Traditional IRA Contribution and Income Limits | IRA Rules

IRAs are simply investment accounts with some additional benefits and restrictions tacked on. The main benefit of contributing money to an IRA is that when you do, you get an above the line deduction for the amount of the contribution.

The Benefits of Investing in an IRA

After money has been contributed to an IRA, you can invest it in (almost) anything you’d like: stocks, bonds, mutual funds, CDs, etc. The money then continues to grow tax-free while it remains in the account. However, when you do eventually take money out of the account, the amount of the withdrawal is taxable as income.

Because of this tax-deduction-now, taxable-withdrawals-later structure, IRAs are sometimes referred to as “tax-deferred” investment accounts. There are two primary advantages to tax-deferred investing.

The first advantage is the result of good timing. Assuming you make your contributions during your pre-retirement years, you get your deductions in years while your income is at a high point thus maximizing the value of the deduction. Then, when you begin to make withdrawals during retirement, you’ll be taxed on the withdrawal, but by then you’ll likely be in a lower tax bracket because you’re no longer working.

The second benefit to tax-deferred investing is that your money can grow more quickly when it’s not being taxed on its growth along the way. Even when you account for the fact that it will be taxable when you withdraw it, you still (usually) come out with more after-tax money than you would if you were simply investing in a taxable investment account.

The Rules for Investing in an IRA

In exchange for granting you a tax deduction for investing in an IRA, the government requires you to jump through a few hoops in order to take full advantage of having an IRA. There are restrictions on both the deduction that you get for investing in your IRA and on your ability to withdraw money from your IRA.

First, as of 2010, you’re only allowed to invest up to $5,000 into an IRA each year (unless you’re 50 or older, in which case you’re allowed to invest up to $6,000).

Second, if your income reaches a certain level, (see below) you may no longer qualify to receive a deduction for the amount that you contribute to your IRA. However, even if you do reach this point, you are still allowed to make a contribution to an IRA, and you will not be taxed on the growth until you withdraw the money from the account.

The income limits for being able to receive a deduction for IRA contributions only come into play if either you or your spouse is covered by a retirement plan at work (such as a 401k).

If you are covered by a retirement plan at work, your deduction for an IRA contribution will begin to decrease (and eventually disappear entirely) as your Modified Adjusted Gross Income (MAGI) for 2010 surpasses:

• $89,000 for married taxpayers filing jointly.
• $56,000 for single taxpayers.

If your spouse is covered by a retirement plan at work, but you are not, your deduction for an IRA contribution begins to be phased out once your joint Modified Adjusted Gross Income passes $167,000 for 2010.

IRA Withdrawal Rules

Congress’s goal when originally creating the laws that allow for IRAs was to encourage people to save for retirement, so they implemented some restrictions regarding when you’re allowed to take money out of an IRA.

The most notable restriction is that any withdrawals you make before age 59½ will be subject to a 10% tax (in addition to being subject to normal income taxes). There are several exceptions to the 59½ rule, however. A withdrawal will not be subject to the additional 10% tax if:

• You are disabled.
• You have unreimbursed medical expenses that are more than 7.5% of your adjusted gross income.
• The distributions are used to pay for qualified higher education expenses (e.g., college expenses for yourself, your spouse, your child, or grandchild).
• You use the distribution to buy or build your first home. (Note: only the first $10,000 of distributions for this purpose will be free from the additional 10% tax.)