How do tax-deductible contributions help me save for retirement?
If you can deduct contributions to a Traditional IRA, you will receive a tax break up front, thereby reducing your taxable income in that year. Let’s assume you’re in the 25 percent federal marginal tax bracket for the 2017 tax year and you make the maximum annual IRA contribution of $5,500; you essentially might save $1,375 in current-year federal taxes. The bottom line is that after tax, your $5,500 contribution actually only costs you $3,625. In addition to the up-front tax break, money in a Traditional IRA accumulates tax-deferred, which means that until the year you withdraw the money, you won’t have to pay taxes on it. At the time that you do withdraw the money, both your deductible contributions and earnings will be taxed at your regular income tax rate, which may be higher or lower at retirement.
How do I know if I am eligible to make tax-deductible contributions?
Assuming you are under age 70½ and you have eligible compensation, your eligibility to take a tax deduction for a Traditional IRA contribution depends on your modified adjusted gross income (MAGI)*, tax filing status, and whether you or your spouse actively participate in an employer-sponsored retirement plan. If neither you nor your spouse is an active participant, you are eligible to deduct your full contribution. Otherwise, refer to the chart below to determine how much of a deduction you may take.
|Tax-Filing Status||Active Participant||Year||Full Deduction if MAGI is||Partial Deduction if MAGI is||No Deduction if MAGI is|
|Single||Yes||2016||$61,000 or less||$61,000–$71,000||$71,000 or more|
|2017||$62,000 or less||$62,000–$72,000||$72,000 or more|
|Married, filing jointly||Yes||2016||$98,000 or less||$98,000–$118,000||$118,000 or more|
|2017||$99,000 or less||$99,000–$119,000||$119,000 or more|
|Married, filing jointly||No, but spouse is||2016||$184,000 or less||$184,000–$194,000||$194,000 or more|
|2017||$186,000 or less||$186,000–$196,000||$196,000 or more|
*Modified adjusted gross income (MAGI) is your adjusted gross income before certain deductions or adjustments to income.
Am I eligible for a Traditional IRA?
You are eligible to contribute to a Traditional IRA if you are under age 70½ and you (or your spouse if married, filing a joint tax return) have eligible compensation. For IRA purposes, eligible compensation generally is defined as what you earn from working and includes wages, salary, tips, commissions, bonuses, and self-employment income, but not investment or pension income. Traditional IRA eligibility is not affected by whether you are covered by an employer-sponsored retirement plan.
Why would I make nondeductible contributions to a Traditional IRA?
Making a nondeductible contribution to a Traditional IRA may be your only IRA option if you make too much money to contribute to a Roth IRA and you or are not eligible to make deductible contributions to a Traditional IRA. There still are benefits to making IRA contributions. Regardless of whether you were able to deduct your Traditional IRA contribution, the earnings accumulate tax-deferred and therefore, will not be taxed until you take money out of your IRA. And because your contributions were not tax-deductible, when you withdraw the money later, you won’t owe any tax on the nondeductible contribution portion of that withdrawal. For any year that you do not deduct your Traditional IRA contributions, you will need to file IRS Form 8606, Nondeductible IRAs, with your tax return to let the IRS know that your contribution was nondeductible. Failing to file this form may result in double taxation and possible penalties.
Can I withdraw money from my IRA before age 59½?
Because Congress created Traditional IRAs as a tax-deferred way to save for retirement, most distributions from a Traditional IRA will be taxed as ordinary income and an additional 10 percent early distribution penalty tax may apply if the money is taken out before you reach age 59½ (six months after your 59th birthday). The early distribution penalty tax does not apply if your distribution is taken for any of the following reasons (subject to certain restrictions).
- Payments to beneficiaries after an IRA owner’s death
- Disability (permanently disabled under the IRS definition)
- First-time homebuyer expenses
- Unreimbursed medical expenses that exceed a certain amount of income
- Health insurance premiums during unemployment
- Qualified higher education expenses
- IRS levy
- Substantially equal periodic payments
- Qualified reservist distributions
Once you reach age 59½, you can withdraw money from your Traditional IRA for any reason without having to pay the 10 percent early distribution penalty tax.
What things should I think about if I am considering taking substantially equal periodic payments?
Consider the payment size. Substantially equal periodic payments is a distribution method some taxpayers elect when they need to access their IRA money before they reach age 59½. Before you use the periodic payment exception, consider that the size of your payments may be relatively small, unless you have a substantial IRA balance. Payments are calculated based on your life expectancy, and your life expectancy is still quite long when you’re under age 59½.Therefore, if you think you’ll need more than small amounts of money doled out regularly, these payments might not be enough to meet your needs. Consider other alternatives Before using the periodic payment exception, consider your other alternatives. If you need the money because you’re taking early retirement, consider the possibility you may return to work at a later date and no longer need the income. Or if you are still relatively young or you only need money for a one-time expense, consider postponing the expense until you reach age 59½, especially if that’s not too far off. If that’s not possible, consider making a single early withdrawal, paying the 10 percent tax, and leaving the rest of your IRA intact to grow tax-deferred. If you elect the periodic payment option, you will be required to distribute a specific annual amount from your IRA for several years. Consider other sources of money too. For example, if you plan to leave your job when you reach age 55 or later and you have a 401(k) plan, you can tap into your 401(k) plan without incurring an early distribution penalty tax. Decide on a distribution method The IRS provides different distribution methods by which you can receive payments, and pros and cons to each, so make sure you get the details. Also consider consulting with a financial representative or tax advisor experienced in IRA distributions, especially if your IRA balance is substantial. The payment method that’s appropriate for you somewhat depends on whether you want to minimize or maximize the size of your payments. Although you may initially consider a method that calculates larger payments, you’ll deplete your IRA faster and lose the benefit of future tax-deferred growth. And if it turns out that you don’t need the larger payments after all, you cannot put your withdrawals back into your IRA or roll them over to an IRA or other retirement plan. Keep in mind that when you do begin to take payments, you—not your IRA custodian—are responsible for making sure you take the right amount each year. Keep good records and documentation for any follow-up questions. Consider income taxes When deciding to use the periodic payment exception, also consider the income taxes you will owe on the distributions. Although you’ll avoid the 10 percent penalty tax, you still have to pay ordinary income taxes on the taxable portion of each withdrawal; the larger your payments, the more tax you’ll owe. You may have to pay estimated income taxes on the payments.
Why and when must I start taking money from my Traditional IRA?
Congress created Traditional IRAs as a tax-favored way to save for retirement, not as a way to permanently shelter savings from income taxes. Consequently, the law requires you to start distributing your Traditional IRA assets once you reach a certain age. You must begin taking money out annually once you turn age 70½. You must take your first payment by April 1 of the year following the year in which you reach age 70½. This is called your required beginning date (RBD). These annual minimum payments are called required minimum distributions (RMDs). For years after your RBD, you are required to take RMDs by December 31 of each year. You can always withdraw more than the minimum amount, but if you do not take at least the RMD amount, you may be subject to a 50 percent excess accumulation penalty tax on the amount you did not take.
What are the general rules and penalties for RMDs?
Each year, beginning with your 70½ year, the financial organization administering your IRA must notify you that an RMD is due. If it does not provide the RMD amount within this notice, it must offer to calculate the amount for you. In addition, financial organizations are required to annually notify the IRS of all IRAs that are subject to RMDs. You are then responsible for ensuring that your RMD is satisfied each year. You can always withdraw more than the RMD amount, but if you do not take at least the RMD amount, you may be subject to a 50 percent excess accumulation penalty tax on the amount you did not take.
How is my RMD calculated?
Your RMD is calculated each year by dividing the prior year-end balance in your Traditional IRA by your life expectancy factor. You can refer to the IRS’ Uniform Lifetime Table in IRS Publication 590, Individual Retirement Arrangements (IRAs) to get the life expectancy factor that is based on your age in the distribution year. If your spouse happens to be more than 10 years younger than you and is the sole beneficiary of your IRA, you can use the joint life expectancy factor from the IRS’ Joint Life Expectancy Table (also found in Publication 590).
Do I still have to take an RMD if I don’t need the money?
Even if you don’t need the money from your Traditional IRA, you still must take your RMD.
If I name a trust as the beneficiary of my IRA, does that change how my RMD is calculated?
No. You still will use the Uniform Lifetime Table to calculate your RMD.
If I name a charity as my beneficiary, does that change the calculation of my RMD?
No. You still will use the Uniform Lifetime Table to calculate your RMD.
FAQs are not intended to provide tax advice. Contact a tax professional