En español | The economic uncertainty brought about by the COVID-19 pandemic might have you thinking about pausing retirement contributions, but 2020 changes to contribution rules could make this the perfect time to take advantage of an individual retirement account (IRA).
"Given this new, uncertain environment, it's especially important to contribute toward your retirement funds to set yourself up for long-term success,” says Melissa Ridolfi, vice president of retirement and college leadership at Fidelity Investments.
There are two main types of IRAs, and the contribution limits are the same for both.
- With traditional IRAs, your contributions may be tax deductible and you defer paying taxes until you withdraw the money in retirement.
- Roth IRA contributions are not tax deductible, and you pay taxes on the money upfront. Since you won't be paying taxes on the money when you withdraw it, “you will save yourself from creating a massive retirement bill,” explains Dennis Notchick, a certified financial planner at Stratos Wealth Advisors in San Diego.
In 2019 tax law automatically increased the amount that can be stashed in an IRA each year to a maximum of $6,000, up from $5,500 in 2018. If you are 50 or older, you can take advantage of a catch-up provision, letting you sock away an additional $1,000 — for $7,000 in total. Those limits apply to the 2020 and 2021 tax years, too.
Although you can contribute to a Roth IRA at any age, 2020 is the first year you can add money to a traditional IRA past the age of 70 1/2, thanks to the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in December 2019. You have up until April 15, 2021, to make your contributions to Roth or traditional IRAs.
You can contribute earned income only to an IRA; Social Security payments, pension payouts dividends and other types of income don't count. And these annual limits are per person, not per type of account: You can't contribute $7,000 to a traditional IRA and $7,000 to a Roth IRA in the same tax year. You can, however, split your maximum contribution amount between a Roth IRA and a traditional IRA.
2020 and 2021 deduction limits for traditional IRAs
If you and your spouse don't have a retirement plan available to you at work, such as a pension or a 401(k) plan, then you can deduct your entire contribution to a traditional IRA. You have until April 15, 2021 to make a 2020 IRA contribution, and until April 15, 2022 to make a 2021 IRA contribution.
If you or your spouse has a retirement plan available from work — even if you don't take advantage of it — the amount you can deduct for a traditional IRA is limited according to your modified adjusted gross income, or MAGI (that's your total adjusted gross income plus tax-exempt interest).
2020 and 2021 income limits for Roth IRAs
The amount you can contribute to a Roth IRA is limited by your MAGI.
Creating your IRA contribution strategy
So where should an IRA fall on your financial planning priority list?
Before you max out an IRA, make sure you have your emergency funds in place, advises Rick Myers, founder and president of Integrated Financial Services in Grand Rapids, Michigan. Also, if you're in a lot of debt, it might make more sense to dig yourself out first, since high-interest credit cards could be outweighing the IRA's investment returns, Myers says.
And make sure you leverage employer-sponsored retirement accounts first. If you're working and your company offers a 401(k) plan, consider maxing that out before contributing to an IRA, or at least take full advantage of the employer match, Myers suggests. Contributing to your 401(k) can “really turbocharge your savings because not only are your pretax dollars being taken out of your paycheck, but the company is matching that amount,” he says. “So not taking advantage of that in order to put money in an IRA typically is not the right move.”
Bear in mind, though, that your 401(k) plan, which has contribution limits of $19,500, with a $6,500 catch-up provision for those over age 50 in 2021, may not be enough to accumulate the savings you need or want, Ridolfi says. “An IRA can help you supplement your savings in an employer-sponsored retirement plan while also taking advantage of tax-deferred or tax-free growth and gaining access to a potentially wider range of investment options.”
Some people choose to write one $6,000 check to make their annual IRA contribution, but you can spread your payments out, Ridolfi says. “We see many clients treat their contribution like a bill they pay to their future self on a monthly basis. Some people set up a direct deposit from their employer, while others automate their contributions,” she adds.
Also make sure you have a withdrawal strategy. The earliest you can withdraw funds from an IRA without incurring penalties is at age 59 1/2. If you take the money out sooner, you could pay a 10 percent penalty. On the flip side, you must start taking withdrawals from a traditional IRA when you turn 72, whereas there are no required minimum distributions for Roth IRAs.