As the tax-filing deadline approaches, many taxpayers contribute to a traditional IRA to lower their taxable income. If you are considering doing so, it is important to know the eligibility requirements; otherwise, the Internal Revenue Service (IRS) may assess an excess contribution penalty. Here are some important reminders.
- Retirement accounts such as IRAs make saving for retirement easier.
- IRAs are tax-favored, but there are deadlines and contribution limits.
- For 2020 and 2021, the maximum contribution is $6,000.
- Taxpayers 50 and older can make a "catch-up contribution" of an additional $1,000.
To contribute to an IRA, you must first have eligible compensation. This includes wages, salaries, tips, sales commissions, taxable alimony, or maintenance payments received under a divorce decree or separation agreement. If you are self-employed (as a sole proprietor or partner), eligible compensation includes net earnings from your business, minus contributions made to any retirement plan, and the deduction allowed for self-employment taxes.
Not all income qualifies. Rental income, interest, dividends, pension, or annuity income, as well as deferred compensation payments and any amounts you exclude from your income, are not considered eligible compensation for IRA purposes.
For 2020 and 2021, the maximum allowable IRA contribution is $6,000. Taxpayers at least 50 years of age in the year for which the contribution applies can also make a catch-up contribution of another $1,000.
If your eligible compensation is less than the $6,000 limit (or $7,000 if you're over 50 years old), then you are permitted to contribute only up to the amount you earned for the year.
Adam, a full-time college student, earned $2,000 from his part-time job in 2019. He also earned $1,500 in dividends and interest on his investments. Adam can contribute only $2,000 to his IRA for 2020 because that is the amount he earned in eligible compensation.
Previously, taxpayers who were 70½ years of age or older could not contribute to a traditional IRA. But as of Jan. 1, 2020, this age limit no longer applies. This greatly helps individuals save towards retirement, as people are living longer and thus working longer.
Typically, taxpayers have until the income tax filing deadline to make an IRA contribution for the prior tax year. Deadlines for SEP IRA contributions work a bit differently. Taxpayers can make a SEP IRA contribution as late as the due date (including extensions) of the return. So, in a typical year, if you file for a six-month extension, you would have until Oct. 15 to contribute.
Similar to your tax return, the postmark date is considered timely. If you are sending your IRA contribution to your financial institution by mail, make sure the envelope is postmarked by the appropriate deadline.
Military Personnel Exception
If you are a member of the armed forces who served in a combat zone or provided qualifying services outside of a combat zone, you receive an automatic extension for making your IRA contribution. The extension is usually 180 days after one of the following:
- The last day you serve in a combat zone or complete your qualifying service outside a combat zone
- The last day you serve in a contingency operation
- The last day of any continuous qualified hospitalization for injury from service in either of the above
Make sure your financial institution knows the year to which your contribution applies and ask about their documentation requirements for contributions made during your extension period.
When sending a check to fund an IRA contribution, be sure to write the applicable tax year in the memo field. Otherwise, your financial institution could apply the contribution to the incorrect tax year.
The Bottom Line
Check to make sure you meet the eligibility requirements and that you received eligible compensation for the year before you make your IRA contribution. To be sure that your contribution was deposited for the right tax year, check your account statement for the month the amount is deposited.
Financial institutions are more likely to correct processing errors if the errors are detected early. And most importantly, check with your tax and financial professional for assistance with determining whether contributing to your IRA is a good financial decision for you.