We’ve all been a little busy recently! Adjusting to a pandemic. Figuring out how to get food safely. Worrying about what life will look like when we get out.
The last thing on our minds has been the decision we usually make in April. Will we put money in our IRAs this year or not? We know we should. And we know that – when retired – we’ll be glad we did.
Well, you’re in luck. Because life has been so full of distractions, the IRS has extended the deadline for personal tax filings from April 15 to July 15. It has also extended the deadline for contributing to your 2019 IRA. So, if you haven’t contributed, you still have time.
Should I or shouldn’t I contribute to an IRA? The answer will come down to how the shutdown of the economy has affected you.
If you are among those who lost their primary source of income – whether from a job or a business – this may not be the time. Instead, it’s time to focus your energy and your resources on taking care of yourself and your family. You need to bridge the gap until you know how you’ll stabilize your income and start to rebuild.
But if you still have financial stability, from a job or a business, think about maintaining the momentum of regularly contributing to your IRA. It’s a pillar of a secure retirement.
Will you be getting a stimulus check from the government? It could be for $1,200 as an individual or $3,400 as a family of four. If you don’t need it to cover your basic financial needs, you might want to think of that check as a perfect contribution to an IRA.
The stimulus payment is coming as the equivalent of a tax refund, so it’s not taxable. Yet if you contribute it to a tax-advantaged account, it can be a deduction against other taxable income. So, that increases its value.
What are the IRA contribution rules? You put money in an individual retirement account – or IRA – to let it grow in what’s called a tax-favored environment. So, you certainly don’t want to break some IRS rule, and have it cost you money in penalties.
So, let’s look at the basics of IRA contributions, where you might break a rule accidentally, and how to avoid penalties as you make corrections. And to keep it simple, let’s focus on just IRAs.
What are the basics of IRA contributions? IRAs can be either “traditional” or “Roth.” With the more familiar traditional IRAs, you can fully or partially deduct the money you contribute from the income you report for that tax year. For most, you are contributing pre-tax dollars (some taxpayers are phased-out and lose the deduction). When you withdraw the funds in retirement, you will pay taxes on the withdrawal.
IRAs make the most sense if you contribute when your tax rate is high, and withdraw later in life when your tax rate might be lower. (Although there’s no guarantee that will be the case.)
With Roth IRAs, it’s a bit different. Your contributions are not tax-deductible, so you’re making them with after-tax dollars. You don’t get any tax break up front. But, your money does grow tax-free and can be withdrawn tax-free in retirement if you follow the IRS’s rules. (Again, some taxpayers are phased-out and not allowed to contribute to a Roth.)
How much can I contribute each year? The government limits how much you can contribute. For 2019 and 2020, the limit is a total of $6,000 (or $7,000 if you’re 50 or older) in any combination of IRAs (traditional, Roth, or both). Obviously, you can contribute less than your limit, but you can’t carry the shortfall over to future years. And you can’t contribute more than you have in earned income.
What is earned income? Today the IRS defines earned income as taxable employee compensation, net earnings from self-employment, and specific disability payments. What doesn’t it include? Social Security, alimony, child support, pensions, annuities, rental income, investment income, dividends, interest, royalties and others. When can I contribute to IRAs? Typically, you can contribute any time during the tax year, and up to April 15 of the following year. You can contribute to IRAs at any age as long as you have earned income.
How contribution mistakes can lead to excess contributions:
• Not noticing you contributed more than $6,000 (or $7,000 if you’re 50 or older) because you have multiple IRA accounts in different brokerages or banks.
• Contributing more than the amount you earned.
• Using the wrong kind of income to justify your contribution.
• Not realizing that the limit is for all forms of IRAs combined, and not per type of IRA.
There are more complicated mistakes that you could make. Instead of delving into the intricacies of IRS rules here, the best bet when you feel unsure is to consult first with a CPA, tax specialist or financial advisor.
Can I correct a mistake and avoid penalties? If you made a mistake, the IRS might waive it, but not without you following their procedures and having a good explanation. If not, it will apply a penalty of 6% of the value of the excess contribution for each year it stays in your IRA. And, if you ignore it, you will face multi-year penalties, plus penalties for failure to file, failure to pay, and applicable interest. Don’t count on the issue simply going away. You do have ways to correct a mistake:
• Correct the excess before Oct. 15: You can attach a filled-out Form 5329 to your return before the Oct. 15 filing deadline (with extensions). Before that date, remove the excess contribution and any earnings made on the excess. (You may need help calculating those earnings and will have to pay tax on them as income.) File an amended return if you’ve already filed for the year.
• Correct the excess after Oct. 15: You can withdraw the excess between Oct. 15 and Dec. 31 and pay the 6 percent penalty for every year the funds were incorrectly in your account.
• Let the excess correct itself: You can leave the excess funds in your account and apply them to each successive year’s contribution until they are used up. Meanwhile, you’ll pay the 6 percent penalty on the excess balance remaining each year until it is gone.
Unless you’re sure you understand how you created the excess contribution and how to correct it, you might want to run your corrective strategy by a qualified tax or financial professional.
While IRA contributions – at a maximum of $6,000 or $7,000 a year – may not seem all that important, they do add up – and grow. We see every day what a valuable role they can play in retirement. If you can, keep making those contributions!