Deductibility of Contributions
While anyone with earned income may make a contribution to a traditional IRA, only some contributions may be tax-deductible. The deductibility depends upon your income level, whether you’re an active participant in an employer-sponsored retirement plan (e.g., 401(k) or pension plan), and your income tax filing status.

If neither you nor your spouse participate in an employer-sponsored retirement plan or if you’re single and don’t participate, you may deduct up to the maximum contribution:

1. Single persons who are active participants in an employer-sponsored retirement plan and have a modified adjusted gross income of no more than $125,000 in 2020 may make the maximum IRA contribution and deduct it

2. Married couples filing jointly who are active participants in an employer-sponsored retirement plan and have a modified adjusted gross income of no more than $198,000 in 2020 may make the maximum contribution and deduct it. For a married person filing separately (who lived at least part of the year with his or her spouse and either spouse was an active participant in an employer-sponsored retirement plan), the deduction is reduced for income between $0 and $10,000, and then it is eliminated completely. If you live apart from your spouse the entire year and file an income tax return as a married person filing separately, you calculate your IRA deduction as if you were single. Your spouse’s participation in a plan is ignored.

3. If one spouse is an active participant in an employer-sponsored retirement plan and the other isn’t, then the non-working spouse may make a deductible contribution if the joint income is no more than $198,000. The deduction is reduced for income between $198,000 and $208,000. Then it is eliminated completely

Benefits of an IRA

1. Contributions may be up to $6,000 per year (up to $12,000 for married couples, including a contribution for a non-working spouse)

2. Contributions may be tax deductible

3. Earnings are tax-deferred without any reduction for income tax each year

4. Contributions don’t need to be made every year

5. You may be eligible to convert to a Roth IRA

6. Special creditor protection may be available

Possible Drawbacks of an IRA

1. Distributions of earnings and tax-deductible contributions are taxed at ordinary income tax rates (from 15% to 40% for federal tax plus state tax as of January 1, 2021). However, distributions of non-deductible contributions are income tax free

2. The tax deduction for contributions may be limited or eliminated if your income is over a certain limit and you are an active participant in an employer-sponsored retirement plan

3. Contributions stop at age 70½

4. Distributions must start by April 1 of the year after reaching age 70½

5. You can’t borrow from an IRA

Timing of Distributions
Traditional IRAs have mandatory distribution deadlines (the law calls for the first required distribution to occur by age 70½). You may face penalties if you receive a distribution too early (before age 59½) or too late. You must take the mandatory amount (also known as required minimum distribution or RMD) no later than April 1 of the year after the year you reach age 70½. So, if you reached age 70½ in the year 2020, your first mandatory distribution must be made by April 1, 2021. If you don’t take a required minimum distribution on time, there is a 50% penalty on the portion that should have been distributed. Required minimum distributions are mandatory each year after you reach age 70½.

You may start taking distributions before age 70½. It is important is to plan ahead for distributions before you reach age 70½. Here’s why. In the example above, the first distribution was taken on April 1, 2021. That was a distribution for the year 2020. Another distribution will need to be taken by December 31, 2021 (for the year 2021). By waiting until the year after age 70½ was reached to take the first required distribution (for the year 2020), two distributions (for 2020 and 2021) would be made in one taxable year (increasing taxable income and the possibility of moving to a higher income tax bracket). Instead, the first distribution could have been taken in the year 2020 to avoid a bunching up, or doubling, of income in the year 2021 and thereby possibly decrease the income tax due on the two distributions.

By age 70½, you need to choose your method of distribution and your designated beneficiary. These choices can affect the payout options for you and your beneficiary. Consult with your tax advisor for guidance on these issues.

Income Taxes
Distributions of earnings and tax-deductible contributions are usually subject to federal and state ordinary income tax (the federal rate is from 15% to 40%, as of January 1, 2021). In the special case of non-deductible contributions to a traditional IRA for which no income tax deduction was taken, the distribution of those after-tax contributions is not subject to income tax (however, income tax is still due on the earnings from those non-deductible contributions).

Income Tax Penalties
Penalties can apply in these cases:

1. Making too large a contribution can be subject to a 6% excise tax

2. Withdrawing too little once the age 70½ distribution rules apply can result in a 50% penalty

3. Taking a distribution before you reach age 59½ is subject to a 10% penalty unless an exception applies (see below)

Exceptions to Early Distribution Penalty
Distributions of contributions or earnings before age 59½ will be subject to a 10% penalty unless:

• You are disabled or

• Your beneficiaries are receiving distributions due to your death or

• You are using the funds (up to $10,000) for a first-time home purchase or

• You are using the funds for qualified educational expenses for yourself, your spouse, your children, your spouse’s children, your grandchildren or your spouse’s grandchildren or

• You are taking the distributions under an approved annuity formula or

• You are paying medical expenses in excess of 7.5% of your adjusted gross income or

• You are paying health insurance premiums during a year where you are unemployed for more than 12 consecutive weeks or

• You are taking a distribution of after-tax contributions or

• You make a qualifying rollover to another IRA 

The term “first-time home purchase” means you didn’t own part or all of a principal residence in the two-year period before buying the new house. This $10,000 amount is a lifetime limit and is not an annual limit.

Beneficiary Designations
Legal and tax advice is useful when determining how to complete beneficiary designations. Properly completed designations can help save estate (death) tax, avoid probate, allow better income tax opportunities and avoid creditor claims on retirement assets.

Extra care needs to be taken in naming trusts as a beneficiary of most retirement assets in case of a death. Sometimes, naming trusts as a beneficiary can trigger income tax sooner than it would otherwise be owed and reduce the amount ultimately shielded from death tax.

Note that many plans require the participant’s spouse to be the beneficiary, unless the spouse provides written permission for another beneficiary to be named.

Creditor Protection
Retirement plans and accounts may have special creditor protection under federal and/or state laws. Different types of plans and accounts may have varying degrees of protection. State protection rules may also vary from state to state.

If you convert from one type of plan to another (e.g., from a traditional IRA to a Roth IRA), you may be changing how much protection you have. This may be also be the case if you move to another new state where the new state rules are different.

Consulting with an attorney for guidance on the creditor protection issue may be helpful.

Estate & Death Taxes
Retirement assets are added to your other assets and may be subject to federal and/or state death (estate) tax. It depends upon the size of your overall estate and the estate planning done for you. Consult with your advisor about ways to defer or avoid estate tax.

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Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.

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