An IRA, or Individual Retirement Arrangement, allows you to make a tax-deferred investment for your retirement. IRA contribution limits may change each year, and the IRS sets the limit. Understanding the IRS limits for IRA contributions is necessary to remain within the contribution limit and therefore avoid tax penalties.
Types of IRAs
There are two types of IRAs, Traditional IRAs and Roth IRAs.
If you have a traditional IRA, you can contribute (or your spouse if you file jointly), if you have taxable compensation per the IRS. Traditional IRAs require a minimum distribution which begin by April 1st following the year you turn age 72, and by December 31 of later years. Deductible contributions and earnings that you withdraw from a traditional IRA are taxable. If you’re under the age of 59.5, you may have to pay an additional early penalty of 10% tax unless you qualify for an exception as laid out by the IRS.
To contribute to a Roth IRA, you must have taxable compensation per the IRS, and have an income below a certain limit, which can change each year. The limits for 2021 can be found on the IRS website here. With a Roth IRA, you do not have to take minimum distributions as you would with a traditional IRA. Also, distributions are not taxable if they are a qualified distribution. As with traditional IRAs, the 10% penalty for withdrawals prior to the age of 59.5 still applies.
With both Roth and Traditional IRAs, you can withdraw money at any time. The deadline for contributions for 2021 is April 15th of 2022.
IRA Contribution Limits for 2021
The IRS sets limits for what you can contribute to your IRA, either Traditional or Roth.
In 2021, the most you can contribute to all your IRAs, either Traditional or Roth is the smaller of $6,000 (or $7,000 if you’re age 50 or older by the end of the year) – or your taxable compensation for the year.
The limit for 2021 is the same as 2020 and 2019 and will remain the same for 2022.
What The Limits Don’t Apply To
The IRS does specify certain scenarios where the contribution limit does not apply. These include rollover contributions and qualified reservist repayments.
IRAs can be rolled over by depositing the payment into another retirement plan or IRA within 60 days. This defers the tax since it is not a withdrawal of the money, and the money will continue to grow tax-deferred.
Rollovers may be a direct rollover, where the money goes directly into another account. You may also use a trustee-to-trustee transfer, where you can ask a financial institution to make a payment from your IRA directly to another IRA, where no taxes will be withheld on the transfer. If you choose to have a 60-day rollover, the distribution is paid to you, and you must deposit that money into another account within 60 days. Taxes are withheld in this scenario.
The IRS generally limits you to one rollover per year.
What If I Contribute Too Much to an IRA?
If you contribute too much to an IRA, the IRS considers this an excess contribution. This happens when you contribute beyond the contribution limit or make an improper rollover contribution to an IRA.
If you contribute too much to your IRA, you are taxed at 6% per year for each year the excess amounts remain in the IRA. To avoid that tax penalty, you must withdraw the excess contribution by the due date of your tax return and any income earned on that excess contribution.
IRAs and Tax Professionals
IRAs and taxes can be a complicated matter. When trying to make the best decision for your financial future that is also tax savvy, it’s best to contact a tax professional. Tax professionals, especially when working in conjunction with a financial planner, can assist you with determining the best course of action for your IRAs and retirement accounts.
This post first appeared on Forbes.