The easiest way to lower your tax rate is to become a billionaire, but if that’s not in the cards right now there’s a little trick you might want to try instead: use your IRA to move into a lower tax bracket!
If you have an Individual Retirement Account (an IRA, and as financial professionals we highly recommend that you have an one) you can use it to your advantage to save on this year’s taxes.
The money you put into your IRA is pre-tax, which means anything you put in will effectively lower your yearly income and allow you to legally avoid higher taxes. There are limits to your annual IRA contributions (put in place to prevent completely gaming the system with this move) but as the end of the year closes in, it’s worth doing some quick calculations to see if you can change your 2019 tax bracket.
What is an IRA anyway?
An IRA is an investment tool used to save and grow money for your retirement. There are many different types, but the most common are Traditional and Roth IRAs. The difference between the two is that contributions to Traditional IRAs are tax-deductible while contributions to Roth IRAs are not—the money you take out after retirement isn’t taxable. You don’t have to pay capital gains taxes or income taxes on money you draw from a Roth IRA once you reach retirement age.
You can make up to $6,000 in tax-deductible contributions to your IRA each year. If you’re over the age of 50, that can be up to $7,000 per year. When you file your taxes, you can deduct the amount you put in that year from your taxable income. That means that if you’re within $6,000 (or $7,000 if you’re over 50 years old) of a lower tax bracket, you can contribute just enough to qualify for that lower bracket. Simple, right?
For example, if you’re filing as a single filer and making $40,000 per year, you’re in the 24% tax bracket. If you put $2,100 in your Traditional IRA, your taxable income drops to $37,900, putting you in the 22% tax bracket. That could be hundreds of dollars saved on your taxes owed, and the money placed in that IRA is going to come back to you in the not-too-distant future!
If you’re using tax software to file your taxes, you can plug in different deduction amounts to see how much you can save by contributing to your IRA and decide if it’s worth it to you. You can make IRA contributions that count towards the previous year right up until the April 15 tax deadline. You can even make them after you file.
Know the Rules
You do need to be aware of the rules regarding IRA contributions. If you’re over age seventy and a half, you can no longer contribute to a Traditional IRA. You also need earned income equal to or greater than the amount of your contributions. If you have a 401(k) plan or another retirement account provided by your employer, there may be income-based limits on the tax-deductible amounts you’re allowed to put into an IRA. (If you’re not sure, we can help!)
Married couples can’t own joint IRAs, but each spouse can open their own IRA account. When filing together, you can claim the deductions for each of your contributions—effectively doubling your savings. Even if you or your spouse aren’t working, you can claim the deduction as long as the working spouse’s earned income meets or exceeds the amount of the combined IRA contributions.
What if You Have a Roth IRA?
If you have a Roth IRA, you will not be able to use it to lower your income taxes this year. Contributions toward Roth IRAs aren’t deductible. However, you will save on taxes when it comes time to make your withdrawals. Once the Roth IRA is at least five years old, and you’ve reached the age of fifty-nine and a half, all the money you withdraw from the account is completely exempt from income taxes. When you’re trying to decide whether a Traditional IRA or a Roth IRA makes better financial sense for you, a lot depends on your age and income level. This is a good question to take to your financial advisor.
Maximizing the Benefits of Your IRA
IRAs are designed to help people save money for retirement. As such, the government encourages your investment in these accounts by providing tax breaks, depending on the type of IRA you have. With a Roth IRA, the savings come when you reach retirement age and are able to start taking the money out. With a Traditional IRA you can claim the tax savings right away by making tax-deductible contributions to your account.
An IRA is a win-win situation for you: the more money you put in, the more it will grow and the more you’ll have when you finally retire. If you contribute enough, you can reduce the income taxes you have to pay right now. If you have a Traditional IRA, be sure to make your account contributions before the April tax deadline to take advantage of all of the tax savings available to you.