With the holidays in the rear-view mirror it's time for consumers to officially begin thinking about doing their taxes. Luckily, most people still have a few more weeks to get into the "tax mood," with W-2s and other income statements not due to reach taxpayers until the end of this month.
Although preparing your taxes is as exciting as going to a dentist appointment, more than 80% of tax filers receive a year-end refund from the Internal Revenue Service. This extra cash in people's pocket can be critical for retailers looking for a post-holiday sales boost and for consumers themselves, many of whom are notoriously bad savers. A tax refund could be the perfect impetus to add to an emergency fund or an investment portfolio.
Good news! You can still make this tax move for 2014
I have especially good news for all taxpayers: there's still a tax move you can make right now -- in fact, all the way up to April 15 -- that you can use in retroactive fashion on your 2014 taxes. This mystery move is none other than opening and/or adding to an individual retirement account.
There are two primary types of IRAs, a traditional IRA and a Roth IRA, and each offers its own advantages and disadvantages.
Traditional IRAs: the good and the bad
Individuals under age 50 can contribute up to $5,500 per year into a traditional IRA and use that contribution as a deduction against their adjusted gross income. A "catch-up" allowance of $1,000 is allowed for people aged 50 and up, thus a $6,500 maximum annual contribution. In other words, if you want a nice tax break for your 2014 filing and also want to contribute to your retirement, a traditional IRA might be the way to go.
Keep in mind that there are also disadvantages to a traditional IRA. For example, when retirees begins to take distributions between age 59.5 and 70.5 they'll owe taxes on the profit they netted. Also, retirees are required to begin taking distributions at age 70.5 or face hefty penalties, and contributions into a traditional IRA must cease in the year the plan owner turns 70. You'll also want to check the IRS' phase-out eligibility requirements. If your modified-adjusted gross income is at or over a certain level, you might be required to contribute a smaller amount to an IRA, or perhaps nothing at all.
Roth IRAs: advantages and disadvantages
Like a traditional IRA, the Roth IRA contribution limits are $5,500 for a person younger than 50 and $6,500 for people aged 50 and up. However, unlike a traditional IRA, contributions to a Roth IRA can grow during the life of the account completely tax-free! Contributions can also be made by account owners beyond their 70th birthday, and no distribution is required to be taken by age 70.5.
The downside to a Roth IRA is that it provides no up-front tax benefits. Instead, the benefits are all at the back end in the form of tax-free capital growth. Therefore, opening or adding money to a Roth IRA before April 15 will not affect your taxable income for your 2014 tax return. Also, as with a traditional IRA, modified adjusted-gross income contribution limits exist for Roth IRAs.
One account will probably net you more money
How do the differences between contributing to a traditional IRA and Roth IRA work out over time? While traditional IRAs are liable to lead to less tax liability or a beefier current-year tax refund, a Roth IRA is more likely to positively impact your wallet over your lifetime due to the effect of time and compounding gains. Using Bankrate's traditional IRA calculator, I entered the following assumptions for a fictitious IRA investor:
- 10% annual average stock market growth
- A current 25% tax rate
- A 15% tax rate upon retirement
- An annual contribution of $5,500 beginning at age 30 and ending at age 65
- Annual income of $50,000 (which is about the national average)
Based on this scenario in which our fictitious investor began with $0, he or she would have made $192,500 in contributions over a 35-year period and netted $1.64 million in total value by age 65. Unfortunately, after taking a full distribution, our retiree would have handed over nearly one-quarter of $1 million in taxes to the IRS in a traditional IRA. If this were a Roth IRA, our retiree would get to keep this extra $246,000!
Consider this food for thought as we head into tax season. It's never too late to start focusing on your retirement -- and if you haven't already, perhaps now is the time.