The Basics of Individual Retirement Accounts and Your Taxes

Although the calendar says 2011 already, you can still make a 2010 IRA contribution. In fact, you can make a contribution until April 15, 2011. Furthermore, some taxpayers are eligible to deduct their IRA contributions, thereby lowering their taxes for a year long since over. Crazy? Not in the wonderful world of arcane tax rules. Here’s an overview of how IRAs affect your taxes and vice-versa.

What’s an IRA?

An IRA is an Individual Retirement Account. A regular IRA (contrasted with a Roth IRA, below), allows you to save money on a tax-deferred basis. Consequently, your account grows without an annual tax on its growth and income. Only upon distribution, ideally in retirement, do you pay tax on your regular IRA. Depending on your income, marital status, and ability to contribute to a workplace retirement plan, you might also be eligible to deduct your IRA contribution. (Here are the 2010 and 2011 IRA tax deduction rules.)

What is a Roth IRA?

A Roth IRA is an individual retirement account which creates the opportunity to save on a tax-free basis. While no Roth IRA contribution is ever tax-deductible, the growth of a Roth IRA, subject to fairly minimal requirements, is never taxed – not even during retirement when you might begin your money out. Unfortunately, not everyone can contribute to a Roth IRA, as there are certain maximum income limits (Here are the 2010 and 2011 Roth IRA contribution limits.)

Why Contribute to an IRA?

The tax benefits alone provide an enormous incentive to save for retirement by using a regular or Roth IRA. In addition, because the money is not easily available without income tax implications (and possible penalties), you are less likely to spend the IRA money than you would if the money were in your checking account. Numerous investment options – from mutual funds (including low-cost index funds) to stocks, bonds and CDs – are available via an IRA. As of 2010, you can even reverse a Roth IRA conversion.

Maximum IRA Contributions Limits

In 2010 and 2011, the maximum amount anyone can contribute to their IRA(s) is $5,000. For people who will be 50 or older by the end of the calendar year in question, an additional $1,000 “catch-up” contribution is permitted.

Earned Income Requirement

In order to contribute to either type of IRA, you must have earned income. For this purpose, earned income is defined as money earned via employment or self-employment. The only exception to the requirement you have earned income is if your spouse has sufficient earned income instead. If, for example, you do not work for pay but your spouse makes $30,000, both of you can make the maximum $5,000 contribution to your respective IRAs, since $30,000 exceeds the $10,000 ($5,000 x 2 IRAs –one for each spouse) earned income requirement.

Mixing and Matching Permitted

If you are otherwise eligible for both accounts, you may contribute to both a regular and a Roth IRA. However, the total annual limit of $5,000 ($6,000 if 50 or older), is a combined limit. Therefore, if a 45 year old contributes $3,000 to a Roth IRA, the most he may contribute to a regular IRA is $2,000.

When Can You Contribute to an IRA?

The deadline for an IRA contribution is the tax filing deadline for the year in question. Therefore, you can contribute for your 2010 IRA until April 15, 2011. Note that if you extend your tax return, you do not get an extension of time to make your IRA contribution.

Still, you can contribute to an IRA at anytime. Right now — in January 2011 —you can contribute to both a 2010 and a 2011 IRA. In fact, you can contribute to your 2011 IRA at any time from January 1, 2011 to April 16, 2012 (you get an extra day because April 15, 2012 is a Sunday).

What if You Want to Make a Deductible IRA Contribution But Don’t Have the Money?

Here’s one “trick” to consider. If your IRA deduction would be deductible but you don’t have the money, you can file your tax return indicating your intention to make the contribution by the deadline of the return. (Simply take the deduction as though you have already made the contribution). For example, you can file in February indicating a $2,500 IRA contribution. Let’s say your refund (due, in part, to this tax deduction) will be $2,500 and you receive it in March. As long as you move the money to the IRA before April 15, you’re in business—you’ve found a way to save for retirement without laying out the cash to do so. Want to report your IRA in TurboTax? It’s easy.

Michael Rubin

Author of the bestseller Beyond Paycheck to Paycheck, and the upcoming The Savings Solution, Michael B. Rubin is a Certified Public Accountant (CPA) and a CERTIFIED FINANCIAL PLANNER professional. In addition to his experience providing sophisticated financial advice to affluent clients, Michael has been a key source of information for over a decade to countless others. He speaks passionately about and provides guidance on virtually all personal financial planning topics. Michael has appeared in various media, including radio and TV stations across the country, plus national media such as CNN Money.com, latimes.com, The Wall Street Journal, SmartMoney.com, Chicago Tribune, Financial Advisor Magazine, and Investment News. Prior to founding Total Candor LLC, Michael worked in the personal financial services practices of two of the former "Big Six" accounting firms. Subsequently working for several years as a new venture executive for Toys "R" Us, Inc., he made sure that he never actually grew up. He holds an undergraduate business degree from the Ross School of Business at the University of Michigan and an MBA from the Kellogg School of Management at Northwestern University. Michael lives in New Hampshire with his wife and children.

Comments (3) Leave your comment

  1. This web site really has all the information and facts I needed about this subject and didn’t know who to ask.

  2. Money in your IRA can go towards a variety of investment options. The IRS does not allow you to invest in collectibles, including gemstones, stamps or paintings, or investments that offer personal benefits, such as purchasing stock in your small business, even if those investments would otherwise be allowed.

Leave your comment* = required field