An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you’re contributing to a 401(k) or other plan at work, you might also consider investing in an IRA.
Learn the rules for Roth IRAs
Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation in 2023 is at least $6,500, you may be able to contribute the
full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status:
• If your filing status is single or head of household, and your MAGI for 2023 is $138,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $138,000 and less than $153,000, and you can’t contribute to a Roth IRA at all if your MAGI is $153,000 or more.
• If your filing status is married filing jointly or qualifying widow(er), and your MAGI for 2023 is $218,000 or less, you can make a full contribution to your Roth IRA. Your Roth IRA contribution is reduced if your MAGI is more than $218,000 and less than
$228,000, and you can’t contribute to a Roth IRA at all if your MAGI is $228,000 or more.
• If your filing status is married filing separately, your Roth IRA contribution is reduced if your MAGI is less than $10,000, and you can’t contribute to a Roth IRA at all if your MAGI is $10,000 or more.
Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that if you meet certain conditions, your withdrawals from a Roth IRA will be completely income tax free, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement. In addition, one of the following must apply:
• You have reached age 591/2 by the time of the withdrawal
• The withdrawal is made because of disability
• The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit)
• The withdrawal is made by your beneficiary or estate after your death
Qualified distributions will also avoid the 10% early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made. You must aggregate all of your Roth IRAs — other than inherited Roth IRAs — when calculating the tax consequences of a distribution.
Another advantage of the Roth IRA is that there are no required distributions. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution.
Choose the right IRA for you
Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don’t qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA Contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you’re still working (and probably in a higher tax bracket than you’ll be in after you retire). A
financial professional or tax advisor can help you pick the right type of IRA for you.
Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $6,500 for 2023 ($7,500 if you’re age 50 or older).
Know your options for transferring your funds
You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You’ll still avoid taxes and the penalty as long as you complete the rollover within 60 days from the date you receive the funds.
You may also be able to convert funds from a traditional IRA to a Roth IRA. This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.
Note: The IRS has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.