Rules for Traditional and Roth IRA contributions

Both Traditional and Roth IRAs offer tax advantages for long-term retirement planning. As you compare the two options, you’ll want to understand the implications and rules for the Traditional and Roth IRA contributions. Read on as we guide you through the nuances.

What is an IRA?

You may have heard this common acronym before, but if not, an IRA is an Individual Retirement Arrangement, and it’s a term used to describe two different types of accounts: Roth and Traditional. Both have tax advantages yet have different rules to be mindful of. For example, earnings in either of these accounts can accumulate tax-free, but depending on your situation they may be taxed at a later date.

Income sources for Traditional and Roth IRAs

You can start either a Traditional or Roth IRA if you receive taxable compensation from the following sources:

• Wages, salaries, and tips
• Sales commissions
• Professional fees
• Bonuses
• Self-employment income
• Military compensation while serving in a combat zone tax-exclusion area
• Certain alimony or separate maintenance payments included in gross income
• Non-tuition fellowship and stipend payments included in gross income

Income sources not included as compensation for IRA purposes are:

• Profit from the sale of stocks or other property
• Interest income or dividend income
• Rental income
• Pension or annuity income
• Income from certain partnerships
• Deferred compensation

Traditional IRA Rules

While the income sources for both types of IRAs are the same, the differences between the two account types become clear when you start looking at the details.

Traditional IRA contributions

With a Traditional IRA, the income limit to contribute to all accounts (both Traditional IRAs and Roth IRAs) must be the smaller of:

• Your taxable compensation for the year
• $6,500, the maximum IRA contribution for 2023 or $7,500 if you’re age 50 or older and are making catch-up contributions

You must start withdrawing from your Traditional IRA by April 1 of the year after the year you reach your required beginning date (RBD), no matter your tax rate. Learn more about these withdrawals, which are called Required Minimum Distributions.

Are Traditional IRA contributions tax deductible?

You might have heard that contributing to your IRA is a great way to lower your taxable income. That’s true, but this is only possible with a Traditional IRA (not a Roth). What’s more, not everyone qualifies to have their contributions count as a deduction. What’s more, some people may only be able to deduct a portion of their contribution from their income.

These two tests determine how much of your IRA contributions are tax-deductible:

Active participant test

The W-2 your employer sends reveals if you’re an active participant for the tax year in an employer-sponsored plan like a 401(k). On the form, the “Retirement Plan” box should be checked if you’re an active participant.

If neither you nor your spouse were active participants in a company-sponsored plan, you can deduct your Traditional IRA contributions regardless of your taxable income.

IRA income test

If you’re covered by a company plan, a second test indicates how much of your IRA contribution you can deduct. If you’re an active participant in a company plan, the Traditional IRA deduction for 2023:

• Begins to phase out when your Modified Adjusted Gross Income (MAGI) reaches $73,000 if you are Single or Head of Household, or $116,000 if Married Filing Jointly
• Is phased out completely when your MAGI is more than $83,000 if you are single or head of household, or $136,000 if Married Filing Jointly
• The phase-out range increases to $218,000 to $228,000 for a spouse who is not an active participant when the other spouse is an active participant in a company plan

If your MAGI is equal to or less than the lower phase-out threshold, you can deduct your full IRA contribution even if you’re an active participant in a company plan.

As a refresher, your MAGI is your AGI with these items added back:

• Traditional IRA deduction
• Student-loan interest deduction
• Foreign earned-income exclusion
• Foreign-housing exclusion or deduction
• Excluded U.S. Savings Bond interest
• Excluded employer-provided adoption benefits

If you and your spouse file separate returns, the income limit (phase-out range) is $0 to $10,000. So, you can’t claim the IRA deduction if your MAGI is more than $10,000.

You’re considered unmarried for purposes of the IRA deduction limitation if you’re married but:

• You didn’t live with your spouse at any time during the year
• You and your spouse filed separate returns

Traditional IRA recordkeeping

If you have contributed to a nondeductible Traditional IRA, keep track of your basis to make sure you don’t pay tax on the money again when you withdraw it.

Basis is usually the combination of nondeductible IRA contributions made and the basis from after-tax amounts in qualified retirement plans rolled over to your Traditional IRA accounts. If so, you’ll need to calculate the taxable portion of any withdrawals.

You might receive both taxable and nontaxable distributions. If so, use Form 8606 Instructions to help you figure the taxable portion of your IRA withdrawals. File Form 8606 for any tax year you made a nondeductible IRA contribution and to track your total IRA basis.

Roth IRA rules

Roth IRAs are subject to many of the same rules as Traditional IRAs. However, there are exceptions:

• You must designate the account as a Roth IRA when you start the account.
• You can’t deduct your contributions to a Roth IRA on your tax return, but your withdrawals, assuming you follow the rules (i.e. make qualified distributions), will be tax free.
• You can make contributions to your Roth IRA regardless of your age, however; you must receive taxable compensation to make contributions.  (Starting in 2020 you can continue to make Traditional IRA contributions as well.)
• You don’t have to take withdrawals starting at any age.
• The balance in your Roth IRA account when you pass generally goes to your heirs tax-free. The account must have been open and contributed to for at least five years.

Roth IRA contributions

Roth IRA contribution limits are the same as those for Traditional. We’ll list them here again for reference.

The maximum amount you can contribute to all accounts (both Traditional IRAs and Roth IRAs) must be less than:

• Your taxable compensation for the year
• $6,500, the maximum IRA contribution for 2023 or $7,500 if you’re age 50 or older and are making catch-up contributions

Additionally, in 2023, Roth contributions:

• Begin to phase out when your MAGI reaches $138,000 if you are Single or Head of Household, or $218,000 if Married Filing Jointly
• Is phased out completely when your income is more than $153,000 if you are Single or Head of Household, or $228,000 if Married Filing Jointly
• Married couples Filing Separately can’t make Roth IRA contributions if their MAGI is more than $10,000 and you lived together at any time during the year.
• You can file Married Filing Separately and contribute to a Roth IRA if you didn’t live with your spouse at any time during the year. Your MAGI limits are the same as the Single or Head of Household filing status as mentioned above.

How are Roth IRA contributions taxed?

Roth IRA contributions are taxed as normal income because they aren’t deductible. Because your contributions are included in your normal income the year you contribute, you can withdraw your contributions (but not your earnings) tax-free and penalty-free at any point you wish to do so. Rollover contributions are subject to a different set of rules.

Learn more about how Roth IRA contributions are taxed.

IRA contributions: Additional details

If you contribute more than the limits mentioned above, there’s a consequence.  It’s called an excise tax and it’s equal to 6% of the amount you go over the limit (i.e., an excess contribution). The penalty applies each year until you either withdraw the excess or use the excess as a future year’s contribution. But, you don’t have to pay the excise tax if you withdraw the extra amount by the tax return deadline (plus extensions).

IRA contribution age limit

There’s no minimum age to participate in an IRA. If your teenage child has compensation from a part-time job, your child can contribute to an IRA up to $6,500 (or their compensation amount if lower).

Due date for IRA contributions

The last day to make your IRA contribution each year is when your tax return is due, not including extensions. You can mail your IRA contribution, and you’ll meet the deadline if it’s postmarked by the original due date for filing Form 1040.

Spousal IRAs

If you’re married and your spouse doesn’t have earned income or makes less compensation than you, you can open an IRA account for them. You can contribute up to the maximum for your spouse as long as you don’t exceed the total compensation received by both spouses on a Married Filing Jointly return. When you are 50 or older, the limit increases to $7,500 per spouse in 2023.

You can have many IRA accounts and can:

• Contribute to a single Traditional IRA or Roth IRA account each year
• Open a different account each year
• Divide each year’s contribution among several accounts
• Divide your contribution between a Traditional IRA and a Roth IRA, subject to the MAGI limits that apply

However, by having more than one account you might also pay multiple trustees for annual fees or other bookkeeping fees.

No matter how many accounts you have, your total annual contributions can’t be more than the maximum allowable limit. Speak with a financial professional for investment guidance.

IRA rules – Moving your money around

You don’t have to keep your IRAs in the same investment types or financial institutions from your contribution date to your retirement date. You can move your money around to take advantage of changes in the market or in your investment philosophy.

However, you must follow certain rules. Some financial institutions might impose penalties if you change investments before the maturity date is up (Ex: CDs and annuities).

Converting your Traditional IRA to a Roth IRA

Moving money from your Traditional IRA to a Roth IRA is called a conversion. Many people take advantage of this method because you can convert funds from your Traditional IRA to a Roth IRA regardless of income. Take note: Any money in your Traditional IRA that wasn’t previously taxed (contributions and earnings depending on your situation), will be taxed the year you do the conversion to a Roth. Also, once you convert funds from your Traditional IRA to a Roth IRA you can’t change your mind and return the money to your traditional IRA.

Roth or Traditional IRA: Which is best for you?

Retirement accounts can complicate your taxes, so consider tax guidance. Whether you choose to file with a tax pro or file with H&R Block Online, you can rest assured that we’ll get you the biggest refund possible and help use deductions and tax strategies to reduce your tax rate.

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