IRA Tax Deductions: A Primer

Mon Jun 15 2020

If you contribute to a retirement account, you may qualify for extra tax deductions. A tax-deferred retirement account grows money without creating annual tax bills for interest or capital gains.

Combined with your homeowner tax deductions, these can reduce your tax liability and help you save for retirement faster.

But not every tax-deferred account gets you a tax deduction in the year you make the contribution. There are three main types of tax-deferred retirement accounts: employer-sponsored plans like a 401(k), traditional IRAs, and Roth IRAs. Of these three, only contributions to a traditional 401(k) and traditional IRA are tax deductible.

Let’s start with IRAs to get a better understanding of what is deductible and what isn’t.

Note: This is meant to be educational only. For retirement advice, please seek professional guidance.

IRA Tax Deductions: A Tale of Two IRAs

Once upon a time, there was only one type of IRA: the traditional IRA. It allows you to make a contribution and reduce your annual income dollar for dollar by the amount you contribute. Then came the Taxpayer Relief Act of 1997 that aimed to send a large flow of tax dollars into the system by giving people an option of how they established their IRA. The Roth IRA was born.

In short:

  • A traditional IRA is a tax-deductible IRA whose contributions grow tax-deferred.
  • A Roth IRA is a non-deductible IRA whose contributions grow tax-free.

Either of these can be a “contributory” or “rollover” IRA. What that means:

  • A contributory IRA is an account opened to make annual contributions to it.
  • A rollover IRA is opened and funded by a 401k or another IRA.

A full contribution for 2020 is $6,000. Those who are over the age of 50 can contribute an extra $1,000 to IRA accounts for a total contribution of $7,000.

You must meet income eligibility requirements to make a full contribution and to be able to deduct some or all of it.

Understanding IRA Tax Deferrals

Think of both IRAs as a box. Any money that sits inside the box is sheltered from taxes and the tax-deferred. That means that you can grow $10 to $10,000,000, and as long as it’s in the box, you don’t pay taxes on the interest your account generates.

How money goes in and out of the box determines your tax deduction or liability now and later.

Whereas the traditional IRA (in most cases) allows you to deduct contributions for the year, the Roth IRA doesn’t – those contributions are taxed upfront.

The IRS also handles money coming out of IRAs differently. Because you got a tax deduction on the traditional IRA contributions, you’ll have to pay taxes on it when you retire.

By contrast, if you didn’t deduct contributions (and therefore paid taxes) for Roth IRA contributions, you can take as much of it out as you want without paying additional taxes.

Pro tip: What you have in the box is up to you. The IRS allows a lot of investment options as long as the custodian is properly record keeping. These options include savings accounts, stocks, mutual funds, and even gold bullion.

Taxes on Traditional IRAs and Roth IRAs: An Example

Say that you invest $6,000 a year starting when you are 35 years old into a traditional IRA. First, you take $6,000 off of your annual income when you file your taxes. Then assume that your account averages six percent of interest each year.

According to this IRA calculator, when you retire at 65, your account would be valued at $524,000 – and you saved $122,771 total in taxes.

If you then take $100,000 out of the traditional IRA, you add $100,000 to your income. According to the 2020 tax brackets, that’s a 24 percent tax bracket for a single person. If your only other income was Social Security, you will have to pay taxes on the distribution and some on your Social Security.

That same $100,000 coming out of a Roth IRA would not increase your taxable income one penny.

That’s the real draw of a Roth IRA.

IRA Contribution & Deduction Limits

The tables below give you an idea of whether you can make a contribution to an IRA and whether that contribution is deductible. The limits depend on whether you (or your spouse) have an employer contribution plan, how much money you make, and the type of IRA you want to contribute to.

Roth IRA Contribution Limits

Filing Status Modified Adjusted Gross Income Contribution Limits
Married Filing Jointly <$196,000 Up to the limit
≥$196,000 but <$206,000 A reduced amount
≥$206,000 Zero
Married Filing Separately <$10,000 A reduced amount
≥$10,000 Zero
Single or Head of Household <$124,000 Up to the limit
≥$124,000 but <$139,000 A reduced amount
≥$139,000 Zero

Source: IRS

Traditional IRA Contribution Requirements and Deductions (with Work Retirement Plan)

Filing Status Modified Adjusted Gross Income IRA Deduction Limit
Married Filing Jointly ≥$104,000 Full deduction
>$104,000 but <$124,000 Partial deduction
≥$124,000 No deduction
Married Filing Separately <$10,000 Partial deduction
≥$10,000 No deduction
Single or Head of Household ≥$65,000 Full deduction
>$65,000 but <$75,000 Partial deduction
≥$75,000 No deduction

Source: IRS

Traditional IRA Contribution Requirements and Deductions (with No Work Retirement Plan)

Filing Status Modified Adjusted Gross Income IRA Deduction Limit
Married Filing Jointly (Spouse Covered by Plan) <$196,000 Full deduction
≥$196,000 but <$206,000 Partial deduction
≥$206,000 No deduction
Married Filing Jointly (Neither Covered by Plan) Any amount Full deduction
Married Filing Separately <$10,000 Partial deduction
≥$10,000 No deduction
Single or Head of Household Any amount Full deduction

Source: IRS

If you’re in a higher income tax bracket, chances are you will have some limitations on whether you can contribute to a Roth or take the full deduction. For those who can’t deduct the contribution to an IRA, you can still contribute to it so the money grows tax-deferred. The good news is that the non-deductible traditional IRA contributions are not going to be taxed when you pull them out – only the growth is taxed upon withdrawal.

It’s also worth noting that anyone can convert a traditional IRA into a Roth IRA regardless of their income. A conversion takes the value of the traditional IRA, pays the taxes on it, and restructures it as a Roth. This means even if you aren’t eligible for the Roth contribution based on income limitations, you can convert your traditional IRA.

401(k) Deduction Limits

The other main tax-deferred retirement plan is an employer sponsored plan such as a 401(k).

When you have an employer-sponsored play such as a 401(k), you don’t need to worry about the reporting since the plan will deduct relevant to the tax election. All 401(k) plans prior to 2006 were traditional, meaning the contributions were deducted from your paycheck prior to taxes, growing tax-deferred like the traditional IRA.

In 2006, the Roth 401(k) became available, which means after-tax contributions grow tax-free. Participants in employer-sponsored plans usually have the choice of which type of plan they want: traditional or Roth.

Your 401k tax deduction limit for 2020 is $19,500. If you’re able to contribute this much, do so. You’ll save even more if your employer matches a percentage of your contributions. Many employers match dollar for dollar up to a capped amount, in many cases three percent of what the employee contributes. This matching contribution gives employees added incentive to contribute through a 401(k) even when they can’t max out contributions.

Which Is Better: Traditional IRA, Roth IRA, or 401(k)?

As with most financial answers, choosing a tax-deferred retirement account depends on your situation and your desired outcomes. Because most employer plans offer some type of company matching for contributions and have higher limits, this is usually the best option. If you’re maxing out your 401(k) and still have money to save for retirement, you can then start to fund an IRA based on the contribution limits outlined above.

As for whether the traditional or Roth contribution is better, it depends on your current and projected tax benefits. If the contribution and its deduction only saves you a few hundred dollars in taxes, maybe growing that money in a Roth IRA makes more sense.

Talk with a financial advisor or tax professional to understand how a deduction will affect your budget.

Retirement Contributions and IRS Forms

If you have an employer-sponsored 401k plan, you don’t need to worry about noting the deduction amount on your tax return. That appears on your W2.

But if you make contributions to a traditional IRA, you want to note how much is being deducted. You also want to note when Roth contributions are made because the Roth must hold any contribution for at least five years to be eligible for tax-free status. To pull out your contributions (called your basis) before five years, you will need to note when that contribution was made. While contributions are noted by your IRA custodian (where your account is managed), some records might not follow the account if you decided to transfer an IRA to another company – say from a bank to an investment account.

The following forms are the official records for tax returns that correspond to your IRA contributions:

  • Form 5498: Sent by IRA custodian to state how much was contributed.
  • Form 8606: Where you note non-deductible contributions to traditional and Roth IRAs, conversions, and distributions.

The information on these forms is used on a Schedule 1 when filing tax returns Form 1040. The Schedule 1 then adjusts your income (lowers it) on line 8a of the Form 1040. While you may not turn in all forms with your tax return, keep them for your records if there is a question about the contribution date.

Pro tip: You can use your tax return to fund your IRA prior to the tax deadline. So if you want to use $1,000 to contribute to your 2019 traditional IRA, you can take the deduction, get the return, and make the contribution. Just make sure you will get your refund before the filing deadline.

Properly saving for retirement with the right deductions can open up some extra cash for home improvements, emergency funds, or just extra savings. Make sure you get all the deductions you are entitled to. If you have questions about retirement contributions and getting the maximum deductions, talk to a tax professional.

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