Get Uncle Sam to Pay for Your IRA

In tough times, many people have trouble saving enough extra money to make an IRA contribution. But with thousands in tax breaks available to IRA investors, you can't afford to pass up the chance to get free money from the government to support your retirement.

The first thing most people know about IRAs is that they're one of the only ways you can cut your taxes after the end of the year. Because you can make contributions to an IRA up until the April 15 tax deadline and apply them to tax year 2008, an IRA essentially lets you go back in time to reduce your tax liability.

Get paid now
That deduction can be worth a lot. Many taxpayers can get a full deduction up to the $5,000 maximum contribution limit, and if you're age 50 or older, you can contribute an extra $1,000 using what's called a catch-up contribution. If you're in the 35% tax bracket, contributing as much as you can could mean an extra $2,100 in your refund check after you file your tax return.

If you're not earning nearly enough to qualify for that top tax bracket, you might think it's not worth it to make an IRA contribution. But there's another immediate tax benefit that doesn't get nearly as much attention. An additional retirement contribution credit can cut as much as $2,000 off your tax bill, over and above the regular tax reduction your deductible contribution would pay you. This credit is available to couples making up to $53,000 or singles with incomes of $26,500 or less.

Save big later
But the upfront benefits of opening an IRA pale in comparison to the magnitude of the savings you can reap later on. That's because IRAs give you a tax deferral, letting you put off paying any taxes on your gains until after you retire.

That's especially useful if you buy and sell stocks in your IRA over the years. Ordinarily, selling shares to lock in profits can result in a big tax bill thanks to capital gains. But in an IRA, you can just sell and not worry about any tax consequences. Just look how much that could save you if you had invested $6,000 in shares of these winning stocks in an IRA back in 2004 and wanted to take profits now:

Source: Yahoo! Finance. Assumes maximum 15% tax on capital gain outside IRA.

Of course, when you retire and start taking money out of your IRA, you'll owe tax on the withdrawals you make. And it's possible that those withdrawals could end up getting taxed at a higher rate than you'd pay now, if your income goes up over time. (For those who are pretty sure this will be the case, you might consider giving up the upfront deduction and choosing a Roth IRA instead, if you're eligible.)

Yet IRA owners still benefit in a couple of ways:

• Unlike shareholders in taxable accounts, you get to reinvest the full proceeds from your stock sale, including all your profits. The money that would otherwise go to the IRS now instead keeps earning you the same return as the rest of your account, letting compounding do its work over the coming years and decades.
   
• In a taxable account, as soon as you sell, you know you'll owe tax in that year. On the other hand, in an IRA, you get to control when you pay taxes by choosing exactly when and how much you withdraw from your account after you retire. Often, you can manage your withdrawals to minimize your tax liability.

Given how much extra money Uncle Sam wants to pay you to open a retirement account, you can hardly afford to pass it up. Even if you have to struggle to save that little bit extra to contribute to your IRA, you'll find it well worth the effort in the long run.

For more on making the most of IRAs, read about:

• The best stocks for your IRA.
• One tough call that could make you rich.
• The first thing you should do in 2009.