A popular annual American deadline is right around the corner, that’s right, the Individual Tax Filing deadline. For some individuals, it’s a date (April 15) to look forward to as they know there will be a tax-refund on the other side. For others, they dread this date because they know it will require them to pay additional taxes. Individuals that are in the latter category, individuals that owe money, may be able to reduce the amount they owe for current and future taxes through a number of methods. Those methods may include: applying tax credits, charitable donations and capital losses. Another method to reduce your potential tax bill, and one that provides retirement benefits, is contributing funds to a deductible Individual Retirement Account (IRA).
Dependent upon your tax situation, an individual can make a deductible contribution to an IRA, or a non-deductible IRA contribution. If an individual is attempting to reduce their potential taxes owed, they may be able to contribute to a deductible IRA. The amount someone can deduct will be based on the deductible IRA account they contribute to and in an addition to other factors like, but not limited to: marital status, income level and amount contributed to your employer’s plan. Do remember when making a potential deductible contribution, the amount contributed to the deductible IRA does not work like a tax credit, which reduces taxes on a dollar for dollar basis. Instead, by contributing to a deductible IRA, the individual effectively lowers the taxable income. Therefore, the tax bill is reduced by the dollar amount that would have been used to pay income taxes (according to their tax rate) on the funds had the individual chose not contribute to a deductible IRA. We always recommend you speak to a tax professional when considering tax situations like this.
Traditional IRAs, SEP IRAs and SIMPLE IRAs are all examples of accounts that someone can use for deductible contributions. That is because deductible contributions are made with pre-tax dollars, as you are reducing your taxable income, as mentioned above. With each of these IRA accounts all of the contributions will grow tax-free and all of the withdrawals will be taxed as ordinary income at the individual’s income tax rate.
Sometimes it is best to see an example to fully understand a concept. To see an example of how someone’s tax bill is reduced by a deductible IRA contribution, I’ve attached a link to an example here.
For those individuals that do not face a tax-bill, may be in a lower tax-bracket or expect their tax rate to be higher when funds are withdrawn (retirement), contributing to a non-deductible IRA, like a Roth-IRA can provide excellent retirement benefits. These contributions are done with after-tax dollars, which can then grow tax-free as long as the funds stay in the account. Additionally, all withdrawals at retirement will not be taxed under current tax law. Consider that for a moment, tax-free growth with tax-free withdrawal. Regardless of what IRA account you use, tax-free growth will still occur, which is a very powerful investing tool. For example: If you deposited $10,000 into any IRA and it grew at 6% for 30 years without being taxed, it would be worth over $57,000.
For more information on the benefits and rules of IRA contributions, review the sources for this newsletter linked below. If my sources cannot answer your questions or you are still unsure, please give us a call. We advise our clients about investments in their IRAs frequently.
Links to IRS Code:
IRA Deduction Limits
IRA Contribution Limits
Benefits of IRA Contributions: