Annual Contribution Tax Deduction (in Most Cases)
Did you know that you don’t have to do anything additional to claim a traditional IRA deduction? That’s right! It’s a provision of the IRS tax code that has been in effect since 1978. It’s not the most generous of tax deductions, but the good news is that it’s pretty much automatic.
In order to qualify for a traditional IRA tax deduction, you have to meet a few basic requirements. But even if you don’t, you still get to take advantage of the deduction if you have an employer-sponsored retirement plan (i.e. 401k, 403b, 457 plan, etc.). And if you would like to participate in a SEP IRA, you can still deduct your contribution under certain conditions.
Here’s a quick overview of the qualification requirements:
You’re not eligible if:
- You’re under the age of 18.
- You’re not a U.S. citizen.
- You’re a non-resident alien.
Investment Earnings Tax Deferral
If you are planning to store your extra cash in a safe investment somewhere – you should consider opening an Individual Retirement Arrangement, or IRA, account. Typically, you will be able to choose between two types of IRAs: traditional and Roth. Both of them offer a great tax benefit for you.
While both types of accounts enable you to reduce your taxable income, traditional IRAs have some tax advantages over Roth IRAs. The biggest benefit is the ability to defer taxes on the money you contribute. If you have a traditional IRA, you won’t have to pay taxes on your contributions until you start taking money out of the account. On the contrary, contributions to a Roth IRA are considered after tax, and you cannot defer paying taxes on them.
Whether or not it is better to claim a traditional IRA account or a Roth IRA account is not always clear, since the answer would depend on your individual situation, and your tax bracket at the time the contributions were made. As long as you meet the qualifications, you can contribute as much as you want to your traditional or Roth IRA account every year, and take advantage of the tax benefits of the accounts. If you don’t understand the tax implications or the pros and cons of each type of account, it may be wise to consult a financial planner for professional advice.
Lower Adjusted Gross Income (AGI)
Because each IRA contribution is subtracted from AGI, that means less entry on a tax form and less tax paid. The money contributed also gets to grow tax-deferred, and taxes owed on withdrawals are generally taxed at a lower rate than earned income.
Savings account interest is taxed at ordinary income tax rates, usually a tax bracket that is higher. So, if you can channel a portion of your extra savings to an IRA, it can really add up.
Tax-Deferred Investment Income Up to Age 70½
When you deposit money into a traditional IRA, you will not be taxed as you earn the money.
Instead, the government gives you a tax break, saving you money. So rather than paying income taxes as you earn it, you pay it when you take it out.
But one end of the deal is that if you get a paycheck, you don’t get to take a deduction for your IRA contributions.
However, if you are self-employed, a large portion of your income is probably considered deductible if it is business profits, and you can take a full or partial deduction for your IRA.
You may also be able to deposit your Roth IRA earnings in a Roth 401(k). However, your employer may not offer this option, and you may not have to take part in the 401(k) plan because you are self-employed. In this case, you may want to look into depositing your contributions into a Roth IRA.
Additional Tax-Deferred Retirement Savings
As a U.S. citizen or permanent resident, if you are at least 18 years of age and have qualifying taxable income, you are eligible to open and contribute to an IRA, a type of tax-advantaged retirement plan. If you have earned income from a job, you can have a salary deferral IRA, or salary deferral 401(k) plan through your employer if they offer it. Your employer may also offer a traditional IRA, a Roth IRA, a Simple IRA, or a SEP IRA.
The IRA or 401(k) plan is a vehicle that allows your money to grow tax-deferred during contribution years. Unlike a 401(k), however, you have more investing options within an IRA for your savings to grow in. With compounding interest on your money, you can benefit from tax-deferred savings year after year until you are ready to withdraw it in retirement.
Many employers will match your contributions to a retirement account up to a certain percentage (to encourage their employees to save for retirement). If your employer offers to match contributions to your IRA or 401(k), it is worth investigating. Some will contribute up to 50% of the amount contributed by you for the year up to a maximum amount. Invest at least as much as your employer will match to be sure you receive the full benefit of the employer contribution.
A Catch-All Fund for Other Accounts
If you’re saving up for a down payment for your first home, your emergency fund, or even for your retirement, a Traditional IRA might be able to help you. The idea behind the Traditional IRA is simple: the contributions you make every year are tax-deductible, as long as you have no other funds in your account, and so when you withdraw that money after you reach retirement, you’ll only have to pay tax on your earnings … that is, if you qualify.
But if you’re part of a married couple with one IRA for both of you, this means that you won’t be able to count on that money while you’re still working, because you’ll have to pay taxes on it all up front, and that’s something you might not want to do. Thus, you’ll need to get creative and open a sort of catch-all IRA for working savings. That way, you’ll be able to save up for that emergency fund or for a down payment, without having to pay taxes on the money you’re putting into it.
By opening a Traditional IRA, you won’t be able to deduct any of those contributions from your taxes.