Using a tax-advantaged retirement account is one of the best ways to save for your retirement. To get the biggest financial benefit from an IRA, you should learn how to make the maximum IRA contribution each year.
An Individual Retirement Account (IRA) gives you flexibility with when you make your contributions as well as a bit more control over your assets compared to other retirement account choices.
If you can’t make the maximum, you can at least strive to contribute as much as you can each year.
Here, you’ll learn why you should aim for the maximum IRA contribution, as well as steps you can take to make sure your retirement plan in on track. We’ll cover:
- What is an IRA?
- What is the maximum IRA contribution for 2020?
- Should I do Roth IRA or traditional?
- How do I open an IRA?
- How much does it cost to open an IRA?
- Is an IRA and a 401k the same thing?
- What is the 401k maximum contribution?
- Can you contribute to an IRA and a 401k in the same year?
- Can I make more than the max IRA contribution?
- Key ways to make more than the maximum IRA contribution
- How does a SEP IRA work? Or a Simple IRA?
- What are the best IRA accounts?
What is an IRA?
An IRA is a tax-advantaged retirement account designed to encourage you to save.
The government offers tax advantages so that you will want to put more money toward your retirement. That will keep you in good financial health in the long-term. From the government’s perspective, this is a good thing for both you and the economy.
IRAs are offered by banks and credit unions, and through brokerages. Some employers even offer IRAs, but that’s not very common.
Keep in mind that IRAs are not completely tax-free. You still must pay some taxes, but you do get a significant tax break.
You can get the tax advantages in one of two ways. One, you can deduct whatever you contribute from your total taxable income when you file taxes (you will pay taxes usually at a lower rate when you withdraw in retirement). Or, two, in retirement you can withdraw the funds and their gains tax-free, but you would not deduct the contributions from your current taxes. You’ll learn more about the difference between the two IRA accounts – the traditional and Roth – below.
What is the Maximum IRA Contribution for 2020?
For 2020, the maximum contribution you can make to an IRA is $6,000. (That’s up from $5,500 in 2019.) However, if you’re over age 50, you can make an additional $1,000 in “catch up” contributions for a total of $7,000 for the max IRA contribution for 2020.
The good news is that you actually have longer than the end of the year to contribute. You can make deposits up until 2020 taxes are due – which is currently April 15, 2021 – and still have it count toward your 2020 contributions.
So technically, you have more than 15 months to contribute to a certain year’s IRA. You can make several small contributions over that time, or even make one lump sum contribution.
You’ll learn more about how to best use an IRA below.
Should I do Roth IRA or Traditional?
IRAs can take one of two forms – a Traditional IRA or Roth IRA. The best one for your depends on your financial situation and goals. In general, choose a traditional IRA if you want tax advantages now. Choose a Roth IRA if you want tax advantages on your investments’ gains, which can be a greater savings. You just won’t see it for years.
You report your total IRA contributions with both types of IRAs.
With a traditional IRA, you can deduct the total amount you contributed from your taxable income. So that reduces the total amount of taxes you owe for that year. However, when you go to withdraw your funds in your retirement years, you will have to pay income tax on your withdrawal, including on any gains your investments made over the years.
You’ve got to pay the full amount of taxes you owe when you contribute to a Roth IRA. You don’t take a deduction for that year. However, the beauty of Roth IRAs is that as your investments grow, the gains you make won’t be taxable. Once you retire, you can withdraw everything you contributed to a Roth IRA plus any gains you made, and you will pay no taxes at all.
Generally, a Roth IRA is more ideal for younger people. They have ample time to allow their investments to make gains. That way, they can save significantly on taxes if their investments make substantial gains.
A traditional IRA may be better suited for people closer to retirement years. That’s because people often move to a lower tax bracket when they retire. So, they pay a lower tax rate. It might make more sense for some people to take an income tax deduction now and then pay the lower tax rate when they make the withdrawals during retirement.
Each person’s situation is unique. Weight the pros and cons of whether a Roth IRA or a traditional IRA is right for you. Regardless, it’s best to try to make the maximum IRA contribution each year.
How do I open an IRA?
Opening an IRA account only takes a few minutes and is a very straightforward process. You can easily open an IRA account online through a bank or through a broker. Then, you just transfer funds and get started with investing. You can either choose your own investments or have your portfolio professionally managed.
You can open an IRA any time. You can even open an IRA up until tax day and make contributions for the previous year. So, you could open an IRA before April 15, 2021 and make contributions for 2020 up until then.
How much does it cost to open an IRA?
Typically, it costs nothing at all to open an IRA account, but some brokers do have a minimum deposit requirement. The IRS does not have a minimum for how much you can contribute to an IRA. However. there are some costs to be aware of. Namely, consider the fees for trades.
Think about how much you plan to be trading in your account. If you think you will be making a lot of trades and changing your investment holdings frequently, fees will be more important. After all, more trades mean more fees.
If you usually buy an investment that you can hold for the long-term, fees on trades might be less important. Also, some brokers take a small percentage of your assets each year (about 0.25% for many brokers.) The fee is for managing and servicing your IRA account.
Of course, it’s good to compare fees and expenses. But, honestly, don’t get too caught up in it. The most important thing is that you have an IRA account, and that you are aiming to make the maximum IRA contribution.
Is an IRA and a 401k the Same Thing?
Both an IRA and a 401k are tax-advantaged retirement accounts. But they are not the same thing. An IRA account is one that you usually open and control yourself, while a 401k is offered through employers. They have different maximum contribution limits.
The maximum amount you can contribute to a 401k in 2020 is $19,500, up from $19,000 in 2019. If you’re over 50, you can contribute $26,000.
In addition, with a 401k you might get the advantage of matching employer funds. If your workplace offers to match a certain percentage of what you contribute, definitely try to make at least that minimum contribution. Otherwise, you’d be leaving free money on the table.
What is the 401k max contribution?
The maximum contribution limit of $26,000 for a 401k does not include what employers can contribute. With their added money, the maximum combined contribution limit is $57,000. You employer can contribute up to $57,000 or 100% of your salary, whichever is less.
Unlike with an IRA, your contributions to a 401k are usually automated and the same each time. They are usually just deducted from your paycheck as a percentage of your salary. You choose the percentage you’ll contribute annually.
The tax advantage to a 401k is similar to that of a traditional IRA – your contributions are tax deductible for the year you contribute. Whatever you contribute is subtracted from your taxable income.
Then, when you take payments during your retirement years, those payments are considered taxable income.
Can You Contribute to an IRA and a 401k in the Same Year?
Yes! You can contribute to both an IRA and a 401k. So, even if you have a 401k through your employer, you can still open an IRA account if you want to save additional money with tax advantages.
If you are maxing out your 401k contributions, you may want to consider expanding your saving options further. Or you may just want both accounts working in tandem even if you’re not making the max IRA contribution.
Can I Make More than The Maximum IRA Contribution?
No, you cannot make more than the maximum IRA contribution limit. Otherwise, you will face a penalty. As long as your money remains in an IRA account, any excess over the max IRA contribution limits will be charged a fee of 6% per year.
Many banks or brokerage firms will notify you if your contribution will put you over the annual limit. Still, it’s something to watch out for.
Also be aware that your maximum IRA contribution limit will be lower if you are earning more than average. For 2020, your limit will decrease starting at $124,000 ($196,000 for couples). You will not be able to contribute to an IRA if you earn over
If you notice you exceed your contribution limits before it’s time to file taxes, you can simple remove the funds from your IRA.
If you notice an over contribution within six months of filing taxes, you can remove the funds and file an amended tax return. Otherwise, you will have to pay the 6% penalty for that year. But in the latter case you can count the excess contribution toward the next year’s limit – you don’t have to remove the funds. Just remember to contribute less that next year!
Key Ways to Make the Maximum IRA Contribution
To get the best results from an IRA, you should plan ahead of time for how much you want to contribute for the year. Try to set your goals high and make contributing to a tax-advantaged retirement account a top priority.
Try to incorporate regular payments to an IRA in your monthly budget. Ideally, you would set up automatic payments from your bank to your IRA. That way, you can “set it and forget it” and make the process of building wealth something you won’t have to think about.
And if you do run into a windfall of money, like an inheritance or a bonus, aim to make even more deposits to your IRA. Again, try to reach the max contribution for the year.
Don’t forget that you have until tax filing day to contribute. So if you’re not a the limit by the end of the year, you actually have a few more months to put money in.
The earlier you open and start saving in an IRA, the better. That way, your investment have more time to work in your favor. And you can get the most tax benefit out of your retirement savings plan.
If you have questions about how to best manage your contributions for your situation, consult a professional financial advisor.
How Does a SEP IRA Work? Or a Simple IRA?
If you’re self-employed, you might be able to take advantage of even higher IRA contributions through SEP IRAs (Simplified Employee Pension) or SIMPLE IRAs. Both accounts offer tax breaks in the form of deductions.
With a SEP IRA, the employer (you) makes contributions to their employees’ accounts. The employer is granted a tax deduction on their contributions. SIMPLE IRAs are for employee contributions.
For SEP IRA, the 2020 contribution limit for employers is 25% of your salary or up to $57,000. For SIMPLE IRAs, the contribution limit for employees for 2020 is $13,500, or $16,500 if you are over 50.
What are the Best IRA Accounts?
The Best IRA Accounts are ones that meet your own personal needs. Some of the larger brokers like E*Trade, TD Ameritrade, Charles Schwab and Fidelity are known for providing excellent tools to help investors.
Your own bank may be an ideal option to open an IRA. If you have a relationship with your bank, you can keep your IRA account together with your other accounts online. Having all your accounts in one place can be convenient.
Here is a list of some of the more popular financial institutions offering IRAs:
- E*Trade IRA
- TD Ameritrade IRA
- Charles Schwab IRA
- Fidelity IRA
- Firstrade IRA
- Merrill Edge IRA
- Ally Invest IRA
The Bottom Line
Having an IRA helps put you on the right path toward a secure retirement. If you can, aim to make the max IRA contribution so you can get the most tax savings.
Try to start saving for retirement as early as possible. And consult a financial professional for more help setting your goals and a strategy for how to achieve them.