One goal of retirement planning should be to save in the most tax-effective way possible. And, for the most part, if you or your spouse are employed and earn compensation, you can likely take advantage of tax-sheltered retirement savings accounts. One of the most popular ways to build a retirement nest egg is by saving through an individual retirement account.
There are two types of IRAs: traditional and Roth. For 2017, anyone with earned income can contribute the lesser of $5,500 or their total yearly compensation. And individuals aged 50 or older can save an extra $1,000. You can mix and match and save in both, as long as your total contributions don't exceed the annual limit. However, a traditional IRA and a Roth IRA operate somewhat differently. Generally, money that goes into a traditional IRA can be deductible, but then grows tax-deferred until the money is withdrawn, when it is taxed as ordinary income. On the other hand, money goes into a Roth IRA on an after-tax basis, but then grows tax-free and remains tax-free when withdrawn, assuming all other requirements are met.
However, there's a lot more to IRAs than that (after all, anything that's regulated by the Internal Revenue Service is bound to be more complex than it seems at first). In particular, there are various income restrictions imposed on IRA accounts, which can lead to confusion over who can contribute and whether their contributions are deductible.
Don't let the following three misconceptions keep you from using this powerful retirement-saving tool.
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1. If you don't work, you can't save through an IRA
While it's true that you must have earned income in order to contribute to an IRA, the IRS makes an exception for an unemployed spouse. As long as there is one working spouse, the non-working spouse can save in what's known as a spousal IRA.
A spousal IRA is a great option for women who take time out of their careers to raise children or care for elderly family members. According to a recent survey by the Transamerica Center for Retirement Studies, men have more than triple the household retirement savings of women (a median of $115,000 compared to just $34,000 among women). A spousal IRA can help their retirement savings stay on track if they need to take some time off work for any reason.
In order to qualify for a spousal IRA, you must be married, file a joint income tax return, and have at least enough household earned income to match whatever contributions are made to the working spouse's IRA and the non-working spouse's IRA. Otherwise, all the usual IRA rules apply. See this article for the annual limits on contributions, eligible income, and tax deductions.
2. You're disqualified if you earn more than the income thresholds
Earning taxable income is the first main requirement you need to meet to be eligible to save in a tax-sheltered retirement account. And while earning a high income is never a bad thing, it can limit your options when it comes to saving in an IRA.
First, the good news: If you are not covered by a workplace retirement plan, you could make a $1 million salary and still be able to contribute and fully deduct your contribution to a traditional IRA. There are no deductibility limits if you're employed but have no access to a workplace retirement account. There's one caveat, though: If you are not covered but your spouse is, then your deductions may be limited or phased out. See the chart listed in this article.
Unfortunately, your income can affect your eligibility if you are covered by a workplace retirement plan. If you're single and make $72,000 or more, or if you're married and make $119,000 or more, then you cannot deduct any portion of your traditional IRA contribution if you're covered by a retirement plan at work. However, you can still contribute to a non-deductible traditional IRA.
As for Roth IRAs, a high income can disqualify you from contributing directly. Even if you aren't covered by a plan at work, you're subject to the income limits for 2017. That said, there is still a way for a high-income earner to save in a Roth IRA in what's known as the "backdoor" option. If you're ineligible to make a direct contribution to a Roth, you can make a non-deductible contribution to a traditional IRA and then convert that into a Roth. You can read more about how this process works here.
3. You can't contribute to an IRA if you already contribute to a workplace plan
You might think that since you're contributing to your workplace retirement plan, like a 401(k), then you can't also contribute to an outside IRA -- but you can. In fact, anyone under the age of 70-1/2 who has earned income can contribute to a traditional IRA -- you just may not be able to fully deduct your contribution. Meanwhile, anyone with earned income below a certain threshold, regardless of age, can contribute to a Roth IRA.
Retirement savers need to know about every tool at their disposal. The IRA was designed specifically to reward American workers for saving for retirement, so you should familiarize yourself with it and consider saving through one today.
