It's not often that Uncle Sam lends you a helping hand in the form of a tax break, but retirement accounts are one of those rare occasions. The key to ensuring you're financially comfortable in retirement is starting early and taking advantage of time. If you're going to be saving and investing for retirement -- and you absolutely should be -- you might as well get some tax breaks along the way.
Individual retirement accounts (IRAs) are the gifts that keep on giving, and you should make it a point to utilize them throughout your career. Although the maximum annual IRA contribution allowed is relatively small at $6,000 ($7,000 if you're 50 or older), the rewards from the tax breaks can pay off big time.
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Traditional IRA deductions
A traditional IRA works similarly to a 401(k) because contributions are potentially tax-deductible. Whether or not you're able to deduct your contributions depends on three things: your tax filing status, income level, and if you have a retirement plan at work.
Here's how much of your traditional IRA contributions you can deduct if you are covered by a retirement plan at work:
| Tax Filing Status | Income | Deduction Allowed |
|---|---|---|
| Single | $68,000 or less | Full amount up to contribution limit |
| Single | $68,001 to $77,999 | Partial deduction |
| Single | $78,000 or more | No deduction allowed |
| Married, filing jointly | $109,000 or less | Full amount up to contribution limit |
| Married, filing jointly | $109,001 to $128,999 | Partial amount |
| Married, filing jointly | $129,000 or more | No deduction allowed |
| Married, filing separately | Less than $10,000 | Partial deduction |
| Married, filing separately | $10,000 or more | No deduction allowed |
Data source: IRS.
Here's how much of your traditional IRA contributions you can deduct if you are not covered by a retirement plan at work:
| Tax Filing Status | Income | Deduction Allowed |
|---|---|---|
| Single | $68,000 or less | Full amount up to contribution limit |
| Single | $68,001 to $77,999 | Partial amount |
| Single | $78,000 or more | No deduction allowed |
| Married, filing jointly | $109,000 or less | Full amount up to contribution limit |
| Married, filing jointly | $109,001 to $128,999 | Partial amount |
| Married, filing jointly | $129,000 or more | No deduction allowed |
| Married, filing separately | Less than $10,000 | Partial amount |
| Married, filing separately | $10,000 or more | No deduction allowed |
Data source: IRS.
Roth IRA tax break
A Roth IRA differs from a 401(k) and traditional IRA because your tax break is on the back end in retirement. Instead of being able to deduct your Roth IRA contributions, you contribute after-tax money and then get to take tax-free withdrawals in retirement after age 59 1/2.
Imagine that you contribute $6,000 annually to a fund inside a Roth IRA that returns, on average, 10% annually over 25 years. At the end of those 25 years, your investment would be just over $590,000, although you only personally invested $150,000. That means $440,000 of the total is capital gains. The fact that it's in a Roth IRA means all $590,000 would be yours in retirement.
If you made those investments in a regular brokerage account, you'd owe capital gains taxes on the $440,000 in profit. Assuming you're in the 15% capital gains tax bracket (most people are), that's $66,000 owed in taxes.
Deciding between a Roth and traditional IRA
Although you can technically contribute to both a Roth and a traditional IRA, the contribution limit applies to both accounts combined, so there's usually no reason to do so. Which account you go with generally depends on your current tax break versus your expected tax bracket in retirement.
If you're on the younger side and your tax bracket will likely be higher in retirement, you should consider using a Roth IRA. The first reason is that Roth IRAs have income limits, and you may eventually be ineligible to contribute to one someday (although you can use the backdoor Roth IRA method, which involves contributing to a traditional IRA and then converting it to a Roth IRA). The second reason is that it makes sense to pay taxes now when your tax bracket is lower instead of later when it'll likely be higher.
If you're at the height of your career and these are your peak earning years, you should consider contributing to a traditional IRA now (taking the deduction if you're eligible) and then paying income taxes on your withdrawals in retirement. It's all about taking the tax break when it's most valuable.
