Saving for retirement is always a good idea, but investing in a traditional IRA has an added benefit: You save on taxes in the year you make the qualifying contribution. Although most workers can make contributions to an IRA, the Internal Revenue Service places tighter restrictions on who can deduct their contributions to reduce their federal income taxes.
Basic Contribution Qualifications
You can make contributions to your IRA until you turn 70 1/2, as long as you receive earned income at some point during the year. Earned income is money you receive through active participation in work, rather than through investments. Although the IRS limits the annual contribution amount to $5,000 -- or $6,000 for anyone 50 or older -- you can’t contribute more than you earn in a year. For example, if you were mostly unemployed and you received $3,500 in wages for the year, you couldn’t contribute $4,000.
Employer-Sponsored Retirement Programs
If your employer provides a tax-deductible retirement plan that you actively participate in – through contributions from your paycheck – that might limit your chance to claim IRA contributions as a deduction. If you’re single and you have an adjusted gross income higher than $68,000 you can’t claim the deduction, and married couples with adjusted gross income that exceeds $112,000 don’t receive the deduction either. The allowable deduction on contributions begins phasing out for individuals at $58,000 and for married couples at $92,000.
How Contributions Save on Taxes
If you make a contribution that qualifies as deductible, that amount is deducted from your adjusted gross income. Because of this, for tax purposes, it’s as if you hadn’t earn the money contributed, and income taxes aren’t assessed on those earnings. In turn, your tax bill is reduced proportionately by your marginal tax rate. For example, if you contribute $5,000 and you are in the 25 percent tax bracket, the deduction produces a bottom-line savings of $1,250.
Don’t think you can make a contribution to an IRA just to reap the tax benefits and access the funds later. You can’t touch money in an IRA until you turn 59 1/2 without incurring a penalty of 10 percent on the early distribution. In addition, the distribution is taxed as ordinary income, so you'd owe the income taxes you deferred when you made the contribution. For example, if you take an early distribution of $5,000 and you’re in the 25 percent bracket, you’ll owe a penalty of $500 and income taxes of $1,250.
- Form 1040 Tax Forms image by Viola Joyner from Fotolia.com