Ask An Advisor - Individual Retirement Accounts (IRA)

Today I am featuring questions and answers that commonly come up about IRAs in a new series I am calling "Ask an Advisor." Note, the following responses were originally posted on Investopedia's "Advisor Insights" page. To see all of my Q&A responses or to keep up with future commentary you can use this link and click on the follow button. By the way, I welcome any and all types of questions from my current readers. Simply email me at 

How Does A Roth IRA Grow Over Time?

Think of the Roth IRA itself as a shield around your money that provides tax-deferred growth and then when you go to retire you can take out all of the growth and contributions tax-free. The avoidance of tax is not available had you just invested with after-tax dollars and did not own a Roth IRA. In fact, capital gains, dividends, and ordinary income taxes apply in that case. Also note, a Roth, unlike a Traditional IRA, receives after-tax dollars as the contribution. Traditional IRAs on the hand usually receive pre-tax contributions that grow tax-deferred, however, at retirement, the money withdrawn is fully taxable at ordinary income tax rates. The other scenario you might see is non-deductible IRAs. These allow money to grow tax-deferred, but the original investment originates from after-tax dollars. Only the growth is taxable at the time of distribution. Note, the growth gets pulled before the original cost basis (the amount you originally invested).

A Roth is especially appealing to younger investors because the growth is often 4-8 times what was invested by the time they retire. The actual growth rate will largely depend on how you invest the underlying funds within the Roth account. Investors can select from any number of investment vehicles, such as cash, CDs, bonds, stocks, ETFs, mutual funds, real estate, MLPs, private equity, or even a small business. Historically with a properly diversified portfolio, an investor should expect anywhere between 7%-10% average annual returns. Time horizon, risk tolerance, and the overall mix are all important factors to consider when trying to project how your money might grow.  

What is the 5-year waiting rule for Roth IRAs? 

The short answer is the 5-year Rule allows for qualified distributions to avoid income tax and IRS penalties, assuming the investor is older than age 59 1/2 and owned a Roth account for at least 5 tax years.

However, it is important to remember that contributions to a Roth IRA are always tax-free because the source of funds is after-tax dollars. Other exceptions to the taxation of earnings apply when the owner dies, becomes disabled, or uses up to $10,000 for a first time home purchase.

An investor should also be aware that there are 2 Roth IRA withdrawal situations when the 5-year Rule applies: 1) Roth Contributions and 2) Roth Conversions. Both scenarios have their own set of rules and considerations, which are further detailed below:

1) 5-year Rule Roth Contributions 

  • Earnings distributions qualify for tax-free status when the owner is over the age of 59 1/2 and contributed to a Roth IRA account within the last 5 tax years. 
  • Earnings are subject to income taxes and penalties whenever it doesn't meet both of the criteria above.
  • For example, if a 58-year old withdrawals earnings from her Roth IRA, she pays income taxes and a 10% IRS penalty, even if she met the "5 tax years" aspect of the rule. This type of withdrawal is commonly referred to a nonqualified distribution.  
  • Tax years refers to the timing of when a contribution is made to a Roth IRA, allowing for the owner to make a prior year contribution as late as April 2018 and have that count as a contribution as of January 1, 2017.  This means that in actuality the waiting period could be as short as 3 years and 8 months (not 5 calendar years).

2) 5-year Rule Roth Conversions

  • A qualified tax-free distribution is met when the converted Roth IRA funded the account within 5 tax years and the owner is age 59 1/2.  
  • A conversion occurs when an investor transfers their pre-tax retirement account (Traditional IRA, Traditional 401k or 403b) to a Roth IRA.
  • When an investor elects a conversion they pay income taxes on the converted funds either out of pocket or by withholding taxes before the difference goes into their Roth IRA.   
  • The benefit of a conversion is that it allows what is normally considered an early withdrawal to avoid incurring a 10% IRS penalty.  However, the 5-year Rule must be met as well.
  • When the 5-year rule is not met, it is considered a nonqualified distribution. In other words, the principal withdrawn is subject to a 10% IRS penalty. Notice how income taxes don't apply since taxes were already paid at the time of conversion. 

The primary reason Roth conversions have a 5-year stipulation is so that investors don't take advantage of a loophole, whereby, the owner contributes to a Traditional IRA and then 1 year later converts those funds to a Roth IRA in order to avoid the 10% IRS penalty.   

Do IRA Contributions Reduce Adjusted Gross Income (AGI)?

Traditional IRA contributions will reduce your adjusted gross income (AGI), assuming you meet certain requirements. If you are not an active participant in a company sponsored retirement plan (e.g. 401k), then you can make as much money as you want and continue to benefit from deducting your IRA contributions from your AGI. However, if you are an active participant in your company's retirement plan, then the following income amounts will phase-out the deductibility of your IRA contributions (2018 tax year):

  • Single = $63,000 - $73,000
  • Married Jointly = $101,000 - $121,000
  • Married Separately = $0 - $10,000

Here's how the phase-out works... A single person making $68,000 may only deduct $2,250 (50%) of a $5,500 IRA contribution. In other words, any active retirement plan participant who is single and makes more than $73,000 is not eligible to deduct their IRA contributions. Instead, such contributions are treated as a non-deductible contribution, which creates a planning opportunity for Roth conversions. This conversion strategy is commonly referred to as a backdoor Roth IRA. Learn more about the Roth conversion strategy here. 

Can IRAs Be Held Jointly By Spouses?

No, IRAs cannot be owned jointly. IRA is an acronym for Individual Retirement Account. The keyword being "individual." The IRS mandates individual ownership because IRAs have tax benefits that are tied to a person's income. Furthermore, there are age requirements that must be satisfied before withdrawing from an IRA without incurring a 10% IRS penalty. Given these stipulations, IRAs can only be owned at the individual level. 

However, there is a workable solution for spouses. A spouse can be named as the primary beneficiary and any additional loved ones can be named as contingent beneficiaries. Note, you have full discretion over what percentage each contingent beneficiary receives -- it does not have to be equal shares. 

Also note, should an IRA owner predecease their spouse, the survivor inherits the IRA and may elect one of the following options

  • Rollover assets to surviving spouses' IRA
  • Transfer assets to a beneficiary IRA, titled in the decedent's name and for the benefit of the surviving spouse
  • Lump sum withdrawal, which is taxed as ordinary income
  • 5-year stretch withdrawal -- this option is only available when the deceased owner passes before they have to take Required Minimum Distributions (RMDs)  

I'm a physician and I do a lot of contracts with 1099 Income. I always max out my 401(k) and IRA. How much can I contribute to that SEP account?

Assuming you are employed as a physician by a separate company where the 401(k) plan is offered and the SEP IRA is tied to your 1099 income, then you can contribute to both retirement plans, along with your IRA. What's great about this is that your contributions are treated independently and allows you to tax shelter significantly more income as a result. In other words, you may contribute up to an aggregate total of $77,500 if under age 50, and $84,500 if 50 or older.

Breaking it down... You can put $18,000 of annual salary towards your 401k ($24,000 if age 50+), with a total limit of $54,000 ($60,000 for age 50+) when including employer contributions. Due to your SEP contributions being considered employer contributions from a separate employer, any amount deferred is not counted against the $18,000 salary deferral limit. Therefore, you are able to contribute an additional 25% of your 1099 income, up to $54,000. Note, if your 1099 income is $100,000 your contribution would be capped at $25,000 -- $100,000 x 25%. So in order to hit the SEP limit of $54,000, you need to make $216,000 from your independent contract work. Furthermore, you may contribute up to $5,500 ($6,500 for age 50+) towards a traditional IRA. Possibly even a Roth IRA if you are at or below the IRS income phaseout limits

Be mindful that if you have any employees working for your LLC S Corp, then everyone must receive equal percentage contributions to the company SEP IRA plan. Also, since you are electing to incorporate, you are permitted to contribute 25% to a SEP IRA. However, sole proprietors, LLCs, and unincorporated partnerships must contribute 20% of their net adjusted self-employment income. The last detail to keep in mind is that your traditional IRA contribution probably does not qualify for any type of tax deduction because most of my physician clients make too much money. Click the following link to see the IRS' income limits as it applies to deductions with traditional IRAs. With the IRA phase-out limits in mind, something to think about is the "backdoor Roth IRA," but I would consult with a CPA to see if such a strategy is advantageous or not. 

My mother inherited her sister's Traditional IRA. What rules should I be aware of when inheriting a previously inherited Traditional IRA?

As the second person to inherit the IRA, you are required to take distributions based on your mother's life expectancy factor. Refer to the previous hyperlink and verify her factor using the tables provided.  In the event your mother already took her distribution this year, you do not need to take another.  However, if she did not take her full distribution this year, then you need to withdraw up to the shortfall amount not yet received. You are always permitted to withdraw more than the required amount by the way. The good news is you have until December 2017 to satisfy the withdrawal requirement. Although I wouldn't wait until the last minute. For an exhilarating read, check out the IRS' explanation about when must you withdraw IRA assets.

Can I return funds to my IRA after taking a withdrawal?

Yes, you may return the funds back to your IRA account or rollover the funds to a new IRA within 60 days.  Employer sponsored 401(k)'s are also eligible to receive funds.  Note, you are limited to doing 1 indirect rollover by the IRS per year -- known as the IRA One-Rollover-Per-Year Rule.  However, any amount coming from Required Minimum Distributions (RMDs) cannot be redeposited into a qualified retirement account.