Table of Contents
- What Is an Individual Retirement Account (IRA)?
- What is a Traditional IRA?
- What is a ROTH IRA?
- Conventional IRAs
- Assets Held
- Tax Treatments
- Contribution Limits
- Distribution Rules/Required Minimum Distributions
- Income Limits
- Early Withdrawals
- When can IRA Contributions be Made?
- What is a Self Directed Individual Requirement Account (SDIRA)?
- What Type of Custodian is Required for an SDIRA?
- What are SDIRA Account Holder Responsibilities?
- What Asset Types Can and Cannot be Held in an SDIRA?
- How Does an SDIRA work?
- How Do You Open an SDIRA?
What Is an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) is a tax-advantaged retirement account. It is an account that must be established at a financial institution, like a bank, a brokerage, or a mutual fund company.
A custodian must hold an IRA on behalf of an individual where these retirement investments grow on a tax-free* or on a tax-deferred* basis. All custodians must be approved by the Internal Revenue Service (IRS).
There are two types of conventional IRAs. There is the traditional IRA where contributions to the account are made with pre-tax dollars and there is the Roth IRA where contributions to the account are made with after-tax dollars. Both the traditional IRA and the Roth IRA have their own rules and restrictions regarding fund accessibility, tax consequences, and eligibility.
What is a Traditional IRA?
Contributions to a traditional IRA are tax-deductible but there are strict eligibility requirements. These requirements are mandated by the IRS and are based on an investor's income, filing status, and availability of other retirement plans.
Transactions in the account, including interest, dividends, and capital gains, are not subject to tax while the funds remain in the account. However, when funds are withdrawn from the account in retirement, withdrawals are subject to federal income tax.
What is a ROTH IRA?
Unlike traditional IRAs, contributions to a Roth IRA are not tax-deductible since they are made with after-tax dollars. With a Roth IRA, contributions grow tax-free* and are not subject to taxes at withdrawal in retirement.
The U.S. Tax Code identifies what type of assets are permitted to be held in conventional IRAs. Typical assets that can be held in conventional IRAs (either traditional or Roth IRA) include stocks, cash, bonds, equities, mutual funds, U.S. government securities, certificate of deposit, money market accounts, and ETFs.
However, the IRS does not allow alternative assets such as real estate or cryptocurrencies in a conventional IRA.
Withdrawals from an IRA are treated differently, depending on the type of IRA. For example, taxes are paid upon the withdrawal from a traditional IRA.
In contrast, there are no taxes due upon withdrawals from a Roth IRA, on either contributions or earnings, provided the account holder meets certain requirements.
For 2022, the total contributions that an investor can make each year to all traditional IRAs and Roth IRAs is limited to $6,000. However, if the investor is age 50 or older, all contributions are limited to $7,000.
Distribution Rules/Required Minimum Distributions
Required Minimum Distributions (RMDs) are the mandatory minimum amount that must be withdrawn from an IRA each year after an account holder reaches a certain age.
- Investors can withdraw more than the RMD each year.
- RMDs from traditional IRAs will be included as taxable income in the year withdrawn. Withdrawals are tax-free* if withdrawn from designated Roth accounts.
- The required minimum distribution for any year is the account balance as of the end of the immediately preceding calendar year divided by a distribution period which can be obtained from the IRS’s “Uniform Lifetime Table.”
- For a traditional IRA, an account holder must begin taking RMDs by April 1 of the year you turn 72, or 70½ if you turned 70½ before January 1, 2020.
- RMDs do not apply to Roth IRAs during the account holder’s lifetime. However, heirs may need to take RMDs to avoid penalties.
More information about RMDs is available from the IRS here: Retirement Plans FAQs regarding Required Minimum Distributions | Internal Revenue Service.
Traditional IRA contributions can be tax-deductible or partially tax-deductible based on an investor's modified adjusted gross income (MAGI) even if you contribute to an employer-sponsored plan, such as a 401(k).
In 2021, an individual with a MAGI between $66,000 to $76,000 is eligible for at least partial deductibility. A married couple filing jointly with a MAGI of between $105,000 to $125,000 is eligible for at least partial deductibility. For 2022, the MAGI for individuals is $68,000 to $78,000, and for married couples filing jointly, it is $109,000 to $129,000.
There are no income limits on who can contribute to a traditional IRA.
However, there are income limits on who is eligible to contribute to a Roth IRA. In 2021, only individuals with a MAGI of $140,000 or less are eligible to participate in a Roth IRA. The phase-out for singles starts at $125,000. For those married filing jointly, the MAGI limit is $208,000.
Early withdrawals (which occur before age 59½) from traditional IRAs are subject to a 10% penalty along with the payment of any income taxes due.
There are some exceptions to this rule. IRA holders may be able to avoid the 10% penalty for making an early withdrawal from a traditional IRA based on the following scenarios:
- For qualified higher education expenses for yourself, your spouse, or children or grandchildren of yours or your spouse.
- For using the withdrawn funds to buy, build, or rebuild a first home.
- For paying unreimbursed medical expenses that exceed a certain percentage of adjusted gross income.
- You are in the military and are called to active duty for more than a certain number of days.
- You have become totally and permanently disabled.
- You are the beneficiary of a deceased IRA owner.
In a Roth IRA, withdrawals of contributions are penalty-free and tax-free* at any time. Earnings may be withdrawn without penalties or taxes as long as you are age 59½ or older and you have held the Roth IRA account for at least five (5) years.
When can IRA Contributions be Made?
Tax day is the deadline for all US taxpayers to file and pay their taxes. For 2022, tax day is April 18.
Tax day is also the last day on which investors can contribute to an IRA for the current tax year.
To open an IRA, there is no minimum deposit required and there are no rules about how much money you must deposit. Note that brokers may set their own account minimums.
Contributions can be made to both a traditional IRA and a Roth IRA in a given year. The combined contribution amount to any type of IRA must not exceed the applicable annual limit as referenced above.
What is a Self Directed Individual Requirement Account (SDIRA)?
A Self Directed Individual Requirement Account (SDIRA) is an IRA that must be set up as a conventional IRA, that is, either a traditional IRA or a Roth IRA. Whether you select a traditional or Roth IRA for your SDIRA, the same limitations and eligibility guidelines apply to SDIRAs as conventional IRAs.
An SDIRA is different from a conventional IRA in that it allows the account holder to invest in alternative assets within the retirement account. For example, these alternative assets may be real estate, precious metals (gold and silver), private equity, commodities, or digital assets (such as cryptocurrencies). Importantly, SDIRAs have the same contribution and income limits as conventional IRAs.
All individual retirement accounts including SDIRAs are covered under Internal Revenue Code 408.
What Type of Custodian is Required for an SDIRA?
One important distinction between conventional IRAs and an SDIRA is the type of account custodian required.
The custodian for conventional IRAs typically plays the role of being an active custodian. This custodian is oftentimes a financial institution that is responsible for maintaining and administering the IRA. The custodian holds an account's investments for safekeeping and is responsible for complying with all IRS and government regulations. For example, an IRA custodian has the responsibility of filing IRS Forms 5498 and 1099-R.
IRA custodians must abide by the IRS requirements to have the authority to hold title to the assets, investments, or properties of their clients.
With an SDIRA, the custodian plays a more passive role. Custodians of SDIRAs are referred to as directed custodians as they have only limited duties to investigate the assets or the background of the account assets.
In its role as a passive custodian, a directed custodian solicits no investments and provides no advice or recommendations to account owners with regard to investments acquired by or held in the SDIRAs.
It is important to choose a qualified custodian and consult with a qualified investment professional in this regard.
What are SDIRA Account Holder Responsibilities?
Unlike with conventional IRAs, SDIRA account owners are “self-directed.” These owners must be mindful that this means that the owner - and not the directed custodian - must directly manage the alternative assets held within the account.
What Asset Types Can and Cannot be Held in an SDIRA?
SDIRAs are designed to hold alternative assets that cannot be held in conventional IRAs. Alternative assets include things like precious metals, tech startups, private equity, investment property, wind farms, promissory notes, and cryptocurrencies.
There are, however, limits and restrictions on the types of assets that can be held in an SDIRA and these assets are outlined by the IRS. For example, you cannot hold life insurance, collectibles, or S-corporations in an SDIRA.
Collectibles include works of art, rugs or antiques, certain metals, gems, stamps, and certain coins, alcoholic beverages, and any other tangible personal property that is a "collectible" under IRC Section 408.
How Does an SDIRA work?
The IRS requires custodians or trustees to hold all SDIRA accounts. Therefore, it is always best to fully investigate your options and your requirements before opening an SDIRA.
A self-directed IRA includes complex rules and presents potential risks for the SDIRA owner. Such rules include prohibiting certain types of transactions along with how the assets can be used while they are held in the SDIRA.
A violation of the rules can result in costly tax consequences for the SDIRA owner. It is best practice to consult with a tax advisor if you are unsure of the potential tax ramifications of any transaction that you may initiate as the self-directed owner of an IRA.
A few of these prohibited transactions are summarized below.
First, the SDIRA owner (or account beneficiaries) cannot engage in a transaction with a disqualified person. Disqualified persons are individuals or entities that cannot perform any direct or indirect deals, investments, or transactions with the IRA. That would include the SDIRA owner, IRA beneficiaries, or SDIRA owner family members.
Second, the SDIRA owner cannot use the SDIRA for personal benefit. For example, revenue that is generated from real estate held in an SDIRA must be deposited back into the SDIRA account. Such funds cannot be deposited into a personal account. All income generated by SDIRA assets must be invested back into the SDIRA.
How Do You Open an SDIRA?
Use the following steps to open your own self-directed IRA:
- Find a custodian or trustee for the account. Remember, not all IRA administrators are authorized to custody an SDIRA.
- Determine what type of alternative asset you would like your account to hold.
- As you will be directing the investment activity for this self-directed account, you must perform your own due diligence on the investment, including consulting with a qualified investment professional.
- Find a party to purchase the investment. If you are purchasing a cryptocurrency, you might select an exchange or platform that offers the type of currency that you are looking to add to your retirement account.
- Request that your account be initiated to hold your desired investment.
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This article is for information purposes only. It does not constitute investment advice in any way. It does not constitute an offer to sell or a solicitation of an offer to buy or sell any cryptocurrency or security or to participate in any investment strategy.
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