A contribution refers to funds that you deposit into an investment account. Depending on the type of account, contributions can have tax advantages – especially in accounts intended for retirement planning. There can also be limits on contributions and restrictions on when they can be withdrawn without penalty.
Along with the types of investments you choose, the amount you contribute to your accounts is the biggest influencer of your investment success. Simply put, the more you contribute to your investment accounts, the more opportunity you will have for growth. If investing as part of your retirement planning strategy, your contributions now influence how much money you’ll have available for living expenses in retirement.
Before making a contribution to an investment account, be sure to discuss the tax implications with your financial professional.
Traditional IRA Contribution
Contributions to a traditional IRA are tax-qualified, meaning they are pre-tax contributions. In practice, this means that you can deduct contributions to a traditional IRA from your taxable income in the year the contribution is made.
Tax on these contributions is deferred until the money is withdrawn. At that time, the contributions are combined with any growth in the account and taxed as ordinary income. In addition to income tax, traditional IRA withdrawals taken before age 59½ are subject to an additional 10% tax penalty.
Roth IRA Contribution
Roth IRAs have different tax characteristics than traditional IRAs, but they too have tax advantages. Roth contributions are not pre-tax, or tax-deductible in the year they are made.
If the contributions are left in the account for at least five years, however, withdrawals from the account – including contributions and earnings – are completely tax-free. This benefit only applies to withdrawals taken after age 59½, though. As with traditional accounts, premature withdrawals are subject to a 10% tax penalty.
IRA Contribution Limits
The Internal Revenue Service (IRS) sets limits on the amount that can an individual can contribute to an IRA in a given year. Currently, this limit is $5,500 per year. The limit is set across all IRAs a person owns. For example, if you have a traditional IRA and a Roth IRA, you could contribute $2,750 to each account, but not $5,500 to each account.
Investors over age 50 can make “catch-up” contributions of $1,000 in addition to the $5,550 maximum, for a total maximum of $6,500 per year.
Taxable Account Contribution
Taxable brokerage accounts don’t quite have the tax benefits of retirement planning accounts, but they do have more flexibility.
Contributions to taxable accounts are not tax-qualified. They are also never tax-free. The tax treatment of these accounts is pretty straightforward, however; contributions are taxed, and gains are taxed in the year they are realized. The tax rate on gains depends on whether the gains are short-term or long-term, and it also depends on the investor’s top marginal tax rate.
As a tradeoff for lack of tax advantages, taxable accounts have more flexibility than retirement accounts: there are no contribution limits for taxable accounts. Also, there are no age-based penalties or restrictions when withdrawing money from taxable accounts.