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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It’s always smart to consider investing in a tax-advantaged account when you're saving for retirement, such as an individual retirement account (IRA) or a 401(k). These accounts allow you to reduce the taxes you'll pay on your income, 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 one works. IRAs are great vehicles for retirement savings because they allow an individual to invest in almost any security in a tax-advantaged way.

Traditional IRAs: Tax Savings Upfront

An investor can contribute up to $6,000 into a traditional IRA investment account annually as of tax year 2021. This increases to $7,000 if you're over age 50. Your contributions can be deducted from your taxable income, so would only pay taxes on the remaining balance.

A single person's taxable income would be reduced to $69,000 simply from the IRA tax deduction if they were age 35, had a salary of $75,000, and took advantage of the full $6,000 contribution limit. Their savings could be even greater if the deduction dropped them into a lower tax bracket.

Anyone who can report earned income can contribute to a traditional IRA. It is an especially useful option for workers who don’t have a 401(k) plan through their employer.

There's no limit to how much a taxpayer can contribute to a traditional IRA, although they can't claim a deduction for contributions over the annual limit. And workers with high incomes might not be able to claim the full tax deduction limit for their contributions if they're also covered by a workplace retirement plan.

Eligibility breaks down like this in the 2021 tax year:

  • Full deduction: Single filers making less than $66,000 and joint married filers making less than $105,000
  • Partial deduction: Single filers making between $66,000 and $76,000 and joint filers making between $105,000 and $125,000

The deduction is also phased out for anyone who contributes to an IRA and who isn't covered by a workplace retirement plan but is married to someone who is. The phaseout applies if the couple’s income is between $198,000 and $208,000 in 2021.

In addition to the tax deductions available for contributing to a traditional IRA, any gains or earnings on the investments held in the account aren't taxed until the money is withdrawn from the account. Contributions are also finally taxed at this time. This could result in additional tax savings if the investor is in a lower tax bracket in retirement than they were at the time they make contributions.

Roth IRAs: Tax Savings in the Future

A Roth IRA is something like a traditional IRA in reverse. Investors can contribute up to $6,000 into an investment account as of 2021, or $7,000 if they're over 50, but contributions are taxed upfront, unlike with a traditional IRA. The key feature of a Roth IRA is that investment gains can be withdrawn at retirement age completely tax-free.

There are also income limits to investing in a Roth IRA, however. Single filers earning more than $140,000 and joint filers of married returns earning $208,000 or more aren't permitted to contribute to a Roth IRA in 2021. This drops to just $10,000 if you're married and file a separate return.

Which IRA to Choose?

The good news is that you don’t have to choose between a Roth or traditional IRA. There's no rule that says you can't contribute to both.

It can be difficult to predict what your income and tax bracket will be when you retire, so it often makes sense to put money in both types of accounts so you'll see tax advantages either way—up front with a traditional IRA that offers tax deductions, and on the back end with a Roth IRA that provides for tax-free withdrawals.

A traditional IRA might not be necessary if you already have access to a 401(k) or similar plan through your employer. Both of these accounts provide upfront tax deductions.

Get that Last-Minute Deduction

Don't fret if it’s late in the calendar year and you haven’t yet contributed to an IRA. You're permitted to contribute up until April 15 of the ensuing year. It will still count toward the previous year. A contribution made in March 2021 can offer a tax deduction in the 2020 tax year.

Article Sources

  1. IRS. "Income Ranges for Determining IRA Eligibility Change for 2021." Accessed Dec. 18, 2020.

  2. IRS. "New Income Ranges for IRA Eligibility in 2021." Accessed Dec. 18, 2020.

  3. IRS. "Traditional IRAs." Accessed Dec. 18, 2020.

  4. IRS. "Retirement Topics—IRA Contribution Limits." Accessed Dec. 18, 2020.

  5. IRS. "Amount of Roth IRA Contributions That You Can Make for 2021." Accessed Dec. 18, 2020.