Saving for retirement by investing in a traditional individual retirement account (IRA) can be a tricky proposition. Invest less than your annual limit, and you will lose out on the income tax deductions associated with the pretax retirement account. Invest too much, and you face a penalty. Because maximum contributions to traditional and Roth IRAs are cumulative, investing more in an IRA can reduce your amount of taxable income, it also reduces the amount you can invest in a Roth IRA.
IRA and Roth Contribution Limits
The Internal Revenue Service limits the amount you may contribute to an IRA or a Roth IRA. If you’re under 50 years old at the end of the tax year, you can contribute $5,000 --$6,000 if you're 50 or older. The maximum contribution limit applies to all IRA and Roth accounts considered together, and not the individual balances. For example, if your maximum contribution is $5,000, and increase your annual contribution to your IRA to from $2,500 to $3,000, the amount you can contribute to a Roth or another IRA account is reduced to $2,000 from $2,500.
Reducing Taxable Income
Contributions to IRAs directly reduce your taxable income in the year you make the contribution. Because contributions to IRAs are made on a pretax basis, they’re not counted against your income when you calculate your income taxes. Although your employer must assess Social Security and Medicare taxes on these earnings, the contributions directly reduce your tax bill. For example, if you’re in the 25 percent tax bracket, a $1,000 contribution saves you $250 in income taxes.
When it comes to contributing to IRAs, you can get too much of a good thing. If you contribute more than your annual limit, the excess doesn’t reduce the balance of your IRA, but it has tax consequences. You don’t receive a tax deduction for any excess contribution, essentially negating the largest advantage to IRA contributions. If you leave the excess contribution in your account until the end of the tax year, the IRS assesses a 6 percent tax on the excess amount. The IRS assesses this penalty each year until you remove the excess from your IRA account.
Correcting Excess Contributions
If you contribute too much to your IRA and catch your mistake before the end of the tax year, the IRS allows you to correct the excess contribution by withdrawing the excess amount and any interest it earned while in the account. Although you’ll need to report the interest as income, you avoid the 6 percent excess contribution penalty. If you don’t catch the error until after the tax year closes, you can claim the excess as a contribution in a prior year. The IRS assesses the 6 percent penalty in the year the contribution was originally made, but the penalty stops in the year in which you claim the excess as a contribution. You can also withdraw excess contributions and interest in a later tax year to stop receiving the 6 percent annual penalty.