If you are new to individual retirement accounts, you may not be familiar with all of the key tax breaks that they can provide.
Current Year Deductions for Contributions.
The tax benefit that most taxpayers (even those who haven’t yet set up an IRA for themselves) are familiar with is the possibility that the annual contributions they make to their account can be deducted from their tax return for the year of contribution.
There are some limitations and requirements in order to receive this deduction. First of all, the deductibility of IRA contributions only applies to traditional accounts. Contributions to Roth self-directed IRAs (or any other Roth IRA) are never deductible.
In addition, with respect to traditional self-directed IRAs, the deductibility of contributions depends on whether the account holder is covered by a retirement plan at work. If the account holder is not covered by a retirement plan, then they’re contributions will be deductible regardless of their level of income.
If the account holder is covered by a retirement plan, then deductibility will hinge upon their tax filing status and Modified Adjusted Gross Income for the year contribution. For 2014, for example, a single taxpayer will have full deductibility if their Modified AGI is $60,000 or less. There is a deductibility phase-out (i.e., a contribution is partially deductible) between $60,000 and $70,000, and no deductibility is available if their income is $70,000 or more. Taxpayers who are married and file jointly receive a full deduction for a Modified AGI of $96,000 or less, and a partial deduction for income between $96,000 and $116,000.
Tax Deferred Investment Growth
Perhaps the bigger tax benefit of a self-directed IRA is that your investments are not subject to taxation while they grow within your account. In contrast, consider what happens when you sell a stock or mutual fund that you hold a taxable investment account. If the investment gained in value, you’ll be subject to tax on the gain in that tax year, even if you don’t withdraw the investment proceeds from your account. The situation is similar for investment interest or stock dividends. Even if you immediately reinvest the money you receive, you are still subject to taxation on those amounts.
In contrast, the balance in your self-directed IRA can grow inside the account without tax liability. If your self-directed IRA is structured as a traditional account, you’ll only be subject to taxation when you take a distribution of funds from that account. This taxation may only be after several decades of growth, so the benefit can be quite significant.
Tax Free Investment Growth
The benefits of a Roth self-directed IRA are even greater. You won’t ever be eligible to adopt the contributions you make to that account, but the withdrawals you make during retirement will be tax free. That’s right – the rules on Roth IRAs mean that you won’t ever have to pay taxes on the investment growth and income within your account.
Because the long-term tax advantages of a self-directed Roth IRA are so significant, many individuals choose to convert their traditional accounts into Roth accounts (and pay the tax bill that comes with such a conversion) in order to receive that benefit.