User:Fyre4ce/IRA

From Bogleheads
< User:Fyre4ce
Revision as of 14:46, 24 February 2020 by Blbarnitz (talk | contribs) (→‎Comparison to employer accounts: reference formatting)
Jump to navigation Jump to search
Flag of the United States.svg.png This page contains details specific to United States (US) investors. It may not apply to non-US investors.

An individual retirement arrangement, or IRA, is a personal savings plan which allows you to set aside money for retirement, while offering you tax advantages. You may be able to deduct some or all of your contributions to your IRA. Amounts in your IRA, including earnings, generally are not taxed until distributed to you. IRA's cannot be owned jointly. However, any amounts remaining in your IRA upon your death can be paid to your beneficiary or beneficiaries.

You can open an IRA at a bank or other financial institution or with a mutual fund or life insurance company. You can also open an IRA through your stockbroker. Any IRA must meet Internal Revenue Code requirements.[1]

ICI (Investment Company Institute) reports that at year end 2018, Traditional IRA's held an estimated $8.806 trillion of investor's wealth accounting for 85% of total IRA assets,[2][note 1]

Types of IRAs

The User:Fyre4ce/Traditional IRA was created in 1974 with the passage of the Employee Retirement Income Security Act (ERISA)[note 2] Over the years, the Traditional IRA has been expanded to include a growing number of specialized plan types. These include:

Type of IRA Description
Traditional IRA Original type of IRA. Allows tax-deductible contributions, subject to income limitations, and offers tax-deferred growth. Withdrawals are taxable, except for return of basis, which is "pro-rata."
Roth IRA Contributions are after-tax but all future growth and withdrawals are tax-free. Contributions are subject to income limits. Shares a contribution limit with the Traditional IRA.
SEP (Simplified Employee Pension) IRAs Retirement plan for self-employed individuals with no employees, and a simpler alternative to the Solo 401(k). Contributions are tax-deductible, growth is tax-deferred, and withdrawals are taxable. Contribution limit is independent from Traditional and Roth IRAs.
SIMPLE IRAs Retirement plan for small businesses with employees, and a simpler alternative to the 401(k). Its use excludes the use of any other employer retirement plan, including the SEP-IRA. Employer matching is permitted. Contributions are tax-deductible, growth is tax-deferred, and withdrawals are taxable. Contribution limit is independent from Traditional and Roth IRAs.
Coverdell Education Savings Accounts (ESAs) IRA-based account for education. Contributions are after-tax, growth is tax-deferred, and withdrawals for higher education are tax-free. Contribution limit is independent form other IRAs.

See Roth versus Traditional for more guidance on how to choose between pre-tax and Roth contributions.

Other IRA terminology

In addition, various terms are used to describe specific types of IRAs that fit into the above categories, and some have specific legal implications. These terms include:

Type of IRA Description
Inherited IRA Inherited IRAs can be either Traditional or Roth, and Traditional IRAs inherit the basis of the original IRA. Inherited IRAs work like normal IRAs, but have special distribution requirements. See also: Required Minimum Distribution
Stretch IRA IRAs inherited prior to January 1, 2020 can be kept (and "stretched" out) for the heir's entire life, providing life-long tax-deferred or tax-free growth. RMDs are required every year regardless of the heir's age, although they should be smaller than the rate of return of reasonable investments until the heir is well into their 70's, so the balance could continue to grow for decades. Following the passage of the SECURE Act, IRAs inherited after January 1, 2020 have no RMDs, although must be emptied within ten year of being inherited. It remains to be seen whether these will be commonly referred to "Stretch IRAs" too.
Rollover IRA A Rollover IRA is created when the account holder rolls over funds from a qualified retirement plan into an IRA, and they can be either Traditional or Roth. While Rollover IRAs generally work like normal IRAs, some employer plans limit incoming rollovers to Rollover IRAs and exclude Contributory IRAs, so contributing to a Rollover IRA could preclude a future rollover into these plans. Can also have legal consequences related to asset protection.
Contributory IRA A Contributory IRA is an IRA into which the account holder has directly contributed. Some employer plans prohibit incoming rollovers from Contributory IRAs. Can also have legal consequences related to asset protection.
Spousal IRA Non-working married spouses are generally allowed to contribute to their own IRAs using money earned by their spouse, subject to income limitations. Otherwise, spousal IRAs work exactly the same as a regular IRA. Can be either Traditional or Roth.
Non-deductible IRA A "Non-deductible Traditional IRA" or "Non-deductible IRA" is a Traditional IRA to which after-tax contributions have been made. Inherited, Contributory, and Spousal Traditional IRAs can all be non-deductible. The Traditional IRA page discusses the mechanics of basis tracking and withdrawals, and the main page discusses suitability and performance of non-deductible IRAs.
Self-Directed IRA or "Checkbook" IRA Self-Directed IRAs can be either Traditional or Roth, and allow for a much wider range of investments than would normally be permitted in an IRA; see below.

Allowable investments

IRAs available with most custodians allow a wide range of publicly-available investments, such as: stocks, bonds, mutual funds, savings accounts, money market accounts, Certificates of Deposit (CDs), Treasury Inflation-Protected Securities (TIPS), and Real Estate Investment Trusts (REITs). Annuities are allowed to be purchased inside an IRA as well, though this is typically done with an immediate annuity such as a Single Premium Immediate Annuity (SPIA) in the distribution phase. The tax benefits of a Variable Annuity would be wasted inside an IRA because they would be redundant.

Some IRA custodians offer "Self-directed" or "Checkbook" IRAs that allow an even wider range of investments, including: IPO stock, privately-owned businesses, loans (mortgages, hard money loans, etc.), domestic or foreign real estate (including undeveloped land), private real estate funds or syndications, certain derivatives (including stock options), foreign currencies, tax liens, and others. These IRAs usually have additional fees to cover the higher management costs for these investments.

Prohibited investments and transactions

Regardless of whether an IRA is self-directed, the following types of investments and transactions are prohibited:

  • Collectibles (artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, etc.), except for:
    • 1 oz, ½ oz, ¼ oz, or 1/10 oz US gold coins
    • 1 oz silver coins minted by the US Treasury Department
    • Certain platinum coins
    • Certain gold, silver, platinum, and palladium bullion
  • Life insurance contracts
  • Certain types of derivatives
  • Self-dealing transactions involving yourself, your family, or your beneficiary, including:
    • Loans to yourself or other disqualified persons
    • Personally using property purchased with IRA funds, including real estate
    • Acting as a property manager or performing maintenance on an IRA-owned rental property

Required Minimum Distributions

Traditional, SEP, and SIMPLE IRAs have Required Minimum Distributions that generally begin the year the account holder reaches age 72. See the main page for a discussion of the details.

Inherited IRAs (Traditional and Roth) inherited prior to January 1, 2020 have Required Minimum Distributions calculated by IRS Publication 590-B Distribution Table I. Inherited IRAs (Traditional and Roth) inherited after January 1, 2020 have no RMDs, but must be emptied and closed within ten years of being inherited, unless certain exceptions apply.

Roth IRAs have no RMDs.

Comparison to employer accounts

Traditional and Roth IRAs have many similarities with employer retirement plans: contributions are either pre-tax (traditional) or Roth, growth is tax-deferred or tax-free, withdrawals before age 59½ are penalized unless exceptions apply, and are subject to RMDs (except the Roth IRA). However, IRAs are individually-controlled accounts, and employer plans are subject to the plan rules set by the employer and the provider, and they can have important differences. Many investors will face a choice between investing in an IRA and an employer plan, such as when not contributing enough to reach the limit in both accounts, and/or when separating from an employer and deciding whether to leave investments in the existing plan or roll it into an IRA. The following table lists the differences between IRAs and 401(k)'s (the most common employer retirement account) that should help investors choose the best account given their own personal situation. This comparison is mostly independent of the choice between Traditional versus Roth tax structures, which is a complex topic discussed on its own wiki page. Other employer plans, such as the 403(b) and 457(b), have important differences from the 401(k), and those differences are discussed on their respective plan pages.

Comparison Between IRAs and 401(k)'s
IRA 401(k) Advantage
Contribution Limits $6,000 ($7,000 for age >=50) combined for all Traditional IRAs and Roth IRAs. Spousal contributions permitted. $19,500 ($26,000 for age >=50) elective deferral for all employer retirement accounts. $57,000 ($63,500 including catch-up) total employee and employer contributions into each unrelated employer plan. No spousal contributions permitted. While the 401(k) has higher contribution limits, this is not a good reason to not invest money first into an IRA, and/or roll over money from an employer plan into an IRA, if it were otherwise the preferred account.
Income Limits Deducting Traditional IRA contributions has low income limits, although it is higher for spouses. Roth IRA contributions have a higher limit, and this limit can be circumvented by the Backdoor Roth IRA. Generally no income limits for 401(k) contributions, although there is a limit on the compensation that can be used for matching calculations ($285,000 as of 2020[3]) 401(k)
Available Tax Structures Traditional and Roth IRAs are always available, although deductible Traditional contributions may be prohibited by income. Roth is available to almost all investors by way of the Backdoor Roth IRA. Traditional contributions are always available, but Roth is only available if the plan allows it. Depends on the 401(k) and the investor's income.
Employer Contributions/ Matching IRAs are individual accounts, and have no matching. Some 401(k)'s offer employer matching contributions, usually 50% or 100% up to some limit. Solo 401(k)'s allow large employer contributions, which effectively raises the contribution limit for the self-employed. 401(k), if matching is offered. Getting an employer match should be a top financial priority.
Investment Choices IRAs allow a wide range of investments, and this can be expanded further with a Self-directed IRA. 401(k)'s only allow a set of investments offered by the plan. Some plans have a brokerage option allowing trading of stocks and ETFs, and occasionally a plan will have unusual investments (a stable value fund, annuities, real estate funds, etc.) that could be uniquely valuable to certain investors. For the self-employed, Solo 401(k)'s are available at no cost and with a similarly wide range of investment choices as an IRA, and Self-directed Solo 401(k)'s are available that are similar to Self-directed IRAs. IRA when compared to most employer 401(k)'s, and a tie compared to a Solo 401(k). Exceptions exist.
Fees IRAs are available from many custodians for no cost and only the expenses within investments (~0.1% per year or less). 401(k)'s can have much higher fees (~1-2%+ per year) than IRAs. However, 401(k) fees have come down on average in recent decades, and many are competitive with IRAs. Some plans offer access to "institutional class" or other funds with even lower expenses than similar funds in a retail IRA. Usually the IRA, although exceptional employer plans are slightly better than IRAs.
Compatibility with Backdoor Roth IRA Pre-tax Traditional (along with SEP and SIMPLE) IRA balances interfere with the Backdoor Roth IRA 401(k) balances do not interfere with the Backdoor Roth IRA. Major advantage to the 401(k) for pre-tax money for those wishing to make Backdoor Roth IRA contributions.
Early (before age 59½) distribution options Exceptions to the age 59½ rule: disability, education expenses, SEPP, first-time homebuyers (up to $10,000), IRS levy, medical expenses, unemployed health insurance premiums[4]. Roth IRAs also allow withdrawal of contributions at any time without penalty. Exceptions to the age 59½ rule: disability, SEPP, IRS levy, medical expenses, separation from service age 55 or older.[4] Plans may offer hardship withdrawals and/or in-service withdrawals, but whether these withdrawals incur penalties is subject to IRS rules. Some plans also allow loans to the participant. The IRA has a slight advantage, particularly the Roth IRA, although this depends partly on the plan.
Required Minimum Distributions Traditional IRAs generally require RMDs starting at age 72. Roth IRAs have no RMDs. Traditional and Roth 401(k)'s require RMDs at age 72, but they are waived if you are still working. Roth 401(k)'s have RMD's after age 72 or you stop working, but these can be avoided by rolling over into a Roth IRA. Traditional and Roth Solo 401(k)'s start RMDs at age 72 regardless of whether you're still working. 401(k) has an advantage for those working after age 72 and looking to avoid RMDs. Otherwise, close to a tie.
Asset Protection[note 3] IRAs receive state-level protection from civil judgments, which varies widely by state. Traditional and Roth IRAs are exempt from federal bankruptcy up to $1.0M, and SEP and SIMPLE IRAs receive unlimited exemption. Can be divided in a "transfer incident to a divorce." ERISA 401(k) plans are protected from civil judgments and bankruptcy at the federal level. Solo 401(k)'s are generally not ERISA plans, and receive state-level protection similar to IRAs. Can be accessed by a Qualified Domestic Relations Order (QDRO). ERISA 401(k)'s have an advantage over IRAs. Solo 401(k)'s are about equal to IRAs. Highly dependent on the state.

Notes

  1. Traditional IRA assets 1997 - 2018 (in billions). Source: Investment Company Institute Factbooks.
    • Share is the percentage of total IRA assets.
    • Traditional IRAs include contributory and rollover IRAs.
    • ᵉ Data are estimated.

    Sources: Investment Company Institute, Internal Revenue Service Statistics of Income Division, and Government Accountability Office

  2. See "The Individual Retirement Account at Age 30: A Retrospective". Perspective, V11, N1. Investment Company Institute. February 2005. https://www.ici.org/pdf/per11-01.pdf. for a history of the Traditional IRA to 2003.
  3. Asset protection is a complex legal subject that is further complicated due to many laws being state-specific. The information presented here is only high-level, and as noted on the wiki page, legal ambiguity exists in some areas. For asset protection legal advice, consult a competent asset protection attorney in your state.

See also

References

External links

IRS

Bibliography