It’s always smart to consider investing in a tax-advantaged account, such as an individual retirement account (IRA) or a 401(k), when you're saving for retirement. These accounts allow you to reduce the taxes you'll pay on your income, and to increase the amount you'll 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. An IRA is a great vehicle for retirement savings, because it allows an individual to invest in almost any security in a tax-advantaged way.
Traditional IRAs: Tax Savings Upfront
You can contribute up to $6,000 into a traditional IRA investment account annually as of tax year 2021 or $7,000 if you're 50 or older. Your contributions can be deducted from your taxable income, so you 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 were to drop them into a lower tax bracket.
Anyone who can report earned income can contribute to a traditional IRA. It's an especially useful option for workers who don’t have a 401(k) plan through their employer.
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 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to a traditional IRA, any gains or earnings on the investments held in the account aren't taxed until the money is withdrawn from the account.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 that 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 made 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 consist of after-tax dollars, unlike with a traditional IRA. The key feature of a Roth IRA is that investment gains can be withdrawn in retirement 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, but the contribution limits apply to them collectively, not individually.
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—upfront 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 Tax Day of the following year. It will still count toward the previous year.
Because the tax filing deadline was extended for all personal returns to May 17, 2021, a contribution made on May 15, 2021, can offer a tax deduction in the 2020 tax year.
Taxpayers in Oklahoma, Louisiana, and Texas have until June 15, 2021, to make 2020 contributions, because the tax filing deadline has been extended for them in response to the 2021 severe winter storms.