When individual retirement accounts were introduced in 1974, only traditional IRAs existed. These are funded with pretax contributions. Later the Taxpayer Relief Act of 1997 created a Roth IRA option, which allows investors to save with after-tax dollars. Depending on your financial circumstances, you might benefit from contributing to both types of IRA.
Meet All Eligibility Criteria
Traditional and Roth IRAs both require you to have taxable compensation for the year you make the contribution. If your taxable compensation does not exceed your contribution limit, the IRS restricts your annual contribution to the amount of taxable compensation. To make a contribution to a traditional IRA, you must be younger than 70 1/2 at the conclusion of the calendar year. To contribute to a Roth IRA, your modified adjusted gross income cannot exceed the annual contribution limits, set by the IRS in Publication 590 based on your filing status.
Cumulative Contribution Limits
The contribution limits for Roth IRAs and traditional IRAs are cumulative, meaning that the limit applies to the total amount contributed to both accounts. You can split this contribution limit as you wish, but you cannot exceed the overall limit. For example, as of 2011, the limit for contributions by people younger than 50 equals $5,000. Therefore, if in 2011 you contribute $3,100 to your traditional IRA, you may not contribute more than $1,900 to your Roth IRA.
Effects of Contributing Too Much
If you contribute too much in total to your IRAs, the IRS imposes a 6 percent excess-contributions penalty. For example, if your contribution limit is $5,000 but you add $4,000 to your traditional IRA and $4,000 to your Roth IRA, you are $3,000 over your limit and owe $180 in excess-contributions penalties. If you did not correct the distribution, you could pay the penalty and then count the excess contributions toward the next year's limit. However, if you continue to have excess contributions in the account, the penalties continue to accumulate each year.
Why Contribute to Both
If you could predict the future perfectly, you would know for certain your taxable income in the years you would take distributions, and the income tax rates during those years, so you could determine whether you would pay a higher rate then or in the current year. However, income tax rates could rise or fall, and your income could be higher or lower than you anticipate. Therefore, to hedge your bets, you can put some of your annual contribution into a traditional IRA to benefit from the tax-deferred savings, and some in the Roth IRA to benefit from the after-tax savings.
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