IRA and Roth IRA Basics: Rules and Contributions Limits

An Individual Retirement Account, most often called an IRA, is a type of retirement savings account that offers special tax treatment when you contribute funds to save for your retirement.

Can anyone contribute to an IRA? Not exactly.

A set of IRS rules determine if you can make an IRA contribution, the type of IRA you can contribute to, and how much you can contribute. Knowing the regulations can help you save thousands in taxes while growing your nest egg.

Can I Make an IRA Contribution? The Earned Income and Age Rules

The first qualification for being eligibility to contribute to an IRA of any type is that you have earned income. Earned income comes from wages, salary, and other taxable employee compensation. It also includes money earned from being self-employed or owning a business, as long as you are reporting it on your tax return.

What isn’t considered earned income is money received on interest or dividends, pensions or annuities, child support, alimony, or Social Security benefits.

You must have earned income in an amount that equals or exceeds the amount of your IRA contribution. For example, if you earned $4,000, the most you can contribute to an IRA is $4,000.

There is one exception to this earned income rule. If you are married and your spouse is not employed but you make enough money to contribute on their behalf, then you can make a “spousal IRA” contribution to an IRA for your non-working spouse. Your spouse would open an IRA in their own name so that their contributions are not mixed in with yours.

There used to be a maximum age limit for IRA contributions but with the passage of the SECURE Act in 2019, this age limit no longer applies. Now, individuals who are still working at later ages can continue to put money into IRAs.

What Type of IRA Can You Contribute To?

There are several types of IRAs, including Traditional IRAs, Roth IRAs, SEP IRAs (for self-employed persons), and SIMPLE IRAS (an IRA savings plan for small businesses.) The two main types of IRAs we focus on in this article are Traditional IRAs and Roth IRAs, each with its own tax treatments and set of rules.

With a Traditional IRA, the funds grow tax-deferred, and you pay taxes on the gains when you withdraw funds in retirement. With a Roth IRA, the funds grow tax-free, and when you make a qualified withdrawal in retirement, the amounts you take out, and all gains, are tax-free.

As long as you have enough earned income, you are eligible to contribute to a Traditional IRA. Then, there are income limitations which determine whether you can deduct some or all of your contribution on your tax return. If you aren’t eligible to deduct the contribution, instead, you can make a non-deductible contribution or possibly contribute to a Roth IRA instead.

With a Roth IRA, you also have to have enough earned income, but if you have too much income, you aren’t allowed to contribute to one.

First, let’s look at the rules around Traditional IRA contributions and whether you can take a tax deduction for the amount of your contribution.

How Much of My IRA Contribution Can I Deduct from Taxes?

If you and your spouse (if married) are not covered by an employer plan, then you are eligible to deduct the full amount of your Traditional IRA contribution.

Note that, even if you are not contributing to an employer-sponsored plan, you are still “covered” by your employer’s retirement plan if your employer is making contributions for you, such as profit-sharing or non-elective matching contributions.

Before deciding to deduct your Traditioal contributions, weigh out the pros and cons of making a Roth contribution (where funds are not deductible but grow tax-free) versus a Traditional one (which is deductible now – but will be taxed later.)

Generally, if you expect your tax rate to be about the same or higher once you are retired, then the Roth contribution will be most beneficial for you in the long run. If you expect your tax rate will be lower in retirement than it is now, then the Traditional IRA contribution may be your better choice.

If you are covered by an employer retirement plan, then your contributions to a Traditional IRA are only deductible if your adjusted gross income (AGI) falls below the following limits.

If your income is below the lower amount in the range above, then up to the full amount of your Traditional IRA contribution is deductible. If your AGI falls within the range above, then only a portion of your contribution is deductible. And if your AGI exceeds the range, you are not eligible to deduct the contribution but you can still make a non-deductible IRA contribution. You’ll want to file IRS Form 8606 to keep track of your total non-deductible contributions so that they are not taxed later when you withdraw them.

A non-deductible IRA contribution is not the same as a Roth contriution. Next, we cover Roths.

How to Qualify for a Roth IRA

A Roth IRA offers one of the few ways to earn tax-free growth on your money. Tax-free distributions in retirement are not subject to many other tax law provisions such as means-testing for Medicare Part B limits, or the formula that determines taxation of Social Security.

The downside – if your income is too high, you are not eligible to make a Roth IRA contribution. (Other options described below may still allow you to get money into a Roth IRA, however.)

What are the Roth IRA Income Limits?

If your AGI is less than the lower range below, you can contribute to a Roth IRA. If your income is within the range, a partial Roth IRA contribution is allowed. And if your income exceeds the range, then you are not eligible to contribute to a Roth IRA.

But these income limitations do not count towards Roth conversions. You can convert money in an existing IRA to a Roth IRA as long as you pay the taxes owed. This can be done at any time and without any age restrictions.

Also, Roth 401(k) contributions are not limited by your income. And 401k(s) have much higher contribution limits. Many employers now offer Roth 401k options sometimes called a Designated Roth Account.

If your employer offers a match, the match portion cannot go to the Roth side of your 401(k). For example, if your employer offers a match and all of your contributions are directed towards the Roth 401(k), you will have two accounts growing side by side. Your money can go into the Roth 401(k), while the match portion will go into the Traditional 401(k).

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How Much Can I Contribute to an IRA Each Year?

The IRS places limits on the amount of money you can contribute to a Traditional IRA and to a Roth IRA. The maximum amount an individual can contribute to either type in 2020 is $6,000 if you are age 49 or younger. Those who are 50 or older can contribute an additional $1,000 as a catch-up contribution, making their total allowable contribution amount $7,000.

No matter how many IRA accounts you have, you can only contribute a total of the maximum allowed amount. For example, if you are age 49 or younger and you contributed $4,000 to a Traditional IRA, you would only be able to contribute $2,000 to a Roth IRA. The total you contribute cannot exceed $6,000, no matter how many IRA accounts you have. If you are age 50 or older, you could contribute $5,000 to a Traditional IRA, but then only contribute an additional $2,000 to a Roth IRA.

You can transfer money between IRA accounts or from an employer plan into an IRA (called a rollover) and those types of transfer or rollovers do not count as a new contribution. Traditional 401(k) funds would roll into a Traditional IRA and Roth 401(k) funds would roll into a Roth IRA.

Roth conversions are also not counted as new contributions so you can convert any amount from a Traditional IRA or plan to a Roth, with no concerns about income or contribution limits.

What Happens If I Contribute Too Much Money to an IRA?

If you contribute more than the allowable amount, first see if you can withdraw the excess contribution, or make it a different type of contribution, such a non-deductible contribution to a Traditional IRA. If you don’t correct the excess contribution you could be subject to a 6% excise tax on the excess as long as it remains in the account.

When is the IRA Contribution Deadline?

When contributing to an IRA account, you have until April 15th of the year following the tax year to do so. For example, if you wanted to make a contribution for 2018, you would have had to make the contribution by April 15th of 2019. To make the most of your money, it’s usually best to contribute as early as possible, giving your money more time to grow tax-deferred. Note that for 2020 the contribution deadline for IRA contributions for 2019 has been extended until July 15th (per IRS Notice 2020-18).

Get in the habit of funding your IRAs each and every year. You can use these contributions to decrease your cumulative tax bill and reach your retirement goals sooner.

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