You can deduct money from your taxable income if you invest in a traditional IRA. There are basically two types of Individual Retirement Accounts, and both are tax-favored savings vehicles. The only difference is when you get that tax savings: when you contribute or when you take the money out to use it during retirement.
Types of IRAs
There used to be only one type of IRA, which was nice and simple for investors who wanted to set up their own retirement savings account and save on taxes at the same time. You could put up to a certain amount of money in each year, and that amount was hacked out of your taxable income when you went to do your taxes. So, let’s say you contributed $1000 to your IRA back in 1991 (the other type of IRA didn’t come into existence until 1997). Come time to do your federal income taxes, you deducted that much from your taxable income. Pretty good, eh?
Then along came the Roth IRA to make us forever forgetting which IRA was which…the one is tax deductible now and the other is tax deductible later. Well the Roth IRA contributions are not tax deductible. But when you start withdrawing money during retirement, you won’t have to pay taxes on it, either.
The original IRA, which is now called the Traditional IRA, is actually tax deductible. If you are likely to be facing a large tax bill this year, then a traditional IRA is one way to reduce it. Worry about retirement withdrawals and taxes later. Some people think, well …
I’ll be poorer once I retire so that will put me in a lower tax bracket, so better to pay taxes on my IRA then than now when I’m making lots of money.
Which is Better: Tax Deduction for Roth or Traditional IRA?
The contributions you make to your Roth IRA can be withdrawn at any time. The distributions (when you take money after age 59 1/2) will not be added to your Adjusted Gross Income. That’s because of the already noted fact that you don’t pay taxes on distributions or withdrawals. But that also has significance because for every little bit that’s added to your AGI you are in danger of being pushed into a higher tax bracket. If that happens, your IRA distributions will be affecting the way your other income is taxed, too: higher.
You can use money from your ROTH IRA to fund your new home, up to $10,000. That means you are using $10,000 of tax-free money to buy a home.
SEP IRA Tax Deduction
If you are self-employed, you may be participating in a SEP IRA. That’s a traditional IRA for business owners. It behaves just like a traditional IRA that your would set up for yourself but in this case your company sets it up and contributes on your behalf. The company gets a nice IRA tax deduction. You as an individual may contribute as well. You can deduct the contributions you make, too. If you are the company, then it’s a win-win situation. More on the SEP IRA tax deduction here on the IRS website.
The IRA Tax Deduction Limits
You can only deduct a certain amount of money off your AGI for contributions to your traditional IRA. There is a limit on how much you can actually contribute, too, right now it’s hovering around $5000. That’s the maximum you can take for the IRA tax deduction.