Traditional Individual Retirement Accounts (IRAs)
A traditional Individual Retirement Account (IRA), also called an ordinary IRA or a regular IRA, is a retirement plan where the taxpayer can deduct annual contributions. Earnings accumulate tax-free until distributed. However, both contributions and earnings are tax-deferred, not tax-free, so distributions are taxable: both contributions and the earnings are subject to the marginal tax rate applicable at the time of the distribution. Furthermore, so that the government can get its money eventually, the taxpayer must start receiving distributions soon after reaching age 73.
An IRA account is generally set up at a financial institution that is approved by the IRS to serve as custodian for the account. An IRA can also be part of a simplified employee pension (SEP), which is subject to the same withdrawal and tax rules as the traditional IRA, or an association trust account provided by employers for employees. The IRA trustee (aka issuer, sponsor) must give the taxpayer a disclosure statement, either 7 days before the IRA account is opened or the trustee must provide 7 days for the taxpayer to cancel the account, after which, the trustee will return all the money contributed. The closure statement must state in plain language when and how the IRA can be revoked and the name, address, and telephone number of the person who is to receive the cancellation notice.
The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.
Secure Act 2.0 changes for IRAs:
- Increases the required minimum distribution (RMD) age from 72:
- to 73 in 2023
- to 75 in 2033
- The penalty for not taking an RMD on time has been reduced from 50% of the amount that should have been withdrawn to 25%, and to 10% for IRAs if corrected within 2 years and by filing Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts and attaching a statement explaining that a reasonable error caused the underpayment and that you have or will correct the shortfall.
- In 2024, the catch-up contribution for IRAs will be adjusted annually for inflation in increments of $100.
- Employers could allow their employees to make 1 withdrawal, up to $1000 annually from their 401(k) or IRA, for certain emergency expenses without owing the 10% additional penalty for nonqualified distributions.
- An emergency is defined as an unforeseeable or immediate financial need related to the employee or his family.
- Employees can choose to repay the amount within 3 years, but if they choose not to, then they cannot make another emergency withdrawal for 3 years.
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:
- beneficiaries of tax-deferred retirement plans must receive the full distribution within 10 years after the death of the employee or account holder, unless they are eligible designated beneficiaries, in which case, they can take distributions over their lifetime;
- the age limit to contribute to a traditional IRA has been repealed (previously 70½), starting with contributions for tax year 2020 and thereafter;
- the age for starting required minimum distributions has been increased from 70½ to 72;
- up to $5000 of distributions from retirement plans can be penalty-free if used to pay for expenses of a birth or an adoption; and
- pension and benefit plan administrators must disclose the plan's lifetime income stream to the beneficiaries;
- for graduate or postdoctoral students, taxable non-tuition fellowship and stipend payments may be treated as compensation to allow more IRA contributions for tax years after 2019.
- 2 new exceptions to the 10% additional tax on early distributions was added:
- emergency personal expense distributions
- domestic abuse victim distributions
Eligible designated beneficiaries include:
- the surviving spouse or minor child of the account owner
- a disabled or chronically ill individual, or
- an individual no more than 10 years younger than the account owner
A minor child who reaches the age of majority, age 21, is no longer an eligible designated beneficiary unless they are disabled or chronically ill. If an eligible designated beneficiary dies with money left over in the account, then the beneficiaries of that account will be subject to the 10-year rule.
A Brief History of the Traditional IRA
- Introduced in 1974, with a maximum annual contribution of $1,500 and only available to workers without an employer-sponsored retirement plan.
- In 1981, anyone younger than 70½ could contribute and the maximum annual contribution increased to $2,000.
- The Tax Reform Act of 1986 phased out eligibility for higher-income taxpayers who were also covered by an employer plan.
- Roth IRAs were introduced in 1997: contributions were not deductible but earnings and qualified withdrawals were tax-free.
Investments
Allowable investments include:
- stocks
- bonds
- exchange-traded funds
- certificates of deposit
- mutual funds
- certain limited partnerships.
Self-directed IRAs are accounts that allow the taxpayer to actively manage the account, and they also allow alternative investments:
- real estate
- undeveloped land
- tax lien certificates
- water rights
- promissory notes
- precious metals
- mineral, oil, and gas rights
- livestock
- LLC membership interest
- cryptocurrency
However, only some financial institutions allow a self-directed IRA. The IRS model form is Form 5305, Traditional Individual Retirement Trust Account and the model custodial account agreement is Form 5305-A, Traditional Individual Retirement Custodial Account.
Avoid Self-Directed IRAs!
Although self-directed IRAs allow alternative investments, they have many drawbacks. Only certain custodians offer self-directed IRAs, and they charge hefty fees for these accounts, including transaction fees, account setup fees, annual fees, and fees per asset. These fees could easily exceed hundreds of dollars annually, depending on the size of the account, because the custodian must purchase the investments or perform any other types of transactions.
Furthermore, the custodian only manages the administration of the account; they do not verify whether you are managing your account according to tax rules, including whether your account can hold certain types of investments. Failure to follow tax rules can result in hefty tax penalties. Record-keeping and tax reporting requirements are complex.
If you have illiquid investments, then there could be problems when you must receive RMDs, although you can avoid this problem if the self-directed IRA is a Roth IRA.
You also cannot use or manage the assets personally. For instance, if you buy real estate, you cannot stay in it, including using it as a vacation home. Professionals must do any repairs; you cannot do the repairs yourself, and you can only pay the professionals with money from the IRA account. You cannot use your own funds since that would be considered a contribution to the IRA. Furthermore, it is the IRA that holds title to the property, so you cannot claim any deductions for repairs, depreciation, mortgage interest, property taxes, or any type of losses. In fact, you cannot claim any deductions in an IRA since you only pay tax on distributions. For Roth IRAs, you do not pay tax on distributions, but you cannot claim any deductions either.
Some types of investments are not permitted in any IRA account:
- collectibles
- life insurance
- your residence
Any investment in collectibles, such as artworks, antiques, gems, rugs, metals, guns, stamps, and certain coins, will be treated as a distribution for which the taxpayer must pay tax.
However, certain coins are exempt from this treatment, including state issued coins and certain US issued coins minted of gold, silver, and platinum. An IRA trustee can hold gold, silver, platinum, or palladium bullion if the metal meets commodity market standards; if the bullion is held by a company rather than the IRA trustee, then the investment is considered a deemed distribution.
Losses from an IRA are not deductible unless the taxpayer fails to recover his nondeductible contributions after receiving the total amount in all IRA accounts.
Individual Retirement Annuity
A taxpayer can also open an individual retirement annuity provided by a life insurance company, so no trustee or custodian is involved. Since an IRA cannot be used as collateral for a loan, the annuity cannot contain loan provisions. However, only the taxpayer or her designated beneficiaries can receive any benefits from the annuity. Additional requirements include:
- the entire interest must be nonforfeitable;
- no portion of the contract can be transferred to anyone else other than the issuer;
- the annuity or endowment contract must provide that contributions cannot exceed the lower of the taxpayer's compensation or the statutory contribution limits;
- refunded premiums must be used to pay future premiums or to buy more benefits by the next calendar yearend;
- distributions must start by April 1 of the year after the year when the taxpayer reaches age 73.
Contributions Limited by Statutory Limits, Compensation, and Modified Adjusted Gross Income (MAGI)
Statutory contribution limits are the maximum annual contribution allowed by law. In addition to statutory contribution limits, contributions may be further limited by earned compensation and may also be limited or eliminated for high income taxpayers. Furthermore, only people younger than 73 at year-end can contribute for that year.
Compensation is earnings from work. It does not include investment income, inherited income, pensions and annuities, deferred compensation, passive partnership income, nor any compensation — except for nontaxable combat pay — that is not taxed, such as foreign earned income and housing costs. It does, however, include taxable alimony and separate maintenance payments. Self-employment income also qualifies as compensation, but it is reduced by the self-employment tax deduction and by any deductible contributions made on behalf of the taxpayer to his retirement plans.
Taxpayers aged 50+ by year-end can contribute at least an additional $1000. Starting in 2024, the catch-up contribution for IRAs will be adjusted annually for inflation in increments of $100. Contributions are limited to the lesser of taxable compensation or these statutory limits:
Year | Age < 50 | Age ≥ 50 |
---|---|---|
2025 | $7,000 | $8,000 |
2024 | $7,000 | $8,000 |
2023 | $6,500 | $7,500 |
2019 - 2022 | $6,000 | $7,000 |
2013-2018 | $5,500 | $6,500 |
2012 | $5,000 | $6,000 |
- Age is determined at calendar year-end.
- If taxable compensation is lower, then that is the limit.
The statutory limit applies to the total of all contributions to all IRA accounts within any given year, regardless of whether the contribution is deductible. The contribution limit is also reduced by any contributions to a §501(c)(18) plan.
Lower income plan participants may also receive a Retirement Savings Contribution Credit (Saver's Credit) of up to $1,000 for a contribution of $2,000.
A spouse can also contribute to a separate IRA plan for a nonworking spouse if they file a joint return. If both spouses receive compensation and satisfy the age requirement, then each can have a separate IRA, with separate compensation limits for both, even in community property states. For joint filers, the spousal IRA limit is the lesser of double the statutory limit or the total compensation that is includable in the gross income of both spouses minus the other spouse's IRA contribution to a traditional IRA + any nondeductible contribution made on behalf of the spouse with the greater compensation + any contributions made on behalf of the other spouse to a Roth IRA. But if a couple divorces or legally separates before the year-end, then any contributions made on behalf of the other spouse are not deductible by the contributing spouse. If a spouse works for the taxpayer, then the taxpayer can set up an IRA account for the spouse but only if the employee-spouse performs actual services and receives wages.
Income limits are also lower than for Roth IRAs. Contributions cannot be made or the contribution limits may be reduced if modified adjusted gross income (MAGI) exceeds certain amounts:
MAGI Threshold | |||
---|---|---|---|
Filing Status | 2025 | 2024 | 2023 |
Married filing jointly or separately or qualifying surviving spouse (QSS). | $236,000 | $230,000 | $218,000 |
All others. | $150,000 | $146,000 | $138,000 |
Source: COLA Increases for Dollar Limitations on Benefits and Contributions | Internal Revenue Service
Taxpayers Covered by an Employer Retirement Plan
MAGI limits for deducting contributions differ for taxpayers or their spouses covered by an employer retirement plan:
MAGI Threshold | |||
---|---|---|---|
Filing Status | 2025 | 2024 | 2023 |
Married filing jointly or qualifying surviving spouse (QSS) | $126,000 | $123,000 | $116,000 |
Married filing separately | 0 | 0 | 0 |
All others, including married filing separately for spouses who did not live together at any time during the tax year. | $79,000 | $77,000 | $73,000 |
- These limits apply if the taxpayer is eligible for an employer plan, even if the taxpayer chooses not to participate in the plan.
- Likewise, a nonparticipating spouse must be ineligible for the other spouse's employer's plan for these limits to apply.
- Source: COLA Increases for Dollar Limitations on Benefits and Contributions | Internal Revenue Service
Note that if only 1 spouse participates in an employer plan, then that spouse is limited by the joint filing status, but the nonparticipating spouse can still contribute to an IRA if joint income is less than the MAGI limits for a joint filing with 1 nonparticipating spouse. So if Jim and Amy report joint income exceeding the MAGI limit, while Jim participates in a plan but Amy does not, then Jim can make no contributions, while Amy's contribution is limited only by the statutory limit, even if Amy's income = MAGI limit and Jim earns considerably less.
However, taxpayers limited by the MAGI limitation can still make nondeductible contributions to a traditional IRA that will grow tax-free until it is withdrawn. Withdrawal of the nondeductible contributions is also tax-free, but the portion attributed to earnings will be taxable. However, if allowed, the taxpayer should contribute to a Roth IRA since both contributions and earnings are tax-free when withdrawn.
If the employee is an active plan participant, then Form W-2, Wage and Tax Statement will show this in Box 13, the retirement plan box. If a self-employed individual has a Keogh plan or SEP, then the taxpayer is treated as an active participant regarding the phaseout rules. For the active participant rules to apply, the taxpayer only must participate at any time during the year even if she has forfeitable benefits.
If the taxpayer's income exceeds the phaseout limit, then the taxpayer cannot make deductible contributions to an IRA. With regard to IRAs, MAGI = AGI − IRA conversions or rollovers + these deductions and exclusions:
- non-taxable Social Security or Railroad Retirement Benefits
- student loan interest deduction,
- tuition and fees deduction,
- exclusion of qualified bond interest, reported on Form 8815,
- foreign earned income exclusion,
- foreign housing exclusion or deduction,
- domestic production activities deduction,
- exclusion of employer-provided adoption benefits, reported on Form 8839, Qualified Adoption Expenses.
Any taxable Social Security benefits received by the taxpayer increases MAGI by the amount of the taxable benefits. If no part of the benefits is taxable, then it does not affect contribution limits.
Active Participants in an Employer's Retirement Plan
Active participant status for taxpayers with a 401(k), profit sharing, stock bonus, or money purchase pension plan are treated as active participants if any contributions were made or allocated to the account for the plan year that ends within the taxpayer's tax year. So it is possible to be considered an active participant even if the employer made no contribution during the tax year to the employee's plan. Active participant status is not affected by whether the taxpayer has a vested right to receive the benefits from the account.
Taxpayers with defined-benefit pension plans are considered active participants if they are eligible to participate, even if the taxpayer does not actually participate. For defined contribution plans, the taxpayer will be considered an active participant if:
- the taxpayer makes elective deferrals to the plan;
- the employer contributes to the account; or
- forfeitures are allocated to the account.
Calculating the Contribution Limit for Spouses with MAGI over the Phaseout Threshold
Steps to calculate the deductible limit for taxpayers with MAGI over the phaseout threshold:
- Excess MAGI = MAGI − Applicable Phaseout Threshold.
- Multiply Excess MAGI by applicable factor:
- If married filing jointly or a qualifying surviving spouse (QSS) and
- younger than 50:
- MAGI Reduction = Excess MAGI × 25%;
- 50 or older:
- MAGI Reduction = Excess MAGI × 30%;
- younger than 50:
- all others:
- younger than 50:
- MAGI Reduction = Excess MAGI × 50%
- 50 or older:
- MAGI Reduction = Excess MAGI × 60%.
- younger than 50:
- If married filing jointly or a qualifying surviving spouse (QSS) and
- Tentative MAGI Contribution Limit = Statutory Contribution Limit − MAGI Reduction.
- If the result is not a multiple of $10, then round up to the next highest multiple of $10. If under $200, then the deductible limit is $200.
For tax year 2024:
Example 1: Taxpayer is single and under age 50 and an active participant in an employer retirement plan.
49-year-old Single Taxpayer Who is an Active Participant in an Employer's Retirement Plan, MAGI | $81,512 | |
Phaseout Threshold for Single Taxpayer | $77,000 | |
Contribution Limit | $7,000 | |
Excess MAGI | $4,000 | = MAGI − Phaseout Threshold |
MAGI Reduction | $2,000 | = Excess MAGI × 50% |
Reduced Contribution Limit | $5,000 | = Statutory Contribution Limit − MAGI Reduction |
If Last Number of Reduced Contribution Limit is Not 0, Round Up to the Next Highest Multiple of $10 | $5,000 |
Example 2: Both spouses are under age 50 and file a joint return. Both are active plan participants.
Contribution Limit for each Spouse | $7,000 | |
Husband and Wife MAGI | $132,000 | |
Phaseout Threshold for Married Couples Filing Jointly | $123,000 | |
Excess MAGI | $9,000 | = MAGI − Phaseout Threshold |
MAGI Reduction | $2,250 | = Excess MAGI × 25%= |
Reduced Contribution Limit | $4,750 | = Statutory Contribution Limit − MAGI Reduction |
If Last Number of Reduced Contribution Limit is Not 0, Round Up to the Next Highest Multiple of $10 | $4,750 | Applies to both spouses separately. |
Example 3: Same facts as Example 2 but only 1 spouse was an active participant. The same deduction limit applies to the active participant. However, the nonparticipating spouse is subject to a $178,000 threshold for nonparticipant spouses, so that spouse is subject only to the statutory contribution limits.
Contributions
The IRA trustee reports contributions on Form 5498, IRA Contribution Information, both to the IRS and to the taxpayer. A taxpayer making a contribution between January 1 and the date in which the previous year's tax return is due, not including extensions, should designate which year for which the contribution is being made; otherwise, the trustee will assume that the contributions are for the current year and will report that to the IRS accordingly. A tax return can also be filed before making the contribution, but then the contribution must be made by the due date of the return. There is no requirement that contributions be made every year, even if the taxpayer can do so. A taxpayer can set up different IRA accounts and put differing amounts in different accounts, both traditional and Roth IRAs, but the contribution limits apply to all accounts.
Administrative fees billed separately by the trustee of an IRA account are not deductible as contributions. Brokerage commissions, however, are deductible as part of the contribution.
The self-employed may contribute based on self-employment earnings, after netting profits and losses among all the businesses, and deducting Keogh or SEP retirement plan contributions + the self-employment tax deduction, equal to 1/2 of the self-employment tax. Profits and losses from multiple businesses owned by the same taxpayer must be netted to determine whether the taxpayer may make a contribution. If losses exceed profits, then no contribution is allowed. However, if the taxpayer also works as an employee and receives wages, then IRA contributions will be limited by the wages even if the taxpayer suffers self-employment losses exceeding the wages.
Taxable alimony must be subject to a written agreement under a decree of divorce or legal separation; otherwise, the alimony payments cannot be used as a basis for determining IRA contribution limits.
A taxpayer older than 73 can make a contribution for a younger spouse who has not yet reached the age limit.
A taxpayer who is called to active duty for more than 179 days or indefinitely, and received distributions from his IRA during the active duty period, may repay the distribution within the 2-year period beginning on the day after active duty, regardless of any other regular IRA contributions made during the year. However, the repayment amount is not deductible since the original contribution has already been deducted. The qualified reservist repayment is reported as a nondeductible IRA contribution on Form 8606.
Excess Contributions
There is a 6% tax penalty on excess contributions that is cumulative, in that it is applied for each year for which the excess contributions are still present by year-end. Taxable earnings will be reported on Form 1099-R. If the excess contributions are withdrawn after the due date but before the 6-month extension period, then the penalty can be avoided if the related earnings are reported on an amended return, explaining the withdrawals. If any excess contributions were not withdrawn for a new tax year, then the excess amount can be re-characterized as a contribution for the new tax year if the contribution limits have not been exceeded.
Spousal IRA
A taxpayer cannot contribute to an IRA unless they have earned income, but there is an exception for married couples filing jointly. A working spouse can contribute to a traditional or a Roth IRA for a spouse who is not working or earns income below the statutory contribution limit, but the IRA must be in the name of that spouse. The limit to contributions to the IRAs of both spouses is the lesser of joint taxable income or the sum of the contribution limits that apply to each spouse:
Total 2024-2025 statutory contribution limits:
- both spouses younger than 50: $14,000
- 1 spouse aged 50+: $15,000
- both spouses aged 50+: $16,000
Nondeductible IRAs
Over-the-MAGI-limit taxpayers can still contribute to a traditional IRA, but the contributions are nondeductible. Nondeductible contributions add to the tax basis of the IRA account and are reported on Form 8606, Nondeductible IRAs. Nondeductible contributions are not taxable when they are distributed, unless the contributions were not reported on Form 8606. The main benefit of nondeductible IRAs is that earnings are not taxed until withdrawn, so earnings can grow tax-free.
There are 2 tax penalties regarding Form 8606, Nondeductible IRAs:
- A $100 penalty for each overstatement of nondeductible contributions in any given year.
- A $50 penalty for the failure to file a required Form 8606.
Both penalties can be avoided if there was a reasonable cause for the overstatement or failure.
Tax-Free Rollovers and Direct Transfers to Traditional IRAs
Rollovers and direct transfers allow a taxpayer to transfer funds to an IRA account tax-free from an employment or self-employment retirement plan, a §403(b) plan, or a government §457 plan or from a Roth or another traditional IRA account.
A rollover occurs when a taxpayer receives a distribution from a retirement account and contributes the money to an IRA. For the rollover to be tax-free, the contribution must occur within a 60-day period after receiving the distribution.
If a distribution is received and not rolled over into a new account, then the amount not rolled over is treated as a taxable distribution for the year in which the distribution was received, even if the 60-day period expires in the next tax year. If the taxpayer is younger than 59½, then a 10% tax penalty for an early distribution may apply.
Taxpayers can benefit from the 60-day rule by borrowing money from an IRA account. If it is repaid within the 60-day period, then it's not treated as taxable income.
If there are problems completing the rollover within the 60-day period, then the IRS may allow more time if the rollover cannot be completed because of events beyond the taxpayer's control, such as a natural disaster, insolvency of the financial institutions, or illness. The deadline may also be extended if the money in the account is frozen because the financial institution is insolvent or bankrupt. If an account is frozen because of insolvency, then the 60-day period is extended until the funds become available; thereafter, the rollover must be completed within 10 days. If a distribution is used to buy or build a qualifying 1st home, but the deal falls through, then the deadline may be extended to 120 days. The IRS will automatically extend the 60-day period to one year if the taxpayer deposited rollover funds with the financial institution within the 60-day period, properly followed its rollover procedures, but, because of the institutional error, the account was not established in time. In other cases, the taxpayer must request a private letter ruling from the IRS, explaining the failure to meet the 60-day deadline. Generally, the IRS will consider the length of delay and whether the taxpayer cashed a check for the distribution.
A rollover from any given account can only be done once a year; otherwise, it must be reported as taxable income. However, if the taxpayer has more than one IRA account, then each account can be rolled over within the same 1-year period that started with the 1st rollover.
An exception to the 1-year waiting period applies to a subsequent distribution made from an insolvent financial institution, where the Federal Deposit Insurance Corporation is acting as receiver, who distributes the money to the taxpayer because it is unable to find a buyer for the distressed institution.
A direct transfer occurs when money or property is transferred directly from one retirement account to an IRA through a transfer between financial institutions or between accounts managed by the same custodian. Direct transfers, unlike rollovers, are not subject to the 1 year limitation.
To effect a direct transfer, the receiving IRA custodian will send forms to the taxpayer to fill out and return. Thereafter, the forms are forwarded to the IRA custodian holding the account to be transferred.
A direct transfer need not be reported on a tax return, but a rollover must be reported — the total distribution should be reported, then the taxable amount is entered as 0. A rollover that must be reported as income may also be subject to the 10% tax penalty.
There are also many rules regarding distributions. See IRA Distributions for more information.
If a traditional IRA, SEP, SIMPLE, 401(k), or 403(b) account is converted to a Roth account, then the account cannot be recharacterized back to a traditional IRA (per Tax Cuts and Jobs Act).