The Dirty Secrets of the IRA

Should you roll your employer plan into an IRA? How the main IRA types differ, and the trade-offs, like the pro-rata rule, that few people mention.

What does your Individual Retirement Account (IRA) look like? Do you have one? Is it time to roll over your Employer Sponsored Plan into an IRA account? These are legitimate questions you need to be asking yourself, as retirement inches closer by the second and every minute counts. Let’s spend the next few minutes addressing these questions and uncovering the “dirty secrets of the IRA.”

Types of IRAs

If you are unfamiliar with retirement accounts, there are a few options you should consider when it comes to an IRA:

• Deductible Traditional IRA
• Nondeductible Traditional IRA
• Rollover IRA
• Roth IRA
• Spousal IRA
• And specialized IRAs (e.g., SIMPLE IRA and SEP IRA)

For the purpose of this article we will be referring to the deductible, nondeductible, Roth and spousal IRAs.

For context, the IRA came to be in 1974 as part of the Employee Retirement Income Security Act (ERISA). It was created in part to lower one’s tax liability during a high-tax era and to enable the individual to save for retirement. Since its creation, there have been many modifications and adjustments along the way, mainly associated with inflation. Let’s take a look at some similarities, differences and secrets.

Commonalities

The most common thread among all four types of accounts is the yearly contribution limit. An individual, or an individual on behalf of their spouse via a Spousal IRA, can contribute $6,000 a year to their respective IRA account(s) in 2022.

For those over age 50 there is a catch-up contribution of an additional $1,000 per year, for a combined contribution of $7,000 a year.

If an individual has multiple IRAs, the total contribution is still limited to the annual limits above. This means if you overfund an IRA you will pay an additional 6% tax on the excess contribution until the excess amount is withdrawn.

Another commonality is the minimum age at which you are allowed to make distributions without a 10% penalty (there are exceptions to the age limit, but we will not cover them in this article).

So what’s the age limit? Well, you have to wait until age 59½ before you can access your contributions and growth penalty free. However, this age limit does not apply to Roth principal contributions if you intend to withdraw principal only. Complicated, right? I know… like I said, there are a number of dirty secrets you have to know, or navigate, when planning your future.

Another similarity relates to the growth in the IRA being capital gains tax-free. However, depending on the IRA, the growth may be subject to ordinary income taxes, which could be greater than capital gains tax rates.

Lastly, there are income restrictions that may limit your options and benefits. This is why you need to speak with a qualified financial professional before incorporating IRAs into your overall retirement plan.

Traditional IRA vs. Roth IRA

Which one do I choose? It depends… The main distinction between the two accounts is when you pay the taxes. For a Traditional IRA the contributions can be tax-deductible, depending on your income and active contributions to an employer sponsored plan, but future distributions during retirement could be taxed as ordinary income. On the other hand, for a Roth IRA, the contributions are not tax-deductible. However, the future distributions in retirement are tax-free.

Both of these accounts can be used to benefit people depending on their circumstances. For instance, if you are in a higher tax bracket, using a deductible IRA could allow you to lower your taxable income in the year the contribution is made, assuming you’re eligible to make a deductible contribution. This could lead to lowering your current tax bracket.

Now here is an interesting question to contemplate. Will you be in a lower tax bracket now or during retirement? If you expect your income to be less in retirement, your tax bracket could be lower during retirement. But if you expect your income to increase over time, you may be in a lower tax bracket now.

Another difference between the two accounts is the impact of required minimum distributions (RMD). Traditional IRAs require distributions to begin at age 72. The amount is determined based on a predefined schedule. This results in a minimum amount distributed each year. On the other hand, Roth IRAs do not have an RMD requirement.

In your traditional IRA, if you do not take out your RMD in any given year, you will be penalized 50% of that year’s RMD. For example, if your required minimum distribution in 2022 was $6,000 and you forgot to withdraw that from your IRA before the deadline you would forfeit $3,000 to the IRS.

While the Traditional IRA was created to help high income earners reduce their taxes, it was the Roth that was created to benefit the hard-working middle class. This is why there are strict income limitations for contributing to a Roth. If your income is more than $144,000 (single filer in 2022) or $214,000 (married filing jointly in 2022) you cannot contribute to a Roth IRA account during that year. Well, not directly… (enter the backdoor!) Wait… that doesn’t sound right. Let me explain.

After 2010, those prevented from contributing to a Roth IRA due to their income exceeding contribution limits were again able to contribute to a Roth IRA via a “backdoor” conversion concept. For example, a high income earner could fully fund ($6,000/$7,000) a non-deductible traditional IRA. Then two business days later they can convert that contribution into a Roth IRA. Doing this would result in only paying taxes on the negligible gains while the contribution resided in the traditional non-deductible IRA for two days.

You should know this dirty secret became possible as a result of the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005. However, this tricky move has been a controversial debate within our government for many years now. Should you decide to do this, we strongly encourage you to speak with a qualified financial professional. Without careful thought there is a potential that you could trigger the pro-rata rule.

The pro-rata rule

The following is an example to explain the pro-rata rule. In this example, Bob is a 50-year-old who has $100,000 in a traditional IRA account. His current yearly income is $200,000 and he never realized he could contribute to a Roth IRA with such a large income. He has just found out that he can use the backdoor concept to fund a Roth IRA. Bob meets with his advisor and puts $7,000 (traditional plus catch-up contributions) into a non-deductible IRA. Then a couple days later he converts it into his new Roth IRA account.

When tax season comes Bob receives a Form 1099-R. It states Bob owes taxes on a portion of his Roth conversion. In fact, it states $6,542 of the converted amount is taxable to him.

In this example Bob thought his entire $7,000 contribution to the non-deductible IRA was going to be converted to his Roth without a tax impact. Unfortunately, that is not the case due to the IRS’s pro-rata rule. Why? Well the pro-rata rule adds all of the balances associated with your Traditional, Rollover, Simple, and SEP IRA accounts together. It then calculates the amount of pre-tax dollars vs. after-tax dollars within the various accounts.

In this example Bob had $100,000 of deductible/pre-tax money in one IRA and $7,000 of nondeductible/after-tax money in another IRA account. This means he held $107,000 among all of his non-Roth IRAs. This also means $7k / $107k is the ratio used to calculate the pro-rata rule. In other words, 6.54% of Bob’s conversion (or $458) is excluded from being taxed. The remaining 93.46% of the conversion (or $6,542) is subject to taxes.

But wait! Let’s complicate things more…

First, the remaining $6,542 (from the non-deductible contribution) will remain in the pro-rata calculation UNTIL all of the IRA assets are withdrawn or converted. Second, it is Bob’s responsibility to keep track of his after-tax basis each year by keeping a copy of his IRS Form 8606. If the IRA owner does not keep track of this, all of the nondeductible money in their Traditional IRA could be treated as deductible/pre-tax. This could result in potentially triggering double taxation on the non-deductible payments simply because Bob cannot prove the remaining $6,542 was associated with a non-deductible contribution from years earlier.

Conclusion

Funding retirement is tricky, but an absolute requirement for all income earners. These were just a few ways to save money for retirement, now and in the future. While a lot of these tips and tricks may be at your disposal, the nuances of tax breaks, tax law and the ever-changing rules around retirement are worth reviewing with a qualified financial professional.