One of the surest ways to bolster your nest egg is to take advantage of special tax breaks offered by the IRS. That basic precept explains the popularity of individual retirement accounts, or IRAs, one of the cornerstones of asset planning in the U.S.

Like employer-sponsored 401(k)s, IRAs can dramatically reduce the amount of income you have to fork over to the federal government. Investors generally contribute pre-tax dollars and the balance grows on a tax-deferred basis until retirement. Withdrawals after the age of 59½ are then subject to ordinary income tax rates.

Key Takeaways

  • Retirement savers can set aside up to $6,000 per year in an individual retirement account, in addition to whatever they contribute to their 401(k) plan at work.
  • The limit is reviewed by the IRS and raised every few years to keep up with inflation.
  • This $6,000 limit includes any and all contributions made to either a traditional or Roth IRA - so if you add $3,000 to each in a year, that would be the max.
  • Traditional and Roth IRAs have different eligibility rules as well as different tax treatment.
  • Those over age 50 can contribute an additional $1,000 in IRA money as a catch-up each year.

IRAs vs. 401(k)s

As the name implies, these independent accounts are completely separate from your place of work. There are pros and cons to that autonomy. It’s easy to open an account at your brokerage firm, a mutual fund company or bank, for instance. (For details, see Take These Simple Steps to Open an IRA.) But unlike 401(k)s, there are no matching funds from the employer to shore up your savings. That’s why it’s a good idea to put money into a 401(k) and maximize the subsidy before you add to other accounts.

Once you’ve reached the limit on the company’s 401(k) match, IRAs are often a great place to go next. First and foremost, you’re not confined to the limited menu of investment options that your company selects. In addition to mutual funds and exchange-traded funds (ETFs), many IRAs allow you to pick individual stocks and bonds as well. 

Be aware, though, that there are limits on how much you can contribute. It’s also worth bearing in mind that the two most common varieties of this savings vehicle – traditional IRAs and Roth IRAs – have different rules.

Traditional IRA Limits and Restrictions

For 2019, the standard contribution limit for both traditional and Roth IRAs is $6,000. If you’re 50 years of age or older, the IRS provides a “catch up” feature that allows you to contribute an extra $1,000 each year for a total of $7,000. If you’re rolling over another retirement plan into an IRA, these caps don’t apply.

That may not sound like a lot of money, but it’s enough to make a big dent in your account performance over a long period of time. As an example, let’s take a 30-year-old who contributes the full $6,000 every year until she retires. Assuming a 7% annual return, her account will have a balance of $951,940 by age 65. After taxes – assuming a 22% tax rate in retirement – it’s still worth $742,513. And remember, the contribution limit is increased over time by the IRS to keep up with inflation.

Let’s say that her effective tax rate right now, while she’s earning steady income, is 24%. Had she put the same portion of each paycheck in a taxable savings account, it would be worth far less. Why? Because the IRA's tax deduction gives her greater purchasing power. Suppose, after paying taxes, that our 30-year-old could only afford to put $4,560 into a standard savings account. If she put the money into an IRA instead, it would reduce her tax bill, allowing her to put in an additional 24%, or $1,440. And over time, that drastically increases the size of her nest egg. 

Figure 1. The tax advantages of an IRA can have a dramatic impact on savings over the course of several decades.

Source: AARP 

While anyone can contribute up to $5,500 (or $6,500 for individuals age 50 and older) to a traditional IRA, and $6,000 in 2019, not everyone can deduct that full amount on their tax return. If you have a retirement plan at work, you’re subject to certain income-based restrictions.

If you’re single and make more than $63,000 and less than $73,000 a year, for example, you’re only allowed a partial deduction on IRA contributions. Single filers who make $73,000 or more can’t deduct any of theirs.

Here are what count as an employer retirement plan: 

  • 401(k) accounts
  • Profit-sharing programs
  • Stock bonus programs
  • IRA plans (including SEP or SIMPLE IRAs)
  • Pensions

If either you or your spouse has one or more of these plans through your place of work, you will be subject to the income-based restrictions.

Different Rules for Roth

When setting up an IRA, most investors have two choices: the traditional version of these savings accounts and the Roth variety. In some respects, the tax treatment of the Roth is just the opposite of its older brother. Instead of getting a tax deduction on contributions up front, account holders kick in post-tax money that they can withdraw tax-free in retirement.

The Roth version of the IRA has the same contribution limits as a standard IRA – $5,500 annually, also up to $6000 in 2019, with a $1,000 catch-up allowance for those age 50 and older. But unlike traditional accounts, the government places restrictions on who can contribute.

To determine your eligibility, the IRS uses a metric called modified adjusted gross income (MAGI). Basically, it’s your total income minus certain expenses. 

Most taxpayers qualify for the full contribution allowance, although certain higher-earning individuals are only permitted a reduced amount. Single filers with MAGI of more than $135,000 per year and joint filers who bring in more than $199,000 are disqualified from Roth IRA contributions altogether.

There’s another area in which Roth IRAs differ from traditional IRAs. With a conventional account, you can’t make contributions past the age of 70½ and you have to start taking required minimum distributions from your account at that age. Neither are true with the Roth version, which has no age restriction for contributions and no RMDs.

The Bottom Line

If you’ve already maximized your company’s match on 401(k) contributions, an Individual Retirement Account is probably the next place you’ll want to park your retirement money. If you meet the criteria to fund a Roth account or deduct 100% of contributions to a traditional IRA, you’re getting the biggest tax break of all.