Saving for retirement is important for your long-term financial security, and IRAs are one of the best ways to save for retirement in a tax-favored way. IRAs can help you save on your taxes in many different ways, but it's important to know the rules that cover IRAs so that you can make the most of the opportunity they offer. Below, you'll find essential information on IRAs and how they can affect your taxes.
The deadline for making an IRA contribution is the same as the tax-filing deadline for that year. Therefore, if you want to make a 2015 contribution, you still can as long as you do so before April 18. For the 2016 tax year, you'll have until April 2017 to make a contribution.
Regardless of whether you're making a contribution for the 2015 or 2016 tax year, the contribution limits are the same: $5,500 if you're under age 50, or $6,500 if you're 50 or older. As you'll see below, though, some additional restrictions can apply in some situations.
Limits on traditional IRA deductibility
If neither you nor a spouse has access to a 401(k) or similar workplace plan, then you can deduct your traditional IRA contributions in full. If you do have a 401(k) plan, however, there are income limits for deductions, as you can see below.
If you don't have a 401(k) but your spouse does, then higher limits apply. Joint filers get a full deduction with income up to $183,000, and it phases out between $183,000 and $193,000.
Limits on contributing to a Roth IRA
In addition, those with incomes above certain limits aren't allowed to contribute to Roth IRAs. The limits differ based on filing status, as you can see below.
Note that the limits for single and joint filers are $1,000 higher for 2016 than they were for the 2015 chart shown above.
How to pick between a traditional and Roth IRA
Many taxpayers have a choice between either contributing to a traditional or a Roth IRA. It can be tough to figure out how to pick between the two, but knowing how each works can help make the choice easier.
Traditional IRAs give you an upfront tax deduction. The higher your tax bracket, the greater your upfront savings. However, when you take money out of a traditional IRA, you have to pay taxes on it as ordinary income. Therefore, the higher your tax bracket will be in retirement, the more you'll end up paying in taxes when you make withdrawals from your traditional IRA.
By contrast, a Roth IRA doesn't give you any tax deduction when you contribute to it. Therefore, the lower your tax bracket, the less you're giving up in tax savings by choosing the Roth instead of a traditional IRA. The trade-off is that you don't have to pay taxes on Roth IRA withdrawals in retirement. The higher your tax bracket in retirement will be, the greater the savings from having used a Roth instead of a traditional IRA with its taxable distributions.
Early withdrawal penalties
Taking money out of an IRA before you reach 59 1/2 can have consequences. If you don't qualify for an exception, then early withdrawals are subject to a 10% penalty.
There are several exceptions that let you avoid the penalty, however. Money used to pay qualifying expenses for higher education aren't subject to the penalty, and up to $10,000 toward a first-time home purchase is also eligible. Those who become disabled can make withdrawals, and if you need to pay medical expenses that exceed 10% of your adjusted gross income, then you take out IRA money to do so without penalty. Finally, setting up a series of substantially equal periodic payments lets you get out of the penalty.
Bear in mind that none of these methods prevents you from paying tax on traditional IRA withdrawals. It only avoids the 10% penalty.
IRAs can be a great way to save on your taxes. By knowing what you need to know about how IRAs are taxed, you'll be in a better position to take maximum advantage of them for your tax situation.