The IRA tax break can put $6,000 into your retirement account, and lower your taxable income by $6,000.
And anyone can take advantage of the IRA tax break, regardless of if you’re self-employed or employed at another company.
Still, many people are not taking advantage of this simple tax break.
And some of the people who are, are being surprised by a huge mistake they are making that is preventing them from taking this tax deduction.
So keep reading to find out how all of this works, how to avoid the mistake many people make, and ultimately knock off $6,000 from your taxable income.
In some of our past posts, we’ve covered things like the SEP IRA and the Solo 401K to help self-employed individuals deduct up to $58,000 from their tax bills.
Those plans, while beneficial, had some rules and regulations attached to them that may not be applicable to everyone.
That’s why today’s post is all about the traditional IRA tax break, which anyone reading this article can take advantage of.
With that being said, let’s discuss the IRA tax break. Let’s run through the basics and get to the fun stuff.
What is an IRA?
An IRA is an individual retirement account that allows individuals to save for retirement on a tax-deferred basis or tax-free basis.
There are two basic types of IRA accounts – a Traditional IRA and a Roth IRA.
Traditional vs Roth IRA
A Traditional IRA is where the contributions you make to your IRA are tax-deferred.
So basically, you are not paying any taxes on the contributions you make until you withdraw them.
For example, if you make $50,000 per year and contribute $5,000 of your income to your IRA, then hypothetically, you would only pay taxes on $45,000 in income.
You would not pay any taxes on the $5,000 you contributed until you withdraw it, which is typically after you are 60-years old to avoid paying early withdrawal penalties.
The Roth IRA, on the other hand, is taxed differently than a Traditional IRA.
With a Roth IRA, you make contributions with money you’ve already paid taxes on.
So let’s say you make $50,000, and after-tax your net income is $40,000. Then, you put $5,000 into a Roth IRA.
Well, that $5,000 would not lower your tax bill when you file your taxes.
However, on the flip side, you would not pay taxes on this amount when you withdraw them at a later date.
While the Roth IRA has some other pros, we are going to focus on the Traditional IRA and how you can take advantage of the associated tax break successfully.
How the Traditional IRA Tax Break Work
According to the IRS, the maximum contribution you can make to an IRA account is $6,000 per year, or $7,000 if you are aged 50 or older.
If this is contributed to a Traditional IRA, then this would typically mean that you would deduct this amount from your taxable income when you file your tax return.
So basically, if you contribute $1,000, you would be able to deduct $1,000 from your taxable income.
Or if you contribute $5,000, you would deduct $5,000 from your taxable income.
You are essentially funding your retirement and reaping tax savings at the same time.
The #1 Traditional IRA Tax Break Mistake
But there is a big mistake that trips up many people when trying to claim the deduction.
This mistake can be summarized by not understanding the IRA deduction limits.
A lot of people do not know this but your deduction can be limited if you meet certain criteria.
The first criteria is if you are covered by a retirement plan at work.
The IRS specifically says that your deduction may be limited if you are covered by a retirement plan at work, and your income exceeds certain levels.
We’ll discuss those income levels in a second, but basically, if you or your spouse is employed by a company that offers a retirement plan, your deduction may be limited.
If you or your spouse’s employer contributes to a profit-sharing, 401k, stock bonuses, or any IRA-based plan, then you are considered covered.
This means that your deduction may be limited if your income surpasses a certain amount.
So let’s take a look at those income limits.
Here are the 2021 income limits.
As you can see, your deduction is “phased-out” once you start earning over a certain amount of money.
Remember, these phase-outs only apply if you or your spouse is covered by a retirement plan at work.
So let’s say you’re single and your employer contributes to your 401k.
If your income is less than $66,000, then you can enjoy the tax benefits of your 401K and your Traditional IRA.
But if your income exceeds $66,000, but is less than $76,000, then you will only receive a partial deduction for your IRA contribution.
And if you make more than $76,000 as a single taxpayer, then you will receive no tax deduction.
The same applies to married taxpayers.
If you are married filing jointly and your joint income exceeds $198,000, but is less than $208,000, you can only take a partial deduction of your contribution to your IRA.
And if your joint income is above $208,000, then you can forget it – you won’t be able to take any deduction for contributing to your IRA account.
If you aren’t able to get the tax deduction for your contribution to an IRA, then you’re basically locking up your money without the tax benefits.
Sure, your money will grow and you will not be taxed on the earnings you accumulate in your account, but missing the deductions for contributions is a big blow.
So again, if you or your spouse is not covered by a retirement plan, then there is no income limit. You can take the full deduction.
If you are covered by a retirement plan, then you need to look closely at the income limits by the IRS.
We would hate for you to think you are getting a tax deduction and put your hard-earned money into an account that has limited tax-saving potential.
And the last thing we’d suggest is to make sure you understand the deadline to make contributions to your IRA account.
Typically, you need to have made contributions to your IRA account before the tax deadline for the year you are filing your taxes for.
This is actually good because it allows you to make contributions into your IRA after the close of the year.
For example, assuming the tax deadline to file your 2021 tax return is April 15th of 2022…
…then you could go the entire year of 2021 without making any contributions and still take advantage of the deduction so long as you contribute by April 15th of the following year.
Check out our post about tax season 2021 to learn more about these deadlines.
So there you have it, you can pay less taxes by contributing to your retirement through a Traditional IRA.
Just make sure you understand your coverage through other employers you might work for, even if you are the employer.
And if you need more advice for your specific financial needs, talk to one of our CPA tax experts today!
Contact us at 470-240-1437 to schedule a meeting.