If you are saving for retirement, contributing to an IRA (Individual Retirement Account) allows your investments to grow and save money at tax time. Sounds great, doesn’t it? But, there are a few things to know about your IRA tax deduction to make sure you get the most benefit when you file your taxes.
#1: Only Traditional IRA contributions are Tax-Deductible
When you sign-up for an IRA, you have two different account types to choose from, Traditional or Roth. The first is funded with pre-tax income dollars like an employer 401k plan. Roth IRA’s, on the other hand, are funded after your income taxes have already been withheld, but you don’t pay a tax when you begin to withdraw in retirement.
With a traditional IRA, you can claim the amount you contributed to reduce your taxable income for the current tax year. This can be a good strategy if you might have to pay a tax penalty because enough wasn’t withheld through the year. By making a contribution, you might be able to get a refund or at least “break even.”
#2: You Can Contribute Until April 15th for the Previous Tax Year
April 15th is the long-standing deadline for when you must file your federal income taxes to avoid any additional penalties. For 2017, you have until April 18th to file and make a tax-deductible contribution for your 2016 taxes.
Unlike other tax deductions that must be completed before New Year’s Eve, you have an additional 3 ½ months to maximize this tax deduction. Once again, making it easy to reduce your taxable income to turn a penalty into a refund or increase the size of your current refund.
#3: You Can Only Contribute $5,500 per Tax Year to an IRA
As with other tax deductions, there are limits to how much you can deduct each year. For the 2016 & 2017 tax years, that limit is $5,500 for any person younger than 50 years old for a traditional or Roth IRA. If you are older than 50, you can contribute up to $6,500.
This means if your adjusted gross income is $50,000 before making any traditional IRA contribution, contributing $5,500 will drop your taxable income to $44,500.
#4: You Will Pay Taxes Later
One way or another, Uncle Sam will get his money. You save money on your taxes today, but, will pay them as you withdraw your funds. This means you could be potentially paying more in taxes when you retire if you are in a higher tax bracket than you are currently.
On the positive side, your contributions grow tax-deferred. You don’t pay capital gains each year like you do with your non-retirement investment accounts. So, your contributions still save you money long-term.
Is the IRA Tax Deduction Worth It?
Deciding whether to contribute to a Traditional IRA to get a tax deduction is a decision you have to make. It ultimately depends if you want to pay the tax now or in retirement.
If you need the tax savings now, it might be better to claim the deduction and contribute as much as possible to your Traditional IRA or 401k plan to lower your taxable income. Nobody can predict the future, but, you can at least make a decision based on your immediate financial circumstances.
If you don’t need the extra savings at the moment or simply want to hedge against paying a higher tax rate in the future, contributing to a Roth IRA or Roth 401k is the better option. Your earnings still grow tax-free and another affordable way to save for retirement.