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 total into all of your traditional IRA and Roth IRA accounts annually in 2021 and 2022, and $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.
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. These limits are calculated using your modified adjusted gross income (MAGI).
Eligibility for Traditional IRAs break down like this for 2021 and 2022:
Full deduction: Single filers making less than $66,000 and joint married filers making less than $105,000 in 2021; single filers making less than $68,000 and joint married filers making less than $109,000 in 2022.
Partial deduction if covered by work plan: Single filers making between $66,000 and $76,000 and joint filers making between $105,000 and $125,000 in 2021; single filers making between $68,000 and $78,000 and joint married filers making between $109,000 and $129,000 in 2022.
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 ($204,000 to $214,000 in 2022).
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to a traditional IRA, any gains or earnings on the investments held in the account aren't taxed until the money is withdrawn from the account.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 since 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.
Since you're contributing after-tax dollars into a Roth IRA, those contributions are not deductible.
As with traditional IRAs there are income thresholds and limits that determine if and how much money you are able to contribute into a Roth IRA.
Eligibility for Roth IRAs break down like this for 2021 and 2022:
Maximum Contribution: Single filers with MAGI lower than $125,000 in 2021 and $129,000 in 2022 will be able to utilize the entire contribution limit for Roth IRAs. That threshold is earnings less than $198,000 for married filers filing jointly in 2021 and less than $204,000 in 2022.
Limited Contribution: Single filers with MAGI greater than $125,000 but less than $140,000 in 2021 and greater than $129,000 but less than $144,000 in 2022 are allowed limited contributions into Roth IRAs. For married filing jointly in 2021, the MAGI range is greater than $198,000 and less than $208,000 (more than $204,000 and less than $214,000 for 2022). For married filing separately, limited contribution is allowed for MAGI up to $10,000 in both 2021 and 2022.
No Contribution: Single filers with MAGI more than $140,000 in 2021 ($144,000 in 2022) and joint filers of married returns earning $208,000 or more in 2021 ($214,000 or more in 2022) aren't permitted to contribute to a Roth IRA. 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. That means for the 2021 tax contributions can be made until April 18, 2022.
Source: Tim Lemke, The Balance
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For any information regarding taxes, make sure to reach out to a tax professional.