A great retirement starts with a great plan, tools, and an understanding of the rules. Overlooking one IRA rule can throw your retirement plan out of whack. I put together this resource to give you everything you need to know about the traditional IRA rules (and probably some stuff you don’t) so your retirement plan goes off without a hitch.
Why A Traditional IRA?
A traditional IRA (Individual Retirement Account) is one of many retirement savings tools available to help you reach your retirement goals. Still, an IRA is just an account. Once you put money in there, you have to do something with it and there are many possible investment options you can use. Ultimately, your retirement plan will decide which invests you use.
The traditional IRA performs two key functions. First, it allows for tax deferred growth of your retirement savings. That means the money inside the IRA is not taxed until you take it out. Second, it allows for all or part of the contributions made to be deducted from taxable income since contributions are made with pretax income. That means money you put into the IRA is tax-deductible if you meet the requirements.
The IRA is just a simple savings tool with very specific rules. Yet, when the rules were laid out, it was done in a way that allowed it to be very versatile. Thanks to these rules, the traditional IRA can fill several roles in your retirement plan.
- It’s a great compliment to any existing employer retirement plan. When you max out your 401k, you can still put money into an IRA.
- When you leave your job, you have several options, rolling your old employer retirement account into a traditional IRA is one of the best. This gives you the most control of your retirement savings.
- If you don’t have a retirement plan through work, the IRA is your only option.
To sum things up for those eligible, you don’t pay taxes on contributions and can use that amount as a tax deduction. Even if you don’t qualify for the tax deduction, you can still contribute every year. More important, any money you do contribute grows tax-free until you take it out.
Let’s find out if you’re eligible.
Table of Content
- Traditional Eligibility
- Contribution Rules
- IRA Rollover
- Withdrawal Rules
- Open an IRA
Traditional IRA Eligibility
You must meet both the age and income requirements to be eligible.
There are no minimum age requirements to contribute to an IRA, but there is a maximum age limit:
- you must be under age 70½
Basically, if you were born sometime between 70½ years ago and today and meet the income requirements, you can contribute to a traditional IRA. Once you reach age 70½, the required minimum distributions kick in, so you can’t contribute anymore.
This is the most misunderstood area for traditional IRAs. Your ability to contribute is entirely dependent on your income. Mainly:
- You must have earned income
- Your earned income must be equal to or greater than your contribution
- There are no maximum earned income restrictions
You qualify as long as you have earned income in a given tax year. There isn’t an upper income limit either, like with a Roth IRA. Rather, your earned income decides your tax deduction eligibility which is covered below. And you can’t put more money into a traditional IRA than your earned in a year.
First, lets focus on what “earned income” is:
- Self Employed Income
- Non Taxable Combat Pay
Notice it doesn’t include investment income (dividends, interest, capital gains), business income, rental income, or income from pensions, annuities, or deferred compensation.
If you meet the age and income requirements you can put money into a traditional IRA, but only up to the contribution limit for any given year.
IRA Contribution Rules
As I touched on earlier, as long as you meet the age and income requirements you can contribute money to a traditional IRA. That said, the IRS sets the limits on the amount you can contribute, what is considered a contribution, and penalties for contributing too much.
First, all contributions must be in cash. That means transferring stocks, bonds, or fund shares don’t count toward your contribution limit. The same goes for transferring or rolling over an existing IRA or 401k into a new account.
Each year, around October, the IRS announces the IRA contribution limits for the next year. They also announce any increase in the limits too. That decision is based on whether the cost-of-living index rises high enough to warrant it.
|Tax Year||Max Contribution
||Max Catch Up Contribution (Age 50+)|
|2016||$5,500||Additional $1,000 ($6,500 total)|
|2015||$5,500||Additional $1,000 ($6,500 total)|
|2014||$5,500||Additional $1,000 ($6,500 total)|
|2013||$5,500||Additional $1,000 ($6,500 total)|
|2012||$5,000||Additional $1,000 ($6,000 total)|
You can only contribute up to the maximum amount allowed each year. For those age 50 and over, there is an added bonus with the catch up contribution. This allows you to contribute an extra $1,000 each year.
Just make sure you make the deadline.
The end of the year might seem like the logical choice for a deadline. That’s not the case with an IRA. Rather, the IRA contribution deadline is the same as when your tax return is due. That’s almost always April 15th. I say almost because every few years, the 15th falls on a weekend or holiday. When that happens, the deadline is pushed back to the next business day.
Basically, by extending the deadline till April, the IRS gives you 15½ months to max out your IRA every year.
|Tax Year||Contribution Deadline
|2016||April 15, 2017|
|2015||April 15, 2016|
|2014||April 15, 2015|
|2013||April 15, 2014|
|2012||April 15, 2013|
Reminder: Make sure to credit the correct tax year when adding money to your IRA.
I guess anyone can be over zealous with their retirement savings. But you don’t want to contribute more than the annual limits. When this happens you want to be proactive. If you don’t, you could be stuck with a 6% federal penalty tax.
There are several ways to deal with excess contributions. Depending your circumstance, a talk with your tax advisor or CPA is the best place to start.
The best way to avoid this is to combine your IRAs into one account. You can easily do this with an IRA rollover or transfer. This makes tracking your contributions easier, since most brokers do that automatically.
IRA Deduction Rules
This is where your income matters. Obviously, the ability to deduct your IRA contributions is a great tax benefit. Whether you qualify for the deduction depends on your modified adjusted gross income (here’s how to find your MAGI) and your filing status for that year.
The traditional IRA deduction limits can be broken down into three areas: the full deduction, the partial deduction, and no deduction. The full deduction is capped at a specific income amount each year. After that, there is a small income range where a partial deduction is phased out until the deduction ends.
Full Deduction Limits
Ultimately, the full deduction limit measures your eligibility for a tax deduction. If you qualify, the deduction amount will be the lesser of the contribution limit for that year or the amount you contributed to the IRA.
For example, say you contributed $2,000 to your IRA in 2013. Even though the contribution limit for 2013 is $5,500, you can only deduct the $2,000.
You can find the full deduction limits in the table below, followed by the partial deduction limits.
|Full Deduction Limits||Single or Head of Household||Married, Filing Jointly||Married, Filing Separately|
|2016||$0 – $61,000||$0 – $98,000||not allowed|
|2015||$0 – $61,000||$0 – $98,000||not allowed|
|2014||$0 – $60,000||$0 – $96,000||not allowed|
|2013||$0 – $59,000||$0 – $95,000||not allowed|
|2012||$0 – $58,000||$0 – $92,000||not allowed|
If you’re MAGI doesn’t fall inside the full deduction limits for any given year, you may still qualify for a partial deduction.
Partial Deduction Phase Out
It takes some math to figure out your partial deduction once you qualify. First, you need to check if you’re MAGI falls inside the partial deduction window.
|Partial Deduction Limits||Single or Head of Household||Married, Filing Jointly||Married, Filing Separately|
|2016||$61,000 – $71,000||$98,000 – $118,000||$0 – $10,000|
|2015||$61,000 – $71,000||$98,000 – $118,000||$0 – $10,000|
|2014||$60,000 – $70,000||$96,000 – $116,000||$0 – $10,000|
|2013||$59,000 – $69,000||$95,000 – $115,000||$0 – $10,000|
|2012||$58,000 – $68,000||$92,000 – $112,000||$0 – $10,000|
There’s two possible outcomes here. If your MAGI is higher than the partial deduction limit, than you’re out of luck and get no deduction. However, if your MAGI falls inside the limits, you’ll need to use the formula below to find the amount of your partial deduction.
How To Calculate the Partial Deduction Phase Out
- Partial Deduction = (max phase out range – magi) x (max deduction/(the phase out range))
For example, in 2013, if you are under 50 and married, filing jointly with a MAGI of $100,000:
- (max phase out range – magi) x (max deduction/(the phase out range))
- ($115,000 – $100,000) x ($5,500/($115,000 – $95,000)
- $15,000 x ($5,500/$20,000)
- $15,000 x 0.275 = $4,125
- Round up to nearest $10
- $4,130 is your deductible amount
If math isn’t your best subject, I took the fun out of it and put together the partial deduction phase out tables to show where your deduction amount falls.
Of course, your deduction can’t be more than your contribution or the contribution limits for any given year. If that’s the case, then you use the lesser of the two numbers. In other words, if you use that example, and your partial deduction comes to $4,130 but you only contributed $2,000 that year. Your deduction is only $2,000.
Even if you can’t deduct your IRA contributions, you have two options:
- First, see if you’re eligible for a Roth IRA, and if not
- Make a non deductible contribution to a Traditional IRA
Non Deductible Contributions
There are two types of traditional IRAs: deductible and non deductible. Both follow all the traditional IRA rules except one allows for tax-deductible contributions the other doesn’t.
When you don’t meet the deduction limits, you can still make contributions to a non deductible traditional IRA. To do so, you’ll need to fill out IRS Form 8606 for non deductible IRA contributions.
These days, it’s uncommon to spend a lifetime with the same employer. Every time you change jobs, you need to decide what to do with your old 401k or 403b. Do you leave it with your old employer? Take it with you? Or roll it into an IRA?
Keeping track of all your old work plans for the rest of your life doesn’t sound fun. The two best 401k rollover options are to roll that money into your new employers 401k plan or roll it into an IRA. Either way, the point is to combine your previous work retirement plans into one account.
Of course, the same can be said for multiple IRA accounts. You don’t need to have a bunch of traditional IRA accounts spread between different banks or brokers. You don’t need to open a new account every year either. Find the best broker for your IRA needs and combine your traditional IRAs into one account. It will be easier to track everything and you’ll probably save money in the long run.
Traditional IRA Withdrawal Rules
The traditional IRA is built to be a savings tool. At some point that money needs to come out. In fact, the traditional IRA rules make that perfectly clear. It’s why you can’t add money past age 70½. That’s when the minimum distribution requirement kicks in. Of course, there are other withdrawal rules to deal with too.
You can officially start taking traditional IRA distributions at age 59½. At that point any withdrawals you make are considered normal, penalty-free withdrawals. Of course, this isn’t required until you hit age 70½. Since your built a solid retirement plan, you should already have an idea of the amount of money you’ll need in retirement and when you’ll need it.
It’s also a good idea to build a solid tax plan based on your retirement needs and the tax rates at that time. Remember, any money you withdraw from a traditional IRA is considered income and taxed at the current tax rates.
Required Minimum Distributions
Once you hit age 70½, the rules state you must make minimum withdrawals each year. These required minimum distributions (RMDs) must start by April 1st of the year after you turn 70½. After that, all RMDs must be made by December 31st of that year.
So, if you turned 70½ in 2013, you’d have to take your first minimum distribution for the 2013 tax year by April 1, 2014 at the very latest. After that, your next RMD for the 2014 tax year must be made by December 31, 2014. For tax purposes and savings, you’re almost always better off taking the first RMD in the same year you turn 70½.
But how much is a minimum distribution? That depends on a number of things and the IRS is very specific about the rules. You can use the IRS’s handy worksheet to find the minimum distribution amount you need to take each year.
Of course, there’s a penalty if don’t take the RMD. The IRS will hit you with a 50% penalty on the amount you should have withdrawn. That’s a hefty fine not worth taking.
Early Withdrawal Penalty
One thing you don’t want to do is take money out of your IRA early. Any money you withdraw before age 59½ is hit with a 10% early withdrawal penalty. On top of that, you’ll have to pay income tax on that amount too.
That said, there are a few exceptions:
- Used for qualifying medical expenses
- Used for health insurance if you’re unemployed
- Used for qualified first time home buyer (up to $10,000)
- Used for qualified higher education expenses
- Make substantially equal periodic payments (SEPP) through the rule 72t distribution
You can find out more about these exceptions here.
Rule 72t Distribution or SEPP
The early retirement route might be part of your retirement plan. If that’s the case, a SEPP or substantially equal periodic payments are one work around to getting your money before age 59½ and avoid the 10% early withdrawal penalty.
There are a number of things to screw up when going this route and running out of money early is just one of them. Before you do anything talk with a financial/tax professional first.
Where To Open An IRA
The best time to start is now. If you qualify for a traditional IRA and it fits with your retirement goals you have several choices. You can open an IRA through most banks, brokers, and even fund companies. Remember cost is a big key to growing your money so choose a no-fee IRA. Here are some of the best account options.