In general, contributions to a traditional IRA can be deducted from your taxable gross income, thus, helping you save money on taxes.
However, if you are covered by retirement plan at work, the tax deductions may be reduced or phased out depending on how much your gross income is for the year.
While most people will agree that a Roth IRA is a better option, this may not be the case all the time especially if you do not have any retirement coverage plans at work.
So if you are planning on contributing to a traditional IRA, below are some of the quick facts that you should know about when making a traditional IRA contribution.
1. You can only make contributions if you have earned income
For both the traditional and Roth IRA, you can only make contributions if you have compensation. The IRS defines compensation as money you earned from working. Examples are wages, salaries, commissions, self-employment income, alimony, and non-taxable combat pay.
Income received from pension, annuity, deferred compensation, rental income, dividend income, interest income, income from partnership for which you do not provided services that are material income producing income, and any amount you exclude from income (except for the non-taxable combat pay) are not considered compensation.
2. Spousal IRA – If you do not work (no earned income) but your spouse does , you can still contribute to a traditional IRA.
The only exception to fact #1 is if you are married and your spouse is the only one earning a living. In this case, you can still contribute for as long as your spouse has earned income AND you and your spouse are filing a joint tax return.
3. In general, the maximum contribution to a traditional IRA is $5,000
There is a limit on how much you can contribute to your traditional IRA. Generally, you can only contribute a maximum of $5,000 to your traditional IRA. The maximum limit applies per individual per year and not per IRA account for those people who have multiple traditional IRA’s from different banking or investment institutions. For example, you may have three IRA accounts established from your credit union, Bank of America, or ING.com but you cannot contribute $5,000 on each account in the same year, thus, you have to distribute the $5,000 into those 3 accounts.
However, the following are the exceptions to the $5,000 maximum limit:
- $6,000 Maximum Contribution – If you are 50 years or older, your maximum contribution is increased to $6,000. This is called the catch-up rule to allow late savers, who are much closer to retirement put in additional money.
- Maximum Limited to Your Earned Income – If you’re earned income is less than $5,000, your maximum contribution is limited to your earned income. As an example, you recently just graduated from college but you did not start working until the last week of November. For that year, you have earned a total income from work $4,000 and dividend income of $1,000 for a total taxable income of $5,000. Since your income from work is only $4,000, this is the maximum amount that you can contribute to your IRA.
- Maximum Limits Applies to Both Roth & Traditional IRA – If you are also contributing to Roth IRA in the same tax year, your maximum contribution is reduced by the amount that you have contributed to your Roth IRA. For example, if you have already contributed $3,000 to your Roth IRA, you can only contribute a maximum of $2,000 on your traditional IRA in the same year. In other words, the maximum aggregate contribution to both IRAs is only $5,000 in the same tax year.
4. If you contribute more than the maximum amount, you have to pay an excise tax.
If you contribute more than the limit, you have to pay a 6% excise tax for each year on the amounts that remain in your account for the tax year. However, if you have excess amount in the current year and you withdrew the money before the tax deadline, you do not have to pay the 6% excise tax. As explained in #8, this is treated as you have not made any contribution at all.
5. You can make contributions during the year up to the tax year deadline.
You can make a contribution during the year towards your traditional IRA and you have until the tax year deadline to do so. For example, for tax year 2010, you already contributed $1,000 in June 2010, $3,000 in December 2010. You can still make a $1,000 contribution (to complete the $5,000 maximum) up to the 2010 tax return deadline of April 18, 2011.
6. In general, if you are not covered by retirement plan at work, you can take a full deduction on your contribution.
One key advantage of the contribution to your traditional IRA is that it is tax deductible. It is considered an above-the-line deductions and reduces your AGI (adjusted-gross-income). This allows you to reduce your taxes for the year. In general, if you are not covered by a retirement plan at work, you can take a full deduction on your traditional IRA contribution.
Special rules apply if one spouse is covered by a retirement plan at work while the other is not. The tax deduction benefit of the contribution made by the non-covered spouse may be reduced or phased out depending on the MAGI (modified adjusted gross income).
7. If you are covered by a retirement plan at work, the tax deduction benefit of your contribution may be reduced or phased out depending on the MAGI.
As stated in the last fact, 100% of your allowable contributions can be deducted from your taxable income if you are not covered by a retirement plan. However, if you are covered by a retirement plan at work (even if you do not participate), the amount that you can deduct may be reduced or phased-out depending on your gross income for the year. The following phase-out (reduction) rule applies if you are covered in 2010:
- For single or head of household (HOH) filers, a full deduction can be taken if MAGI (modified adjusted gross income) is less than $56,000 ($89,000 for married filing joint)
- Partial deduction for single or HOH filers with MAGI between $56,000 to $66,000 ($89,000 to $109,000 for married filing joint)
- No deduction for single or HOH filers with MAGI over $66,000 ($109,000 for married filing joint)
8. Contributions made before the due date of the return can be withdrawn without incurring the 10% early withdrawal penalty.
If you make an early withdrawal from your traditional IRA, you have to pay the 10% penalty unless you meet the exemption requirements. However, you will not incur the early penalty if you are just withdrawing the same contributions you made for the year before the due date. This is treated as if you have not made any contributions at all.
For example, throughout the tax year 2010, you have made a contribution of $3,000. On February 2011, you have a financial emergency and you needed money so you took out the $3,000 that you contributed during the year 2010. Since you withdrew the money before April 18, 2011, you will not incur the 10% penalty usually applied for early withdrawal.
9. Contributions are no longer allowed once you reach the age of 70 1/2 years
Once you reach the age of 70 1/2 years, you are no longer allowed to make a contribution on your traditional IRA. This is because 70 1/2 years old is the age where you need to start making a mandatory minimum distribution (withdrawals).
Source: IRS – Publication 590