No one likes to pay taxes. If there’s a way to avoid it, most people will try to take best advantage of it.
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.
Both kinds of IRAs have considerable tax advantages, especially when combined to best advantage. Standard IRAs allow you to defer taxes in years when your income may otherwise place you into a higher tax bracket. Roth IRAs allow you to earn interest and investment income, completely tax-free.
However, the federal government imposes strict limits on IRA contributions, whether it’s a standard or a Roth IRA. The maximum amount which may be contributed to an IRA or combination of IRAs per year is the lower of earned income or contribution limit. There is also an upper income phaseout limit.
These limits are set because the IRA is designed to assist the middle class with building up retirement savings. Different sources of old age security are available to the poor, who may not make enough to build up retirement savings of their own. The IRA is also not designed to give extra tax savings to the rich, or to those who may not be quite so rich but who also have additional income sources for retirement.
Without IRA contribution limits, the ability to take best advantage of a Roth or standard IRA would depend only on how much money a person makes, without limit. The very poor could take advantage of IRA tax shelters only to the maximum of their earned income, but in practice, nearly all of that earned income goes to necessary expenses. In contrast, the very rich could place nearly all of their income into Roth IRAs, ensuring that their interest and investment income would remain tax-free for life.
Thus, the IRA limits only allow a few thousand dollars to be invested each year, at a level which is within the means of most people in the middle class. They also phase out those who already have a separate workplace retirement savings plan and additionally earn upwards of $90,000 (married) or $60,000 (single). For those who don’t have a separate workplace retirement savings plan, the cutoff income level is set about $100,000 higher.