How Much Will an IRA Reduce My Taxes?

How Much Will an IRA Reduce My Taxes?

How Much Will an IRA Reduce My Taxes?

An individual retirement arrangement is a type of account you can open to save for retirement. One of the advantages of an IRA is the IRA tax break that allows you to defer paying taxes on money you put into the IRA until you withdraw it, rather than paying taxes when you earn it. A special type of IRA called a Roth IRA allows you to pay taxes on the money as usual when you earn it but not pay tax on investment income from when the money is in the account.

Tip

How much you can save on taxes with an IRA depends on your tax brackets when you make deductible IRA contributions and make withdrawals, as well as how much you put into the account. If you withdraw money early from your IRA, you may owe a tax penalty that can limit your total earnings or even effectively erase those IRA tax benefits.

Understanding Deductible IRA Contributions

You can open an IRA at many banks, credit unions, brokerages and other financial institutions. Each year you're allowed to contribute a certain amount of money, usually $5,500 if you're under 50 years old and $6,500 otherwise, and you can deduct that contribution from your taxes that year. You can't contribute more than you earned in a particular year, even if you have the money in other savings.

Once the money is in the account, you can invest it in whatever is offered through the account, including stocks, bonds, mutual funds and other typical investments. Shop around for an IRA provider that offers the types of investments you want at prices you want and that provides the level of customer service you need. You can open multiple IRAs with different providers, but your total annual contribution limit doesn't increase and is a cap on the total amount you can place in all your IRAs.

Retirement accounts such as 401(k) and 403(b) plans offered through workplaces are treated separately, as are SEP IRAs and SIMPLE IRAs, which are special types of IRAs set up through employers.

IRA Withdrawals and Taxes

When you withdraw money from an IRA after retirement age, you pay taxes on the withdrawal amount as if it were income for that year. If your tax bracket stays the same or decreases between when you put money into the account and when you take it out, you will have essentially made money off the arrangement. This is common since many people naturally earn less money after retiring than they earn while working. You may want to time your IRA withdrawals to minimize tax, though after you turn 70 ½, you must start taking money out of your account or face a tax penalty.

Early Withdrawal Penalties

If you take money out of your IRA before the retirement age of 59 ½, you will also face a tax penalty, generally 10 percent, in addition to having to pay your ordinary income tax rate on the money you withdraw.

In some special circumstances, you can withdraw money from your IRA early without paying a penalty. If you are a member of the military reserves or the National Guard and you're called for active military duty, you can take withdrawals without penalty in certain circumstances. Anyone can also withdraw up to $10,000 without penalty to aid in the purchase of a first home. Certain educational expenses may be paid from IRA funds without penalty.

You can generally withdraw funds without penalty to pay for your health insurance while you're unemployed or to pay certain medical expenses above a certain percentage of your income, usually 7.5 percent of your adjusted gross income. You also won't face a penalty if the IRS seizes or levies your IRA for back taxes. File IRS Form 5329 if you owe a penalty for an early IRA withdrawal.

About Roth IRAs

There is a special type of IRA called a Roth IRA that functions a bit differently from a traditional IRA. With a Roth IRA, you pay taxes as normal on money you earn and put into the account. You don't pay tax when you withdraw money from the account, including any investment earnings while the money was in the account. This can be a good alternative to a traditional IRA if you expect you will be in a high tax bracket when you retire since you will effectively get the tax savings then rather than when you put the money into the account. You may want to consult with a financial adviser to decide whether a Roth IRA, a traditional IRA or a combination of both is the best deal for you.

Your $5,500 or $6,500 contribution limit includes all IRA accounts, including both Roth and traditional IRAs. There are Roth versions of 401(k) and 403(b) accounts as well that are offered through certain employers. They work similarly to Roth IRAs. Consult your employer or plan manager to see what's available.

About IRA Rollovers

You can transfer money from one IRA to another or from an employer plan, like a 401(k) or 403(b), to an IRA under certain circumstances without any kind of tax penalty. This is called a rollover. Generally, you can only roll over an employer plan after you leave that job, though you may do so at any period afterward.

A rollover doesn't grant you any new tax savings, but it can be advantageous if you can get better investments or pay fewer fees or if you simply want to consolidate your accounts at one provider. IRAs often offer more opportunities than employer-sponsored retirement plans, so this can be an incentive to roll over funds.

When you are doing a rollover, you need to make sure you handle it properly to avoid facing a tax penalty or temporarily having to pay withholding tax on the funds you transfer. Generally, you'll want to work with the financial institutions holding the two accounts so they can directly transfer the money from one to the other. You will often (but not always) have to cash out investments in one account and then transfer the cash to the other account.

If you take possession of the assets for more than a certain amount of time, generally 60 days, you may face a tax penalty unless you can prove there were extenuating circumstances. Usually, the financial institution must also withhold 20 percent of the amount rolled over if it is sent directly to you rather than another account. You must then make up the difference from other savings or face a tax penalty.

You can generally make only one tax-free rollover from an IRA within a one-year period, and if you roll money into an IRA, you can't make a rollover out of that account for another year without paying a tax penalty.

Required Minimum Distributions

Once you turn 70 ½, you must begin to withdraw money from your IRA accounts. This is known as a required minimum distribution. Consult IRS tables to determine your minimum distribution each year based on your age and account balance. If you don't take the distributions, you can be subject to hefty tax penalties of up to 50 percent of the amount improperly left in your account. Special rules apply if you inherit an IRA from someone who passes away. Make sure you understand these if the circumstance arises.

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About the Author

Steven Melendez is an independent journalist with a background in technology and business.. He has written for a variety of business publications and was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism