Contributions to individual retirement accounts (IRAs) fall into two main categories: tax-deferred contributions and after-tax contributions. Tax-deferred contributions, which include both pretax contributions and tax-deductible contributions, give you a tax break when you contribute, while after-tax contributions reward you when you take distributions in retirement.
True pretax contributions can only be made to simplified employee pension IRAs and savings incentive match plans for employee IRAs, both of which are employer-sponsored retirement plans. With a SEP-IRA, your employer's contributions are made with pretax dollars because they aren't included on your W-2 as income at the end of the year. With a SIMPLE IRA, both your contributions — made by taking money out of your paycheck — and your employer's matching contributions are pretax, because neither is included as income.
Tax-Deductible IRA Contributions
Tax-deductible IRA contributions, which refers to contributions you get to write off on your income taxes, are made to traditional IRAs. Essentially, as long as you qualify to deduct your traditional IRA contributions, the end result is the same because the deduction deducts the amount of the contribution from your taxable income. However, if you or your spouse participate in an employer-sponsored plan, you might not qualify. See, when you're covered, the IRS doesn't let you write off your contributions if your modified adjusted gross income exceeds the limits for your filing status.
Roth IRAs accept after-tax contributions because you're never allowed to take a deduction for putting money in. Instead, you always get those contributions out tax-free. Plus, when you can take qualified distributions, the earnings come out tax-free as well. To do so, you need to be at least 59 1/2, permanently disabled, taking out up to $10,000 for a first home, or taking distributions as a beneficiary, and the Roth IRA has to be at least five years old.
If you have a choice between making a tax-deferred contribution or an after-tax contribution, the biggest factor is whether you think you will pay a higher tax rate when you're taking distributions or when you're making the contributions. If you think you're paying a higher rate now, the tax-deferred route is usually best because the deduction will save you more than the tax-free distributions. But, if you're not earning much and paying a low tax rate, the Roth IRA is the way to go because you avoid paying taxes in retirement when your rate will be higher.
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