This is the final episode in "US retirement series".
What is IRA, Roth IRA and Backdoor Roth? We will dig deep into those in this episode.
Hi. My name is Vijay Mohan. You are watching "Investment Insights".
IRA means Individual Retirement Account.
When 401K is a retirement plan offered through our employer, IRA is our own personal retirement account.
It is almost like a brokerage account. We have to manage ourselves.
All major brokerages like Vanguard, Fidelity, Charles Schwab offer IRA accounts.
It is very easy to open an account as well.
But we cannot contribute as much money as in a brokerage account.
There are restrictions on how much money we can contribute in an IRA.
The first condition is that we can only contribute the money that we have earned that year.
Second condition is that we can contribute only $6,000 per year.
While the contribution limit in a 401K is $20,500, it is just $6,000 in IRA.
People older than 50 years can contribute an extra $1,000.
An interesting thing about IRA is, we can contribute to our non working spouse as well.
But that $6,000 has to be an earned income of that year as well.
We cannot contribute the money that we did not earn in an IRA.
So what benefits do we get from an IRA?
Just like a 401K, this is a tax advantaged account as well.
We do not have to pay tax on the contributed money.
But the tax deduction eligibility that we get for everyone from a 401K is not here.
There are some conditions to be eligible for tax deduction.
If there are no retirement plans offered at their work places for both husband and wife, then they both can take tax deduction for their contribution.
That is, if they both contribute $6,000 each to their IRA, they do not have to pay tax for the total $12,000.
But let's say that husband has 401K plan offered by his employer, but wife does not.
Then, only if the family income is less than $109,000, then the husband can take tax deduction for his contribution $6,000.
If their family income is more than $109,000, then the husband will not be able to take tax deduction.
But the income limit for wife's tax deduction is more - $204,000.
Because her employer is not offering 401K right? So she can take a tax deduction for her contribution of $6,000 if the family income is less than $204,000.
All the conditions are shown clearly in investopedia site.
If you have any questions on these conditions, ask below in the comments.
So in summary, anyone can contribute $6,000 to an IRA.
But whether we can take a tax deduction for that contribution is dependent on our family income.
This is for Pre tax IRA. It is called as Traditional IRA as well.
When we say IRA, by default it means this pretax IRA.
Just like in 401K, IRA has Roth flavor as well. Roth IRA.
Roth means Post tax. That is, the contributed money should be our income. But we contribute into this Roth IRA after paying the tax for that income.
But the withdrawal from a Roth IRA after retirement is tax free.
Roth IRA has the same contribution limit $6,000 as in the IRA.
Same $7,000 contribution limit for folks older than 50.
We can contribute for a non working spouse here as well.
But not everyone can contribute to Roth IRA as in an IRA.
For married filing jointly, we can contribute only if the family income is less than $204,000.
For family with income between $204,000 and $214,000, the contribution limit $6,000 will phase out.
That is, the amount that they can contribute starts coming down as the income rises from $204,000.
When the income goes above $204,000, both husband and wife cannot contribute to a Roth IRA.
An unique advantage with Roth IRA is that we can withdraw our contribution anytime without tax or penalty.
But we can do that only with our contribution. Not the earnings (gains).
Let's say that we have contributed $6,000 and it has grown $1,000 to $7,000.
We can withdraw our original contribution $6,000 anytime without tax or penalty.
But we cannot withdraw the gains $1,000.
If we want to withdraw that gains $1,000 before our retirement, we have to pay 10% penalty and tax.
There are some exception rules to withdraw those earnings without paying penalty and tax.
We can withdraw upto $10,000 for first home purchase.
If we are disabled, we can withdraw as well.
Check the investopedia link in the description for all exceptions.
Another advantage with Roth IRA is, there is no RMD (Required Minimum Distributions)
We reviewed more in detail about RMD in last episode.
Both in a 401K and in a IRA, we have to withdraw at least a specific amount every year after 72.
There is no such requirement in Roth IRA.
We have the power to withdraw any amount at any time with a Roth IRA. That is another advantage with Roth IRA.
"All that is OK. But our family income is over $204,000. Is there any way to contribute to Roth IRA?"
There is a Backdoor option for that. It is called "Backdoor Roth".
As per Traditional IRA rule, anyone can contribute $6,000 to it right?
Only the tax deduction eligibility is dependent on an individual's income.
What we can do is, open a traditional IRA account and contribute $6,000 to it.
If our income is over $204,000, then we cannot take tax deduction for our contribution. But that's OK.
What we can do now is, transfer this $6,000 immediately into a Roth IRA.
Normally we should pay tax for the amount we are transferring from IRA to Roth IRA.
But if we do that transfer in the same year as the contribution, then we do not have to pay tax.
So essentially we have contributed to a Roth IRA even though we are not eligible to do it.
That is this is called as "Backdoor Roth".
An important requirement to do this is, we should not have a running balance in Traditional IRA or any other pretax IRA.
We should have zero balance. Then only we can transfer the money without any tax.
Step by step instructions on how to do this is explained in "Physician on Fire" site.
Check it out if you are interested. Link is in the description.
If you are changing job and if you have a balance in your old employer's 401K, then you have 3 options.
1. We can leave the balance there. But that would mean we will end up managing many 401K plans.
2. Another option is to transfer the old 401K balance into new employer's 401K.
It is a decent option as we will have just one 401K account and it will be easier to manage.
The third option is the best option.
We should transfer our 401K balance into a Rollover IRA when we change our jobs. It is totally allowed.
We have to see the 401K as a temporary retirement account.
We should keep them as long as we work with a employer.
But we should see an IRA as our permanent retirement account.
Whenever we change our job, we should move our 401K balance of old employer into our IRA.
Why is moving 401K balance into an IRA better than moving into new 401K?
Because with 401K, we can only invest in the funds offered by the employer.
But with an IRA, we have the complete freedom to invest in any funds or stocks.
Also with 401K, there will be many management fees. Some are apparent and many are hidden.
But with IRA, there is no fees. Simple and Straight forward.
For these 2 advantages, it is better to move our 401K balance into an IRA when we switch jobs.
Regular 401K balance can be rolled over into regular traditional IRA.
Roth 401K balance can be rolled over into a Roth IRA.
Totally allowed without any tax or penalty.
But if you have plans of doing Backdoor Roth, then you should not rollover your 401K into IRA.
Because as we know, for doing a backdoor Roth, we should have zero balance in a IRA.
If you are in a situation like that, it is better to move your 401K balance into the new employer's 401K.
So to summarize this episode, we can say that IRA is like a cousin for 401K.
Both have similar underlying concept. Both are pretax.
Similarly, Roth IRA is like a cousin to Roth 401K. Both are post tax.
We can transfer assets pretax to pretax and also from post tax to post tax accounts.
We can also transfer from pretax to post tax. But we have to pay tax for that transferred amount.
If we understand these basics, then that means we have crossed half way in our US retirement plan.
Many have asked the question of what should we do with our 401/IRA balance if we are returning to India.
For that, I would recommend you to consult a good tax advisor who knows US India treaty pretty well.
I don't want to make any half baked comments here without understanding that well.
We will soon meet again in another episode. Thank You.