The Internal Revenue Service considers all income that is not specifically exempted by law from taxation to be taxable income. Your gross income includes all of your income from taxable sources, including your salary or wages, tips, interest and dividends, capital gains and business income. You can reduce your taxable income if you had certain expenses the IRS categorizes as adjustments to income, such as educator expenses, interest on student loans, moving expenses or qualifying contributions to a traditional individual retirement account. Whatever is left after these adjustments is your adjusted gross income.
Traditional vs. Roth
Congress has authorized two types of individual retirement accounts: traditional IRAs and Roth IRAs. While both types offer significant tax benefits, they also have major differences. One of the most striking differences is how contributions are treated. Traditional IRAs are funded with before-tax dollars while Roth IRAs are funded with after-tax dollars. That means you can take a tax deduction for contributions to a traditional IRA, but you can't take a deduction for contributions to a Roth IRA. If you are interested in reducing your current income taxes by contributing to an IRA, you must make those contributions to a traditional IRA. Contributions to a Roth IRA will not reduce your AGI.
Anyone who is under the age of 70 1/2 and has earned income is eligible to open and contribute to a traditional IRA, but not everyone who is eligible to contribute to a traditional IRA can deduct their contributions. The availability of a tax deduction depends on a combination of filing status, income and whether you are covered by a retirement plan at work. If neither you nor your spouse is covered by an employer-sponsored retirement plan, you can take the full deduction. For the 2012 tax year, if either of you are covered by an employer-sponsored retirement plan, the amount of your deduction will be reduced if your AGI is $92,000 or more, or if you are single and your AGI is at least $58,000.
If you meet all of the IRS's requirements for making a fully deductible contribution to your traditional IRA, you can take a dollar-for-dollar reduction in your AGI for your total IRA contribution, up to a maximum of $5,000 for the 2012 tax year. Taxpayers who are 50 years or older can reduce their AGI by up to $6,000 per year.
The IRS allows you to reduce your AGI by making a contribution to your traditional IRA, and all of the money in your IRA grows without incurring a current income tax liability, but the tax-exempt gravy train will not roll forever. You must begin taking withdrawals from your traditional IRA once you reach age 70 1/2, and the IRS considers all traditional IRA withdrawals to be ordinary income in the year you receive them. If you take withdrawals before you reach age 59 1/2, you will have to pay both ordinary income taxes and a 10 percent penalty tax.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.