IRA Contributions for tax year 2020
Everyone has at least until April 15, 2021 to make IRA contributions for tax year 2020. Tax deductible traditional IRA and Roth IRA contributions are limited to $6,000, or $7,000 if over age 50, up to the amount of your earned income from wages or self-employment. This limit applies in any combination of traditional or Roth IRA. The primary difference between a traditional and Roth IRA is when you pay taxes on the money.
Traditional IRA contributions are tax deductible now, but taxed at earned income rates (higher than capital gains tax rates) on withdrawals that are required to begin at age 72. Nevertheless, traditional IRA owners benefit from tax deferred growth.
In contrast, Roth IRA contributions are not deductible now, but there is no tax on earnings from the account, no tax on withdrawals after age 59 ½, and there are no requirements to withdraw funds, so they can continue providing tax benefits longer than traditional IRAs.
As an example, let’s consider $7,000 contributed to a traditional IRA versus a Roth IRA by a 50-year-old that is invested in the S&P 500 stock market index. In 20 years, the account would be worth about $47,000, applying an average annual growth rate of 10%.
If the investor withdrew all $47,000 at age 70 from a Roth IRA, there would be no tax. If withdrawn from a traditional IRA, all $47,000 would be taxable at the investor’s marginal earned income tax rate.
Let’s say the investor was in the 32% marginal tax rate at age 50 and in the 22% marginal tax rate when withdrawing the money at age 70 for an example of the tax impact, as shown in the table below.
The Roth IRA produced $8,100 more than the traditional IRA in after-tax profit, despite the owner being in a lower future marginal tax rate than at the time of the initial contribution. However, the percentage return on the initial after-tax cost is highest in the traditional IRA.
This example is based on current tax law. If future tax rates rise, the Roth IRA will become even more valuable than in this example. Furthermore, this example doesn’t show the added benefit from the Roth IRA tax benefit continuing long after age 72 when funds begin to be forced out of the traditional IRA.
Eligibility rules limit IRA contributions, but they are different for traditional and Roth IRAs, as shown in the illustrations below:
If you file a joint tax return, you may be able to contribute to an IRA even if you didn’t have taxable compensation as long as your spouse did. Each spouse can make a contribution up to the current limit. However, the total of your combined contributions can’t be more than the taxable compensation reported on your joint return.
If you are married and your spouse is covered by a retirement plan at work and you aren’t, and you live with your spouse or file a joint return, your deduction is phased out if your modified AGI is more than $196,000, but less than $206,000. If your modified AGI is $206,000 or more, you can’t take a deduction for contributions to a traditional IRA.
Age 70 ½ Rule
Contributions can’t be made to your traditional IRA for the year in which you reach age 70½ or for any later year. Contributions can be made to your Roth IRA regardless of your age, but are subject to the income limitations cited earlier.
For Those Who Exceed Income Limits
You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. The amount that you withdraw and timely contribute (convert) to the Roth IRA is called a conversion contribution. If properly (and timely) rolled over, the 10% additional tax on early distributions won’t apply. However, a part or all of the distribution from your traditional IRA may be included in gross income and subjected to ordinary income tax.
For those who are over the income limits to make a tax-deductible or Roth IRA contribution, consider what is known as a “back-door Roth IRA”. Because income limits don’t apply to nondeductible traditional IRA contributions and there are no limits on converting traditional IRA assets to a Roth IRA, there is this “back-door” path to funding a Roth IRA.
In doing this conversion, people who have other traditional IRA assets that have never been taxed become subject to the pro rata tax rule. If your retirement accounts contain both pretax and after-tax amounts, the IRS will generally view any distribution as a pro rata share of both. If you have a lot of pre-tax money in your IRAs, then the tax bill due upon the conversion may be higher than you might anticipate from the amount of the conversion alone.
One of the ways around the pro-rata rule, if you also have an active 401(k) plan, is to roll traditional IRA assets that you aren’t converting to a Roth IRA into your 401(k) plan, assuming that your plan allows it. Assets inside a 401(k) don’t count toward the pro-rata rule.
For Small Business Owners
Although these retirement accounts are not a complete list of what is available, they are commonly used and provide the choice of traditional and Roth vehicles that can, under certain circumstances, be in addition to the above personal IRA investments.
Simplified Employee Pension (SEP)
A SEP is a written arrangement that allows your employer to make deductible contributions to a traditional IRA (a SEP IRA) set up for you to receive such contributions. These are often used by people who are self-employed and small businesses.
The maximum SEP contribution for 2020 is the lesser of $57,000 or 25% of the participant’s compensation. The maximum deduction is 25% of all participants’ compensation. Generally, distributions from SEP IRAs are subject to the withdrawal and tax rules that apply to traditional IRAs.
The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
- Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to $19,500 in 2020 and 2021, or $26,000 if age 50 or over; plus
- Employer nonelective contributions up to:
- 25% of compensation as defined by the plan, or
- for self-employed individuals, total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $57,000 for 2020 and $58,000 for 2021.
A designated Roth account is a separate account in a 401(k), 403(b) or governmental 457(b) plan that holds designated Roth contributions. Designated Roth contributions are elective deferrals that the participant elects to include in gross income. The plan must keep separate accounting records for all contributions, gains and losses in the designated Roth account.
Qualified distributions from a designated Roth account are excludable from gross income. Generally, a distribution qualifies for income exclusion when it occurs more than five years after the initial contribution to the account and when the participant is age 59½ or older or dies or becomes disabled.
The following table shows a comparison of Roth 401(k), Roth IRA, and traditional 401(k) plans.
* This limitation is by individual, rather than by plan. You can split your annual elective deferrals between designated Roth contributions and traditional pre-tax contributions, but your combined contributions can’t exceed the deferral limit – $19,500 in 2021 and in 2020 ($26,000 in 2021 and in 2020 if you’re eligible for catch-up contributions).
Small business owners and sole proprietors can establish solo 401k plans that have a Roth 401k, but will need an administrator, which have additional annual fees. Brokerage firms won’t create an account the same way as an IRA or SEP.
Because everyone’s situation is unique, please check with your financial adviser and/or accountant before implementing financial and/or tax decisions. Do not assume this information fits your individual circumstances. For guidance about your specific situation, contact Jeffrey Barnett at email@example.com.