The Little IRA That Could: How a Small Contribution Today Could Have Big Potential Value Tomorrow
We heard a story recently of an investor whose parents helped her fund an IRA with $1,000 when she was in her early 20s and had just started her first job in 1983. Another $7,600 was invested, mostly in a few $1,000 contributions, through 1993. Then—she left the fund alone. She didn’t touch it. Flash forward 30 years, and that IRA is now worth $670,000. That’s 78 times that first decade’s investment of $8,600, quite an astounding feat and testament to the potential importance of long-term compounded growth.*
We share this story with you, because now is the time of year when we remind clients to consider making a 2022 IRA contribution (if they are eligible) before they file their taxes. Anyone with earned income (i.e., salary or wages) may be eligible to contribute to an IRA up to the annual limit of $6,000, or $7,000 if over age 50 (or up to the amount of your earned income if below the annual limit).
The amount of an annual IRA contribution may seem somewhat insubstantial relative to your overall retirement savings goal. But, as the story above illustrates, this small IRA contribution could be just the seed for growing something much bigger for the future.
In this newsletter, we explain the differences between a traditional pre-tax IRA and a Roth IRA and the eligibility requirements for each, as well as a few powerful tax and estate planning strategies. If you are eligible, you can make a 2022 IRA contribution up to the date that you file your 2022 taxes, with the latest date being Tuesday, April 18, 2023.
If you would like to make a 2022 IRA contribution, or have questions about your eligibility to contribute, give us a call and we can help. You will want to speak with your tax accountant as well, who can also confirm eligibility and any related tax implications.
* This is a hypothetical example for illustration purposes only. Actual investor results will vary. Investing involves risk, and you may incur a profit or loss regardless of the strategy selected.
The Traditional Pre-Tax IRA Option
Often when people think of an IRA, they think of tax deductibility, or the ability to invest pre-tax money similar to a 401(k) plan. This is how a traditional pre-tax IRA works.*
Higher-income wage earners may (correctly) believe that they are disqualified from enjoying the tax benefits of a traditional pre-tax IRA because: 1) they or a spouse participate in an employer-sponsored retirement plan; and 2) they make too much money (see IRS traditional IRA deduction limits).
If this is your situation, consider the Roth IRA. In addition to being a useful, tax-advantaged savings vehicle, the Roth IRA offers some additional estate planning benefits.
* Anyone with earned income (and sometimes a non-working spouse) can make contributions, without income limits, to a traditional after-tax IRA. Although you won’t enjoy any immediate tax benefit, any investment gains will be tax deferred.
The After-Tax Roth IRA Option
Roth IRA contributions are made after taxes, and it does not matter if you already participate in an employer retirement savings plan. While you won’t get a tax deduction up front, the funds in a Roth IRA grow tax-deferred and qualified withdrawals are not taxed.* This means all of the investment earnings over time are yours to keep, tax free—especially good news for younger savers who have a lot of time for their investments to potentially appreciate. But even those closer to retirement can benefit.
Unlike the traditional IRA, there is no requirement with the Roth IRA to take required minimum distributions (RMDs) starting at age 73 (the new RMD age starting in 2023). If you work part time in retirement, you can also continue to fund a Roth IRA.
And if you end up not needing to use the funds yourself, you can leave them to a beneficiary—a powerful tax and estate planning tool. While your beneficiary (if not a spouse) will be required to fully distribute the account within 10 years, these distributions will be tax free. By comparison, a non-spousal beneficiary inheriting a pre-tax IRA will have to fully distribute the account within 10 years AND pay taxes on those distributions, a potentially large tax bill especially for heirs (adult children, for example) who may be in their peak earning years.
But wait a minute. Doesn't the Roth IRA also have income limits for eligibility? Yes, it does, but keep reading ...
* Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted.
The Back-Door Roth Option
The IRS does define income limits to qualify for a Roth IRA. But even if your modified adjusted gross income (MAGI) is over the limit, the IRS allows another method (sometimes referred to as a "back door" Roth) for higher-income individuals to take advantage of the Roth IRA benefits.
It's actually quite simple. You first make an after-tax contribution to a traditional IRA, which has no income criteria for after-tax savings. Then you can immediately convert the account to a Roth IRA. Done.
IMPORTANT: Be aware that, if you already have a pre-tax IRA, using the back-door method could make your after-tax conversion taxable (and potentially impact your tax bracket) and is not advisable. Be sure that you understand the tax implications before deciding to do a conversion.
Roth IRAs Can Also Be for (Working) Kids
While you're thinking about saving for your own retirement, you may also want to think about helping a child or grandchild get a jump start on their savings. Just imagine what a small amount of money invested today can turn into with 60+ years of compounded growth!
If a child is of majority age (18 in most states) and has earned income, they can own their own IRA account. Some parents and grandparents then opt to gift the actual IRA contribution, which can be part of a gifting strategy for tax and estate planning.
If a child is a minor but has earned income (e.g., from babysitting, dog walking, or some other form of employment), parents can open a custodial Roth IRA and fund it up to the total amount earned or the $6,000 limit, whichever amount is lower. The adult will be listed as the custodian, but the account will be in the child's name as the owner. The custodian is responsible for documenting the child's income and demonstrating a reasonable wage rate (i.e., not $1,000 per hour to walk Fido). There are also rules as to whether your child needs to file a tax return, so check with your CPA.
If you choose to fund a Roth IRA for the child (as opposed to using his or her earned income), this is treated as a gift and the amount applies to your annual gift exclusion limit of $17,000 in 2023.
Contributions to a traditional IRA may be tax-deductible depending on the taxpayer's income, tax-filing status, and other factors. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.
Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.
Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
IRA tax deductibility and contribution eligibility may be restricted if your income exceeds certain limits, please consult with a financial professional for more information.
Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.
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