Looking forward to a big tax refund this year? It's always nice to get money back from Uncle Sam -- plus, if your refund is large enough, it can fund a vacation, a big-ticket item, or your savings.
If you're seeking to maximize your tax refund this tax season, consider opening a traditional Individual Retirement Account (IRA) and funding it. For the 2018 tax year, the maximum contribution is $5,500 for folks under 50 and $6,500 for folks 50 and older. Maximum contributions are going up $500 for the 2019 tax year, too, so the new limits will be $6,000 if you're under 50 and $7,000 if you're 50 and over.
More good news for IRA savers: You can always contribute for the taxable year up to April 15 of the next calendar year. In other words, if additional tax deductions for 2018 would help boost your tax return, you have until April 15, 2019, to contribute to an IRA for 2018. Next year, you'll have until April 15, 2020, to contribute for the 2019 tax year.
Tax season is a real boon for folks whose retirement savings or deductions may be anemic most of the year but who receive bonuses, raises, or holiday gifts toward the end of the year, which can be socked away into a traditional IRA.
If you're covered by a retirement plan at work: the rules
Keep in mind, though, if you are covered by a retirement plan at work, like a 401(k), there are limits not just on what you can contribute, but on what you can deduct from your taxes. "Covered," according to the Internal Revenue Service, means that your employer offers such a plan and that any contributions you made were allocated in the relevant tax year.
If your adjusted gross income (AGI) for the 2018 tax year is over $63,000 as a single filer or over $101,000 if you're married filing jointly, the amount of your IRA contribution that you can deduct will be reduced. If your AGI is more than $73,000 as a single filer or more than $121,000 if you're married filing jointly, you can't deduct your traditional IRA contributions from your taxes at all. (Note that these limits are increasing for the 2019 tax year.)
That doesn't mean you can't contribute to a traditional IRA; it just means the tax deduction is either reduced or not allowed. Any taxable contributions you make will not be taxed when you withdraw them in retirement, but any earnings on them are subject to tax.
IRAs are self-directed accounts, offered by financial institutions like banks and brokerages. Most let you choose from stocks, mutual funds, or exchange-traded funds (ETFs), as well as bonds and money market funds. If you participate in a traditional IRA, your taxable income is lowered by the amount you contribute, assuming you meet the income qualifications. That can save hefty bucks as well as fund your retirement. Let's look more closely at both those benefits.
1. Traditional IRAs lower your taxable income
The beauty of traditional IRAs is that your contributions can lower your taxable income for the year you make them. If you're a single filer with adjusted gross income of $60,000, and you contribute $6,000, you'll end up paying taxes on just $54,000. If you're married filing jointly and making $100,000 and contribute $6,000, you pay taxes on $94,000.
There are two kinds of IRAs, traditional and Roth, and they differ in how they are treated for tax purposes (this article is focused on traditional IRAs). While Roth IRAs can be excellent retirement savings vehicles, contributions to them are not tax-advantaged in the year of contribution. Roth IRA contributions must come out of income that has already been taxed, so they do not provide an up-front tax deduction. However, qualified withdrawals from Roth IRAs are tax-free, so when you retire, you don't have to share a dime of those funds with Uncle Sam.
2. Traditional IRAs are deductible whether you itemize or not
The sheer pre-tax contribution isn't the only tax perk of a traditional IRA, though. IRA contributions are above-the-line tax deductions, which you can claim whether you choose to take the standard deduction or itemize your deductions.
The standard deduction has risen dramatically for 2018, from $6,350 to $12,000 for single filers and from $12,700 to $24,000 for married people filing jointly. It's estimated that the climb means about 95% of American households will choose the standard deduction, up from 70% who chose to do so in past years. However, many specific deductions, such as mortgage and student debt interest, healthcare expenses, and state and local taxes, can only be taken if the taxpayer elects to itemize their deductions and forgo the standard deduction. No matter which route you choose, you can deduct your traditional IRA contributions.
The second benefit of this above-the-line deduction is that it lowers your adjusted gross income (AGI). Lowering your AGI not only reduces your taxable income, but may qualify you for further tax breaks. For example, taxpayers are allowed to deduct qualified healthcare costs exceeding 7.5% of their AGI. If your AGI is $60,000, you'll only be able to deduct healthcare expenses above $4,500. But if you contribute $6,000 to a traditional IRA, you'll be able to deduct expenses exceeding $4,050.
3. IRAs fuel a healthy nest egg for retirement
Hiking your tax return is far from the only benefit offered by a traditional IRA. The money grows over time, compounding tax-free.
You pay taxes on a traditional IRA when you make withdrawals, which can start as early as 59 1/2. Required minimum distributions (RMDs) kick in when you reach 70 1/2, which means the government forces you to take income out of these tax-sheltered accounts so it can reap its tax revenue from your money.
The average person will receive Social Security benefits when they retire, but the average amount for one person is just $1,461 per month in 2019, and the average couple, assuming both receive Social Security, receives just $2,448 per month. Even with the program's cost-of-living adjustments, which periodically raise benefits to keep pace with inflation, Social Security likely won't cover all of your financial needs in retirement.
Thus workers need to save for retirement. The compounding growth and tax advantages help you grow your retirement savings impressively. If you are 30 and save $5,000 in a traditional IRA every year until you hit 65, for example, you will have $930,513 by retirement, assuming an annual average return of 8%.
If you want to grow your tax return as much as possible and fund your retirement to boot, a traditional IRA is a great place to start.
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