Since nobody likes paying taxes, and everybody is interested in having a financially secure retirement, the tax deductions tied to a traditional IRA can be an investor's best friend.
Unlike contributions to a Roth IRA, which are never tax deductible, contributions that are made to traditional IRA account can often be deducted on your tax return, lowering your taxable income and allowing you to sock away thousands of dollars for your golden years.
Creating a game plan
Creating a traditional IRA plan that maximizes your tax savings is one of the best ways to achieve financial success. To develop your plan, the first thing to consider is what your maximum tax-deductible contribution can be each year.
In 2015, the maximum amount of money that can be contributed to a traditional IRA is $5,500, or $6,500 if you're over 50. In both cases, you can't contribute more than your income, so if you're working part-time and earn less than these amounts, you won't be able to deduct anything above what you earn.
There's also another hitch you'll need to consider when determining your tax deductible contribution limit. Namely, the amount of money you can contribute and deduct from your taxable income can be lower than these levels if your employer offers you or your spouse a retirement plan at work, such as a 401(k).
The following table provides the modified adjusted gross income thresholds and tax deductibility in cases where you are covered by a retirement plan at work:
This next table shows you the modified adjusted gross income thresholds and tax deductibility in cases where your spouse is covered by a retirement plan at work, but you aren't:
If you're still not sure what your tax deductible IRA contribution could be this year, it's time for a quick call to your accountant.
If you do end up contributing more to a traditional IRA than is tax deductible, you can withdraw excess contributions, and any income earned on them, from your IRA by the due date of your income tax return. If you don't, you could face a 6% penalty per year for as long as that extra money remains in the traditional IRA -- so don't delay in fixing your mistake.
After determining how much you can contribute to a traditional IRA and still get the deduction, your next step is to create a plan that ensures that amount actually gets contributed.
Investors have until the income tax due date, which for most people is in April, to make traditional IRA contributions; however, waiting until then to make a lump sum contribution could result in a cash flow problem -- especially since life can throw financial curve balls at the worst possible times.
Instead of putting off your contribution until the last moment, spreading out your contributions in equal installments over the course of the year, such as monthly, could be a better plan. By contributing over a specific period of time, or dollar-cost averaging, you eliminate any issues associated with a large lump-sum payment. Also, since markets are unpredictable, dollar-cost averaging your contribution can spread out the risk of investing a lump-sum at a less than advantageous time.
A couple more things
Remember, contributions to a traditional IRA are tax-deferred, not tax free. That means you get the deduction today, but have to pay the piper later. That may or may not be a good thing, depending on your income tax rate in retirement.
If your tax rate in retirement is lower than it is during your working years, then contributing to a traditional IRA can make more sense; however, if your tax rate in retirement is higher than during your working years, you could end up paying out more in taxes in the future than you bargained on.
Investors should also remember that while a traditional IRA can offer investors a big tax deduction, they come with a catch: The IRS will tax withdrawals from a traditional IRA, and investors must begin taking withdrawals from a traditional IRAs no later than age 70.5. Also, because mandatory withdrawals kick in at 70.5, the IRS doesn't allow you to contribute -- or get the tax deduction -- if you're older than that.