WIll Opening an IRA Help You Save Money on Taxes?

Go after those deductions by investing in a traditional or Roth IRA

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If you are saving for retirement, it’s always smart to consider investing using a tax-advantaged account, such as an individual retirement account (IRA) or a 401(k).

These accounts will allow you to reduce the amount you pay in taxes, thus increasing the amount you get to keep in retirement.

Different accounts offer different kinds of tax advantages, so it’s important to understand the mechanics of how each works.

IRAs are great vehicles for retirement savings because they allow an individual to invest in almost any security in a tax-advantaged way. In this article, we’ll focus on the two major types of IRAs and the ways they allow you to save on taxes while saving for retirement.

Traditional IRA - Tax Savings Up Front

With a traditional IRA, an investor can contribute up to $5,500 per year into an investment account ($6,500 if they are over age 50), and that money is deducted from their taxable income. These limits will rise to $6,000 and $7,000 in 2019.​

So for example, if a single person age 35 had a salary of $75,000 per year in 2018, their taxable income can be lowered to $60,000 simply from the IRA tax deduction. Under 2018 tax brackets, that could represent a tax savings of $3,300. In some instances, the savings can be much greater if the deduction moves the person into a lower tax bracket.

A traditional IRA is available to anyone who can report earned income. It is especially useful for those workers who don’t get a 401(k) plan through their employer.

There is no limit to how much a person can contribute to a traditional IRA, but workers with high incomes may not be able to claim the full tax deduction. Here’s how the eligibility for tax deductions breaks down for the 2019 tax year:

  • Full Deduction - Single filers making less than $64,000 and joint filers making less than $103,000.
  • Partial Deduction - Single filers making between $64,000 and $74,000 and joint filers making between $103,000 and $123,000.

Anyone who contributes to an IRA and who is not covered by a workplace retirement plan but is married to someone who is, the deduction is phased out if the couple’s income is between $193,000 and $203,000 in 2019.

In addition to the tax deductions from traditional IRAs, it’s important to note that any gains on investments in the account won’t be taxed until money is withdrawn from the account. This could result in additional tax savings if the investor is in a lower tax bracket in the future than they are today.

Roth IRA - Tax Savings in the Future

A Roth IRA is sort of like a traditional IRA in reverse. In 2019, investors will be able to contribute up to $6,000 into an investment account ($7,000 if they are over 50). But unlike a traditional IRA, that money is taxed up front. The key feature of a Roth IRA is that investment gains can be withdrawn at retirement age completely tax-free.

For example, if you contribute $100,000 into a Roth IRA over the years and see the account grow to $250,000 due to investment gains, that extra $150,000 is exempt from capital gains taxes. Under current tax laws, that’s a savings of $22,500 for most people.

There are income limits to using a Roth IRA. In 2019, single filers making more than $137,000 and joint filers making $203,000 or more are not permitted to contribute to a Roth IRA.

Which IRA to Choose

Given the tax advantages of each kind of IRA, you may be confused as to which account you should invest in. The good news is that you don’t have to choose; there’s no rule against contributing to both a traditional and Roth IRA.

It is generally hard to predict what your income and tax bracket will be when you retire. That’s why it often makes sense to put money in both accounts to receive tax advantages either way, with a traditional IRA offering tax deductions up front and Roth IRA offering tax savings on the back end.

One thing to consider is whether or not you already have access to a 401(k) or similar plan through your employer. If so, a traditional IRA may not be necessary, because both accounts provide up-front tax deductions.

Get that Last-Minute Deduction

If it’s late in the calendar year and you are seeking a tax deduction but haven’t contributed to an IRA, don’t fret. Investors are permitted to contribute to an IRA until April 15 and have it count toward the previous year. So a contribution made in March of 2019 can offer a tax deduction for 2018​ if the investor prefers.