One of the surest ways to grow your nest egg is to take advantage of special tax breaks offered by the Internal Revenue Service (IRS). That explains the popularity of individual retirement accounts (IRAs), which have become one of the cornerstones of retirement planning in the United States.
- For the 2022 tax year, individuals can set aside up to $6,000 per year. People aged 50 and older can save an additional $1,000.
- For the 2023 tax year, the maximum contribution increases to $6,500 a year. The “catch-up contribution” for people ages 50 and up remains $1,000.
- The annual contribution limits apply to all of a taxpayer’s retirement accounts. The collective total contributed over the year can’t exceed the limits.
- High income earners are ineligible to use a Roth account or have limited access to them depending on income.
How Traditional IRAs Work
Like employer-sponsored 401(k)s, traditional IRAs can dramatically reduce the amount of income you have to fork over to the federal government. Investors generally contribute pretax dollars, and the balance grows on a tax-deferred basis until retirement. Withdrawals after the age of 59½ are then subject to ordinary income taxes at the rates of your current tax bracket.
Be aware, though, that there are limits on how much you can contribute. It’s also worth bearing in mind that the two most common varieties of this savings vehicle—traditional IRAs and Roth IRAs—have different rules.
IRA Contribution Limits
For the 2022 tax year, the standard contribution limit for both traditional and Roth IRAs is $6,000. If you’re 50 years of age or older, the IRS provides a catch-up feature that allows you to contribute an extra $1,000 each year for a total of $7,000.
For the 2023 tax year, the maximum contribution increases to $6,500 a year. The “catch-up contribution” remains $1,000.
If you’re rolling another retirement plan over into an IRA, annual contribution caps don’t apply.
That may not sound like a lot of money, but it’s enough to have a big impact on your savings total performance over a long period of time.
For example, let’s take a 30-year-old who contributes the full $6,000 every year until retirement. Assuming a 7% annual return, the account will have a balance of $887,481 when the investor reaches age 65, not including any catch-up contributions the person makes. After taxes—assuming a 22% tax rate in retirement—it’s still $692,235 in spending power.
And don’t forget, the contribution limits are adjusted for inflation every year.
The chart below shows how the tax advantages of an IRA can have a dramatic impact on savings over the course of several decades.
Let’s say that the retirement saver’s effective tax rate right now, while they’re earning a steady income, is 24%. Had they put the same portion of each paycheck in a taxable savings account, it would be worth far less. Why? Because the annual tax deduction gives retirement savers greater purchasing power.
Suppose, after paying taxes, that our 30-year-old could only afford to put $4,560 into a standard savings account. If the money was put into an IRA instead, it would reduce the tax bill, allowing the account holder to put in an additional 24%, or $1,440. Over time, that drastically increases the size of the nest egg.
How Employer-Sponsored Plans Affect IRAs
Though anyone can contribute up to $6,000 (or $7,000 for individuals age 50 and older) to a traditional IRA, not everyone can deduct the full amount on their tax return. If you or your spouse participates in a retirement plan at work, you’re subject to certain restrictions based on your modified adjusted gross income (MAGI).
For the 2022 tax year, if you’re single and make more than $68,000 and less than $78,000 a year, you’re only allowed a partial deduction on IRA contributions. For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is between $109,000 and $129,000.
For the 2023 tax year, the phase-out range for single people increases to between $73,000 and $83,000. For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is increased to between $116,000 and $136,000.
Common types of employer retirement plans include:
Different Rules for Roth IRAs
When setting up an IRA, most investors have two choices: the original or “traditional” version of these savings accounts, which dates back to the 1970s, and the Roth variety, introduced in the 1990s.
The principal difference between the two is in the tax treatment:
The owner of a traditional IRA does not immediately owe income taxes on the money deposited into the account. That money is shielded from taxes until the person retires and starts taking withdrawals.
The owner of a Roth account pays income taxes on the money before it is paid in. But when withdrawals are taken correctly, no further taxes are due on the principal or interest it earns.
The contribution limits are the same for both types of accounts.
Income Limits for Roth Eligibility
The government places restrictions on who can contribute to a Roth, basically limiting or eliminating its use by high-income earners.
To determine your eligibility, the IRS also uses modified adjusted gross income (MAGI) as a metric. Basically, that’s your total gross income minus certain expenses that not everybody has.
For the 2022 tax year, single filers with a MAGI of more than $144,000 per year and joint filers who brought in more than $214,000 were disqualified from Roth IRA contributions altogether. For the 2023 tax year, single filers with a MAGI of more than $153,000 per year and joint filers who brought in more than $228,000 were disqualified from Roth IRA contributions altogether.
There’s another area in which Roth IRAs differ from traditional IRAs. If you have a traditional IRA, you have to start taking required minimum distributions (RMDs) from your account starting at age 72. The RMD age used to be 70½ but was raised to 72 following the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act. You can keep your Roth money forever, if you wish.
How to Contribute to IRAs
You can contribute to either type of IRA as early as Jan. 1 or as late as the tax year’s filing deadline in mid-April each year. It’s up to you whether you make one large contribution or make periodic contributions throughout the year.
If you have the money, it can make financial sense to make the full contribution at the beginning of the year. That gives your money the most time to grow.
If you can’t come up with that kind of cash all at once, you can set up a schedule that works for you. It’s easy to set up automated payments that transfer money from your bank account into your IRA account on a regular schedule. That could be every two weeks (when you get your paychecks) or once a month.
Setting up periodic contributions makes that $6,000 more manageable. It has another benefit, too: you’re dollar-cost averaging your investments.
Dollar-Cost Averaging for IRAs
Dollar-cost averaging is a strategy that requires an investor to invest the same amount of money in the same asset over time rather than in a lump sum. If the price of the asset is volatile, as in stocks, this means buying the same asset at its highest highs and its lowest lows. Over time, the results are likely to be superior to lump-sum investing.
The strategy is ideal for IRA contributions. You can earmark a certain monthly sum for your retirement account and have it automatically deducted. You’re investing that money in mutual funds or stocks, but acquiring more or fewer shares depending on its current market price.
You end up investing in assets at their average price over the year. Hence the term dollar-cost averaging.
If you’re risk-averse, spreading out your money is a good idea. Invest in a mix of conservative and aggressive funds. This reduces the average cost basis of your overall investment—and hence, your breakeven point. The approach is known as averaging down.
Here’s an example. Let’s say you have $500 to invest in a mutual fund every month. In the first month, the price is $50 per share, so you end up with 10 shares. The next month, the fund’s price falls to $25 per share, so your $500 buys 20 shares. After two months, you would have bought 30 shares at an average cost of $33.33.
Using dollar-cost averaging, you only need to commit $500 per month in order to reach the annual limit, or $250 every two weeks if you invest on a paycheck-to-paycheck basis.
How Much Should You Contribute to an IRA?
That’s a good question. It’s tempting to say you should fund it to the allowable maximum each year—or at least up to the deductible amount if you’re going with the traditional type.
Lovely as it would be to furnish a hard-and-fast figure, though, a real-life answer is more complicated. Much depends on your income, needs, expenses, and obligations.
Laudable as long-term saving is, most financial advisors recommend you clear your debts first, if possible—unless it’s “good” debt, like a mortgage that is building equity in your home. But if you have a bunch of outstanding credit card balances, paying them off should be your first priority.
Much also depends on how much money you think you’ll need or want in retirement, and how long you have before you get there. There are a number of ways to figure out this golden sum.
But it might make more sense to come up with an ideal number and then work backward to calculate how much you should contribute toward your accounts. That means figuring out average rates of return, the investment time frame, and your capacity for risk.
Figure in what other sorts of retirement-savings vehicles are open to you, too—such as an employer-sponsored 401(k) or 403(b). It’s often more advantageous to fund these first up to the max, especially if your company generously matches employee contributions.
After you’ve gotten the maximum employer match, you could then deposit additional sums into a Roth IRA or a traditional IRA, even though the contributions are nondeductible.
If your workplace plan has little or no match and poor investment options, make your IRA the primary nest for your retirement funds. It’s easy to open an account at a brokerage firm, mutual fund company, or bank, for instance.
In addition to mutual funds and exchange-traded funds (ETFs), many IRAs allow you to pick individual stocks, bonds, and other investments as well.
Can You Contribute the Same Amount to a Roth IRA as to a Traditional IRA?
Yes. The contribution limit for both types of IRAs is the same: For the 2022 tax year, single people can set aside up to $6,000 per year. People aged 50 and older can save an additional $1,000. For the 2023 tax year, the maximum contribution increases to $6,500 a year. The “catch-up contribution” for people ages 50 and up remains $1,000.
What Is the Deadline for Making Contributions to an IRA?
IRA contributions can be made up to the mid-April filing deadline for that year’s taxes.
Contributions for 2022 can be made between Jan. 1, 2022, and April 18, 2023. Contributions for 2023 can be made from Jan. 1, 2023, until April 15, 2024.
Can You Have an IRA and a 401(k) Account?
You can have both an IRA and a 401(k). The limit for the year is the maximum amount that you can squirrel away in both accounts.
The Bottom Line
Learning the difference in rules between contributing to a traditional versus a Roth IRA pays off in the long run. Though there are no limits on income for contributing to a traditional IRA, there are limits on how much of your contributions you can deduct from your taxable income. A Roth IRA is not deductible—you pay tax upfront on your contributions, then make tax-free withdrawals in retirement—but eligibility is based on income limits.
Whichever account best meets your individual situation, it’s always wise to set aside current income against your retirement years.