• IRA Contributions Might Lower Your Taxes. What’s The Right Strategy For You?

  • You now have an extra month to lower your tax bill with contributions to your individual retirement account (IRA).

    Just like last year, the IRS has extended the 2020 tax filing deadline to May 17, allowing Americans an extra month to make IRA contributions that can potentially ease their IOU to Uncle Sam while also helping them save for retirement.

    But are these contributions the best way for you to save for retirement? And just because you can effectively go back in time to lower your tax bill, should you?

    How to Reduce Your Taxable Income with IRA Contributions

    First, a few IRA contribution basics. Each year you can put a total of $6,000, or $7,000 if you’re 50 or older, into your individual retirement accounts.

    With a traditional IRA, you’re generally able to deduct any contributions you make from your taxable income now. Investments you purchase with this money then grow tax-free until you start making withdrawals after you turn 59 ½, when you’ll pay income taxes on everything you take out (Roth IRAs are different, but more on that in a sec).

    Traditional IRA contributions can save you a decent amount of money on your taxes. If you’re in the 32% income tax bracket, for instance, a $6,000 contribution to an IRA would shave $1,920 off your tax bill. This helps you not only decrease your current tax burden but also provides a strong incentive to build your retirement nest egg.

    You have until tax day, generally April 15 of the following year, to make IRA contributions (and therefore also reduce your taxable income).

    Note: If you have access to other certain other types of IRAs, like a SEP IRA, you can also make last-minute contributions to these. SEP IRAs, which are designed for small businesses or the self-employed, offer contribution limits that are almost 10 times the limits of normal IRAs, and you can contribute to both a SEP IRA and a personal IRA. You can even file an extension and get until October 15, 2021 to make a 2020 SEP IRA contribution, giving you almost 10 months to lower your taxes for the prior year.

    How to Get a Tax Deduction with IRA Contributions

    Anyone with earned income can open a traditional IRA, contribute the max and benefit from tax-deferred investment growth. But there are strict rules about who’s eligible to reap tax deductions from contributions that can lower your income tax.

    Anyone not covered by a workplace defined contribution plan, like a 401(k), can deduct all of their traditional IRA contributions from their taxes. It’s a bit more complicated if you and/or your spouse are covered by a retirement plan at work.

    If you’re a single filer in this situation:

    • You may fully deduct all your IRA contributions from your taxes if your modified adjusted gross income (MAGI) is $65,000 or less
    • Partially deduct your IRA contributions if your MAGI is between $65,000 and $75,000
    • You cannot deduct any of your IRA contributions if your MAGI is greater than $75,000

    For married filing jointly households where both spouses have a 401(k):

    • You may fully deduct all your IRA contributions if your MAGI is $104,000 or less
    • Partially deduct your IRA contributions if your MAGI is between $104,000 and $124,000
    • You cannot deduct any of your IRA contributions if your MAGI is greater than $124,000

    For married filing jointly households where your spouse has a 401(k) but you don’t:

    • You may fully deduct your IRA contributions if your MAGI is $196,000 or less
    • Partially deduct your IRA contributions if your MAGI is between $196,000 and $206,000
    • You cannot deduct IRA contributions if your MAGI is greater than $206,000

    Does A Last-Minute IRA Contribution Make Sense For You?

    Just because you can make one of these last-minute IRA contributions doesn’t mean you necessarily should.

    If you’re a high earner eligible for a full or partial deduction, getting a contribution under the wire could make a lot of sense. Out of all the retirement tax moves at your disposal for the previous year, you might stand to benefit from this the most.

    And if you’re not in one of the higher tax brackets now? You certainly can still contribute to a traditional IRA, but your deduction may not be that great. Someone in the 12% tax bracket, for instance, might only save $720. Nothing to sneeze at, sure. But you might actually get better tax advantages in the long run from what’s called a Roth IRA instead.

    Roth IRAs Can Save You Big on Taxes Later

    A Roth IRA is funded with dollars that have already faced Uncle Sam’s wrath. That means no upfront tax deductions (and no decreases to your taxable income now), but you never have to pay a dime on qualified withdrawals made after you turn 59 ½.

    If you’re in a lower tax bracket now, then, you could save potentially upwards of double of the taxes you’d owe later if you move into a higher bracket in retirement, assuming you moved from a 10% or 12% to any of the other brackets. That’s why a Roth IRA makes a ton of sense for younger earners who are in a lower tax bracket today than they’ll see once they hang up their boots.

    In fact, anyone who’s able to contribute to a Roth now may stand to benefit long term. “If you’re eligible for a Roth IRA, you’re probably better off paying taxes now,” says Wealthfront CPA Tony Molina. “We’re in a period of historically low tax rates.”

    Unfortunately, not everyone can contribute to a Roth IRA. Much like the traditional IRA tax deduction limits we covered earlier, there are income cut-offs that put the Roth IRA out of reach of high earners. Single filers earning less than $125,000 in 2021 can contribute up to $6,000, or $7,000 if you’re 50 or older, while those making between $125,000 and $139,999 can save a reduced amount. If your income is over $140,000, you’re out of luck.

    While Roth contributions today won’t lower your taxes today, there’s more to retirement savings strategies than saving a few bucks on your tax bill in the here-and-now.

    When a Traditional IRA Makes More Sense for Low Earners

    Still there may be some scenarios where it makes sense for those without the biggest incomes to use a traditional IRA.

    To see if these might be right for you, start by preparing your 2020 tax return to determine your adjusted gross income. Once you have that number in hand, you can see if you’re close to qualifying for an income-based tax deduction, says Mike Piper, a St. Louis-based certified public accountant (CPA), which would make utilizing a traditional IRA more appealing to save substantially more money in the here and now.

    You might even get a tax break you’ve never heard of, like the saver’s credit, which less than half of taxpayers know about but that could credit you with up to $2,000.

    How would contributing to an IRA help you qualify?

    Well, the amount of the credit depends on your specifics, but married couples filing jointly with an AGI between $43,001 and $66,000 receive a credit worth 10% of their contribution (up to $2,000) to a retirement account. If that couple earned even $66,001 in 2020, however, they’d get nothing.

    But if they contribute $4,000 to an IRA, they could not only lower their potential income tax liability by $480, but they’d also lower their AGI enough to qualify for a $400 bonus from the saver’s credit.

    Even if you can’t qualify for an additional tax break by making a last-minute contribution for 2020, running through the steps to figure out which deductions and IRAs you might take now positions you to fully take advantage of them next tax year.