Saving for the future, especially when just starting out on your own, may seem easier in theory than in practice. However, the government wants to help. It has created tax-advantaged individual retirement accounts that make saving more rewarding by postponing taxes on the growth of your money. You even get a tax deduction for the pre-tax money you contribute to traditional IRAs, subject to limits. Roth IRAs accept after-tax contributions, that is, money on which you’ve already paid taxes. Under certain circumstances, you can contribute post-tax dollars to a pre-tax traditional IRA. Doing so has implications when you start withdrawing from your IRA account.
Traditional IRA Contributions
A traditional IRA accepts pre-tax contributions, which means you normally do not pay income tax on the money you contribute each year, up to the annual maximum contribution. As of 2018, the limit on your IRA contribution is the lesser of your gross income and $5,500 (or $6,500 if you’ve reached the age of 50). If you are married and file jointly, you and your spouse can make separate contributions to each of your own IRAs based on your joint income. Your pre-tax contributions are excluded from your taxable income and you also may be eligible for a saver’s tax credit using IRS Form 8880, Credit for Qualified Retirement Savings Contributions.
Traditional IRA Growth and Distributions
You can choose among many savings and investment vehicles within an IRA, such as stocks, bonds and mutual funds. If you open a self-directed IRA, your universe of investments expands to other alternatives, including futures, currencies, options, real estate, certain precious metals and more. You do not have to worry about tracking interest income versus capital gains, because all withdrawals are taxed as ordinary income. You cannot withdraw before 59 1/2 years of age without incurring a 10 percent penalty, subject to certain exceptions. You also must start taking minimum required distributions from your traditional IRA when you reach age 70 1/2, based upon your life expectancy as determined by the IRS. You might benefit from a lower tax bill when you withdraw from your traditional IRA because distributions are taxed at your then-current marginal rate, which is frequently lower for retired people.
2018 Traditional IRA Deductibility Limits
Normally, you can deduct your entire contribution to a traditional IRA. However, the IRS imposes limits on deductibility based on your modified adjusted gross income, but only if you or your spouse are covered by a retirement plan at work (such as a 401(k) or 403(b) account). For 2018, if you are single filer and you are covered by a retirement plan, your contribution is fully deductible if your modified adjusted gross income is $63,000 or less, partially deductible for a modified adjusted gross income more than $63,000 but less than $73,000, and not deductible for a modified adjusted gross income of $73,000 or more.
If you’re covered at work and file a joint return with your spouse, partial deductions begin at a modified adjusted gross income of $101,001, and you lose all deductibility starting at $121,000. If you are a joint filer and only your spouse is covered by a retirement plan at work, you can take a full deduction up to a modified adjusted gross income of $189,000, a partial deduction from $189,001 and $198,999, and no deduction for a modified adjusted gross income of $199,000 or higher.
2019 Traditional IRA Deductibility Limits
The 2019 traditional IRA deductibility limits are higher than those for 2018:
- For single filers covered at work by a retirement plan, full deductibility ends at $64,000 and all deductibility ends at $74,000 or higher.
- For joint filers where the IRA owner is covered at work, full deductibility ends at $103,000 and all deductibility ends at $123,000 or higher.
- For joint filers where only the IRA owner’s spouse is covered at work, partial deductibility begins at $193,000 and all deductibility ends at $203,000 or higher.
Your IRA Basis
The potential partial or full loss of deductibility means that some or all of your traditional IRA contributions might be post-tax. For a traditional IRA, your total post-tax contributions form the “basis” of the IRA. When you eventually distribute money from your IRA, you do not pay taxes on the basis amount, since you already paid taxes on these contributions. You cannot simply draw off your post-tax dollars when you withdraw from your traditional IRA. Rather, withdrawals are a mix of pre-and post-tax dollars. IRS Form 8606 is used to calculate the taxable portion of a distribution from a traditional IRA that has post-tax dollars. The post-tax dollars included in each distribution reduce the IRA’s basis.
Using IRS Form 8606
You use IRS Form 8606, Nondeductible IRAs, when you contribute or distribute post-tax dollars from your IRA. If you are simply making a nondeductible contribution to your traditional IRA, enter the previous basis and the current year’s total nondeductible contribution on Form 8606. Adding the two together gives you your total traditional IRA basis for the current year and earlier years, which you report by filing Form 8606.
If you’ve distributed money during the year from a traditional IRA with a non-zero basis, use Form 8606 to calculate the taxable portion. The procedure is to find the ratio between your adjusted basis and the total balance. The basis is adjusted by subtracting out any contributions made retroactively in the next calendar year. The total balance is the sum value on Dec. 31 of your traditional IRAs, SEP IRAs and SIMPLE IRAs, plus any distributions and Roth conversions you made during the year. The resulting ratio is applied to the sum of the year’s distributions and Roth conversions to find their nontaxable portions, which you subtract from the year’s starting basis to obtain the new year-end basis. Finally, subtract the nontaxable distributions from your total distributions to find the taxable amount, not including any penalty tax for early withdrawals.
Roth IRA Qualifications
Roth IRAs do not provide tax deductions on contributions. That is, you make after-tax IRA contributions to your Roth IRA, and there is no pre-tax money in the Roth account. In a Roth IRA, your savings and investments grow tax-free. You can withdraw contributions at any time tax-free. Your distributions of earnings, if qualified, are also tax-free. For earnings withdrawals to qualify, you must wait five years from the year of the first contribution before taking a distribution of earnings. You also must be age 59 1/2 or older, subject to a few exceptions. The amount of unqualified earnings distributed from your Roth IRA is taxable and might be subject to the 10 percent early withdrawal penalty.
Roth IRA contributions are subject to income caps, and do not have minimum required distributions. Roth contributions are also eligible for the Form 8880 tax credit.
Saver’s Tax Credit
You can receive a tax credit for your retirement plan contributions, both pre- and post-tax, for the year by filing Form 8880. The credit is based on your total contributions to IRAs, ABLE accounts and qualified employer plans. The credit rate ranges from 50 percent to 0 percent, depending on your adjusted gross income. To be eligible for the tax credit, you must be at least age 18, not a full-time student and not a claimed dependent on another person’s tax return. The total credit amount cannot exceed $2,000.