Should You Make IRA Contributions After 65?

As I was listening to my voicemail on a Saturday morning, I picked up a message from a relative. "Christine, I have some extra money to invest," she said. "I put some cash into my traditional IRA earlier this year, but this time I wonder if I should make a Roth contribution instead. Call me back, please."

Uh-oh, I thought to myself.

Her 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. But my relative is already retired--she's no longer earning an income--and that's where the "uh-oh" comes in. She can't make an IRA contribution at all, because all of her income is unearned income--she lives on income from Social Security and her investment accounts. Only people with earned income (usually income from paid work or some variant of it, discussed below) can contribute to an IRA.

I hear some version of my relative's question from retirees a lot. 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'm retired? (Yes, but you'll be subject to the annual IRA contribution limits and you need to have enough earned income to cover the contribution.) And so on.

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're 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're 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 didn't 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, pension income, annuity payments, RMDs, and rental properties--doesn't count. (This handy chart from Ed Slott and Company details exactly what qualifies as earned income and what doesn't.)

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 aren't allowable after age 70 1/2. Not coincidentally, that's 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. (You can see details for 2018 contribution limits here.) Anyone can make a traditional nondeductible IRA contribution, regardless of income, assuming they’re younger than age 70 1/2. Those contributions could then be converted to Roth for a "backdoor Roth IRA." However, such a maneuver isn't advisable in the (likely) scenario that a retiree has significant traditional IRA assets that have never been taxed yet, as discussed here.

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're 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 won't owe any taxes on the money on a year-to-year basis, either. In the case of Roth contributions, they'll 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's not to say that older adults, even those past age 65, shouldn't 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, let's say a 65-year-old woman who's 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'd 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 wouldn't 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'd have to pay taxes on any income and capital gains that her holdings kick off during her holding period, and she'd also owe capital gains taxes when she withdraws the money. She'd 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’s 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's a pretty small differential, for sure--an inevitable outgrowth of the fact that IRA contributions are limited to $7,000 for 2019 ($6,500 for 2018) as well as her short holding period and modest return. But the advantage of funneling her contributions through the IRA grow if she's able to keep the money in the account longer, as she can do with a Roth IRA, provided she doesn't need the money. (Roths, in contrast with traditional IRAs, don't carry required minimum distributions.) If she leaves the money in the account until age 80 and continued to earn 4% on her dough, she'd 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's 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 wouldn't get a lot of bang from traditional IRA contributions because required minimum distributions from the IRA account 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.)

Accidents Will Happen
Finally, what about my relative's IRA contribution, which she made before she realized she was ineligible? Her first job is to contact the investment provider and let them know her mistake. Her improper IRA contribution is classified as an excess contribution, so she'll need to fill out a form spelling out the excess contribution--when it was made and when it was corrected. The taxes due--as well as whether the 6% excess contribution penalty would apply--would depend on when the excess contribution was corrected and appreciation in the account since the contribution was made. This article takes a closer look at fixing excess IRA contributions. 

A version of this article appeared on Sept. 21, 2017.