Quick Reference: The 2011 IRA contribution Limit is $5,000 if you are under 50 and $6,000 if you are over 50.

If you haven’t started thinking about how you’re going to support yourself in your retirement, there is no time like the present. No one else is going to do it for you. You’re not going to be able to live in the lifestyle to which you are accustomed on Social Security. Even if you are up in years already, it is never too late to start saving for your retirement. You need to set up an IRA, and you need to do it today.

But how does it work? What are the tax consequences? And for the purpose of this article, what are the IRA contribution limits? How much does the IRS allow you to contribute every year? We will get into that in detail, but first let’s go over exactly what an IRA is.

Kinds of IRAs

With most financial situations, it is always very complicated. There are always dozens if not hundreds of different schemes and you need a master’s degree to figure it all out. But not with the IRA. The IRA is very straightforward. Really, there are just two kinds of IRAs, the traditional and the Roth IRA. Both are very similar, you can contribute the same amounts, you can invest the same amounts of money, but there are some subtle yet distinct differences.

First there is the Roth IRA. There is really just one big difference between the Roth and the traditional IRA. With the Roth IRA, the money that you contribute has already been taxed. When you go to take out the money for your retirement you will know, the taxes have already been taken out on the front end so all the money that’s in your Roth IRA is your money to keep. No more taxes will be levied on your Roth IRA account.

So what are the advantages to this? The differences in the two accounts are all about the tax liabilities. Those with higher incomes, those who are making more money now but especially those people who are expecting to have high incomes in their retirements, they’re the ones who like the Roth IRA and can take advantage of backend, tax-free advantages it has to offer. For example: you are in the top tax bracket now and deducting $5000 for your contribution to your traditional IRA isn’t going to make one bit of difference. It is not going to move you down into a lower tax bracket. So setting up a traditional IRA is not going to help you in any way tax-wise. But when you retire, you are still going to be making good money. Maybe in retirement you are assuming you’ll no longer be in the top tax bracket, but under it by just a little bit. With the Roth IRA, because you do not have to pay taxes on it when you withdraw it, you will not get bumped up into the higher tax bracket. The Roth IRA is for those who want to realize the tax benefit of the IRA later instead of sooner, on the backend instead of the front end.

With the traditional IRA, the tax consequences are exactly the opposite. The money you contribute every year is tax deductible. This is more popular with say middle-income people who want that tax savings now. With the traditional IRA, the money you contribute at the time is tax deductible in that same fiscal year. You’re not going to have to worry about the taxes until way down the road, when you withdraw the money. If you are say middle income, then the taxes levied on you in your retirement may not make much difference at all. The money in your IRA will be growing all these years and you should have quite a little nest egg to help you along in your retirement.
So how much can you contribute into your IRA? As much as you want? Are there limits?

Limits on Contributions to your IRA

It would be nice if you could contribute unlimited funds to either your Roth or traditional IRA. What tax breaks that would give you. You would have retirement fund to live like a king. That sounds great, but unfortunately there are limits to how much you can contribute every year.

The limits on how much you can contribute, both to your Roth IRA and your traditional IRA, as of the fiscal year 2011, for people under the age of 50 is $5000 per year. For those over the age of 50 the amount increases to $6000 per year. While this may not seem like a lot, be aware that the amount used to be only $2000.

Now there is one caveat. You must be aware that ALL money you contribute to either your Roth IRA or traditional IRA MUST come from money earned. This means, in essence, that the money you contribute must come from a job. The money you contribute to your Roth IRA or traditional IRA cannot come from some stock you parlayed or winnings from the track. There are a few exceptions, although. Money made from farming, or money you have received through alimony, are exceptions to the rule and allowable under IRS law. Any income that uses the standard IRS form W-2 is applicable. You can work for a small company or a big company or you can even work for yourself, just as long as the money earned is like that from a job.

Can you contribute more the next year if you contributed less the last year?

Meaning, if you contributed only $3000 in say 2010, can you make for it or even it out in 2011 by contributing $7000. It seems fair. It makes sense. The answer is: no. You cannot ever exceed the limit, whether it is $5000 or $6000, in the course of a single year. So do your best to make the maximum contribution every year. The tax benefits as well as your nest egg for retirement will be all the better if you do.

Be advised that the contribution limits are planned to be raised in increments of $500 after the year 2010. The time they will be raised will be at the discretion of the IRS, but the raise itself will be made under the consideration of inflation.

Why does the IRS limit your IRA contributions

Just like with any other tax break, the tax deduction for your Roth IRA and traditional IRA were put in place so you would want to set aside money for your retirement. That is to say, the tax break is an incentive to save. But why the limits? Why does the IRS limit the amount you can contribute to either your Roth IRA or your traditional IRA? How come you can’t put aside all the money you want?

Well, you can put aside more money if you want. You can put all the money you want into your savings account, into stocks and bonds, into a certificate of deposit, anywhere you like. There is no limit to how much money you can sock away for your retirement. It’s just that the IRS is not going to allow you to deduct more than $5000 or $6000 from your taxes in doing so. Remember, the IRS is a business. They can’t just let you deduct your whole tax burden away. Tax deductions are meant as incentives, but are only small incentives as such. You are still going to have to pay your taxes.

But be mindful of this. That $5000 or $6000 you are contributing to your IRA today may not seem like a lot, but let’s do the math on what happens to that money over say, 30 years.

Let’s say you started your IRA when you’re 35 years old. You’re married now, you’ve got kids, you’re a homeowner, and finally it comes over you that you’re going to need to start thinking about the future. That $5000 you put away in your IRA today, times 30 years that’s going to $150,000. Without getting into the daunting task of compounding interest and growing principal, let’s just say with your money invested in the right fund you’re going to have well over a million dollars for your retirement. And remember, if you put that money into a Roth IRA, then all that money is yours. It’s all tax free.

Other ways to seemingly increase your contributions

Although you are limited on how much money you can contribute to your Roth IRA or traditional IRA, that doesn’t mean you cannot make those contributions grow. Think of it like this: while the contributions are limited, the growth is not. If you invest your money wisely, if you had started early and given yourself ample time to save, you can invest part of your IRA soundly, like in bank CDs or bonds, but some of the other contributions you can invest in mutual funds like Vanguard or Fidelity. Fund like these have an average growth of 10% per year over long periods of time. Remember that the stock market can be a good investment if you look at it long term. Sure the market drops 500 points in one day, then goes up 600 the next. Seems high risk. Seems too volatile a place to be investing your valuable nest egg. But remember that the stock market has averaged a 10% gain each year on average ever since 1926. If you look at this long term, the amount of your IRA when you retire could well be in the millions. Again, without getting into the whole aspect of compound interest and increasing principle, let’s just say that by the time you retire you could be a very wealthy person. Nothing is more important than security in your golden years.

So you see, even though there are limits as to what you can contribute initially to your IRA, there are no limits on how much that IRA can grow. Of course, you are not going to be allowed to invest your IRA in the lottery or get-rich-quick schemes, and there are good reasons for this, but over time, your money is going to grow. Time is your main ally here. Let time grow your nest egg into an account of wealth for you.