You can reduce your taxable income by contributing to an individual retirement account, or IRA. However, you only defer taxation when you invest in an IRA. You eventually must pay taxes when you begin withdrawing from the account. Furthermore, restrictions apply to IRA contributions, and you may find yourself unable to contribute if you have access to an employer-sponsored retirement plan.
As of 2011, you can make an annual contribution of up to $5,000 to an IRA, or $6,000 if you are over age 50. Some people confuse the limit on contributions to IRAs with the limit on annual contributions to Roth IRAs. While the Internal Revenue Service imposes the same annual dollar restrictions on contributions to IRAs and Roths, a Roth IRA contains after-tax earnings so your Roth contributions do not lower your tax burden and have no effect on your ability to contribute to a traditional IRA.
If your employer sponsors a pension plan and you have access to the plan, then you can only make a full IRA contribution if your adjusted gross income (AGI) does not exceed annually set limits. As of 2011, if you pay your taxes as a single filer then you can make the maximum contribution if your AGI does not exceed $56,000. The AGI limit rises to $90,000 for joint tax filers unless you are married and file separately, in which case you cannot make a full contribution. Some higher earners can make partial contributions although many people cannot contribute at all due to AGI contribution limits.
If you are a single taxpayer and your employer sponsors a pension plan, you can make a full annual contribution to a traditional IRA regardless of your income. However, income restrictions apply to you if you are married and file jointly or separately but only if your spouse has access to a work-based pension plan. No contribution restrictions apply if neither you nor your spouse has access to a pension at work. As a married couple filing jointly, you could potentially reduce your AGI by up to $12,000.
The IRS does not assess income tax on IRA money until you make withdrawals. At that time you have to pay income tax. You also pay a 10 percent tax penalty if you withdraw money from an IRA before reaching the age of 59 1/2. When you reach age 70 1/2, you have to begin taking required minimum distributions, or RMDs. RMD amounts are based on your age and life expectancy. You pay a 50 percent tax penalty if you do not withdraw the required amount.
- IRS.gov; 2011 IRA Deduction Limits - Effect of Modified AGI on Deduction if You Are Covered by a Retirement Plan at Work; November 2010
- IRS.gov; 2011 Deduction Limit - Effect of Modified AGI on Deduction if You Are NOT Covered by a Retirement Plan at Work; November 2010
- IRS.gov; Retirement Plans FAQs Regarding IRAs; July 2011
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