Why Contributing to an IRA can Reduce Tax Expenses

In preparing for later years, the use of an individual retirement account, also known as an IRA, can be very beneficial. There are several different types of IRAs, but the most common are the traditional IRA and the Roth IRA. Both exist as investment vehicles and almost always have a better return than parking money into standard savings accounts. Besides this obvious financial advantage, there is another reason why using IRAs has become standard practice for people who are concerned about having enough money when they retire – it can lower the amount of income tax that a person is forced to pay by the IRS.

When a person decides to open a traditional IRA, they can contribute up to $5,000 each year ($6,000 for those over the age of 50) into the account that will not be taxed. The best way to see how this can be advantageous is to use an example. Assuming a person makes $40,000 per year in income, they will be obligated to pay 25%, or $10,000, in taxes. Because the first $5,000 is considered to be untaxed, the IRS sees the income as only being $35,000, meaning that the tax needing to be paid is lowered to $8,750. Therefore, by putting the money into a traditional IRA rather than any other investment vehicle, the person would stand to gain $1,250 from the very beginning, not to mention the interest they will earn from the IRA during the year.

While it seems like an excellent choice, there are some restrictions and limits. If a person makes over $66,000, they cannot use the traditional IRA. In a similar vein, those that make between $56,000 and $66,000 can only deposit a limited amount and not the full $5,000. Also, when a person decided to withdraw the money during their retirement, it is treated as income, which means that income taxes will need to be paid as per normal. Even with these restrictions, the traditional IRA is still a positive way to save money for retirement.

On the other hand, some IRAs, such as the previously mentioned Roth IRA, do not directly reduce the income tax that must be paid. Unlike the traditional IRA, the Roth IRA is not considered to be tax deductible, meaning that the same income tax must still be paid. However, the interest that is generated is not taxed each year or when a person makes a withdrawal. This option is better for people who would rather pay the taxes now and have more money when they enter retirement.

Essentially, both the traditional and Roth IRA do save money on tax expenses, but it comes at different times and a person will need to decide whether they prefer to pay the taxes now or when they withdraw the money for retirement. To determine which type will make the best fit for an individual situation, a tax professional or financial planner should be contacted to discuss the differences between the two and other investment options that may also have a high rate of return.

Have a tax question? Ask one of our tax professionals.