Tax-favored retirement accounts are an essential component of a smart retirement savings strategy, and IRAs are the most flexible of the options you have to shelter your retirement nest egg from the wrath of the Internal Revenue Service. Yet even though most people know that IRAs can help you save for retirement, the rules that govern IRAs are complicated enough that it's not always easy to understand even the most basic elements of using them as part of your financial planning.
Fortunately, you can distill all of the complex provisions of IRAs into just a handful of priority items. If you learn these five IRA rules, you'll know most of what you need to take full advantage of these tax-deferred retirement savings vehicles.
1. The 2 main types of IRAs
The first thing you need to know is that there are two different types of IRAs. Traditional IRAs give most taxpayers an upfront tax deduction on the amount you contribute, letting you reap tax savings now and keep your money growing on a tax-deferred basis until you make withdrawals from the IRA. At that point, you'll typically pay tax on the amount you withdraw from the traditional IRA. Roth IRAs, on the other hand, don't give you a current tax break, but they grow tax-free, and you can typically make withdrawals in retirement without paying any further tax at all.
Choosing between traditional and Roth IRAs is a long topic in itself, but the most important element tends to be whether your tax rate now is higher or lower than you expect it to be when you retire. Those in high tax brackets now can often take greater advantage of the current deduction of a traditional IRA, while those who are in low current brackets benefit from having tax-free treatment later in life. You can always balance your contributions between both types, getting the best of both worlds.
2. How much you can contribute to an IRA
There are limits on how much you can contribute to IRAs. 2018 contribution limits are $5,500 for those under age 50 and $6,500 for those 50 or older. However, you can't contribute more than you earn from a job or self-employment, unless you're married and your spouse has enough excess earnings to allow you to open a spousal IRA.
Roth IRAs are subject to income-based limits on contributions. If you're single with income above $120,000 or file jointly with income of more than $189,000 in 2018, then your allowed Roth contributions will be reduced. Above $135,000 and $199,000 for singles and joint filers respectively, no Roth contribution is allowed at all. No such limit on making contributions to traditional IRAs exists.
3. How IRA deductions can be limited
You're always allowed to make full contributions to traditional IRAs, but you're not always entitled to a deduction for those contributions. Specifically, if you or your spouse if you're married are covered by an employer-sponsored retirement plan at work, such as a 401(k), then income limits apply to your deductible IRA contributions.
You can see the full list of income limits in this article, but as you'll see there, the amount you can earn before your IRA deductions are limited depends on your tax filing status, as well as whether it's you or your spouse who has 401(k) or similar plan eligibility at work. That doesn't mean you shouldn't contribute, but you need not to overestimate the tax savings if these limits apply to you.
4. How IRA penalties work
IRAs are for retirement, so taking withdrawals early goes against their intended purpose. To deter you from making early withdrawals, the IRS imposes a 10% penalty when you take money out of an IRA unless you qualify for certain exceptions. Those include money for higher education expenses, large medical expenses, or up to $10,000 toward a first-time home purchase.
With Roth IRAs, you have a bit more flexibility. The after-tax contributions you make to the account are available for withdrawal penalty-free. But if you want to take out income from those contributions, you'll need to qualify for another exception or else face the penalty.
5. Inheriting an IRA
IRAs were meant to be spent down, but many people have retirement money remaining when they pass away. If you inherit an IRA, then you need to be smart about what you do next in order to take maximum advantage of the account's benefits.
If you're the surviving spouse, you have the ability to take your deceased spouse's IRA and roll it into an IRA in your own name. From then on, it'll be treated the same way as if it had been your IRA money all along. Others are required to start taking withdrawals from the account, either within a specified time frame or gradually over their lifetime. You'll find more specific guidance on inherited IRAs here, but the basic rule is not to act too quickly or else you can miss out on some money-saving strategies.
Be smart with your IRA
IRAs can seem confusing, but their benefits are well worth the effort. If you know these rules, you'll be most of the way toward getting the most out of these valuable retirement savings vehicles throughout your lifetime.