At this time of year, every tax accountant and his software program are screaming reminders at you to make an IRA contribution before April 16.
In particular, they encourage us to contribute to a traditional IRA because that contribution can be deductible. If something is deductible, you won't owe tax on it so it will reduce your overall tax bill. Lower tax bills make you happy and thereby make the accountants look like heroes.
But before you attempt to scrape up money to beef up your traditional IRA, make sure you're even eligible to do so. Unfortunately, if you are covered by a retirement plan at work, you may not be. So let's walk through the rules and determine if you need to start counting the change on the floor of your car.
In the IRA world, your simplest choice is between a traditional IRA and the Roth IRA. While there are many other kinds of IRAs, regardless of how many you have, you only can contribute $2,000 a year to all of them. So if you have a traditional IRA and a Roth, you have to decide where your $2,000 is going.
Depending on the amount of money you earn and whether or not you are covered by a retirement plan at your job, contributions to a traditional IRA may be deductible now. In addition, any earnings generated from those contributions are tax-deferred. That means your tax bill is "deferred" until you withdraw the money in retirement.
On the flip side, contributions to the Roth IRA are never deductible so you must contribute after-tax dollars. The good news is that as long as you leave the account alone for five years and are at least 59 1/2 when you take a withdrawal, you will not pay taxes on any of the money. That means you're getting all the earnings tax-free.
So which should you chose?
Before you answer that question, ask yourself this: Am I covered by a retirement plan, like a 401(k) or pension plan, at my job? If the answer is no, then you need to weigh your options between a traditional IRA and a Roth. If you are covered by a plan at work, then a traditional IRA might not even be an option for you.
No Retirement Plan at Work
You can contribute to a traditional IRA if you or your spouse had taxable compensation during the year and were not age 70 1/2 by the end of the year. You can't make contributions to a traditional IRA in the year you turn 70 1/2 or any year after that.
Compensation mostly is the number reported in box 1 of a
Wages and Tax Statement
, although self-employment income counts as well. Rental income, interest and dividend income are not compensation for IRA purposes.
If you are not covered by a retirement plan at work then you can take a full deduction for your contribution.
The Roth, on the other hand, has income limitations. You can contribute to a Roth IRA as a single person if your adjusted gross income is below $95,000 (contributions are phased out up to $110,000). If you're married filing jointly, your income must be below $150,000 (contributions are phased out up to $160,000). If you're married and filing separately, contributions are phased out between zero and $10,000.
Conventional wisdom used to say that if you expected your tax bracket to be lower in retirement, go with the traditional IRA so that when you start taking withdrawals, you'll pay less tax. If you anticipate being in the same or higher tax bracket in your golden years, then the Roth makes more sense. You're better off paying tax now at a lower rate.
Unfortunately, many people would prefer to get a tax deduction today and don't think long-term, says Maggie Doedtman, manager of tax training at
in Kansas City, Mo. So they automatically go with a traditional IRA, if they qualify.
But it really depends more on how long money will stay in the account, says Doedtman. Younger taxpayers should consider the Roth because of the years of compounding they have ahead of them. Getting those earnings tax-free in retirement may be worth forgoing a tax deduction now with a contribution to a traditional IRA.
If you are covered by a retirement plan at work (that would mean the pension plan box is checked in box 15 of your W-2), then depending on your earnings, your traditional IRA contribution deduction may be limited or disallowed based on the following thresholds.
If you file your tax return as a single person, you can take a full deduction of your IRA contributions as long as your income is less than $32,000. So assuming you contributed $2,000, you can deduct the full $2,000 on your tax return.
Once your income is between $32,000 and $42,000, you only can get a partial deduction. Once compensation is greater than $42,000, you cannot take a deduction for your IRA contribution as a single person.
If you are married filing jointly, you can take a partial deduction between $52,000 and $62,000 but your contribution becomes nondeductible after your joint income is greater than $62,000.
Check out the chart on page 9 of
-- Individual Retirement Arrangements
for the income cut-offs of the other filing statuses.
Does this mean the Roth IRA is your only option?
Let's say you're a single person with an income of $120,000 who is covered by a plan at work. You can't get a deduction for a contribution to a traditional IRA nor can you contribute to the Roth because you have too much income.
Now what? Well, hopefully, you are maxing out your contributions to your work plan. In the case of a 401(k), that means you are socking away the full $10,500 for the year.
If you are still eager to save more money, you can always make nondeductible contributions to a traditional IRA, suggest says Doedtman. That means you are contributing after-tax dollars to an IRA, just like you would to a Roth. The earnings in a nondeductible IRA grow tax-deferred, so, unlike the Roth, you will owe tax on them when you withdraw them in retirement.
It's not an ideal option but at least you're getting some tax-deferred savings.
Granted, you should be saving for retirement. But before you call your broker or mutual fund company and deal with the minutiae of making a contribution to an IRA, make sure you are eligible to do so.
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