Each and every one of us looks forward to that time in life when we can savor the sweet results of years of hard work and toil. There are various options you could choose from when planning your retirement. An IRA is one them and it is one of the most popular investment tools for many reasons. IRA stands for Individual Retirement Arrangement which is a broad term, which further encompasses the term Individual Retirement Account. It is an investment tool used by individuals to earn and plan their savings accordingly.
Based on the type of IRA, you can either set up an IRA individually or it can be set up by a trust or an employer. IRAs are of several types namely: Roth IRAs, traditional IRAs, SEP IRAs, and SIMPLE IRAs. A traditional or a Roth IRA are two of the most popular types of IRAs for individuals. A Roth IRA is not subject to tax exemptions at the outset, unlike a traditional IRA; this is the stark difference. But a Roth IRA gives those tax exemptions back to you in retirement which works out better for many people since their income may be higher than when they first begin investing into a Roth IRA. Either way, all deductions are tax free after the age of 59 1/2; whether or not you want to being withdrawing money for your retirement at this time is up to you and your financial situation.
Now regarding retirement, most people settle into a lower tax bracket because their income drops off. This fact, combined with savings you have accumulated can help you use your IRA for some tax advantages and not just at the end of your working years or in retirement. Since with regular tax deductible contributions during your working years and being in a lower tax bracket during retirement, you can legally manipulate the tax rules to your advantage. You should speak to a financial advisor for exact details.
Transfers and Rollovers
There have been quite a few changes made in the past few decades with new laws in force. The maximum annual contribution is $5,000, and allows all taxpayers under the age of 70 1/2 to contribute to an IRA, with an exception of higher earning workers who were covered by an employment based retirement plan. You can fund an IRA with cash or cash equivalents. Transferring any other type of asset into an IRA is non-permissible and the fund can be disqualified from any beneficial tax treatment. However, transfers and roll-overs from one IRA to another can be done using any assets.
More than One IRA
If you are under 50 years of age, the maximum IRA contribution is $5,000 and $6,000 if you are over 50 years of age. In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act expanded the protection for IRAs. Here certain IRAs are exempt up to at least $1,000,000 without having to show necessity for retirement. The law states that “the amount may be increased if the interests of justice so require.” It is slightly inefficient to have multiple accounts spread around. Irrespective of how many accounts you have, you have to adhere to the $5,000 limit which applies to all IRA accounts, which means you can deposit either $100 in 50 accounts or $1,000 in just 5 accounts, for example.
Investing in Both a 401k and an IRA
Often customers are posed with the doubt of whether investing in a Roth IRA (with after-tax dollars) or a 401k (with pre-tax dollars) is better. A 401k is nothing but a type of retirement savings account which is named after a subsection in the 401k section of the internal revenue code. Moreover, employer contributions pertaining to a 401k are subject to change. But what is not? The rules for IRAs change as well, this is a condition of life. If your job or employer offers a 401k or something like it, you should contribute to that each year. If your employer matches it, that is even better. A 401k lowers your income so this puts you in a better tax situation as well and it comes out before you see the money so you do not even know you are losing any money. In essence, you are not. Yes, you can invest into a 401k and an IRA at the same time; they are two different savings and investment vehicles. If your employer matches your investment in a 401k, that is something truly remarkable. But a Roth IRA for instance is a powerful investment weapon to yield as well; you should talk to a financial advisor in regards to the allocation of each.
Penalties and Dates and Contributing too Much
If you contribute more than you are allowed to in regards to an IRA, a 6% excess contribution penalty will be levied. You will realize that in the eventuality of failing to deduct the excess contribution, a 6% penalty that is submitted your way is damaging. Let’s suppose you made a $5,000 contribution to your Roth IRA earlier in the year, then you received a larger bonus than what was expected after which you find that because you fall under a certain income bracket, your permitted contribution was only $3,000. Therefore, your excess contribution is $2,000. In case you fail to correct the excess, a 6% penalty (6% of $2,000), which is $120, will be assessed. This amount will be carried forward to the next year and you will owe this tax each year until corrective measures are taken. However, the penalty can be avoided if you withdraw the excess before the annual contribution deadline (15th of April) is mandated. If you fail to meet the deadline, you can still rectify the over-sight, as individuals who file tax returns by April 15th receive an automatic extension of about 6 months to deal with the excess amount. In case the excess contributions are made the law provides various measures to rectify erroneous contributions or erroneous corrections by the tax payer. The system sometimes is pretty fair and we will cover your options in more detail down below in regards of excess contribution.
The investment company submits a form (Form 5498) to the Internal Revenue Service (IRS). This form states the amount invested in that year. The IRS computers tally the tax returns to the form and check for any incongruities. If you’re over the income limit, the return will be flagged. If you earn too much to contribute to a Roth IRA, ensure that you max out your 401k, if you have one. If you contribute to a traditional IRA, make sure that if you have both of the above accounts your contributions to a traditional IRA may not be tax deductible.
From a Roth to a Traditional IRA
Based on income, there is a limit on who can contribute to a Roth IRA. A taxpayer can contribute the maximum amount if their Modified Adjusted Gross Income (MAGI) is below a certain level, failing which, their allowed contributions are phased out. The contributions, or any, are not allowed if the MAGI breaches the top income range. Now in terms of a Roth IRA, if there were excessive contributions, a Roth IRA can be changed to a traditional IRA as long as the limit of the combined contributions does not exceed that year’s taxable limit.
There are 4 steps you can take if you find yourself embroiled in such a situation. The situation of excess contributions. Firstly, you can withdraw the excess by the due date of return, which holds good if, you receive a distribution from the IRA for filing returns for the year of contribution and if the distribution includes the amount of the excess contribution. Secondly, a direct transfer can be made from a Roth IRA to a traditional IRA (mentioned above) keeping time lines in mind. Thirdly, you can prevent further loss in case corrective measures were not taken by applying to a subsequent year by withdrawing the excess from your Roth IRA. Lastly, to correct an excess contribution is to make a lesser contribution the following year, since more often than not it is by pure negligence on the part of the tax payer, yourself, for not paying attention. Do not worry, everyone makes mistakes and we lead busy lives.
Vital Information Given
It is not a bad idea to periodically consult with tax professionals who will offer sound advice on preventing excess contributions and ensuring that required steps are taken in case of a slip-up. Unfortunately, excesses are sometimes not known until a few years after the penalties are discovered by tax payers which are significant. When contributing to an IRA, make sure you keep a tab on the contributions and that they are within the allowable limits. If you are investing with a major investment firm, they usually inform you how much you can invest that year, how much you have invested, and how much more you can invest. It is really not that complicated.