Paying Yourself First: Retirement Options for Individuals

By Zeb Elliott, CPA, SGA Team Member

Long gone are the days where a worker could rely on an employer pension plan to completely fund their retirement years. It is now the responsibility of the individual to properly plan and save for their retirement. For many individuals, saving for retirement and paying themselves first is an afterthought. This is especially true for self-employed individuals. According to a recent survey conducted by the Employee Benefit Research Institute, an alarming number of Americans have set aside less than $25,000 for their retirement. In another study conducted by PricewaterhouseCoopers, nearly three-fourths of baby boomers have less than $300,000 saved for retirement, and about 30 percent of all baby boomers have less than $50,000 saved.

Tax season is a smart time to sit down with your Sink, Gordon & Associates LLP tax advisor and identify your options when it comes to paying yourself first and saving for retirement.  For individuals that may not have access to an employer pension, a 401(k) plan or a 403(b) plan, two common alternatives are the Traditional IRA and the Roth IRA.

Traditional IRAs, in general, provide the contributing taxpayer an upfront tax deduction for their contribution. However, when the taxpayer withdraws the money out of the account in retirement, all of it will be taxed at the taxpayer’s ordinary income tax rates (unless there is basis in the IRA). Basis occurs in an IRA fund if there were any nondeductible contributions made to the account at any point in time.  The following are the basic rules regarding traditional IRAs:

• An individual (or spouse) must have earned income and must be under the age of 70 ½ at the end of the year to contribute.
• The contribution deadline is the due date, (not including extensions), of the tax return for the year of the contribution. April 17, 2018 is the deadline for 2017 contributions.
• The limit on the contribution amount is the lesser of:

1. $5,500 (additional catch-up contribution of $1,000 if age 50 or older at the end of the year), or
2. Compensation (earned income).

• A full deduction is allowed if the individual (and spouse) are not covered by an employer retirement plan. If the individual is covered by an employer retirement plan, the deduction for the individual’s contribution is subject to phase-out at the following modified AGI amounts for 2017 based on the applicable filing status:

 

FILING STATUS	MODIFIED AGI AMOUNTS	DEDUCTION
MFJ, QW	$99,000 or less $99,000 - $119,000 $119,000 or more	-Full deduction up to contribution limit -A partial deduction -No deduction
Single, HOH	$62,000 or less $62,000 - $72,000 $72,000 or more	-Full deduction up to contribution limit -A partial deduction -No deduction
MFS	Less than $10,000 $10,000 or more	-A partial deduction -No deduction

 

• If the individual is not covered by a retirement plan at work, but the spouse is covered, the deduction for the individual’s contribution is subject to phase-out at the following modified AGI amounts for 2017 based on the applicable filing status:

 

FILING STATUS	MODIFIED AGI AMOUNTS	DEDUCTION
MFJ, QW	$186,000 - $196,000 $196,000 or more	-A partial deduction -No deduction
MFS	$10,000 or more	-No deduction

 

• Distributions are taxable as ordinary income (unless there are any Traditional IRAs with basis, at which point the taxable portion of the distribution will be based on a pro rata allocation).
• Penalties are calculated at 6% for excess contributions and there is a 10% early withdrawal penalty assessed on early distributions (prior to age 59 ½), unless certain exceptions are met. Consult your tax professional should you have questions about exceptions.
• Required minimum distributions must begin by April 1 of the year following the year the account owner turns ago 70 ½.

 

Roth IRAs, on the other hand, are treated differently for tax purposes. With a Roth IRA, the taxpayer contributing to the account forgoes the tax deduction in the year contributed. However, when the funds are withdrawn in retirement, the entire distribution is tax-free. The following are the basic rules regarding Roth IRAs:

 

• An individual (or spouse) must have earned income (compensation). There are no age restrictions for contributing to a Roth IRA.
• The limit on the contribution amount is the same as Traditional IRAs, but phases out at the following modified AGI amounts:

 

FILING STATUS	MODIFIED AGI AMOUNTS	CONTRIBUTION AMOUNT
MFJ, QW	$186,000 or less $186,000 - $196,000 $196,000 or more	-Up to the limit -A reduced amount -Zero
MFS	$10,000 or less $10,000 or more	-A reduced amount -Zero
Single, HOH	$118,000 or less $118,000 - $133,000 $133,000 or more	- Up to the limit -A reduced amount -Zero

 

****Exception to income limitations: Implementing the back-door Roth IRA technique, where an individual that makes too much money to directly contribute to a Roth IRA, can contribute to a nondeductible Traditional IRA and then subsequently convert the nondeductible IRA to a Roth IRA. This is a move that is unrestricted by income limits and is currently an accepted practice in the eyes of the IRS. The only taxes due on the conversion would be on any appreciation in the investments since the date that the account was opened.

• The contribution deadline is the same as the deadline for Traditional IRAs, noted earlier in this article.
• A qualified distribution is income and penalty tax-free. A distribution is qualified if made after a five-year holding period, which begins on the first day of the first year for which Roth IRA contributions were made, and one of the following applies:

1. The taxpayer is age 59 ½ or older
2. The distribution is due to death or disability
3. The distribution is eligible for the first-time homebuyer exception to the 10% penalty tax on early distributions

• Withdrawals from a Roth IRA are considered to come first from contributions and then from earnings. No income tax or 10% penalty applies until total withdrawals exceed total contributions.
• There are no required minimum distribution rules for Roth IRAs. However, distributions are only required after the death of the Roth IRA owner, (although still nontaxable to the beneficiary).

 

So which option is best for you? A lot of this decision is based on your own unique tax situation. Generally, if you are going to be in a higher tax bracket, it might make sense to contribute to a Traditional IRA (provided that a substantial deduction is allowed). The higher your tax bracket, the more your deduction is worth. If your tax bracket will be lower, a Roth IRA might make more sense, as you will be foregoing the upfront deduction for your contribution, while benefitting from tax-free withdrawals in retirement, (when you may be in a higher tax bracket). A Roth IRA also offers some added flexibility, as contributions can be withdrawn penalty and tax-free at any time. If you are in a pinch financially in the future, you would have access to your Roth IRA contributions without any adverse tax consequences.

Saving for your retirement is ultimately up to you and many times, requires additional funds beyond the retirement fund provided by your employer. However, working with the right tax professional can help take the guesswork out of the process. Please contact Sink, Gordon & Associates LLP today to discuss your options. Call our office at 785-537-0190 or email us at info@sinkgordon.com to see how we can assist you in your retirement planning decisions.

---

 

 

Contributing Author: Zeb Elliott, CPA  |  EMAIL

Zeb has been with SGA since January 2011 and specializes in individual and business tax preparation and planning, and QuickBooks consulting and training. Professionally, Zeb is a member of both the American Institute of Certified Public Accountants and Kansas Society of Certified Public Accountants and became a Certified Public Accountant in 2013. Prior to entering the accounting industry, Zeb earned his Bachelor of Science in Business Administration in 2010 and Master of Accountancy from Kansas State University in 2014. Zeb holds several leadership positions within the community, serving on the Finance Committee for the Young Trustees of the Greater Manhattan Community Foundation and as Treasurer for the Friends of the Sunset Zoo. Outside of his commitments, Zeb devotes his time to his wife, Kilynn, and his son, Kannen. Zeb also enjoys being active and playing any type of sport, including golf, softball, and basketball, grilling, cheering on his Kansas City Chiefs and Royals, catching a good concert and reading about personal finance.