Why an IRA Deduction Is the Same Thing As Free Money

If you think there's no such thing as a free lunch, then clearly you haven't heard of the IRA deduction. Serving as a legal tax shelter for thousands of dollars in income, it's the closest thing to free money the vast majority of us are ever likely to encounter.

How IRAs work for you
The basics of the deduction work like this: Every year, you're entitled to reduce your taxable income by up to $5,500 so long as you contribute the money to a qualified IRA account -- for those of you who are familiar with this, the current discussion is limited to traditional, as opposed to ROTH, IRAs.

While the underlying purpose of the IRA deduction is to encourage Americans to save for retirement, the benefit you get from doing so is much more immediate. Namely, because it reduces your taxable income, it could effectively decrease you tax liability by more than a thousand dollars.

Here's an example of how this works: Let's assume Robert earns $75,000 in taxable income each year working as a manager of a successful fast-food restaurant. Assuming he doesn't qualify for any other deductions, Robert would end up owing the federal government $14,606 in income taxes.

To see how this is calculated, check out the following table, which breaks down the amounts our hypothetical taxpayer owes under the various tax brackets.

Excluding the impact of nonrelated credits and deductions. Source: Author.

By contrast, now let's assume that Robert contributes $5,500 to a traditional IRA, which is equal to the limit for 2014. By doing so, he reduces his taxable income to $69,500 and thereby drives his income tax liability down to $13,231.

The immediate benefit to Robert, in other words, is a $1,375 cut to his tax bill. Another way to look at this, of course, is that it would add the same amount to your tax refund in the event that your taxes are automatically withheld.

Taking this one step further, if you compare the $1,375 tax savings to the amount set aside -- that is, $5,500 -- then he effectively achieved a single-year return on investment of 25%, or nearly triple the long-run average of the S&P 500 (^GSPC -1.04%).

Now, just to be clear, this isn't a no-strings-attached arrangement. The cost to you is the fact that the money you contribute to an IRA can't be accessed before retirement, absent a stiff penalty.

But is this really such a bad thing?

Let me answer that: no. Saving for retirement will become an increasingly pressing problem for many Americans over the coming decades. Consequently, if you're coerced into doing so by the promise of an immediate tax benefit, I think we can all agree that the net result is a win-win outcome.