When you’re young and working, retirement can be an abstract concept, particularly when it comes time to plan contributions to retirement accounts. Ideally, your IRA isn’t your sole source of retirement income, although most retirement planners encourage investors to make use of the tax advantages and the time value of money by contributing as much money as possible to your IRA. Additionally, your contribution to your IRA might be tax-deductible, lowering your taxable income in the year you make the contribution.
IRA Contribution Limits
Many retirement planners encourage workers to contribute the maximum allowed by the Internal Revenue Service to an IRA. As of 2012, contribution limits to IRAs are $5,000 annually for people younger than 50. If you’re 50 years old or older, the IRS allows for “catch-up” payments, which raises your annual contribution limit to $6,000 each year. If you’re married and file jointly, you and your spouse can combine to contribute twice the limit for individuals. The IRS only allows contributions to be made with income earned in the year of the contribution, so you can’t contribute more than your wages for the year, if they’re less than your contribution limit.
Less than Maximum Contribution
Because of the tax advantages of IRAs, nearly all retirement planners urge investors to make the maximum allowable contribution to an IRA if possible. If you can’t afford to contribute $5,000 or $6,000 each year, Kiplinger recommends placing 15 percent of your gross income into retirement savings to maintain your standard of living when you retire. Retirees should aim to have 20 times their annual income in savings and retirement funds, including IRAs, to maintain their standard of living, according to The New York Times.
If you contribute more than the contribution limit to your IRA and don’t withdraw the excess contribution by April 15 of the following year, you face a 6 percent penalty on the excess amount. This is assessed each year until you withdraw the excess amount. If you contributed too much in a prior year, you can still remove the excess and not claim it as part of your gross income by recharacterizing the prior year’s excess contributions to a later year’s contribution. To do this, you must file a form 1040X, an amended tax return, for the year with excess contributions. This recharacterizes the excess contribution as a contribution to the current tax year. You can file a form 1040X up to three years after you filed your return. If you paid your tax bill late that year, you may have two years from the date you paid your bill.
Tax Benefits of Contributions
Contributions to a traditional IRA provide two major tax advantages. On the front end, every dollar you contribute up to the maximum can be claimed as a deduction, and you’re essentially not taxed on those earnings – you might even receive a larger refund because of it. Although you’ll owe the income tax you deferred when you made the contribution when you receive your distribution, funds in IRAs grow free from capital gains taxes you’d owe if you made a similar investment outside of a tax sheltered account.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.