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All Contents © 2019The Kiplinger Washington Editors
By Rachel L. Sheedy, Editor
| Updated October 2014
The traditional IRA is one of the best options in the retirement-savings toolbox. You can open a traditional IRA at a bank or a brokerage, and the universe of investments is wide open to you. But with that freedom comes responsibility. Traditional IRAs have a lot of rules—break one and Uncle Sam will ding you. Follow those rules, however, and you can end up with a sizable nest egg down the road. To make the most of a traditional IRA, here are ten things you must know.
With a traditional IRA, you can turbocharge your nest egg by staving off taxes while you're building your savings. For example, if a 25-year-old opens an IRA and puts in $5,500 a year with an annual return of 6%, he will have a nest egg of $902,262 at age 65. If instead his savings were taxed at an annual rate of 25% over those 40 years, he’d end up with $615,157 at age 65.
You also get a tax break now when you put in deductible contributions. In the future, when you take the money out of the IRA, you pay Uncle Sam at your ordinary income tax rate.
Uncle Sam places an annual cap on contributions to an IRA. For 2014 and 2015, an individual can contribute a maximum of $5,500. People 50 and older by the end of the year can stash away an extra $1,000. If you also invest in a Roth IRA—the traditional IRA's tax-free sister, in which you stash after-tax money in exchange for future tax-free withdrawals—the total amount of money you can contribute to both accounts can’t exceed the annual limit. So if a 40-year-old puts $3,000 into a Roth IRA, he can only stash $2,500 in a traditional IRA. If you put in more than the annual limit, the IRS may sock you with a 6% excessive-contribution penalty.
Your earnings for the year, though, must cover the IRA contribution. So if you only earn $4,000 for the year, that's the maximum you can contribute to an IRA. A tip for parents and grandparents: There is no minimum age for contributing to an IRA. If your child or grandchild earns $2,000 from a summer job, for example, he can put that money into an IRA. Or you can put it in for him; as long as he has earned enough money to cover the contribution, the actual money put in the account can come from you.
Self-employed people and small-business owners, take note: You can open a SEP IRA, which allows you to contribute up to 25% of your income with maximum tax-deferred savings of $52,000 for 2014.
While generally you must have earned income to be able to contribute to a traditional IRA, there is an exception for nonworking spouses. In this case, a working spouse can fund a "spousal IRA" for the nonworking spouse. Say the husband works outside the home, while the wife is at home taking care of the kids. As long as he earns enough income during the year to cover both contributions, he can max out an IRA for himself and his spouse, for a total of up to $11,000 for 2014 (or $13,000 for those 50 and older). To learn more, read IRAs for the Unemployed.
Many tax deadlines fall at the end of the year. But there is an exception for IRAs. You can contribute up to the annual limit by the income tax deadline and still have the contribution count for the previous year. So if you don't contribute to your IRA for 2014, you can still stash up to $5,500 ($6,500 if you’re 50 or older) for 2014 in a traditional IRA by April 15, 2015. And if you want, you can contribute money for 2015 to your IRA at the same time. To learn more, read Fund an IRA, Cut Your Taxes.
What if you have a 401(k) at work? That's no problem. You can max out the contributions to your workplace plan and max out an IRA, too. The catch: You may not be able to deduct all of your IRA contributions. The deduction is phased out for single filers covered by a workplace retirement plan who have modified adjusted gross income between $60,000 and $70,000 in 2014. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $96,000 to $116,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $181,000 and $191,000.
If you don't qualify to deduct IRA contributions, you can still stash money up to the annual limit in a traditional IRA. But be aware that making nondeductible contributions will complicate your life when it comes time to tap your IRA. You can't just remove the after-tax contributions as tax-free withdrawals. Instead, each withdrawal from a traditional IRA is a combination of nondeductible contributions, earnings and any deductible contributions. For example, say you want to withdraw $10,000 from a $300,000 IRA that holds $30,000 in nondeductible contributions. Because those nondeductible contributions make up 10% of your total IRA balance, 10% of your $10,000 withdrawal, or $1,000, will be tax-free. Because that ratio can change, you have to refigure the pro rata calculation each time you make a withdrawal. A better idea: If your income is too high to make deductible contributions to a traditional IRA, but not too high to block contributions to a Roth IRA, fund the Roth. All withdrawals in retirement would be tax free.
When you change jobs or retire, you can choose to roll your 401(k) into a traditional IRA. But be careful: If the company cuts a check payable to you, 20% of the funds will be withheld for taxes. If you were planning to make a tax-free rollover by getting the money into an IRA within 60 days, you will have to make up the amount skimmed off for the IRS. Any portion of the payout not rolled into an IRA within 60 days will be considered a taxable distribution. The best route is a direct rollover from the 401(k) custodian to the IRA custodian. That way the money never reaches your hands, and there's no risk of triggering an accidental tax bill.
If you are moving money from one IRA to another—say, to switch custodians or consolidate accounts—request a direct transfer from one trustee to the other. There is no automatic withholding on an IRA distribution, but there is a once-a-year limit on IRA rollovers. There's no limit on direct transfers. For more IRA pitfalls to avoid, read The IRS Cracks Down on IRA Mistakes.
Although it's ideal to not touch IRA money until retirement, sometimes life gets in the way and you may want to access the money earlier. If you tap the account before you turn 59 1/2, you will have to pay a 10% early-withdrawal penalty, on top of the tax bill. However, if you fit certain exceptions laid out in the section of the tax code known as 72(t), you can avoid that penalty. Exceptions include paying the costs of a first-home purchase or unreimbursed medical expenses.
If you know you will need some of your IRA money to supplement your income before age 59 1/2, you can set up "substantially equal periodic payments" to avoid the penalty. Be certain you will really need the money. Once you start SEPP payments, you must take them for at least five years or until you turn 59 1/2, whichever is longer. Learn more about the complex rules for SEPP payments by reading Tap Your IRA Early Without a Penalty.
All good things must come to an end, and such is the case with the tax deferral of a traditional IRA. When you hit age 70 1/2, you can no longer contribute to a traditional IRA and you must start withdrawing the money. You can delay taking your first required minimum distribution until April 1 of the year following the year you turn 70 1/2. But if you delay, you will have to take your second RMD in the same year. All subsequent RMDs must be taken by December 31. The amount you have to take out is determined by a calculation that factors in your IRA balance and your age; the older you are, the larger the percentage of the balance you'll have to take out. You can figure out your mandatory distribution with our online RMD calculator. But just because you have to take a distribution doesn't mean you have to spend the money; you can conduct an "in kind" transfer of investment shares to a taxable account if you don't want to cash them out.
For more information on RMDs, read our special report.
When you open a traditional IRA, you can name both primary and contingent beneficiaries. Any named beneficiaries will be honored regardless of what a will says. But the rules are different for spousal heirs and nonspousal heirs. Spouses have a lot of leeway; they can remain a beneficiary of the IRA or they can take the account as their own. Spouses who take the IRA as their own don't have to take RMDs until they turn 70 1/2. But spouses who are younger than 59 1/2 and want to tap the account should consider remaining a beneficiary, because the money won't be subject to the 10% early-withdrawal penalty.
Nonspousal heirs of traditional IRAs don't have to worry about the early-withdrawal penalty. They do have to start taking RMDs in the year following the death of the original owner, or they can opt to empty the account within five years of the original owner's death. But nonspousal heirs who follow the IRS's rules get an opportunity to stretch out an inherited IRA over their own life expectancies, which can allow for decades more of tax-deferred growth. To learn more about inherited IRAs and the rules heirs should abide by, read IRA Heirs Beware Mistakes and Maximize an Inherited IRA.