Learn about traditional IRAs because of their tax advantages

Part 2 of “Saving for Retirement”

What is an IRA?

An IRA is another form of a tax-deferred retirement savings account. Money goes in and accumulates without paying taxes. It is not until distributions or withdrawals are made that taxes are paid. In some situations, the contribution may be tax-deductible. Learning about traditional IRAs because of their tax advantages may help you save money in the long-run.

Note: The information below pertains to a traditional IRA only and it does not cover other IRA’s such as a Simple IRA or Roth IRA. We are only providing the basics of the traditional IRA in this post.

Contributions

For the 2021 tax year the contribution limit is $6,000 with those age 50 and older eligible for $1,000 additional as a catch-up contribution. If your taxable compensation is less than $6,000, then that number would be your limit for the year. For married-filing-jointly individuals, the spouse is able to make a contribution even though he or she may not have any taxable compensation for the year. The contribution limit for the spouse is figured by subtracting any IRA contributions made from taxable compensation or if less, $6,000. So, if $50,000 was made by one individual and the maximum $6,000 was contributed to that individual’s IRA, the spousal limit would still be $6,000 (or $7,000 if age 50 or older).

There are some important things to know about making contributions:

• Contributions can be made on behalf of another individual as long as that individual had taxable compensation for the year (such as a grandparent make an IRA contribution for their high school aged grandchild who had a summer job with taxable income)
• Each individual must have his or her own IRA account. This means that a married couple would have two accounts, one for each individual.
• Any contributions made in excess of the yearly limit are charged a 6% per year interest penalty unless the excess contribution AND gain on its investment is withdrawn by the tax return deadline.
• Contributions for the year can be made all the way up to the tax filing deadline the following year. So for the 2021 tax year, contributions could be made until April 15^th, 2022.
• You can file your taxes and declare a contribution before actually depositing the money. The money still needs to be deposited by the tax deadline. (eg. You file your taxes in February 2021 and say $5,000 was contributed for the 2021 tax year, but you wait until March to actually deposit the money into the IRA account.)

Tax Deduction Guidelines

IRA contributions may be tax deductible. The limit is generally the contribution limit, but individuals covered by a retirement plan through their work are subject to a phaseout based on modified adjusted gross income (AGI). Below are two tables from the IRS showing the 2021 limit for individuals covered by a retirement plan and spouses of individuals covered by a retirement plan at work.

Source: IRS.gov Publication 590-A

Source: IRS.gov Publication 590-A

Distribution Requirements

Distributions made from an IRA are considered taxable income. In general, distributions cannot be made until after age 59^1/2. Minimum distributions are required starting at the beginning of April after you have turned 72. If a distribution is made before age 59^1/2 it is generally subject to a 10% penalty tax in addition the taxable income rate. There are certain exceptions to the tax penalty, such as financial hardship but it is best to check with your accountant if you are considering making an early withdrawal.

Required minimum distributions are somewhat complicated to calculate and are beyond the scope of this article, but detailed information can be found in Publication 590-B on the IRS website.

Tax Advantages to a traditional IRA vs. taxable brokerage account

Since IRA contributions are limited in cases where an individual is covered by a retirement-plan through work, it is often advantageous to maximize the tax benefits of a 401k or other employer sponsored plan before contributing to a traditional IRA. However, if you are already contributing the maximum to an employer-sponsored plan or do not have an employer-sponsored plan, then it is important to consider the tax advantages of contributing to a traditional IRA.

To do this, we’ll consider an example of a single 40-year-old individual making $50,000 taxable income per year, without an employer-sponsored plan and solely considering the tax implications of a $3,000 yearly contribution to a traditional IRA or a taxable brokerage account. According to 2021 income tax brackets, this individual would fall into the 22% income-tax bracket. This means that $11,000 would be owed in taxes for the 2021 tax year. A $3,000 contribution to a taxable brokerage account would not change this amount at all. However, a $3,000 contribution to a traditional IRA would qualify as a tax deduction, resulting in taxable income of $47,000. The tax liability for the 2021 year would be reduced to $10,340, a savings of $660 dollars.

This is obviously a very simple example, but you can see, that there are real advantages to considering contributing to a traditional IRA.  Because of the potential complexity of tax planning, talking to an accountant can be advantageous, in order to maximize tax savings.

Next month, we’ll consider ROTH IRAs and how they differ from traditional IRAs.

References

1.     IRS Publication 590-A. Available at https://www.irs.gov/pub/irs-pdf/p590a.pdf

2.     IRS Publication 590-B. Available at https://www.irs.gov/pub/irs-pdf/p590b.pdf