The Ins and Outs of Traditional IRAs

By Glenn J. Downing, MBA, CFP®

In this blog post I want to go just a little bit beyond the basics of traditional IRAs and how they work. 

What are Traditional IRAs?

An IRA is an individual retirement account by definition, with the emphasis on individual. One IRA means one owner, so there can be no joint titling. In order to contribute to an IRA you must have earned income. That is, income from compensation defined as wages, salaries, tips, alimony, and separate maintenance payments. These are all earned income. Income from capital gains, dividends, and interest is not considered earned income by the IRS – they classify it as investment income.

How Much Can I Invest?

Your contribution limit is $6000 per year (2020). If you’re over 50 an additional $1000 catch up contribution is allowed, so the limit becomes $7000.  Age limits on contributions have been repealed in the 2020 CARES Act, so as long as you have earned income you can contribute.

What’s the Big Deal?

The big deal about traditional IRAs is that you may be able to deduct the money off your federal taxes as you make the contributions. Say you’re in a 24% tax bracket and you make a $6000 IRA contribution. You’ve saved yourself $1440 in federal taxes. Another way to look at it is that the $6000 IRA contribution only cost you $4560. This is a great deal!

This is in contrast to a Roth IRA, which works the opposite tax-wise. You do not deduct contributions on the way in, but when it comes out in retirement – it is all tax-free. Watch Jonathan’s video on Roth IRAs.

Can I Deduct my Contributions?

Perhaps.  Traditional IRA contributions are fully deductible if you were not an active participant in an employer plan. Active participation means that nothing – even one dollar – went into your account during the tax year. Even if the employer made no contributions, but there were forfeitures allocated to your account – you had active participation.

You may also be able to do a spousal IRA. In this case only one spouse works, but the working spouse can fund both IRAs. Both IRA contributions will be deductible if neither has active participation. 

What if I Do Have Active Participation?

What if you are covered under an employer’s plan? In that case you’ve got an income phase-out regarding IRA deductibility. If you’re married filing jointly the phase-out range is from $104,000 to $124,000 (2020) of adjusted gross income – AGI. This means you have full deductibility below $104,000; partial deductibility within the phase-out range of $104,000 to $124,000, and no deductibility at all once AGI exceeds $124,000. The phase-out range for single and head of household is $65,000 to $75,000 (2020) of AGI, and the phase-out range for married filing separately begins at zero and goes up to the first $10,000, so very limited deductibility there.

In the case of a spousal IRA, there is a phase-out for the deductibility of contributions. It’s $196,000 to $206,000 (2020) for married filing jointly, assuming the spouse earning the income is participating in an employer-sponsored retirement plan.

Anyone Can Do a Non-Deductible IRA

What if I'm phased out by income?  Every taxpayer can do a non-deductible IRA as long as he has earned income.  Since withdrawals will be part return of contributions (not taxed) and part earnings (fully taxable), meticulous records must be kept.  In fact, we’d advise you – if you have some IRA contributions that were deductible and some that were not – keep them in two separate accounts.  In that way the tax accounting will be easier.

What Are My Investment Choices?

You can invest Traditional IRAs in financial assets – meaning bank accounts, stocks, bonds, mutual funds, ETFs, UITs, real estate investment trusts, and annuities. Life insurance, works of art and collectibles, real estate, and precious metals are prohibited, with the exception of some gold coins. There is such a thing as a self-directed IRA, which can hold some of these assets, but that is beyond the scope of today’s discussion. The account owner cannot use margin to purchase securities, and most brokerage firms will not allow options trading either.

Please don’t confuse the rules between prohibited investments and prohibited transactions. The latter term describes the self-dealing rules. That too is a topic for another day perhaps, but means this: you cannot personally sell an asset into your IRA, not can you buy it out.

When Do I Get Taxed?

When you withdraw the money down the road you get taxed then as ordinary income. This is as opposed to capital gains. Let me explain. If you bought a stock at $100 and you sold it for $120 you have a $20 capital gain. Capital gains rates are 0%, 15%, or 20% depending on your bracket (2020). For most taxpayers it will be 15%. Ordinary income is taxed at one’s marginal rate. For married filing jointly a $150K income is taxed marginally at 22% (2020). This means the next taxable dollar is taxed at that rate. Any distribution from your IRA will be taxed at that marginal ordinary income rate.

See the trade-off now? The upside is the tax deduction of IRA contributions now and deferral of taxation of all gains within the IRA. The downside is that you’ve exchanged the more favorable capital gains rates for higher ordinary income tax rates at withdrawal time.

Big Warning!

One more big caveat: if you’re withdrawing before age 59 1/2 you have a 10% penalty on the amount withdrawn. Say I am age 50 and I want to get my hands on $10,000 quickly, so I withdraw $10K from my IRA. What are the tax consequences? If I'm in a 24% tax bracket $2400 is the tax bill. Because I’m below the 59 1/2 I’ve also got a 10% penalty to pay. That’s another thousand. I’m only going to net $6600 on a $10,000 withdrawal!

What’s the strategy here for distributions? First, realize that this money shouldn’t be touched until 59 1/2 at a minimum. Then, manage the distributions in a way that doesn’t throw you into the next marginal tax bracket. Required minimum distributions are another issue, which I address here.

Get in touch! 

Are you planning your retirement? Come and see us. This is exactly the type of planning we do for our clients. Feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!