IRA contributions and earnings sound very similar. Both represent money flowing into your account. But if you ask the IRS, they aren’t similar at all. If you don’t know the difference, you could find yourself with a hefty tax bill.
An IRA contribution is money that you deposit into an IRA account. That could be automatic deductions from a paycheck or transfers from your bank account if you’re contributing, say, freelance earnings. The money you’re allowed to put into an IRA, has to be employment or business income. You can’t have made it from, say, investments.
The IRS sets limits on how much you can contribute to your IRA each year. In 2017, you can contribute up to $5,500 if you’re under the age of 50 or $6,500 if you’re 50 or older. Why do you get an extra $1,000 if you’re 50 and older? The IRS calls these catch-up contributions. If you find yourself running low on retirement funds heading into retirement, you can “catch up” by contributing more.
IRA contributions might be tax deductible depending on the type of IRA you have. Roth IRA contributions are not tax deductible, but contributions to a Traditional IRA are generally tax deductible at the state and federal level.
How much of your contribution to a Traditional IRA is deductible might be limited if you or your spouse are part of a retirement plan from an employer. You might also be limited based on your annual income. Roth IRA income eligibility limits are not affected by whether you (or your spouse) has an employer retirement plan.
If you have a Roth, here’s the other important thing about tracking your contributions: Because your contributions are already taxed before they enter a Roth IRA, you can withdraw those contributions at any time without a penalty or paying taxes on the funds again.
Traditional IRAs are more complicated. You can withdraw non-deductible contributions tax and penalty free at any time, but other contributions are hit with taxes and penalties if taken before age 59½ unless certain exceptions apply.
The reason you deposit money into investment accounts is to earn income on the funds. Your earnings are the profits you earn on your invested contributions. Any earnings generated in a Roth IRA are tax-free because you pay taxes on the contributions upfront. Earnings follow the same rules as a Traditional IRA—you can only withdraw earnings on or after age 59 ½ unless certain exceptions apply.
In a Traditional IRA, earnings and contributions are taxed at your income tax rate at the time of withdrawal—at age 59½ or later if you want to avoid early withdrawal penalties.
How They Affect Taxes
When deciding between a Traditional or Roth IRA, the earnings portion is where you should put the most thought. Do you believe that your earnings will be considerably higher once you reach retirement age? If you do, a Roth IRA might be a better choice.
The reason: Paying taxes at your current tax rate might be a smaller tax burden than waiting until later in life when you’re in a higher tax bracket. Also, if you believe that state and federal governments will increase tax rates in the future, you might want to pay the taxes at the current rates.
In addition, Traditional IRAs mandate required minimum distributions starting at age 70½. You will pay taxes on those RMDs and they can raise your tax bracket.
Track Both Types of Money
Contributions are the money you deposit into an IRA while earnings are the profits you receive on those IRA contributions.
- If you have a Roth IRA, you pay taxes when you deposit your contributions and it grows tax free after that (you never pay taxes on earnings).
- If you have a traditional IRA, you get the tax deduction on your contributions. When you withdraw the funds, you pay taxes on both your contributions and all the earnings they have made over the years.
The IRS taxes all money. It’s only a matter of when the taxes are due, but the timing of those withdrawals—or distributions as they’re called in retirement planning—can represent large differences in the amount of tax you end up paying.