Take Control by Using IRAs to Cut Your Taxes

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It’s getting to be that time of the year, when we all have to deal with one of the two great certainties of life.

One of them is taxes…and, well, you know what the other one is! And when it comes to taxes, the wealthy and powerful may have all sorts of tax avoidance options available to them. But for the vast majority of ordinary wage earners, the single most powerful, most versatile weapon they have available to cut their taxes could be the IRA deduction. Even if 2015 is already in the rear view mirror, and you’re feverishly working on your tax return at the last minute, wondering what you can do to cut down on that tax bill…the IRA could be the ace up your sleeve. However, there are a myriad of rules that apply in this situation, so no one should EVER just assume that they are eligible for this tax savings vehicle- it’s more complicated than you might think. Will it work for you?

Find out by using this step-by-step decision tree:

1. First of all, keep in mind that you must have “earned income” to make an IRA contribution. This would include wages, salaries, tips, taxable alimony, and net earnings from a trade or business. It would generally NOT include interest, dividends, pensions, annuities, or capital gains. So IRA deductions are generally associated with people who are still in their working years, as opposed to being retired.

2. Secondly, you must determine whether you are eligible to actually take a deduction for your IRA contribution. This is perhaps the single most misunderstood aspect of IRAs…Many people fail to understand that making an IRA contribution is NOT the same as getting a deduction for it. If you’re not eligible for a deduction, making non-deductible contributions to an IRA is generally a bad idea. In that case it’s generally better to consider contributing to a ROTH IRA instead, which is made with after tax dollars.

3. Whether you’re eligible to take a deduction for your IRA contribution depends on whether you’re an active participant in a retirement plan at work. If you have no retirement plan at work, you get a full deduction for your IRA contribution. But if you are an “active participant” in a retirement plan at work, you have to fall under certain income limits to qualify for an IRA deduction. For this purpose, anyone who is covered by a defined benefit plan, or who made salary deferrals into a 401k plan, would be considered an active participant. Since this would apply to most people, we will assume that the answer to this question is YES.

4. Assuming you are an active participant in a retirement plan at work, then your eligibility for an IRA deduction depends on your modified adjusted gross income (AGI). For married taxpayers filing jointly, if they have modified AGI of $98,000 or less, they qualify for a full deduction for IRA contributions. Modified AGI between $98,000-118,000 means a partial deduction, and modified AGI of over $118,000 means NO deduction. This rule disqualifies a lot of people from being eligible to deduct their IRA contributions. Again, if your modified AGI is over these limits, it’s generally better to contribute to a ROTH IRA instead, on an after tax basis (we’ll talk about this in more detail shortly.) In the case of single taxpayers, they get a full deduction for AGI $61,000 or less, partial deduction for AGI between $61,000-71,000, and no deduction for AGI over $71,000. Again, many single taxpayers are surprised when they discover that this rule disqualifies them from deducting their IRA contribution.

5. Assuming you still qualify for a full IRA deduction after considering the guidelines stated above, then you can deduct up to $5,500 for an IRA contribution for 2015. If you turned 50 or older by the end of 2015, you can deduct an additional $1,000, for a total of $6,500. This one move could instantly save you thousands of dollars in taxes!

6. Better yet, you have until April 15, 2016 to make an IRA contribution for the tax year 2015. As a matter of practicality, if you make any IRA contribution between January 1 and April 15 of 2016, be sure to carefully designate on your check the tax year to which the contribution applies. That’s because any contribution made in that time window could apply to either 2015 or 2016.

7. Unfortunately, many taxpayers—especially married couples—have a modified AGI that is too high to qualify for IRA deductions. In this case, they should consider making ROTH IRA contributions instead, on an after tax basis. There are also income limits for eligibility for ROTH contributions…but these are much higher than the limits for IRA deductions. For 2015,married couples filing jointly are eligible to make ROTH contributions as long as their modified AGI is under $183,000.

8. Even though ROTH contributions are made on an after tax basis, which means they won’t save you tax dollars today, there are still some powerful tax benefits to using a ROTH. Earnings on a ROTH are tax deferred, which means the account will grow much faster than the equivalent earnings from a regular non-qualified investment account. Better yet, once you are retired you can generally take money out of a ROTH account on a tax free basis! This can serve as an important planning tool to control your taxes in retirement.

9. It’s important to keep in mind that an individual is limited to a total of $5,500 in IRA contributions for tax year 2015 ($6,500 if age 50 or over), whether that amount goes into a traditional, or a ROTH IRA. In other words, that amount can be split between a traditional and a ROTH IRA…but you can’t put the full amount in both.

The world is filled with taxes that you can’t do anything to avoid. But for most ordinary wage earners, IRAs represent a unique opportunity. IRAs are one tool that can actually be used by a wide swath of taxpayers to actually take control of their tax situation and make a real difference. So while you’re working on that tax return this year (and maybe cursing Uncle Sam under your breath!), keep in mind that knowing these rules, and applying them to your full advantage to potentially save thousands every single year, can have a huge cumulative impact on your ability to build wealth over the course of your working life. If you have any questions about how these rules could apply to your specific situation, by all means give us a call and let’s talk about it!