The Basics of Contributing to a Traditional IRA
Individual retirement accounts (IRAs) have been around for 50 years, and during those decades, they’ve provided taxpayers with an alternative (or supplement) to 401(k)s. Today, IRAs are a popular option among the self-employed and anyone else who doesn’t have access to an employer-sponsored plan.
Here, we’ll address the fundamentals of IRAs and how taxpayers can contribute to them. With proper planning – and some professional guidance from a tax expert – taxpayers can find an IRA that reduces their overall tax burden and sets their household up for post-retirement life.
What is a Traditional IRA and Who Can Contribute to One?
Traditional IRAs were established in 1974 as part of the Employee Retirement Income Security Act (ERISA). IRA funds include a combination of tradable assets, including stocks, bonds, and other types of assets. Anyone may contribute to an IRA if they earned taxable compensation during the relevant tax year, even if they also pay into an employer-sponsored retirement plan.
What does taxable compensation mean for IRA purposes? It includes the following:
- Wages, salaries, or self-employment income
- Professional fees
- Nontaxable combat pay
- Taxable alimony and separate maintenance payments
- Taxable scholarship and fellowship payments (if shown on box 1 of Form W-2)
For IRA purposes, qualifying compensation does not include the following:
- Earnings and profits from real estate, including rent
- Interest and dividend income
- Pension or annuity income
- Deferred compensation
- Income from certain partnerships
- Conservation Reserve Program (CRP) payments
- Any amounts (other than combat pay) excluded from income
As you can see, the majority of taxpayers may contribute to an IRA. There are, however, limits to how much a taxpayer may contribute to an IRA. There are also limits to how taxes may be deducted from IRA contributions. In all, the picture can be complicated for a particular individual, which is why taxpayers need to speak with a trusted tax planning professional before choosing or withdrawing from an IRA account.
Traditional IRA Contribution Limits and Deadlines
Traditional IRAs offer compelling tax benefits to individuals, but there are a couple of rules that taxpayers must follow. One is the contribution limit. Taxpayers are only allowed to contribute up to a certain amount every tax year. For the 2022 tax year, these limits are as follows:
- Under age 50: $6,000
- Over age 50: $7,000
The actual limit is either the above or the total amount of qualifying compensation earned for the tax year, whichever is lower. Contribution limits apply to both traditional and Roth IRAs and are cumulative. So, for example, if an individual contributes $3,000 to a traditional IRA, they may only contribute an additional $3,000 to a separate Roth IRA. Any excess may be subjected to a 6 percent excise tax every year the excess remains in the fund.
The deadline for IRA contributions is through the tax year, up to the tax deadline of the following year. In other words, any 2023 contributions must be made during 2023 or before the April tax deadline in 2024.
Spouses and Traditional IRA Contributions
Spouses may not contribute to the same IRA fund. They may, however, each contribute to a separate IRA fund.
There is a notable exception, though. If married filing jointly, the spouse making less compensation may use their spouse’s compensation as part of their own contribution limit. In other words, a married couple under 50 may contribute a total of $12,000 to a traditional IRA if filing jointly.
The Tax Advantages of a Traditional IRA
There are numerous tax advantages and stipulations associated with a traditional IRA. They include:
- Contributions may be fully or partially tax deductible
- Funds in the IRA (including earnings and gains) are not taxed until distributed
- There is no limit on how much a taxpayer may earn and still contribute to a fund (there are income limits where tax deductions are concerned, however)
- There is no age limit set on IRA contributions
- Required minimum distributions begin after age 72
- Early distributions (those taken out before 59 1/2 years of age) are subject to an additional 10 percent tax
- Distributions are taxed as ordinary income
With a traditional IRA, tax benefits are realized upfront, as contributions are tax deductible. Distributions are taxed as normal income when they’re taken out at a later time, ideally when the taxpayer’s income tax rate is lower – typically the case for retirees.
Traditional IRA Tax Deductions: Rules and Phaseouts
As mentioned above, there are income limits associated with tax deductions. Specifically, IRA deduction limits are set according to a taxpayer’s modified adjusted gross income (MAGI). MAGI is calculated by adding adjusted gross income (AGI) to the following:
- Traditional IRA deductions
- Student loan interest deductions
- Foreign earned income or housing exclusion
- S. Savings Bond interest exclusion
- Employer-provided adoption benefits exclusion
If the taxpayer is not covered by a retirement plan at work, they may take the full traditional IRA contribution deduction. If they are covered by an employer-sponsored retirement plan, though, IRA phaseouts apply. Here’s what the phaseout table looks like:
- For single filers – Single filers with a MAGI of $68,000 or less may take a full deduction. For those with a MAGI between $68,000 and $78,000, a partial deduction is available. For those with a MAGI above $78,000, no traditional IRA deduction is available.
- For married filing jointly or a qualifying widow(er) – MFJ taxpayers may take a full deduction if their MAGI is $109,000 or less. For MFJ filers with a MAGI between $109,000 and $129,000, a partial deduction is available. For MFJ filers with a MAGI in excess of $129,000, no deduction is available.
- For married filing separately – For MFS filers, only a partial deduction is available, and only for those reporting a MAGI of $10,000 or less. Any more, and no traditional IRA deduction is available.
If the taxpayer isn’t covered by an employer plan, but their spouse is, the IRA phaseout table looks like the following:
- Married filing jointly – MFJ filers with a MAGI of $204,000 or less may take a full deduction. A partial deduction is available for MFJ filers with a MAGI between $204,000 and $214,000. No deduction is available for MFJ filers with a MAGI in excess of $214,000. Again, this is only relevant for married couples where only one spouse is covered by an employer retirement plan.
- Married filing separately – For MFS filers, the rules are the same as if the taxpayer was covered by a retirement plan. Only a partial deduction is available for filers with a MAGI of $10,000 or less. No deduction is available for those with a MAGI in excess of $10,000.
IRAs are a Solid Retirement Planning Tool and Can Provide Considerable Tax Benefits if Leveraged Properly
Traditional IRAs have provided taxpayers with retirement security for almost 50 years, along with tax benefits that can help in the present.
If you’re considering putting money away for retirement – good idea – a tax planning expert can provide individualized guidance on what traditional IRA fund to select. As thousands of potential tax benefits are at stake, getting this decision right is important. A tax expert knowledgeable in IRA funds can help steer their clients in the right direction.
- Employee or Independent Contractor: Determining Worker Status and Taxation Rules - November 8, 2023
- Divorce and Taxes: Tax and Alimony Considerations - November 3, 2023
- Charitable Contributions: How to Deduct and What Qualifies - October 20, 2023