As we inch closer to the tax filing deadline, we’re all looking to reduce our tax bill so that we can receive back the largest possible tax refund (or reduce the size of the check we have to send to the IRS). We can decrease the annual tax burden by utilizing the greatest number of deductions that are available.
If the deduction for IRA contributions is available to you, it can prove to be an extremely valuable benefit. Here’s how your self-directed IRA can boost your tax refund:
Deductibility for Traditional IRAs. Depending on your modified adjusted gross income (MAGI), and whether you are covered by a retirement plan at work (such as a 401(k)), the contributions you make to a traditional IRA may be tax deductible.
- Individuals who are not covered by a workplace retirement plan are eligible for full tax deductibility of their contributions, regardless of their MAGI.
- For single individuals who are covered by a plan at work for 2021, IRA contributions are fully deductible for a MAGI of up to $66,000 (with a gradual deductibility phase out between $66,000 and $76,000).
- For married couples filing jointly, where the contributing spouse is covered by a workplace plan, full deductibility is available for a MAGI of $105,000 (with a deductibility phase out between $105,000 and $125,000).
Note that these figures only relate to the deductibility of contributions, not eligibility for contributions. In general, any individual with earned income can contribute to a traditional IRA in an amount not exceeding that earned income. In contrast, being able to make contributions to a Roth IRA (which are not deductible) will depend on your MAGI.
Tax Benefits for Roth IRAs.
Despite the fact that you can’t take a tax deduction for contributions you make to your self-directed Roth IRA, there are still some reasons for you to consider that type of account. Withdrawals from a Roth IRA are made on a completely tax-free basis, instead of having to pay taxes on withdrawals as you would with a traditional IRA.
Furthermore, Roth IRAs are not subject to the rules on required minimum distributions. If you have a traditional self-directed IRA then you are required to make specified withdrawals every year once you reach age 72. If you don’t need to take withdrawals from your self-directed IRA in order to pay your living expenses, the benefits of being able to let the balance of your Roth IRA continue to grow tax-free can be significant.
To learn more about self-directed Roth IRAs, contact an experienced custodian such as Quest Trust Company.
Many individuals first become interested in opening an Individual Retirement Account when they learn that in some situations their annual contributions are deductible on their current year’s tax return. It’s important to understand that the term “deductible IRA” refers to traditional IRAs, as opposed to the Roth IRA structure. But it’s also important to know that the actual deductibility will depend on a number of factors, and that not all contributions to a traditional IRA are deductible.
The concept of a “non-deductible IRA” therefore refers to Roth IRAs and sometimes to traditional IRAs. Here are some reasons why, despite the non-deductibility of contributions to those accounts, they can still be an extremely valuable part of your retirement planning.
To Save on Taxes Later in Life
If you have a Roth IRA, the withdrawals you make in retirement will not be subject to federal income tax. Since the majority of your IRA account balance will likely be comprised of earnings, the total value of tax savings down the road will far exceed the value you’d obtain from having your contributions be tax deductible.
To Avoid the Rules on Required Minimum Distributions
Once you reach age 72, you must begin taking annual distributions from a traditional IRA, and these distributions must be above a certain minimum amount (which varies with your age and account balance). This will not only reduce the amount of savings you have growing on a tax deferred basis, but also subject you to current year taxation on the amount of the distributions. Roth IRAs are not subject to these rules, so some people are willing to give up current year deductibility by making contributions to a Roth account.
Estate Planning Advantages
The rules on passing on Roth IRAs are much more flexible and advantageous; so many individuals choose that account structure in order to help them better achieve their estate planning goals.
If You’re Covered by a 401(k) Plan at Work
All of the advantages of making non-deductible contributions highlighted above apply to Roth IRAs. But there are also situations where you might want to make non-deductible contributions to a traditional IRA as well.
For example, some individuals choose to participate in an employer sponsored retirement program such as a 401(k). Participation in a 401(k) plan won’t affect their ability to contribute to an IRA (either a Roth or a traditional account), but it will impact their ability to take a tax deduction for a contribution to a traditional account. For 2021, single taxpayer who’s covered by a 401(k) can’t take a deduction for their traditional IRA contribution if their modified adjusted gross income is over a certain limit. This means that in order to make a contribution to their IRA account (which is always a good idea from a long term perspective), that person will need to make a non-deductible contribution to a traditional account.