IRAs, and the rules people get wrong

Individual retirement accounts are simple in concept and carry several eligibility rules that produce errors, some of which are expensive to correct.

The two types

A traditional IRA takes contributions that may be deductible, grows tax deferred, and is taxed on withdrawal.

A Roth IRA takes contributions that are not deductible, grows tax free, and generally produces tax-free withdrawals subject to conditions.

Both are subject to a combined annual contribution limit that is adjusted periodically, with an additional catch-up amount available from age fifty.

The eligibility rules

You need earned income. Contributions require compensation from work. Investment income, rental income and Social Security do not qualify.

The contribution cannot exceed earned income for the year.

Spousal contributions. A working spouse can fund an IRA for a non-working spouse where a joint return is filed, which is widely unknown and frequently valuable.

Roth income limits. Direct Roth contributions phase out above certain income levels.

Exceeding them and contributing anyway produces an excess contribution subject to a penalty each year until corrected, which is one of the more common IRA errors.

Traditional deduction limits. A frequently misunderstood point: anyone with earned income can contribute to a traditional IRA, but the deduction phases out at certain income levels if you or your spouse are covered by a workplace retirement plan.

Contributing without a deduction is permitted and creates basis in the account that must be tracked.

The backdoor route

A widely used technique for those above the Roth income limits.

The method is to make a non-deductible traditional contribution and then convert it to Roth. There is no income limit on conversions under current rules.

The complication is the aggregation rule. When calculating the taxable portion of a conversion, all traditional, SEP and SIMPLE IRA balances are considered together, not just the account being converted.

Someone with a large existing pre-tax IRA balance will therefore find most of the conversion taxable, which defeats the purpose.

A common workaround is rolling existing pre-tax IRA balances into an employer plan, if the plan accepts them, leaving no pre-tax IRA balance.

This is an area where errors are common and the paperwork matters — the relevant tax form must be filed to record non-deductible contributions, and failing to file it can result in paying tax twice on the same money.

The five-year rules

Two separate rules that are frequently conflated.

For Roth contributions: earnings can be withdrawn tax free only after the account has been open five years and another qualifying condition is met.

For Roth conversions: each conversion has its own five-year period before the converted amount can be withdrawn without penalty, if you are under the relevant age.

Contributions themselves — as opposed to earnings — can generally be withdrawn at any time without tax or penalty, which is a useful feature and a poor reason to treat a Roth IRA as an emergency fund.

Rollovers

Moving money between accounts is routine and has traps.

A direct transfer between institutions is the safest route and has no limits.

An indirect rollover — where the money is paid to you and you redeposit it — must be completed within sixty days, is subject to a once-per-year limit across IRAs, and may involve withholding that you must replace from other funds to avoid tax.

The practical advice is straightforward: request direct transfers and avoid taking possession of the money.

Beneficiary designations

The item with the largest consequences relative to the effort required.

IRA beneficiary designations generally control who inherits the account, regardless of what a will says.

Out-of-date designations — an ex-spouse, a deceased person, or a blank form that defaults to the estate — are common and produce outcomes nobody intended.

Naming the estate rather than individuals can also produce a worse distribution timetable for heirs.

Reviewing designations after any marriage, divorce, birth or death takes minutes.

Costs and custodians

IRAs can be held almost anywhere, and the differences are real.

Worth comparing: account fees, trading costs, the range of investments available and the cost of the underlying funds.

For most people a low-cost provider offering broad index funds covers the requirement entirely, and complexity beyond that adds expense more reliably than return.

General information only, not financial or tax advice. Limits, thresholds and rules change annually — consult a qualified tax professional about your own situation.