Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

This most basic question, of course, is commonplace—people often want to know which IRA (or 401(k)) contribution type to make, and the right answer is usually not abundantly clear. However one fact is clear—only people with income from paid work (or some variant of it, discussed below) can contribute to an IRA.

Other versions of this question: Can I take my RMD proceeds and use them to invest in a Roth IRA? (No, unless you have earned income.) Are IRA contributions even worth it later in life? (Probably.) Can I put my inheritance into an IRA, even though I am retired? (Yes, but you will be subject to the annual IRA contribution limits and you need to have enough earned income to cover the contribution.)

Indeed, even as a healthy share of the population struggles to make ends meet in retirement, other retirees find themselves in the enviable position of still being able to save, either because they are working part-time and/or because their other sources of income supply them with more than enough to live on. But is investing in an IRA later in life a good idea?

To answer that question, you need to address two separate issues. First, are you allowed to make an IRA contribution, given your age and the type and level of income you have? And if you can make an IRA contribution, should you opt for traditional or Roth contributions, assuming both are open to you? Would you be better off saving in a taxable account instead?

Will It Float?
The answer to the first question—is an IRA contribution even allowable for you?—is easier to answer, and hinges on meeting three requirements.

Having earned income is the first one: Your income from paid work in the year for which you are making the contribution must be at least equal to or above the amount of the contribution. Note that spousal income counts, too. Even if you personally did not have any earned income, if your 65-year-old spouse earned $15,000 from a consulting gig in a given year and wanted to make $6,500 IRA contributions for each of you, that would be perfectly allowable. Income from a job, net earnings from self-employment, and disability benefits received prior to minimum retirement age all count as earned income. Income from other common sources—Social Security, portfolio income, RMDs, and rental properties—does not count.

Age limits also come into play: While Roth IRA contributions are allowable at any age, provided a person meets the earned income test outlined above, traditional IRA contributions are not allowable after age 70 1/2. Not coincidentally, that is the same age when required minimum distributions from traditional IRAs must commence.

Finally, income limits apply to IRA contributions throughout your life. The contribution limits for traditional IRA contributions that you can deduct on your tax return are the most stringent; Roth IRA contributions are allowable at a higher income limit. Anyone can make a traditional nondeductible IRA contribution, regardless of income, assuming they are younger than age 70 1/2. Those contributions could then be converted to Roth for a “backdoor Roth IRA.” However, such a maneuver is not advisable in the (likely) scenario that a retiree has significant traditional IRA assets that have never been taxed yet.

Should You Make Them?
Assuming you meet the income and age tests that apply to IRA contributions, the next question is whether those contributions are advisable. And if you are eligible for both types of contributions, which type is best?

Generally speaking, the longer the holding period, the greater the tax benefits of utilizing any type of tax-sheltered savings vehicle. Young accumulators, for example, have many years to benefit from the tax-deferred compounding on their money. Not only can they stash away assets without paying taxes on them, in the case of deductible contributions, but they will not owe any taxes on the money on a year-to-year basis, either. In the case of Roth contributions, they will benefit from tax-free compounding in the years leading up to retirement, and will also be able to take tax-free withdrawals on the account in retirement. The longer the holding period, the greater the appreciation and the greater the tax-saving benefit of using some type of tax-sheltered wrapper.

Contributions to IRAs made later in life benefit less from the tax-sheltered compounding simply because of a domino effect: with a shorter time horizon, the investment gains are less, and so are the taxes due upon them. That is not to say that older adults, even those past age 65, should not run any additional savings through an IRA, though—just that the benefits may be limited if your plan is to put the money in at 65 and take it out at 70.
To use a simple example, consider a 65-year-old woman who is retired from her full-time occupation, decides to pick up some part-time work and is able to save $6,000 a year in a Roth IRA for five years. Assuming she earns a 4% annualized return on her money, she woud have $32,500 five years later. Her $2,500 in investment gains (the amount over and above her $30,000 in contributions) would be tax-free, and she would not have to pay any income or capital gains taxes during that five-year holding period, either.

By contrast, if she steered the same amount into a taxable account, she would have to pay taxes on any income and capital gains that her holdings kick off during her holding period, and she would also owe capital gains taxes when she withdraws the money. She would receive a step-up in her cost basis to account for the income and capital gains distributions she already paid taxes on, but the fact that she is having to pay those taxes each year means that she has less money working for her during her holding period. Assuming a modest tax-cost ratio of 0.25% (taking her return down to 3.75% from 4%) and a 15% capital gains rate at the time of withdrawal, her take-home return would be about a bit less than $32,000, $500 less than the Roth.

That is a pretty small differential, for sure—an inevitable outgrowth of the fact that IRA contributions are limited to $6,500 as well as her short holding period and modest return. But the advantage of funneling her contributions through the IRA grow if she is able to keep the money in the account longer, as she can do with a Roth IRA, provided she does not need the money. (Roths, in contrast with traditional IRAs, do not carry required minimum distributions.) If she leaves the money in the account until age 80 and continued to earn 4%, she would be able to take a $48,106 tax-free withdrawal from the Roth—even though she only put in $30,000 in those first five years. Meanwhile, her taxable account would amount to $44,086 on an after-tax basis. Again, that is not a huge differential, but $4,000 is $4,000. If her ultimate plan is to not spend the money and instead leave the money undisturbed even longer—or pass it to her heirs—the advantage of the Roth IRA would grow even more.

No RMDs—and the ability to stretch out the holding period—is the key reason that people who can make IRA contributions in the post-retirement, pre-RMD period should prioritize Roth rather than traditional contributions. A person approaching 70 1/2 would not get a lot of bang from traditional IRA contributions because required minimum distributions from the IRA would soon commence. (Of course, there may be extenuating circumstances that would call for prioritizing a traditional IRA contribution over Roth later in life; check with your financial or tax advisor to be sure.)

 

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