligible to contribute to a traditional IRA.
It’s possible that you will be eligible for a partial IRA contribution.
For example, if you are under 50, and you and your employer have contributed a total of $50,000 to other retirement plans, you will still be eligible to contribute up to $5,000 to a traditional IRA. That’s just below the maximum contribution of $5,500.
Tax Deductibility of Traditional IRA Contributions
Contributions to a traditional IRA are tax-deductible if you’re not covered by an employer-sponsored plan.
If you are, they may still be deductible, but it will be determined by your income level. Those income level limits also affect whether or not a spousal IRA will be tax-deductible.
Single or head of household, fully deductible up to $63,000, partially deductible to $73,000, then no deduction permitted.
Married filing jointly or qualifying widower, fully deductible up to $101,000, partially deductible to $121,000, then no deduction permitted.
Married filing separately, partially deductible up to $10,000, then no deduction permitted.
The second set of income limits is also based on MAGI. It applies if YOU are not covered by an employer plan, but your spouse is:
Married filing jointly, fully deductible up to $189,000, phased out up to $199,000, then no deduction permitted.
Married filing separately, partial deduction up to $10,000, then no deduction permitted.
IMPORTANT: Even if you exceed the income limits, you can still make a non-deductible traditional IRA contribution. It just won’t be tax-deductible.
Tax-deferral of Investment Earnings
Hands down, this is the single biggest benefit of an IRA.
Obviously, it’s better if your contributions are also tax-deductible. But even if they aren’t, the tax deferral on investment earnings makes contributing to a traditional IRA worth doing. You get the benefit of accumulating investment income, without having to worry about some of it being reduced by income taxes each year.
That’s no small advantage. If you’re in the 25% tax bracket, a 10% rate of return on investment can be reduced to effectively 7.5% if you invest through a taxable account. A traditional IRA gives you the benefit of the full 10% annual return.
How much of a difference can that make?
Let’s take a simple example. Continuing with the numbers from above, if you invest $10,000 in a taxable account with a net annual return of 7.5%, after 30 years your investment will grow to $87,549.
But if you invest $10,000 in a traditional IRA with the net annual return of 10%, after 30 years your investment will grow to $174,491.
From this simple example, you can see how having the benefit of tax deferral on your investment earnings virtually doubles the value of your account after 30 years. You haven’t done anything extra or special, either. The entire benefit of the increased account value is due solely to tax deferral.
This is why it’s worth contributing to a traditional IRA, even if your contribution isn’t tax-deductible in the year that you make it.
Traditional IRA Investment Options
A traditional IRA is simultaneously the simplest retirement plan to have, but usually provides the largest number of investment options. They’re typically held in self-directed accounts, where you choose not only the trustee who holds the account, but also the investments that you make in it.
You’re also free to manage the account. You can buy investments for the long-term, or be an active trader. It’s completely up to you.
A traditional IRA can be held at just about any financial institution that offers them, and most do. Examples include:
Mutual fund companies
Professionally managed accounts
Peer-to-peer lending platforms
If you choose an investment broker, or even a professionally managed account, you’ll generally have almost unlimited investment options.
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