When saving for retirement, investors have a multitude of options to save their money. Two popular types of investments for retirement savers are traditional and Roth IRAs. Both traditional and Roth IRAs offer tax-free growth for the life of these vehicles and have unique attributes that can assist investors in achieving retirement security and peace of mind. Each year the rules regulating IRA contributions for both traditional and Roth accounts are updated and play a major role in how investors save. While some of the newer changes are rather minor compared to previous years, some changes can have a significant impact on the IRA environment, specifically by way of taxes.
Most recently in 2020, IRA regulations received a significant overhaul with the passage of the SECURE Act, which ultimately ended the Stretch IRA for designated beneficiaries. In terms of contributions, however, the SECURE Act eliminated the maximum age that an account owner can contribute to an IRA, meaning that as long as an account owner has taxable earned income, they can continue to invest in their IRA, even if they are taking required minimum distributions. While there were not as many changes from 2020 to 2021, it is important that investors in or planning for retirement are aware of the limits and regulations for making contributions to their traditional or Roth IRA accounts.
Traditional and Roth IRAs have similar but unique rules when it comes to contributions, and staying up-to-date with changes puts investors in the best position possible to fully take advantage of the retirement vehicles and avoid any potential pitfalls. Traditional IRAs were introduced to investors in 1975 and offer a tax-deductible contribution that grows tax-deferred for the life of the vehicle with the stipulation that when the investor reaches age 72 they will be mandated by the IRS to take required minimum distributions. This vehicle is popular among working investors saving for retirement because the contributions made to a traditional IRA not only have the benefit of being funded with pre-tax dollars, but also have favorable tax implications that could reduce an investor’s income tax liability in the present date when filing their taxes each year.
When it comes to filing income taxes, investors have to be wary of whether or not they can take a full deduction, limited deduction, or no deduction from their IRA contributions. If the IRA owner is an active participant in a workplace retirement plan — 401(k), 403(b), pension, or a SIMPLE IRA — the amount of income that is filed by the participant will determine whether or not the investor will be able to deduct their traditional IRA contributions when they file their taxes. An IRA owner who is not an active participant in a workplace retirement plan has the ability to deduct their entire IRA contribution for the year. In other cases where the IRA owner does participate in a workplace retirement plan, then they would have to check their tax filing status, which is determined by filing as a single individual, filing jointly with a spouse, or filing separately from a spouse.
Each of these categories contains certain income limits that the filer cannot exceed if they wish to make a full or partial deduction. The traditional IRA income limits and modified adjusted gross income (MAGI) must be examined based on any of the three aforementioned categories to determine the deduction status of an investor’s IRA contributions. Single filing active participants may take a full deduction of their IRA contributions in 2021 if they make less than $66,000. A limited deduction can be made if they make between $66,000 and $76,000 in 2021. Anything above $76,000 would result in the single filer being denied any deductions from their IRA contributions.
Married filers where one or both spouses are active participants in a workplace retirement plan also have income limits that determine if they can make a full traditional IRA deduction or not. In 2021, if both spouses are active participants they would have to jointly earn less than $105,000 a year to take advantage of a full deduction. Anything between $105,000 and $125,000 for joint filers who are both participants would result in a limited contribution, while earned income that is more than $125,000 would disqualify any deductions. On the other hand, if only one spouse is an active participant in 2021, then their income limit for a full deduction would be less than $198,000. To make a limited deduction they will have to make between $198,000 and $208,000; no deduction may be made if their earned income exceeds $208,0000. Active participants who are married but file separately generally do not qualify for any deductions unless they make less than $10,000 — in which case they can make a limited deduction.
Unlike traditional IRAs, Roth accounts came into existence in 1998. Investors with a Roth account do not have the option to make tax deductions because Roth IRAs are funded with after-tax contributions and grow tax-free for the life of the vehicle. Roth IRAs do not mandate required minimum distributions because the invested principal was already taxed. These vehicles operate slightly differently than traditional IRAs when it comes to contributions. Instead of placing deduction limits on investors participating in a workplace retirement plan, Roth accounts have contribution limits that are dependent on the income status of the tax filer.
Similar to traditional IRAs, the income categories for Roth accounts are broken down between single filers, spouses filing jointly, and spouses filing separately. Rather than limiting how much of the contributions can be deducted from their taxes, Roth accounts limit how much can be contributed based on the amount of earned income in these three categories. In order to make a full contribution to a Roth IRA in 2021, a single filer would have to earn less than $125,000. A single filer could make a limited contribution if they earn between $125,000 and $140,000, but if more than $140,000 is earned no contribution can be made. For a married couple filing jointly in 2021, to make a full contribution to their Roth IRA they would have to earn less than $198,000. Furthermore, if they file between $198,000 and $208,000 they can make a limited contribution, but they would not be able to make any contributions if they jointly earned more than $208,000 in 2021. Just like a traditional IRA, however, filing separately from a spouse hinders the investor’s ability to contribute to a Roth IRA, although they can make a limited contribution if less than $10,000 is earned.
For both traditional and Roth IRA contributions the limits are the same. An investor can put up to $6,000 in one or both of these types of vehicles in 2021; however, an investor who has both a traditional and Roth account cannot invest $6,000 into each of the IRAs. Therefore, an investor can split the $6,000 limit between the two accounts, but cannot exceed that limit. Investors over the age of 50 have the ability to add an extra $1,000 into their accounts each year, raising the yearly limit to $7,000 in what is known as a catch-up contribution. Catch-up contributions are important for investors over the age of 50 because it allows them to save more money for retirement in a traditional IRA, Roth, or split between both. On top of catch-up contributions every couple of years to maintain pace with inflation, the IRS will increase the contribution limit by $500 in what is known as a cost of living adjustment (COLA). A COLA has not been applied for 2021 and it is not yet known if an adjustment will be made in 2022.
Another important rule about IRA contributions is that investors have until April 15, 2021, to make a 2020 contribution if they haven’t already exceeded the $6,000 investment threshold — $7,000 if the investor is over the age of 50. Making a contribution before taxes are due on April 15 of any year has financial benefits for those making a contribution into a traditional IRA. Not only can an investor make a tax-deductible contribution to a traditional IRA, but that contribution would also decrease the amount of taxable income for the current tax year, resulting in potentially paying fewer taxes.
Although most of the major IRA changes occurred in 2020 when the SECURE Act went into effect, IRA rules and regulations are updated each and every year. It is important for investors saving for retirement and living in retirement with these vehicles to stay up-to-date with all of the yearly changes that could impact their IRA accounts to ensure that they are taking full advantage of contribution increases and other changes.