One of the surest ways to grow your nest egg is to take advantage of special tax breaks offered by the Internal Revenue Service (IRS). That explains the popularity of individual retirement accounts (IRAs), which have become one of the cornerstones of retirement planning in the United States.
To make the most of an IRA, whether the traditional or Roth variety, you'll need to understand how these accounts work in general and their annual contribution limits.
- In 2023, the maximum contribution is $6,500 a year. The "catch-up contribution" for people ages 50 and up remains $1,000.
- The limits are up from the 2022 tax year, where individuals could set aside up to $6,000 per year.
- The annual contribution limits apply to all of a taxpayer's retirement accounts. The collective total contributed over the year can't exceed the limits.
- High-income earners are ineligible to use a Roth account or have limited access to them depending on income.
How Traditional IRAs Work
Like employer-sponsored 401(k)s, traditional IRAs can dramatically reduce the amount you have to fork over to the federal government. You contribute pretax dollars, and the balance grows on a tax-deferred basis until retirement. Withdrawals after the age of 59½ are then subject to ordinary income taxes at your current tax bracket rates.
It's important to be aware that there are limits on how much you can contribute. Additionally, it's worth noting that the two most common varieties of this savings vehicle—traditional IRAs and Roth IRAs—have different rules.
IRA Contribution Limits
The maximum contribution for the 2023 tax year is $6,500 a year. The "catch-up contribution" for those over 50 remains $1,000. This limit is an increase from the 2022 tax year, where the standard contribution limit for both traditional and Roth IRAs was $6,000.
If you’re rolling another retirement plan over into an IRA, annual contribution caps don’t apply.
That may not sound like a lot of money, but it’s enough to significantly impact the total performance of your savings over a long period.
For example, say you're a 30-year-old who contributes the maximum every year until retirement. Assuming a 7% annual return and an adjusted gross income of $80,000, the account will have a balance of $988,326 when you reach age 65, including your catch-up contributions. After taxes—assuming a 22% tax rate in retirement—it’s still $840,077 in spending power.
And don't forget that the contribution limits are adjusted annually for inflation.
The chart below shows how the tax advantages of an IRA can have a dramatic impact on savings over several decades.
For instance, say that your effective tax rate right now, while you're earning a steady income, is 24%. It would be worth far less if you put the same portion of each paycheck in a taxable savings account. Why? Because the annual tax deduction gives you greater purchasing power.
Suppose, after paying taxes, you could only afford to put $4,940 into a standard savings account because taxes took 24% ($1,560) of your $6,500. If the money were put into a traditional IRA instead, it would reduce your tax bill because taxes are deferred until you make withdrawals. This allows you to use that additional 24%—drastically increasing the size of your nest egg because the money you would have paid in taxes is also growing.
How Employer-Sponsored Plans Affect IRAs
Though anyone can contribute up to $6,500 (or $7,500 for those 50 and older) to a traditional IRA, not everyone can deduct the full amount on their tax return. If you or your spouse participates in a retirement plan at work, you’re subject to certain restrictions based on your modified adjusted gross income (MAGI).
For the 2023 tax year, if you’re single and make more than $73,000 and less than $83,000 a year (up from $68,000 and $78,000 in 2022), you’re only allowed a partial deduction on IRA contributions. For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is between $116,000 and $136,000 (up from $109,000 and $129,000 in 2022).
Common types of employer retirement plans include:
- 401(k) accounts
- Profit-sharing programs
- Stock bonus programs
- SEP or SIMPLE IRAs
Different Rules for Roth IRAs
When setting up an IRA, most investors have two choices: the original or "traditional" version of these savings accounts, which dates back to the 1970s, and the Roth variety, introduced in the 1990s.
The principal difference between the two is in the tax treatment. The owner of a traditional IRA does not immediately owe income taxes on the money deposited into the account. Instead, that money is shielded from taxes until the person retires and starts taking withdrawals; the owner of a Roth account pays income taxes on the money before it is paid in. But when withdrawals are taken correctly, no further taxes are due on the principal or interest it earns.
The contribution limits are the same for both types of accounts.
Income Limits for Roth Eligibility
The government restricts who can contribute to a Roth, limiting or eliminating its use by high-income earners. The IRS also uses modified adjusted gross income (MAGI) as a metric to determine your eligibility. Basically, that's your total gross income minus certain uncommon expenses.
For the 2023 tax year, single filers with a MAGI of more than $153,000 per year and joint filers who brought in more than $228,000 were disqualified from Roth IRA contributions. These figures are up from the 2022 tax year, where the limits were $144,000 for single filers and $214,000 for those who were married and filed jointly.
There’s another area in which Roth IRAs differ from traditional IRAs. If you have a traditional IRA, you must take the required minimum distributions (RMDs) from your account starting at age 73 (an increase implemented in 2023). The RMD age has been increased over time, from 70½ to 72, then to its current limit.
You can keep money in your Roth account forever or pass it on to your heirs and beneficiaries if you wish.
How to Contribute to IRAs
You can contribute to either type of IRA as early as Jan. 1 or as late as the tax year’s filing deadline in mid-April each year—meaning you have 15½ months to meet the maximum you can contribute for a year. It’s up to you whether you make one large contribution or periodic contributions throughout the year.
If you have the money, it can make financial sense to make the full contribution at the beginning of the year. That gives your money the most time to grow.
If you can't come up with that kind of cash all at once, you can set up a schedule that works for you. For example, it’s easy to set up automated payments that regularly transfer money from your bank account into your IRA account. That could be every two weeks (when you get your paychecks) or once a month.
Setting up periodic contributions makes that $6,500 more manageable. It has another benefit, too: you're dollar-cost averaging your investments.
Dollar-Cost Averaging for IRAs
Dollar-cost averaging is a strategy that requires you to invest the same amount of money in the same asset over time rather than in a lump sum. If the price of the asset is volatile, like some stocks, this means buying the same asset at its highest highs and its lowest lows. Over time, the results are likely to be superior to lump-sum investing.
The strategy is ideal for IRA contributions. You can earmark a certain monthly sum for your retirement account and have it automatically deducted. You're investing that money in mutual funds or stocks but acquiring more or fewer shares depending on its current market price.
You end up investing in assets at their average price over the year. Hence the term dollar-cost averaging.
If you're risk-averse, spreading out your money is a good idea. Invest in a mix of conservative and aggressive funds. This reduces the average cost basis of your overall investment—and hence, your breakeven point. The approach is known as averaging down.
Here’s an example. Say you have $500 to invest in a mutual fund every month. In the first month, the price is $50 per share, so you end up with 10 shares. The following month, the fund’s price falls to $25 per share, so your $500 buys 20 shares. After two months, you would have purchased 30 shares at an average cost of $33.33.
Using dollar-cost averaging, you only need to commit $500 per month to reach the annual limit, or $250 every two weeks if you invest on a paycheck-to-paycheck basis.
How Much Should You Contribute to an IRA?
How much you contribute depends on your income, needs, expenses, and obligations. Laudable as long-term saving is, most financial advisors recommend you clear your debts first, if possible—unless it's "good" debt, like a mortgage that is building equity in your home. But if you have a bunch of outstanding credit card balances, paying them off should be your priority.
Set Retirement Goals
The amount you contribute also depends on how much money you think you'll need or want in retirement and how long you have before you get there. There are several ways to figure out this golden sum.
But it might make more sense to come up with an ideal number and then work backward to calculate how much you should contribute toward your accounts. That means figuring out average rates of return, the investment time frame, and your capacity for risk.
Prioritize Your Contributions
It helps to figure out what other retirement savings vehicles are open to you, like an employer-sponsored 401(k) or 403(b). It's often more advantageous to fund these first up to the max, especially if your company matches employee contributions.
After you've reached the maximum your employer will match, you could start making deposits into a Roth IRA or a traditional IRA, even though the contributions are nondeductible.
If your workplace plan has little or no matching and poor investment options, make your IRA the primary nest for your retirement funds. It’s easy to open an account at a brokerage firm, mutual fund company, or bank.
Can You Contribute the Same Amount to a Roth IRA as to a Traditional IRA?
Yes. The contribution limit for both types of IRAs is the same: For the 2023 tax year, the maximum contribution increased to $6,500 a year (up from $6,000 in 2022). The "catch-up contribution" for people ages 50 and up remains $1,000.
What Is the Deadline for Making Contributions to an IRA?
IRA contributions can be made up to the mid-April filing deadline for that year's taxes.
Contributions for 2022 can be made between Jan. 1, 2022, and April 18, 2023. Contributions for 2023 can be made from Jan. 1, 2023, until April 15, 2024.
Can You Have an IRA and a 401(k) Account?
You can have both an IRA and a 401(k). However, the contribution limit for the year is the maximum amount you can squirrel away between both accounts.
The Bottom Line
Learning the difference in rules between contributing to a traditional versus a Roth IRA pays off in the long run. Though there are no limits on income for contributing to a traditional IRA, there are limits on how much of your contributions you can deduct from your taxable income. A Roth IRA is not deductible—you pay tax upfront on your contributions, then make tax-free withdrawals in retirement—but eligibility is based on income limits.
Whichever account best meets your situation, it's always wise to set aside current income against your retirement years.