One of the cool things about IRAs as a means of saving and investing for your future is that money in your IRA isn’t taxable as long as it stays in your IRA account. Beyond that, how much an IRA will reduce your taxes, and when, depends on what kind of IRA you have, how much you put in each year and how much you earn.
The money you put into a traditional IRA is usually tax-deductible, so the more you contribute, the more you save on taxes. Tax breaks for Roth IRAs work differently, so we’ll talk about them later. You can contribute up to $5,000 a year to either a traditional or a Roth IRA (as of 2012) as long as you earn at least as much as the amount you contribute. The limit goes up to $6,000 when you turn 50. If you’re married and file a joint return, both of you can have traditonal or Roth IRAs and contribute if at least one of you has earned income. This means a married couple can a maximum of $10,000 to $12,000 each year into traditional or Roth IRAs.
When you sit down to do your taxes each year, one of the first things you do is add up all your income. The total is what the IRS calls gross income. What actually gets taxed is your taxable income. Taxable income is what’s left after you subtract all the deductions you can from your gross income. Because traditional IRA contributions are tax-deductible, they reduce your taxable income. Three is one caveat: if you or your spouse is covered by a retirement plan at work and your adjusted gross income exceeds IRS limits, you’ll lose some or all of the tax deduction for traditional IRA contributions.
To figure out how much a traditional IRA will save on taxes, look at your taxable income before you deduct your traditional IRA contribution. The amount will put you into one of six tax brackets. The more you make, the higher the tax rate is. For example, the tax brackets for 2012 were 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and finally 35 percent. The exact amount of taxable income subject to each tax bracket varies depending on your filing status. Once you find your highest tax bracket, called your marginal tax rate, multiply it by the amount of money you contributed to your traditional IRA. That’s how much a traditional IRA reduces your income tax. For instance, suppose you contributed $4,000 and your marginal tax rate is 25 percent. Multiply 25 percent times $4,000 to get $1,000. Those thousand bucks are your traditional IRA tax savings.
About Roth IRAs
Figuring out how much a Roth IRA can save on taxes is a lot simpler than for a traditional IRA. You can’t deduct Roth IRA contributions from your taxes, so there’s nothing to calculate there. As long as money in a Roth IRA stays in the account, it isn’t taxed. Now, when you take money out of a traditional IRA, you have to pay ordinary income taxes on the withdrawals. But for a Roth, as long as you wait until the it is 5 years old and you are 59 1/2 years old, everything you take out is 100 percent exempt from income taxes. You keep it all and the IRS never gets a dime.