Could you have cut your tax bill by contributing to an IRA this year?
It’s a common question during tax season and the answer is; it depends. Specifically, it depends on a few nuances of your tax situation as well as which type IRA you use.
Let’s look at two common IRA types.
Traditional IRAs are the ones that could lower your tax bill if you’re eligible to deduct your contribution. They also provide deferral of taxes on any growth in the account from year-to-year. The trade-offs? First, you generally can’t use traditional IRA money before age 59 1/2 without incurring penalties. And second, you’ll eventually have to pay taxes when you pull the money out. If your tax bracket when you contribute is higher than when you withdraw the money, traditional IRAs can offer you some pretty big tax savings. Just be aware that not everyone can deduct their contribution to an IRA. Here’s a link to the IRS rules on the topic.
Roth IRAs also offer some significant tax advantages for retirement savers. One major similarity is that Roth IRAs allow you to defer taxes on your earnings just as traditional IRAs do. There is no tax bill for what happens inside the account from one year to the next. There are, however, some major differences. First, with a Roth IRA, you cannot get a tax break for your contributions, they go in after tax. Second, there are differences when you make withdrawals. Unlike contributions to a deductible, traditional IRA, contributions to a Roth IRA can be withdrawn at any time without taxes or penalties (not so for earnings though) and if you clear a couple of hurdles, you may never have to pay taxes on any growth you experience over the life of your account. These accounts tend to work best if you’ve got a lot of time until retirement and you anticipate being in the same or higher tax bracket when you take withdrawals.
Make Sure You’re Eligible
Finally, there are some eligibility restrictions for both traditional and Roth IRAs and some deductibility restrictions with traditional IRAs. IRS Publication 590 has all the information you’ll need for this, but it can sometimes also be wise to check with a CPA or other qualified income tax preparer first.