To be able to understand the limits on IRA contributions, you need to be familiar with how IRA works. The type of investments that the IRA holds can be stocks, bonds, mutual funds, or any of A wide range of financial products. Individuals can create traditional and Roth accounts, which are 2 options out of the 4 types of IRAs. Business owners can create two other types of IRAs, known as SEP and SIMPLE. Since the funds inside an IRA are tax-advantaged, there is a limit to the IRA contributions you’re allowed to make. We’ll help you wrap your head around the exact limitations.
To be able to contribute to an IRA, you need to use earned income. In simple words, earned income is the money you get for working for someone else or for having a business or a farm. It can include anything from wages, salaries, to commissions and freelancing jobs. Disability retirement benefits are viewed as earned income by the IRS until a certain age. Child support, alimony payments, profit from rental property, interest from investments, retirement money, and unemployment benefits are not considered earned income that can be contributed to the IRA plan. It’s worth noting that if your earned income is lower than the contribution limit or cap, you can only contribute funds to a limit set as your earned income.
For the years 2020 and 2021, the cap of traditional IRA contributions has been set to $6,000 for employees below 50 years old. Those who are over 50 are allowed to catch-up contributions as long as it doesn’t exceed $1,000 per year. Each type of IRA has a different annual contribution limit, and the chart from TheEntrustGroup.com mentions the limits for traditional, Roth, SEP, and SIMPLE IRAs, in addition to 401k. Thanks to the new law that was passed recently in 2020, the SECURE Act, it is now possible for individuals to keep contributions to their IRA regardless of their age; the limit was previously set at 70.5 years old.
Pretax dollars, which are funds or contributions put into a tax-deferred investment vehicle, are used to fund traditional IRAs and 401k accounts. These contributions help reduce the tax burden of an IRA owner. It’s worth mentioning that while the contributions can grow in this account without added tax, withdrawing them will make the funds subjectable to income tax. On the other hand, both Roth IRA and Roth 401k funds are made with after-tax contributions, which means they are taxed before they go into a retirement account. Naturally, withdrawing from an after-tax account won’t subject the funds to any penalties like in traditional and 401k IRAs. Roth accounts are often beneficial for people who are in a higher tax bracket. Whether it’s a traditional IRA or a Roth one, all types of IRAs are capped with a contribution limit to avoid it being misused for the benefit of avoiding taxes. The caps will be discussed in specificity as we go on.
The cap on 401(K) contributions changes every year or two. For 2020 and 2021, the cap is set to $19,500. This cap includes both traditional and Roth(K) plans, bearing in mind that the employee’s age is below 50. It is possible for employers to use non-elective deferrals or contribution matching to increase the total amount of contributions that an employee has in their account. It’s important to note that whatever the source of contribution is, it shouldn’t exceed $58,000. As a way to stimulate the contributions of people who are nearing their retirement, the IRS allows something called ‘catch-up contributions’ for those who are employed and over 50. The current catch-up contribution is set to a cap of $6,500, making the total contribution limit from all sources at $64,500 for employees over 50.
The IRS has posed certain limitations and regulations regarding the IRA contributions of employees with big salaries. These rules or regulations are put in place to stimulate the contribution of the biggest number of employees across varying compensation levels. If a high-ranking employee that gets a good compensation package wants to increase their individual contribution to a 401(K) plan, they need to encourage their employees to contribute to a plan as well because the cap is the average of their contributions. This is used to encourage executives and managers to nudge their team to contribute more to their 401(K) plan.
An individual retirement account is one of the most popular tax-advantaged investing tools used to specify funds to invest in through retirement savings. The type of IRA and the individual’s employment play a role in determining the various tax liabilities offered. Using your IRA account to its full extent can help relieve a lot of financial pressure and become a great tool for investment before and after retirement.