IRA Rules and Limits
Rules and Limits for Traditional IRAs
Traditional IRAs have been around since the mid-1970s. They are known as tax-deferred accounts. Taxes are deferred on the income and earnings until a point in the future when distributions begin. Currently, distributions are allowed to begin after age 59 ½ and must begin by April 1 of the year after which the account owner turns 70 ½. While they are becoming increasingly replaced by Roth IRAs, there are still a number of reasons why retirement savers should consider funding a traditional IRA.
First, those under 50 are allowed to contribute a maximum of $5,000 in 2011. But, if you will turn 50 by the end of the year, you are allowed to contribute an additional $1,000. This additional amount is known as the "catch-up" contribution. The catch-up contribution was included as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. In an effort to incentivize older Americans to save more for retirement, Congress authorized an increase in the amount people could contribute. This is an important increase to take advantage of, particularly as more retirees begin to take Social Security payments, and fewer younger workers are there to support them.
Second, depending on your income, you may be able to fully deduct the amount you contribute. The Internal Revenue Service bases the amount that can be deducted on a taxpayer's modified adjusted gross income. The modified adjusted gross income is calculated by taking adjusted gross income and adding back certain income and deductions, like foreign income and student loan deductions. The higher the modified adjusted gross income, the lower the amount of the IRA contribution that will be deductible.
Third, depending on whether or not you are covered under an employer-sponsored retirement savings plan, all or part of the amount contributed to a traditional IRA may be deducted. Again, this is good news for those who need to boost their retirement savings.
IRA Rules and Limits for 401(k) Owners
For 2010 and 2011, deduction rules and limits are as follows if you are covered by an employer-sponsored plan such as a 401(k):
If your tax return filing status is single or head of household and your modified adjusted gross income is less than $56,000, the contribution is fully deductible. If your modified adjusted gross income is between $56,000 and $66,000, then the contribution is partially deductible. If it is above $66,000, then it is not deductible.
If your tax return filing status is married and you file jointly or you are a qualified widow or widower, and your modified adjusted gross income is $89,000 or less, the contribution is fully deductible. If it is between $89,000 and $109,000 it is partially deductible. No deduction is allowed if modified adjusted gross income is above $109,000.
If your tax return filing status is married and you file separately, the contribution is only partially deductible if modified adjusted gross income is less than $10,000.
If you are single, the head of a household or a qualified widow or widower and do not participate in an employer-sponsored plan, or if you are married and file jointly or separately with a spouse who is not covered by an employer-sponsored plan, then your contribution is fully deductible. Further, you can establish and fund a spousal IRA if your spouse is not employed outside the home and has no earned income.
If you file jointly with a spouse who is covered by a plan at work, the contribution is fully deductible if modified adjusted gross income is $167,000 or less, partially deductible if it is between $167,000 and $177,000 and not deductible at all if it is $177,000 or above.
Finally, if you are married and file separately with a spouse who is covered by an employer's plan, a partial deduction can be claimed only if modified adjusted gross income is below $10,000.
It's important to remember that even if the full amount of the contribution made to a traditional IRA is not deductible, earnings on the account will still be tax-deferred. Provided a taxpayer has earned income for the year and will not turn 70 ½ by December 31 of that year, he or she can contribute to a traditional IRA.
Rules and Limits for Roth IRAs
Roth IRAs were introduced in 1997. Unlike traditional IRAs, the amount contributed is not tax-deductible. Just like a traditional IRA, earnings on the account are not taxed, but qualified distributions made after age 59 ½ are paid tax-free. This is significantly different than a traditional IRA on which taxes are paid once distributions begin.
Contribution limits for Roth IRAs are a little less confusing than those for traditional IRAs. Contributions can be made if modified adjusted gross income is $122,000 or less for those who are single, the head of a household or are married and file separately (who did not live with a spouse during the year). The limit is $179,000 for those who are married and file jointly (including qualifying widows and widowers). Finally, it's $10,000 for those who are married and file separately who did live with a spouse for any part of the year.
Just like a traditional IRA, those under the age of 50 can contribute up to $5,000 and those ages 50 and over can contribute an additional $1,000. However, depending on modified adjusted gross income, the amount that can be contributed may be reduced.
Like a traditional IRA, distributions from a Roth IRA that begin before age 59 ½ are subject to a 10% early withdrawal penalty. Unlike a traditional IRA, however, a Roth IRA account owner does not have to take mandatory distributions at age 70 ½. He or she can choose to take distributions later than age 70 ½ or never at all.
Rules and Limits for SEP IRAsA SEP (Simplified Employee Pension Plan) IRA is a plan that is established by an employer for himself or herself and eligible employees. It's important to note that unlike a traditional or Roth IRA, contributions made to a SEP IRA are fully funded by the employer, not the individual account owner.
Contributions can be as high as 25% of an employee's compensation up to a maximum of $49,000 per year for tax years 2010 and 2011. The maximum amount of compensation that can be used to calculate the amount contributed is $245,000.
One significant difference between traditional and Roth IRAs and a SEP IRA is that the $1,000 catch-up contribution cannot be contributed to a SEP IRA. And, like a Roth IRA, contributions can be made even if the account owner is over the age of 70 ½. If the account owner is over the age of 70 ½ he or she will have to take a mandatory distributions.
While we've covered the basics of IRA investing here, there is much more to maximizing the success of you IRA. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More IRA Guidance
- IRA Investment Guide — The complete guide to IRA investing.
- Traditional IRAs — Details about how traditional IRAs work.
- Roth IRAs — Details about how Roth IRAs work.
- SEP IRAs — Details about how SEP IRAs work.
- Roth vs Traditional IRAs — How to choose the right IRA for you.
- IRA Rollovers — How to roll over an IRA and what to watch out for.
- 457 Plans — Detials of how 457 plans work.
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- IRA FAQ — Over 30 in-depth IRA questions answered.