An Individual Retirement Account (IRA) is a tax-friendly retirement savings plan. In a standard IRA, contributions are tax-deductible, but tax must be paid on all withdrawals. In a Roth IRA, designated Roth contributions are included in gross income. However, Roth IRA earnings are non-taxable, providing the conditions of the Roth account are met.
The contribution levels for both standard and Roth IRAs are the same. In both cases, the maximum amount which may be contributed is the lower of earned income or contribution limit. All contributions except rollovers or transfers must be made with cash or cash equivalents.
In 1998, the maximum IRA contribution limit was $2,000. This limit was raised to $3,000 in 2002, to $4,000 in 2005, and to $5,000 in 2008. The limit will remain at $5,000 through the 2011 tax year. After that, future contribution limits will be assessed for a possible increase due to inflation.
Employees who are 50 years of age or older at the end of the tax year are allowed one extra catch-up contribution per year. When this was first introduced in 2002, the catch-up limit was $500, which was raised to $1,000 in 2006. The catch-up contribution will remain at an additional $1,000 through the 2011 tax year. After that, future catch-up limits will be assessed for a possible increase due to inflation.
If you do not use the full amount of your IRA contribution limit in one year, the difference does not carry over into the next year. For example, if you do not contribute the full $5,000 to your IRA in 2011, the difference will not carry over into 2012.
These contribution limits are over and above the contribution limits for a 401k. Employees may hold both an IRA and a 401k at the same time, and contribute the maximum amount to each. However, your IRA contribution limit is for all your IRAs together, even if they are of different kinds. You cannot contribute the maximum amount to each IRA separately.
IRA contributions can also be made on behalf of the spouse. Employees have no reporting obligation for designated Roth contributions made to a Roth IRA. A surviving spouse who also holds a Roth IRA can combine the two Roth IRAs into a single plan without any tax penalty. Thus, in estate planning, it is almost always a good idea to keep money in a Roth IRA.
Funds which are withdrawn from an IRA outside the conditions of an IRA are considered a non-qualified distribution. These withdrawals are subject to an IRA penalty of 10%, and are also taxed normally in standard IRAs. For Roth IRAs, the contributions portion of a non-qualified withdrawal is not taxed, but all income earned by that contribution is taxable and must be included in gross income. A direct rollover to a different IRA plan avoids this penalty and tax.