Since 1974, the acronym “IRA” has historically been referred to as an Individual Retirement Account or Annuity, established and maintained by an individual for his or her own benefit. However, that definition is currently too restricted. This is because Congress has expanded the use of the term IRA to describe any type of individual savings plan receiving federal tax benefits.
Individuals who work, or who do not work but are married to a working spouse, are authorized to open and to contribute to IRAs and in so doing, obtain federal (and often state) tax benefits. The tax-favored status of an IRA, along with the rules that accompany that status, are what distinguish any type of IRA from a general savings plan that an individual may have.
All federal employees younger than age 70.5 are eligible to contribute to some type of IRA for 2019. For 2019, the deadline for contributing to one’s IRA is the 2019 income tax filing deadline of April 15, 2020. Since there is some confusion and misinformation among federal employees about IRAs, the FEDZONE thought it would useful for employees to learn in a series of four columns the true facts about federal employees and IRAs. This week’s column presents some general information about IRAs.
Different Types of IRAs That Individuals May Own
There are three types of IRAs a person can establish on his or her own and that the individual must fund on his or her own. The three IRAs are:
• Traditional IRA. The traditional IRA was created in 1974, and may be either a “deductible” or a “nondeductible” IRA. For 2019, the annual contribution to a traditional IRA is limited to $6,000; for those individuals who are at least age 50 as of 12/31/2019, an additional contribution of $1,000 may be made during 2019 allowing those individuals to contribute a maximum $7,000 to their IRAs for 2019. The issue of whether or not one’s IRA contribution is deductible (as an adjustment to income on one’s federal income tax return) depends on one’s modified adjusted gross income (MAGI) and whether the traditional IRA owner participates in some type of employer-sponsored qualified retirement plan. Earnings in a traditional IRA grow tax-deferred. Individuals generally cannot access their traditional IRAs without penalty until they are age 59.5 or older; at age 70.5 (age 72, for individuals born after June 30, 1949, under the recently passed SECURE Act) individuals must begin taking distributions (“required minimum distributions”). A non-working spouse (for example, a “stay-at-home mom or dad”) of a working individual is allowed to contribute to his or her own IRA. This is called a spousal IRA and may be either a traditional IRA or a Roth IRA.
• Roth IRA. A Roth IRA is a type of nondeductible IRA; that is, the contributions to a Roth IRA are made with after-taxed dollars. However, the Roth IRA’s key feature (that differentiates it from a traditional, nondeductible IRA in which contributions are made with after-taxed dollars) is that the earnings in the account are potentially tax-free at the time of distribution. In other words, individuals taking qualified distributions from a Roth IRA do not have to pay federal (and in most cases, state) income taxes at the time of distribution. Also, the Roth IRA is more accessible than the traditional IRA; individuals may take a distribution of their principal amount (contributions) at any time for any reason and without penalty. Earnings in a Roth IRA (interest, dividends, capital gains) may also be withdrawn penalty-free before age 59.5 (but are taxable) in order to pay higher education expenses of a relative, to pay the expenses for the purchase of a first home, or to pay expenses related to a total disability. The Roth IRAs have the same annual contribution limits as the traditional IRAs.
• Coverdell Educational Savings Account. A Coverdell Education Savings Account or CESA is a trust or custodial account designed to help pay education expenses. It allows an individual to make a nondeductible contribution on behalf of a child (younger than 18). Until 2002, the maximum educational IRA contribution was $500 per child per year; starting in 2002, the maximum annual contribution per child increased to $2,000. The CESA is a different type of IRA in that its sole purpose is to save for a child’s education expenses. This includes qualifying educational expenses for nursery school, parochial and private school grades 1 to 12 (as well as for post-high school).
In addition to an individual retirement account (governed by Internal Revenue Code Sections 408 and 408A), there is an individual retirement annuity. An individual retirement annuity is another type of a traditional IRA that is issued by an insurance company qualified to do business under the laws of the jurisdiction where the contract is sold.
The various types of IRAs available to individuals for 2019 are summarized in the following table:
2019 IRA Comparison Chart
Traditional Deductible IRA
Qualification to Make Contributions: Must have earned income; Cannot be older than 70.5 at end of year
Income (MAGI) Limitations: If active participant in employer retirement plan, subject to MAGI* phase-out rules for- MFJ: $103,000-$123,000
Single & HOH: $64,000-$74,000 (No limits for individuals not actively participating in employer retirement plan)
Contribution Limit: Lesser of $6,000 or taxable compensation. Coordination of IRAs: Limit applies to any combination of IRA plans (except the Coverdell IRA) this means the maximum total yearly contributions to all IRAS are $6,000. (The limit is $7,000 for those who are at least age 50 by December 31, 2019
Tax Treatment of Qualified Distributions: All distributions are taxable
Spousal IRA
Qualification to Make Contributions: A spouse can make contributions based on other spouse’s earned income. Cannot be older than 70.5 at end of year.
Income (MAGI) Limitations: If working spouse is an active participant in an employer plan, the nonworking spouse’s IRA is phased out when MAGI* is between $193,000-$203,000.
Contribution Limit: Lesser of $6,000 or taxable compensation. Coordination of IRAs: Limit applies to any combination of IRA plans (except the Coverdell IRA) this means the maximum total yearly contributions to all IRAS are $6,000. (The limit is $7,000 for those who are at least age 50 by December 31, 2019
Tax Treatment of Qualified Distributions: All distributions are taxable
Traditional Nondeductible IRA
Qualification to Make Contributions: Individual (or spouse) must have earned income. May not be age 70.5 by the end of the year.
Income (MAGI) Limitations: No limitations
Contribution Limit: Lesser of $6,000 or taxable compensation. Coordination of IRAs: Limit applies to any combination of IRA plans (except the Coverdell IRA) this means the maximum total yearly contributions to all IRAS are $6,000. (The limit is $7,000 for those who are at least age 50 by December 31, 2019
Tax Treatment of Qualified Distributions: Cost basis portion of distribution is tax-free; earnings portion is taxable via IRS form 8606
Roth IRA
Qualification to Make Contributions: Individual (or spouse) must have earned income. May be any age (including 70.5)
Income (MAGI) Limitations: Regardless of coverage by employer retirement plan, subject to MAGI* phase-out rules: MFJ: $193,000-$203,000.
Single & HOH & QW: $122,000-$137,000. MFS: $0-$10,000
Contribution Limit: Lesser of $6,000 or taxable compensation. Coordination of IRAs: Limit applies to any combination of IRA plans (except the Coverdell IRA) this means the maximum total yearly contributions to all IRAS are $6,000. (The limit is $7,000 for those who are at least age 50 by December 31, 2019
Tax Treatment of Qualified Distributions: Qualified distributions are nontaxable (including earnings) Certain nonqualified distributions are not subject to 10% penalty but the earnings portion is taxable.
Coverdell Educational Savings Account
Qualification to Make Contributions: Beneficiary of Educational IRA must be under the age of 18.
Income (MAGI) Limitations: Contributor is subject to MAGI* phase-out rules: MFJ: $190,000-$220,000. Single & HOH & MFS & QW: $95,000-$110,000
Contribution Limit: Limited to $2,000 per year per beneficiary. Contributions do not count against the limits of other IRAs.
Tax Treatment of Qualified Distributions: Qualified distributions are nontaxable (including earnings)
**Modified Adjusted Gross Income (MAGI) = Adjusted Gross Income + Student Loan Interest Deduction + Foreign Earned Income Exclusion + Foreign Housing Exclusion or Deduction + Excluded EE Savings Bond Interest Shown on Form 8815 + Excluded employer-provided adoption benefits shown on Form 8839 + Tuition and Fees Deduction.
The main benefits to IRAs that are most appealing to individuals are the tax benefits. All types of IRAs share one common tax characteristic: their earnings grow at least tax-deferred. From that common base, the tax benefits of the various IRAs are different.
With a traditional IRA, individuals may be eligible for a tax deduction for their contribution, but distributions from a deductible, traditional IRA are generally subject to taxation. As will be discussed in the next FEDZONE column many federal employees are not eligible to make a traditional deductible IRA contribution for 2019; however, if they are younger than age 70.5 then they are always eligible to make a traditional nondeductible IRA contribution for 2019. And if their MAGI does not exceed the limits they can make a Roth IRA contribution for 2019 no matter their age (even past age 70.5).
Some of the Specific Attractions of IRAs
For individuals, IRAs (including traditional and Roth IRAs) can provide some or all of the following attractions:
• A convenient depository and a disciplined method for annual savings.
• A tax deduction (for some employees) in the case of some traditional IRA contributions.
• A way to achieve tax-deferred growth of all assets.
• A supplemental source of retirement income.
• A source of emergency funds.
• A source of funds for higher education.
• A source of funds for a first home.
• A vehicle for pursuing several investment options.
• A way to retain transferability.
• An opportunity to maintain individual control of retirement funds or other funds.
• Another instrument for completing an individual’s financial plan.
The key to the savings aspects of IRAs are the tax benefits of IRAs – in particular the tax-deferred (and in the case of Roth IRAs, the tax-free growth). An individual may be eligible for an up-front deduction for making the contribution. It must be remembered, however, that all three types of IRAs (traditional-deductible and traditional-nondeductible, and Roth IRAs) contain penalties if the IRA assets are withdrawn prematurely or for nonqualified reasons – in most cases, a 10 percent penalty. The penalty could cancel out any tax benefit received from the IRA.
Another use for a traditional IRA is as a depository for accumulated retirement money from qualified retirement plans including the Thrift Savings Plan that most Federal employees participate in. Since the passage of the Tax Simplification Act of 1986, holding roll-over assets from qualified retirement plans has been one of the primary uses of the traditional IRA and Roth IRA.
One of the more important reasons that employees (usually, former employees) want to remove assets from a qualified retirement plan is to have more direct control over the investment and distribution of those assets – yet they do not want to incur the full tax consequences of taking the assets directly. A direct transfer from a qualified retirement to an IRA is useful for maintaining a retirement fund that has already been developed under that qualified retirement plan.
By requesting a direct “trustee-to-trustee” of assets from a qualified retirement plan to a traditional IRA, an individual will avoid the 20 percent mandatory federal income tax withholding. Here is an example of such a request:
Peter, age 56, retires from federal service with $350,000 in his traditional TSP account. Peter would like to have more investment control over his retirement, as well as more fund choices. He, therefore, requests online that the Thrift Savings Service Office to directly transfer his entire traditional TSP balance to his traditional IRA that is maintained by the XYZ Company as the custodian for his IRA.
Under a law that took effect January 1, 2010, funds from a qualified retirement plan – this includes a 401(k) plan, a 403(b) plan and the TSP – may be transferred to a Roth IRA. This transfer can be done in-service by a federal employee age 59.5 or older or after an employee retires from federal service. For example, a TSP account owner may request a direct transfer of part of his or her traditional TSP account to an existing Roth IRA. But traditional TSP participants should be aware that a traditional TSP transfer to a Roth IRA is a taxable event. As such, the TSP participant who requests such a transfer will pay full federal and state income taxes on the amount transferred.
Both a Roth IRA and a traditional, nondeductible IRA may also be useful as a depository for emergency funds. Both types of IRAs can serve as a source for emergency funds because a traditional IRA owner (who owns a nondeductible traditional IRA) and a Roth IRA owner can always make a penalty- and tax-free distribution of his or her contributions amounts at any time and for any reason. However, earnings must remain in the account in order to avoid taxes and penalties.
There is also no limit as to the number of “trustee-to-trustee” transfers (qualified retirement plan to traditional IRA, traditional IRA to traditional IRA, traditional rollover (or conduit) IRA to a qualified retirement plan that an individual may request. On the other hand, a rollover (in which the individual initially receives the qualified money and has 60 days from the day of receipt to deposit the funds into another qualified plan or into an IRA) may be accomplished only once a year. However, each IRA has the once-a-year opportunity- and an individual may have as many separate IRAs as he or she wishes to create. The rules limiting rollovers to one annually apply separately to traditional and to Roth IRAs. The one-year period starts on the day that the amount is received from the IRA making the distribution, as the following example illustrates:
Bob directs the TSP to directly transfer his entire TSP account to a traditional IRA-1 Shortly thereafter, Bob rolls over his traditional IRA-1 to a new traditional IRA-2 within the 60 day rollover period. He is not allowed to perform any more rollovers for the next 12 months, for this or any other IRAs that he may possess.
Finally, the traditional and Roth IRA provide powerful ways to help complete an individual’s financial plan. For the wealthy, an individual financial plan may involve only the need for an emergency fund on a tax-advantaged basis. This could be accomplished both through a traditional and a Roth IRA. IRAs can be used to fill any gaps in expected cash flow. For example, a federal employee who retires at age 60 (under FERS) may need additional income to supplement his TSP income until he or she reaches age 62, at which time the FERS annuitant can apply for his or her Social Security monthly retirement benefit, although reduced for starting to receive the benefit before his or her full retirement age.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, located at 833 Bromley Street Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
2019 IRA Contributions
