Individual Retirement Accounts

Individual Retirement Accounts (IRAs) provide tax-advantaged retirement savings independent of employer-sponsored plans. Understanding the differences between Traditional and Roth IRAs, contribution rules, and distribution requirements is essential for CFP exam success and effective client planning.

IRA Contribution Limits

2025 Contribution Limits

These limits apply to the combined total of Traditional and Roth IRA contributions. You cannot contribute $7,000 to each type.

Basic Contribution Requirements

• Earned income required: Must have compensation (wages, self-employment income, alimony from pre-2019 divorce)
• Contribution limit: Cannot exceed earned income (lesser of limit or compensation)
• Deadline: April 15 of the following year (no extensions)
• No age restriction: SECURE Act eliminated the age 70.5 contribution limit for Traditional IRAs

Traditional IRA

Deductible vs. Nondeductible Contributions

Traditional IRA contributions may be fully deductible, partially deductible, or nondeductible depending on:

1. Whether you (or spouse) are an active participant in an employer plan
2. Your modified adjusted gross income (MAGI)

2025 Traditional IRA Deduction Phaseout

If YOU are an active participant in an employer plan:

If you are NOT active but your SPOUSE IS:

Not an active participant (neither spouse active): Full deduction at any income level.

Active Participant Status

You are considered an active participant if:

• Defined contribution plan: You receive any contribution (including forfeitures) or make elective deferrals
• Defined benefit plan: You are eligible to participate (even if you decline)

Your W-2 Box 13 indicates active participant status with the "Retirement plan" checkbox.

Nondeductible Traditional IRA Contributions

Even if you cannot deduct contributions, you can still make nondeductible contributions:

• Creates basis (after-tax amount) in your IRA
• Earnings grow tax-deferred
• Must track basis using Form 8606
• Distributions include both taxable (earnings) and nontaxable (basis) portions

Roth IRA

Key Roth IRA Features

• Contributions: After-tax (not deductible)
• Growth: Tax-free
• Qualified distributions: Completely tax-free
• No RMDs: Not required during owner's lifetime
• Contribution age: No age limit (must have earned income)

2025 Roth IRA Income Limits

Qualified Roth Distributions

A Roth distribution is qualified (tax-free and penalty-free) if:

1. Five-year rule satisfied: 5 tax years since first Roth contribution, AND
2. One of the following applies:
   • Age 59.5 or older
   • Death
   • Disability
   • First-time home purchase (up to $10,000 lifetime)

Non-Qualified Roth Distributions

For non-qualified distributions, the ordering rules determine taxation:

Spousal IRA

A spousal IRA allows a working spouse to contribute to an IRA for a non-working (or low-earning) spouse:

• Working spouse must have sufficient earned income to cover both contributions
• Non-working spouse can contribute up to $7,000 ($8,000 if 50+)
• Each spouse must have a separate IRA account
• Same deductibility and income limit rules apply

Example: Husband earns $120,000; wife has no income. Husband can contribute $7,000 to his IRA and $7,000 to a spousal IRA for his wife (total $14,000), provided he has at least $14,000 of earned income.

Backdoor Roth Strategy

The backdoor Roth allows high-income taxpayers to fund Roth IRAs indirectly:

How It Works

1. Make a nondeductible contribution to a Traditional IRA
2. Convert the Traditional IRA to a Roth IRA
3. Pay taxes only on any earnings (contribution basis is not taxed)

The Pro-Rata Rule Warning

The pro-rata rule requires that conversions be proportionally taxable based on ALL Traditional IRA balances (including SEP and SIMPLE IRAs):

Pro-Rata Formula:

Taxable Portion = (Pre-Tax Balance / Total IRA Balance) x Conversion Amount

Example:

• Existing Traditional IRA: $93,000 (all pre-tax)
• New nondeductible contribution: $7,000
• Total IRA balance: $100,000
• Convert $7,000 to Roth

Taxable amount: ($93,000 / $100,000) x $7,000 = $6,510 taxable

Only $490 would be tax-free (the proportionate nondeductible portion).

Avoiding Pro-Rata Problems

• Roll pre-tax IRA balances into an employer 401(k) plan
• Convert entire Traditional IRA balance to Roth
• Consider timing and tax bracket optimization

Roth Conversion Strategies

When to Consider Conversion

• Low-income years: Sabbatical, career transition, early retirement
• Tax rate expectations: Anticipate higher future tax rates
• Estate planning: Leave tax-free assets to heirs
• RMD avoidance: Reduce future required minimum distributions
• Long time horizon: More years for tax-free growth

Conversion Considerations

Important Conversion Rules

• No income limits: Anyone can convert regardless of income
• No recharacterization: Cannot undo conversions (TCJA 2017)
• Five-year rule: Each conversion has its own 5-year clock for penalty-free withdrawal of converted amounts before age 59.5

Inherited IRA Rules (SECURE Act)

The SECURE Act of 2019 dramatically changed inherited IRA rules, establishing the 10-year rule for most beneficiaries.

Beneficiary Categories

The 10-Year Rule

Non-EDB designated beneficiaries must:

• Withdraw the entire account by December 31 of the 10th year following the owner's death
• No required annual minimums (can take nothing until year 10)
• Exception: If owner died after their Required Beginning Date, annual RMDs may be required AND the 10-year rule applies

Eligible Designated Beneficiaries (EDBs)

Surviving spouse:

• Can roll to own IRA (reset RMDs to own age)
• Can remain as beneficiary (use life expectancy)
• Can elect 10-year rule

Minor children:

• Use life expectancy until age of majority (18 or 21)
• Then 10-year rule applies from that date

Disabled or chronically ill: Life expectancy method applies

Not more than 10 years younger: Life expectancy method (e.g., sibling close in age)

Roth IRA Inheritance

Inherited Roth IRAs also follow the 10-year rule for non-EDBs, but:

• Distributions are tax-free (if original owner met 5-year rule)
• No RMDs during the 10-year period
• Must empty by end of year 10

On the CFP Exam

Expect questions testing your ability to:

• Calculate Traditional IRA deductibility based on income and active participant status
• Determine Roth IRA contribution eligibility and partial contribution amounts
• Apply the pro-rata rule to backdoor Roth conversions
• Identify which beneficiaries qualify as EDBs vs. designated beneficiaries
• Recommend conversion strategies based on client circumstances
• Explain the 5-year rules for both contributions and conversions