Investing

What you need to know about IRA income limits to set yourself up for retirement

Twenty/20

If you want to start saving for the future right now, opening an IRA could be a smart move. 

Individual retirement accounts, or IRAs, are appealing for a few key reasons: They're open to just about anyone, they offer tax advantages, they can be low-maintenance, and they take just minutes to open. About 36% of U.S. households used an IRA to save for retirement as of mid-2019, according to the Investment Company Institute.

Even if you have access to a 401(k) or another retirement plan through work, opening an IRA can give you additional flexibility. And if you earn money with contract work, freelancing, and side hustles, an IRA may be an especially appealing option.

To figure out which kind of IRA makes sense, it helps to understand the income limits that come into play with these accounts. Here are your options.

Traditional and Roth IRAs: What's the difference?

There are several different kinds of IRAs, but the two most common are the traditional IRA and the Roth IRA. For 2020, you can contribute a maximum of $6,000 to either kind of IRA if you're under age 50, or $7,000 if you're older than 50.

The key difference between traditional and Roth IRAs is when you're taxed on the money you contribute to your account.

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Traditional IRA

Your contributions are typically tax-deductible and they grow tax-deferred, explains Ed Slott, a certified public accountant and the founder and president of Ed Slott and Company, LLC. "You receive a tax deduction up front but will pay the tax when you withdraw." 

If you take out money earlier than age 59½, you'll usually owe taxes and an early withdrawal penalty. There are some exceptions, like if you take out funds to purchase your first home or pay for qualified college expenses.

Thanks to the Secure Act of 2019, there is no longer an age limit to making IRA contributions, and you have until age 72 before you have to start making withdrawals, or required minimum distributions.

Roth IRAs

These accounts are funded with after-tax dollars and grow tax-free. Their big advantage is that they offer tax-free distributions in retirement. "If you're younger and in a lower tax bracket, you should shovel everything you can into a Roth account," Slott told Grow recently.

Roth IRAs also give you more flexibility to dip into your money before you retire: You can withdraw your contributions at any time without taxes and penalties. However, you'll typically be hit with taxes and a 10% early withdrawal penalty if you dip into the earnings portion of the account before age 59½. Again, there are a few exceptions.

"Once you have held the funds for five years, and you reach age 59½, everything you withdraw will be tax-free for life," Slott says. Plus, "anything left to your beneficiaries will also be tax-free to them."

Income limits affect your options and the value of contributing

Your contributions to your IRA may have restrictions based on your filing status and income.

Traditional IRAs

While there are no income limitations to contribute to a traditional IRA, there are income limits that determine whether your contributions are tax deductible.

If you're single and covered by a retirement plan at work, your modified adjusted gross income must be less than $65,000 to claim the full deduction for 2020. Earn more than that and your deduction starts to phase out: Earn $75,000 or more and your contribution is not deductible. 

But if you aren't covered by a retirement plan at work, you can deduct your full contribution up to the annual limit, no matter how much you earn. 

It gets more complicated for married couples filing jointly. In that case, if either you or your spouse is covered by a retirement plan at work in 2020, your deduction starts to phase out when you earn more than $104,000 or more than $196,000, respectively. Higher earners may not be able to deduct their contributions at all. 

But again, if neither you nor your spouse are covered by a retirement plan at work, you can deduct your full contribution up to the annual limit, no matter how much you earn. 

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Roth IRAs

With a Roth IRA, income limits determine whether you can make account contributions at all. 

You must earn less than $124,000 if you're a single filer, or less than $196,000 if you're married and filing jointly, to be eligible to contribute the maximum amount of $6,000 to a Roth IRA in 2020. 

You can make a reduced contribution to your Roth IRA if your earnings are more than that but less than $139,000 for single filers and $206,000 for those married filing jointly. And if you earn more than $139,000 or $206,000 for single filers or those married filing jointly, respectively, then you cannot make a Roth IRA contribution. 

That's why Roth IRAs often make the most sense for new graduates and other people who aren't yet earning much, says Slott.

"If you are a younger worker, you should be contributing to a Roth IRA so your retirement funds can grow tax-free," he says. "You won't receive a tax deduction, but you also won't be subject to what could be high tax rates in your retirement years."

Income limit workarounds for high earners

There are ways to make use of IRAs even if your income is higher than the limits set by the IRS.

One option is making nondeductible contributions to a traditional IRA. You won't get the upfront tax break, but your contributions will grow tax-free. And in retirement, withdrawal of your contributions is also tax-free, though you will pay tax on the earnings.

Often, nondeductible contributions to an IRA are an introduction to something called a "back-door Roth," Slott explains. 

"For those whose income exceeds the Roth IRA income limits, they can contribute to a nondeductible traditional IRA (which has no income limits) and then convert those funds to a Roth IRA," says Slott. This way, "the funds end up in a Roth IRA."

These conversions can be tricky, though, and expensive, depending on factors like your income and other retirement savings you have. So consult with your financial advisor beforehand to be sure it makes sense for you. 

If you are a younger worker, you should be contributing to a Roth IRA so your retirement funds can grow tax-free. You won't receive a tax deduction, but you also won't be subject to what could be high tax rates in your retirement years.
Ed Slott
Founder and president of Ed Slott and Company, LLC

How much should you contribute to your IRA? 

Whether you're just starting to save for retirement, or have been saving for decades, experts recommend contributing as much to your IRA as possible. 

"You should try to contribute the maximum, or whatever you can afford each year to make sure you are continually building your retirement savings," Slott says. "If you are not putting away for yourself, then no one is." 

Of those who made a contribution to an IRA in 2016, almost half (47.6%) maxed out their account, according to the latest available data from the Employee Benefit Research Institute.

If you have a retirement plan through your employer, experts usually recommend contributing enough to receive the full company match for your 401(k) before focusing on your IRA. 

But if an IRA is your primary investment vehicle, it's smart to max it out each year, if possible. Broken down per paycheck, that goal may seem more manageable. 

Assuming you receive 26 paychecks over the course of a year, you would need to save approximately $231 from each check to reach the $6,000 limit. Older savers looking to hit $7,000 would need to save $269.

If you can't max out your IRA, you should contribute as much as you can, Melissa Ridolfi, vice president of retirement and college leadership at Fidelity Investments, previously told Grow.

"Whatever you can afford, save and save regularly," says Ridolfi. "Get as close to that $6,000 limit as you can. Think of it like a bill you're paying to yourself each month."

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