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IRA Contributions- Back to Basics

Last Updated April 12, 2016

by Denise Appleby CISP, CRC, CRPS, CRSP, APA

Of all the retirement plans, the Traditional IRA and the Roth IRA are the most accessible retirement saving vehicles which can be used to fund your retirement nest egg. The Traditional IRA and Roth IRA were created with less complex rules than other retirement plans and as a result are not subject to the usual administrative requirements that typically apply to employer plans. Furthermore, unlike employer plans- you need not rely on another party to create the opportunity to fund your IRAs.  

How Much Can You Add (Contribute)

You may contribute up to 100% of your eligible compensation/income, up to $5,500 for the year. If you reach age 50 by the end of the year, you may contribute an additional $1,000. This additional $1,000 is referred to as a catch-up contribution. While $5,500 may not seem like much, continuing to make contributions to an IRA each year will eventually add up to a significant amount of savings by the time you are ready to retire.

Let’s look at examples of individuals who save $5,000 each year, up to age 70, assuming a rate of return of 4%. 

 

An individual who starts saving at age 30, would accumulate $494,132 by age 70, whereas one who starts saving at age 50, would accumulate only $154,846. 

Note: The data in this calculator illustrates the effect of saving the specified amount per year and at the assumed interest rate (compounded). The calculator also assumes no withdrawals are made from the account before the target age (70). Actual interest rates and market performances on investments will very likely produce different results

 

Procrastination Makes it Harder to Save

Starting earlier not only allows you to save more overtime, but it also reduces the financial burden of saving. For instance, assume that you want to save $1,000,000, and want to add level amounts to your account each year, at a 5.5 % rate of return. The amounts you would need to add to the account increases with each year that you procrastinate. Let’s look at some examples:

Assuming a 5.5% rate of return

Years to
Fund

Planned
Payment

Total
Payments

Total
Earnings

Accumulated
Value

20

$27,184.20

$543,683.98

$456,316.02

$1,000,000.00

30

$13,085.68

$392,570.32

$607,429.68

$1,000,000.00

40

$6,938.71

$277,548.56

$722,451.44

$1,000,000.00

50

$3,849.72

$192,485.79

$807,514.21

$1,000,000.00

Calculator available at www.72t.net

As demonstrated, if you want to save $1,000,000, you would require a savings of only $3,849 per year over a 50 year period. Compare that with a required saving of $27,184 per year if you who want to realize that same amount, but have only a  20-year period to do so.

Tip: Consider spreading your contribution over the year- for instance-contribute $413 each month instead of $5,000 in a lump sum. The impact on your disposable income will not be as significant

Eligibility Requirements

In addition to having eligible compensation/income for the year, individuals must meet other requirements in order to contribute to an IRA. The requirements depend on the IRA to which the individual wants to contribute.

  • Age: For Traditional IRAs, contributions can be made for the years preceding the year the in which you reach age 70 ½. There are no age limitations on Roth IRA contributions.
  • Income Cap: There is no income cap on funding a Traditional IRA. However, for a Roth IRA, modified adjusted gross income (MAGI) limits apply. Please see limits here

 Contribution Requirements

  • Deadline: Contributions for any calendar year must be made to an IRA by April 15th of the following year.  For instance, a contribution for 2015 must be made by April 15, 2016.

Tip : Where April 15 falls on a public holiday or weekend, the deadline is extended to the next business day. For 2015, the deadline was extended to April 18,2016)

The postal rule applies to IRA contributions. This means that if the contribution is mailed by tax filing due date, using the US postal service, or an IRS designated private delivery service.

Tip: If the contribution is being made from January 1 through to April 15, be sure to indicate the calendar year to which it applies on the check. This will help to make sure the financial institution applies it to the correct year.


  • Cash Requirement: IRA contributions cannot be made in-kind. This means that you cannot use their favorite stock or mutual fund to make contributions.  Instead, the contribution must be made in cash. You may liquidate stocks, mutual funds etc. and use the cash proceeds to make your IRA contribution. Most (if not all) financial institutions accept checks, and some accept money orders or other instruments. You may also make contributions VIA automated clearing house (ACH) or federal fund wire. Availability should be verified with each financial institution.

You May be Eligible for a Tax Credit
If your MAGI falls below certain amounts, you may be eligible to receive a nonrefundable tax credit of up to 50% of the contribution made to your IRA and any salary deferral contributions made to an employer sponsored plan. This is referred as the Saver’s Credit. The tax credit is capped at $1,000, and the percentage for which the individual is eligible depends on his/her MAGI. Click here to see the income limits, rates and general rules.

Deducting IRA Contributions
While Roth IRA contributions are not deductible; you may be able to deduct your Traditional IRA contributions if you meet certain requirements.

If you are not an active participant for the year, or married to an active participant, your contribution to your traditional IRA for the year is deductible. If you are an active participant or married to an active participant, your eligibility for deducting your Traditional IRA contribution depends on your MAGI. Click here to see MAGI limits and deducibility. 

Nondeductible Contributions- an Option
If you are ineligible to deduct your IRA contribution or contribute to a Roth IRA, you could consider making a nondeductible contribution to a Traditional IRA. Distributions of these amounts are tax-free, but must be pro-rated with pre-tax Traditional, SEP  IRA and SIMPLE IRA assets to determine how much of a distribution is attributed to the nondeductible balance. For any year that you make a non-deductible contribution to a Traditional or SEP IRA, you are required to file IRS Form 8606.

Conclusion

Contributing to an IRA is a great way to fund your nest egg.  This can be done in addition to any amounts added to employer sponsored retirement plans. Consult with your tax professional for assistance with ensuring that you choose the contributions that are more suitable for you.