It’s essential for investors to understand the relationship between IRAs and tax brackets to make the most of the benefits they bring and avoid costly administrative fees and losses.
In this article:
- Changes Will Be Made to Tax Brackets
- Certain Provisions Will Remain the Same for IRAs
- Both the Traditional and Roth IRA Can Save Retirees More Taxes
- Roth IRA Qualifications Still Hold True
- IRA Losses Will Not Affect the IRS Tax Bracket for Investors
- Roth IRA Supports Estate Planning
- New Law Prohibits Roth Recharacterizations
- Higher Qualified Charitable Distributions and Gifts Can Lower the Tax Bracket More
- Higher Contribution Limits Are In Effect for 2019
9 Essential Things Investors Should Know About the IRA-Tax Bracket Relationship
1. Changes Will Be Made to Tax Brackets
Changes in tax brackets can mean tax benefits for potential investors, which may encourage some to invest in an IRA.
The Tax Cuts and Jobs Act of 2017 (TCJA) amended the Tax Code, a law that has been in force since 1986. TCJA has added and changed quite a number of provisions that affect not only every IRA but also how the IRS processes taxes.
One provision, called “indexing,” determines how the IRS will adjust tax brackets based on inflation. This prevents a phenomenon called “bracket creep,” which is when someone is moved to a higher tax bracket due to small pay bumps meant to keep up with inflation.
Perhaps the most critical amendment is the change in how the IRS will conduct indexing for this tax year, which will affect tax brackets and rates. There will be relatively new tax brackets offering tax rates that will be beneficial to taxpayers.
There are still seven brackets, and the list below provides information on the following:
- Amended tax rates
- Tax rate before the amendment (effective for the tax year 2017)
- Starting qualifying cash flow as income bracket for single taxpayers, joint filers, and heads of household
|Amended Tax Rate||Previous Tax Rate||Single Taxpayers||Joint Filers||Heads of Household|
The tax deadline on April 15, 2019 will reflect these new tax rates. Since five of the seven income brackets have lower tax rates, some people argue that 2018 and 2019 are great periods to invest extra money in an IRA.
However, investing intelligently is not as easy as it sounds. Analyzing which industry sectors are expected to grow can give investors ideas on how to implement their investment strategies.
2. Certain Provisions Will Remain the Same for IRAs
An important provision that remained is the accepted asset types in a self-directed IRA. A self-directed IRA retains the flexibility of its investment options. Investors can still invest in unique assets, like real estate and tax liens, which provide better diversification in a retirement portfolio.
In terms of other provisions, the rules and regulations in a self-directed IRA remain the same.
Roth IRA Provisions
- The post-tax contribution for a Roth IRA is still in place.
- Investors pay the taxes upfront, which makes a Roth IRA good for investors who expect their income to increase upon retirement.
- For Roth IRAs, there are no RMDs while the account owner is still alive. However, once the Roth IRA becomes part of a deceased estate, the law requires a distribution.
For Roth IRA investors, the requirements for a qualified withdrawal still apply:
- That the Roth IRA account has been open for at least 5 years, and
- That the investor reached age 59 and ½ or has been declared disabled or deceased.
For a more in-depth discussion about the nuances of a Roth IRA, the Roth IRA withdrawal rules and exemptions can enlighten confused investors.
Traditional IRA Provisions
Not much has changed with the structure for a Traditional IRA.
- Contributions are still tax-deferred, so investors who expect to have a lower tax bracket upon retirement might still prefer a Traditional IRA over a Roth IRA.
- The law still requires an RMD.
RMD Definition: Also known as the Required Minimum Distribution, this is a legal requirement where an investor must distribute a part of an IRA’s value.
3. Both the Traditional and Roth IRA Can Save Retirees More Taxes
As mentioned above, Traditional IRAs are usually most suitable for those who expect to be in a lower tax bracket upon retirement. On the other hand, Roth IRAs will often be useful for investors who prefer to pay their taxes now rather than later.
Traditional IRA Tax Benefits
One important feature that investors forget has still remained applicable, especially for Traditional IRAs. Contributions for a Traditional IRA can lower an investor’s AGI.
Lower AGI = lower taxable income bracket
AGI Definition: Also known as Adjusted Gross Income, this is one’s personal income minus any tax deductions legally available.
Roth IRA Tax Benefits
For Roth IRAs, money grows tax-free.
Longer period an investor has post-tax money inside = lesser tax needs to be paid in the long run when it comes to an IRA
4. Roth IRA Qualifications Still Hold True
It bears emphasis that investors should know what makes a portfolio a valid retirement account to receive tax benefits. The important area to look at is the withdrawals.
Again, for a Roth IRA, there are two things to remember:
- The account must exist for at least 5 years
- The account owner must be 59 and ½ or older upon request of distribution.
This precaution bears emphasis for two reasons:
- A 10% early withdrawal fee applies
- The IRS considers the distribution as ordinary income
Once the IRS gets news of the early distribution, that amount is added to the tax year income. This can increase taxes substantially, as the investors AGI is now higher.
5. IRA Losses Will Not Affect the IRS Tax Bracket for Investors
There are a few developments that may negatively impact an IRA and the tax income brackets. This is particularly applicable with IRA losses.
To clarify, the losses meant in this section apply to those who close their IRA accounts. The losses here do not refer to the loss of market value in an existing IRA, but to a losing IRA that an investor closes out.
A final clarification is that the IRA losses can still apply to other deductions to lower the income tax brackets, provided these are not for the 2018 tax year.
- An investor has an IRA worth $90,000 but started the IRA account with $100,000.
- The actual loss of $10,000 can still apply as a deductible provided that the amount is not greater than 2% of total AGI.
However, because of the 2% cap, as well as other deductions that usually come first before an IRA loss, investors can seldom enjoy an IRA loss as a tax deduction for 2018. Investors planning to close their IRA accounts may want to make sure that their decision aligns with their investment plans.
6. Roth IRA Supports Estate Planning
Another great benefit that a Roth IRA gives to investors lies in better estate planning.
- Estate taxes can eat a big chunk of an inheritance. With a Roth IRA, a beneficiary can bypass a chunk of the estate taxes by taking out qualified distributions rather than a lump sum.
- The assigning of the beneficiary can also assist the heirs with paying estate taxes or at least have a monthly or yearly income through a Roth IRA distribution. This creates another estate planning benefit, which is providing a safe source of income for beneficiaries who may not have the best financial spending behavior.
Since a Roth IRA needs to exist for at least 5 years before the law treats it as such, opening one early is of high importance.
7. New Law Prohibits Roth Re-characterizations
To set the records straight, transferring a Traditional IRA to a Roth IRA is still an option. However, reverting the IRA type is no longer available.
Investors may want to change the tax status of their retirement accounts due to changes in their income brackets. However, the IRS can deem said changing of character final.
Any decision about changing the nature of an IRA these days needs more planning and research than ever.
This prohibition applies as of December 31, 2017. Investors who may not know of such prohibition may receive communication from the IRS regarding the issue.
8. Higher Qualified Charitable Distributions and Gifts Can Lower the Tax Bracket More
Ever thought about giving a loved one a gift this year? With the gift limits raised, some taxpayers can help younger generations get a head start.
Of course, charitable giving is a gift in itself, but no one can deny the tax income deduction benefit gifting can bring.
The IRS has increased the limit to $15,000 for 2018. Usually, the limit increases every 5 years due to inflation, but the IRS can delay or shorten the period whenever they see fit.
How does a higher gift limit benefit IRAs and tax brackets?
- A person can give a donation to a loved one, which in turn can become an IRA investment for those without an income yet, such as a younger person.
- Both can get the benefits afforded by law—the giver gets a lower tax bracket, while the receiver doesn’t pay an income tax on the gift. This is because the giver, not the receiver, pays the gift tax.
- A more common example of how higher gift limits help an IRA lies with spouses.
- If only one spouse is working, then the non-working spouse can receive the gifts and apply the money to his or her IRA. The working spouse can get a lower tax bracket, which frees up more cash for an IRA.
- In this way, both spouses benefit, as the IRA of the non-working spouse receives any excess of the contribution as a gift, rather than the IRS penalizing said contribution.
9. Higher Contribution Limits Are In Effect for 2019
For 2018, both Roth IRAs and Traditional IRAs the contribution limits are $5,500 or $6,500, as per catch up provisions for investors 50 or older.
As for 2019, the limits are now at $6,000 for investors younger than 50 and $7,000 for those 50 and above.
Of course, an investor cannot contribute more than their taxable compensation for the year. A more in-depth discussion about said limits is available at 2019 IRA Contribution and Income Limits.
These nine developments can affect any IRA, even if the investments inside the portfolios perform well. With research and prudence, any investor can decide the most efficient way on how to grow their IRA and make their retirement dreams a reality.
Do you have other questions about a specific IRA provision? What are your thoughts about the new tax brackets? Share them with us in the comments section below.
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