Individual retirement accounts come in two basic flavors, each with different features, requirements and tax treatments. You can't actually contribute pre-tax dollars to an IRA, which means your employer will take federal withholding on your contribution. But you may be eligible to get a tax deduction or credit for the amount you contribute. Tax-deductible IRAs are called traditional IRAs, while Roth IRAs do not offer any tax breaks on your contributions. Distributions from traditional IRAs are taxed, but Roth distributions are tax-free, since you already paid tax on the income.
How to Deduct Your Traditional IRA Contribution
Make sure you qualify. You can open a traditional IRA if you either you or your spouse have compensation (income earned from a job or self-employment) and you are not yet age 70 ½ by the end of the year.
Open an IRA with a bank, credit union, mutual fund company, broker or any other financial institution authorized by the IRS to act as a trustee or custodian. It's important to make sure the account is specified as a traditional IRA or your contributions will not be eligible for the tax breaks associated with IRAs.
Contribute to the IRA. Each financial institution has its own method for handling contributions, but generally you can contribute by check or bank transfer. Most institutions have online access to your account for making contributions. Fill in any required forms to specify the contribution is for your IRA. Your trustee handles paperwork that proves that the funds are strictly for your retirement account.
Invest the money. IRS regulations place restrictions on the type of investments you may purchase and on withdrawals (distributions) from the account, but you can move your money among various investments in the same account without having to pay tax on any profits or capital gains. Dividends and interest are reinvested. Your money grows tax-deferred until you take it out after you hit age 70 ½.
Determine how much of your contribution is tax-deductible. If neither you or your spouse is covered by a retirement plan at work, the full amount of your contribution (up to the maximum) is tax-deductible. If one or both of you is covered by an employer's retirement plan, your contribution may be only partially deductible. The amount of the deduction is based on your modified adjusted gross income and filing status. There is a worksheet in IRS Publication 590 (Individual Retirement Arrangements) that will help you calculate the correct amount of the allowable deduction.
Enter the amount you've calculated for your IRA deduction on Form 1040, line 32, when it's time to file your tax return. If you file 1040A, use line 17. For Form 1040NR, it goes on line 32.
Fill in Form 8606 (Nondeductible IRAs) if your full contribution is not taxable. The nondeductible amount will not be subject to tax when you take a distribution, because you have already paid income tax on it, but the deductible portion of your IRA is taxable at distribution.
Items you will need
- Statement from IRA account
- IRS Form 1040, 1040A, or 1040NR
- IRS Publication 590 (Individual Retirement Arrangements)
- Distributions of deductible and nondeductible IRAs are treated differently. Because you did not pay tax on the deductible portion, the distributions on that will be taxed when you withdraw them from the IRA. The nondeductible portion can be withdrawn tax-free.
- You can contribute up to $5,000 per year ($6,000 if over age 50), or your total compensation, whichever is less, even if the full amount is not tax deductible.
- You can make a contribution as late as April 15 and have it count for the previous year. This is a great way to lower your tax bill if you qualify for an IRA deduction and didn't get around to contributing the full amount during the year. Example: If you contribute after Jan. 1, 2012, you can specify that you want the amount credited to the 2011 contribution. Just be careful not to exceed the maximum allowed for a single tax year or you may be subject to a penalty.
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