This is an individual retirement account arrangement where an employee deposits funds from their salary to cater to their needs after retirement into an individual account. The employer is encouraged to match the contribution made to an individual retirement account up to a percentage of their choosing. In addition, many employers boost employees’ individual retirement accounts (IRA) by depositing additional contributions.
These contributions are saved, and the contributor gets to choose where they will be invested from a variety of options offered by their IRA plan provider. Like all other IRA contribution plans, there is no determined number of benefits upon retirement. Instead, the account balance will be a net of the contributions, investment gains, and losses for the IRA owner.
This is why one should be keen when selecting an IRA or any other retirement plan; it will have a huge impact on the state of your retirement savings.
Due to the associated income tax benefits for an IRA owner, an IRA contribution can be used to evade income tax. Consequently, through the IRS, the federal government sets a maximum amount that can be contributed to an IRA account based on the cost of living every year.
In the 2021 tax year, the annual maximum you can contribute to an IRA account is $6,000. However, if you are 50 years old and above, you are eligible for an extra annual retirement plan catch-up amount capped at $1,000. This will bring your total permissible IRA contribution to $7,000.
Your deductible contribution cannot be above your taxable compensation. The maximum you can contribute is 100% of your computable income. Any other income connected to you is not permissible. This means if your taxable income or gross income is below the limits stipulated above, it becomes your maximum contribution limit.
It is noteworthy that these limits apply to all your IRAs, meaning if you have multiple accounts, the total contribution to all of them should be within limits.
IRAs have no legal lower limit, and contributors decide the amount they are comfortable with for each open account. Some specific IRAs, however, have minimum balances that are set internally as organizational policies.
This feature of contributory IRAs enables married couples who file joint returns to increase their contributions. This comes in handy if one party is not getting any compensation or it is below their target.
The IRA will not be joint, however. Each individual has their own account, but the better compensated can make deposits into their spouse’s account up to the permissible individual limit. It might enable the couple to save more for retirement than would have been possible if they filed returns separately.
The total contributions for both accounts should not exceed the taxable earnings from their joint returns.
Eligibility to Participate
There are basic requirements that must be met every tax year to be eligible to contribute to an IRA, regardless of whether they were previously contributing.
You are prohibited from contributing to an IRA if you did not have taxable compensation for the year in question. This is because the accounts are strictly funded with a compensation income like salary, wages, defined business proceeds.
A spouse can contribute to your IRA if you file joint returns up to your current income limit, provided your total contributions don’t surpass your taxable income limit as declared in the joint returns.
From 2020, the age limit for making IRA contributions was scrapped. You can keep saving for retirement as long as you are working and earning an income.
Can A Contributory IRA Be Combined with Other Retirement Plans?
You can have a contributory IRA even when your business or employer has another retirement plan for you, whether they are contributory or defined benefit plans.
It is even legal to have more than one contributory IRA. So, for example, you can have a traditional IRA and a Roth IRA to mix up the tax benefits.
Tax Benefits of Contributory IRAs
IRAs are intentionally set up with tax advantages to encourage the contributor to leave the funds untouched until retirement. As a result, they provide significant tax relief as you deduct all your IRA contributions from your federal income tax returns or up to certain deduction limits set by the IRS.
Tax payments on contributions are deferred until distribution, meaning tax is not deducted at the point of contribution and will only be applied when you withdraw the funds. This enables you to maximize the value of your IRA in different ways:
- Profits and capital gains without a tax deduction have compound growth, which exponentially increases the value of your retirement account
- The tax applied when you are withdrawing the funds will be subject to your prevailing tax bracket. This is likely to be lower than your current bracket after retirement because your compensation will have significantly reduced. As a result, tax due will be less than when you contribute (unless there is a radical change in tax policy between contribution and withdrawal).
Are Investment Options Available for Contributory IRAs?
Institutions that provide IRAs include investment companies, credit unions, banks, mutual funds, and online brokers. These experienced investors are bound by a fiduciary responsibility to ensure you get a reasonable range of options for the best investment deals.
The Employee Retirement Income Security Act (ERISA) obliges them to act in the best interest of the participants.
Participants can select single fund options if they are not into complicated trades and aim for average results with minimal risks.
You can also pick from individual securities like bonds, stocks, exchange-traded funds (ETFs), or certificates of deposits (CDs) if you are more hands-on.
The third option is to hedge your retirement savings by combining investment approaches in different ratios depending on what you feel is working over the years.
The best contributory IRAs have a diverse menu of investment options with accessible educational resources to help you settle on the right investment combination for your future.
They should also fit within your budget in all features, including whether they have minimum deposits and if the threshold is affordable if there are any commissions for the trades they do on your behalf, and whether their projected returns make sense considering the time value of money and costs incurred.