It is tax time and many of us will be heading to our local CPA or wrestling with Turbo Tax to complete our tax returns before the April 15 deadline. If you are looking for ways to save money on your tax bill, don’t overlook a last-minute contribution to an IRA. It is one of the best ways to reduce your taxes and one of the only ways to you can still impact your taxes before you file. In this article, we’ll cover some IRA basics and outline when an IRA might make sense for you.
What is an IRA?
An IRA, or Individual Retirement Arrangement, is an account set up with a financial institution that provides tax-deferred or tax-free savings for retirement. For example, a traditional IRA allows most taxpayers to make contributions to an account, receive a tax deduction for the contribution, and allows the contribution to grow tax-deferred. I say ‘most taxpayers’ because there are some limitations (more on that later). Some confuse an IRA with a specific investment, but it is not. An IRA is an arrangement with the IRS, a ‘bucket’ if you will, in which you can invest in stocks, bonds, mutual funds, CD’s, annuities, or almost any of the most common investments available. All of the investments in the IRA ‘bucket’ will receive the same tax-advantaged tax treatment under the IRS rules.
What are the types of IRA’s?
There are two basic types of IRA's: the Traditional IRA and the Roth IRA. The fundamental difference between the two is when the money will be taxed. In a traditional IRA, the taxes are deferred or put-off until you use the money in retirement. In a Roth IRA, taxes are paid now but all of the earnings are tax-free when pulled out in retirement. Determining which makes sense can depend on many factors but the most important factor is time – how long you have until retirement. If you are not going to need the money for 15 years or more, then the Roth is generally preferable even though you are giving up a tax deduction now. If you are looking for ways to reduce this year’s taxes or you are within 15 years of retirement then the traditional IRA is generally preferable.
When does an IRA make sense?
As with most investments, it is important to consider your specific situation to determine whether an IRA is right for you. First, it is important to remember that an IRA is a retirement savings vehicle which makes it costly to access the money before retirement. Therefore, an IRA should not be used for short-term savings or ‘safety’ money that you might need. Secondly, your 401k at work has higher contribution limits and is probably the best place to start saving for retirement, but an IRA might also make sense in certain situations. Consider whether one of the following situations apply to you:
You made contributions to your 401k, but you have extra cash now and want to reduce your tax bill.
You maximized your 401k at work and want to supplement your savings.
You work for a small business that doesn’t have a 401k.
How much can I contribute to an IRA?
Unfortunately, contribution rules for IRA’s can be quite complex, so the best way to determine how much you can contribute is to consult your tax advisor or use the functions available within Turbo Tax. The basic contribution limits sound straightforward enough: $5,500 per individual per year for those under 50 years old, and $6,500 for those 50 years old and older. However, if you or your spouse are covered by a pension plan or 401k plan at work, then there are also income limitations for the deductibility of the contributions. As a result, you will need to know your income first to determine whether the IRA makes sense. If you would like to see a table with the most recent limits you can find a link here.