June 7, 2023
Too Old to Make an IRA Contribution?
Take-Away: There are only a couple of limited situations where an individual age 72 or older has earned income who should consider a contribution to a traditional IRA.
Background: One of the changes caused by the SECURE Act that did not receive the amount of attention as the death-of-the-stretch IRA distribution rule, is that an IRA owner can continue to make contributions to a traditional IRA after age 72, just so long as the IRA owner has earned income. Prior to the SECURE Act, an individual could not make a contribution to a traditional IRA if the individual was at the required beginning date (RBD) age or older- 70 ½. [Note, a Roth IRA contribution could be made at any age so long as the contributor, or his/her spouse, met the earned income condition.] Obviously, the delay in the required beginning date (now up to age 72) and the elimination of the age ceiling for traditional IRA contributions reflect the fact that more Americans are working longer than they once did; this may be caused by increasing rates of longevity as well as the dramatic decline in the role of defined benefit pensions that pay pension benefits throughout an individual’s retirement years. The result is that there are more affluent older employees who may be less inclined to have the need to take an required minimum distribution (RMD) and who may have access to more discretionary cash-on-hand to make additional contributions to their retirement account when they continue to have earned income.
Question: All of which leads to the title to this missive. Even though traditional IRA contributions are available to older workers, even those who need to take an RMD, are such contributions advisable? While funds come out of the traditional IRA in the form of an RMD, funds arguably could go back into the same traditional IRA as an annual traditional IRA contribution. Does it make sense to make a deductible contribution to a traditional IRA when the owner is RMD age? Probably not, except in a couple of very limited situations.
IRA Contribution Restrictions: While the SECURE Act lifted the age limit on traditional IRA contributions, IRA contributions still have restrictions that must be complied with for the IRA contribution to be respected.
Earned Income: For starters, the IRA owner must have earned income paid in the calendar year for which the IRA contribution is made, at least equal to, or above, the amount of the contribution made to the traditional IRA. Income from other common sources such as Social Security, portfolio income, pension income, annuity payments, RMDs, and rental properties are not earned income.
Spousal Income: A spouse’s income also counts for who is eligible to make a deductible contribution to a traditional IRA. Even if the IRA owner personally did not have any earned income, a contribution to their traditional IRA is permitted if their spouse had earned income.
Example: Husband Henry, age 73, has earned income as a business consultant of $15,000 for 2022. Henry wants to make a contribution of $7,000 to his own traditional IRA, and he wants to make another $7,000 contribution to his wife Hazel’s traditional IRA. These two IRA contributions, of $7,000 each, would be permissible, since Henry’s consulting income is from his self-employment and is thus earned income, and the total amount to be contributed is less than Henry’s earned income for the calendar year.
Income Limits: Even when there is earned income, other income limits apply that affect the amount of the IRA contribution, regardless of the IRA owner’s age. The contribution limits for traditional IRA contributions that can be deductible are pretty stringent. For 2022, if an individual is married filing jointly, if their modified adjusted income is more than $109,000 but less than $129,000, the individual can take a partial deduction for a contribution to a traditional IRA. If the married, filing jointly, couple’s modified adjusted income is less than $109,000 then the contribution to the traditional IRA is fully deductible. [For a single individual, if their modified adjusted income is $68,000 or less they may fully deduct their IRA contribution for 2022.] Roth IRA contributions are allowable at a higher income limit. Any individual can make a traditional, nondeductible, IRA contribution, regardless of their income or their age, which explains why there are so many ‘back-door Roth IRA conversions’, albeit with an income tax cost since the contribution is nondeductible.
Contribution Amount Limits: For 2023, the total contributions that an individual can make to all traditional IRAs and Roth IRAs is $6,500, or $7,500 if the individual is age 50 or older, or a lesser amount if that is the individual’s taxable compensation for 2023.
Making a Traditional IRA Contribution After RMD Age: As noted earlier, while more individuals who have earned income can now make a contribution to a traditional IRA, should they? Probably not.
Holding Period: As a generalization, the longer the holding period, the greater the income tax benefits of utilizing any type of tax-sheltered savings vehicle. A young IRA owner will have many years to benefit from the tax-deferred compounding on the funds held in their traditional IRA. Thus, the longer the holding period, the greater the appreciation and the greater the income tax savings benefit derived from using a tax deferred traditional IRA. In contrast, contributions to a traditional IRA later in life will benefit less from the tax-sheltered compounding than do earlier contributions, simply because with the shorter time horizon, the investment gains from those contributions will be less, and so will the income taxes due on them. Moreover, investments held in a traditional IRA will benefit even less than from investments held in a Roth IRA, because traditional IRAs are subject to RMDs that are eventually taxed. In summary, contributions to a traditional IRA are akin to a revolving door of IRA money.
Compare to a Roth IRA: Roth IRA contributions made later in life have the opportunity to grow beyond the owner’s RMD age. Because the Roth IRA contributions are not subject to RMDs, Roth IRA contributions are a better choice for older earners who are mainly saving to leave assets behind for their heirs and who do not intend to spend the contributed funds during their own lifetimes. Accordingly, the tax benefits associated with a Roth IRA are stretched out over a much longer time frame.
Compare to a 401(k) Account: Similarly, if the employed individual who has earned income can participate in their employer’s 401(k) plan, they can continue to make deductible contributions to that plan and avoid having to take an RMD from their employer’s qualified plan, i.e., the still working exception to the RMD rules, just so long as the employee is a less than 5% owner of the employer when they turned age 72. In this case, like the Roth IRA which has no RMD requirement, the tax deferral with contributions to a 401(k) can be extended beyond what would be required with a contribution to a traditional IRA.
Limited Exceptions: There might be a couple of limited situations where a deductible contribution to a traditional IRA might be favored over a contribution to a Roth IRA or by a still working employee to a qualified plan, like a 401(k) account. One might be where the older worker who is playing ‘catchup’ on retirement savings: the contributor can deduct the traditional IRA contribution on his/her current income tax return. While income taxes will be due on that contribution when it eventually comes out of the traditional IRA, if the contributor expects to be in a lower income tax bracket at the time of their withdrawal from the IRA, taking the income tax deduction now while receiving earned income may provide an important benefit.
Another situation where a traditional IRA contribution later in life may make some sense is if the individual earns too much to contribute to a Roth IRA directly. Instead, the individual might want to consider a ‘backdoor Roth IRA’ strategy funding a traditional IRA with an after-tax contribution and then converting that traditional IRA to a Roth IRA. But that means some taxes will be incurred on the contribution to the traditional IRA (after-tax) to the Roth IRA. In addition, such a conversion also can trigger the pro rata income recognition rule what affects the income tax incurred on the Roth IRA conversion, all of which can be problematic for an older worker who may own significant traditional IRAs already.
Conclusion: A Roth IRA or an employer’s 401(k) are better sources to save for retirement when an older individual with earned income is subject to taking RMDs.