Why save for retirement with IRAs? For the tax advantages, of course! Roth IRAs let you invest post-tax money and then withdraw it in retirement tax-free. Traditional IRAs, meanwhile, tax your withdrawals in retirement at your ordinary income rate. The appeal of the traditional IRA, though, is the IRA deduction.
How the IRA deduction works
Here's what's so appealing about the traditional IRA, in a simplified example. First off, know that the total IRA contribution limit for 2014 is $5,500, plus an extra $1,000 for those aged 50 and up. So let's say you earn $50,000, which would ordinarily be taxable. If you contribute $5,000 to a traditional IRA, your taxable income drops to $45,000. Let's say you're single and in the 25% tax bracket. The $5,000 that's removed from your income and will thus not be taxed at 25%, so you'll avoid paying $1,250 for the current tax year. That's a significant chunk of change that can improve your financial condition. While the Roth IRA gives you a tax break in the future, the traditional IRA gives it to you up front.
But wait! There's a catch
Of course, few things are as simple as they appear. The Roth IRA has income limits that keep high earners from taking maximum advantage of it. The traditional IRA doesn't have an income cap, but it does restrict deductions.
Here are some rules about how your deduction may be limited:
- If you (and your spouse, if you have one) are not covered by a retirement plan at work (such as a 401(k)), then you're allowed a full deduction.
- If you (or your spouse) are covered by a workplace retirement plan, your allowable deduction may be reduced, depending on your income level and your filing status. My colleague Dan Caplinger explained the details concisely in a recent article on how you can miss out on the IRA deduction:
If your work offers a retirement plan, then you'll get a full IRA deduction only if your modified adjusted gross income for 2014 is less than $60,000 as a single filer or $96,000 as joint filers. If your income is $60,000-$70,000 for singles or $96,000-$116,000 for joint filers, you'll be eligible for a partial deduction. At income levels above $70,000 for singles and $116,000 for joint filers, no IRA deduction is available.
Things get more complicated for married taxpayers whose spouses have retirement-plan coverage. Joint filers with modified adjusted gross income of less than $181,000 can take full IRA deductions for the spouse who isn't covered by a workplace retirement plan. From $181,000 to $191,000, a partial IRA deduction applies, and above $191,000, no deduction is available.
The big picture
These deduction limits end up creating the possibility to have some traditional IRA assets that are deductible and some that are not. This is rarely advisable, though, as nondeductible money in a traditional IRA enjoys no current tax-deferral. Also, while you can withdraw those nondeductible contributions tax-free in retirement (because they were not deducted and therefore didn't avoid taxation), you still get taxed on their earnings. The better alternative to that is the Roth IRA (if you're within its income limits for contributions), where the contributions and their earnings can be withdrawn tax-free in retirement. You might also contribute the non-deductible sum to a 401(k) plan at work, where it will enjoy traditional-IRA-like treatment, being deducted from your income, enjoying tax-deferred growth, and getting taxed in retirement.
There's more to learn about IRAs and retirement planning. Take some time to get savvier, and you can end up making your retirement much more comfortable.