You can reduce your current-year income tax bill with every dollar you contribute to a traditional IRA, provided you fall under the income limits described later. This is because IRA contributions aren't miscellaneous itemized deductions, which reduce taxes only if you itemize, and then only to the extent that your itemized deductions exceed 2 percent of your income for the year. Instead, IRA contributions are "above-the-line adjustments to income" not subject to the 2 percent threshold. And you do not have to itemize to take advantage of the tax benefits of the deferral on IRA contributions.
Those in Workplace Retirement Plans
All taxpayers with earned income can contribute up to $5,000 per year into IRAs. For those 50 or older, the annual limit is $6,000. Single taxpayers covered by a workplace plan may make fully deductible contributions up to the contribution limit if their income is $56,000 or less. Your allowable deduction gradually declines as your income rises above $56,000 per year, until it is phased out completely at $66,000. For married couples filing jointly, the upper and lower income thresholds are $90,000 and $110,000, respectively.
Those Not in Retirement Plans
If you are not covered by a workplace retirement plan and you file as a single taxpayer, you can contribute the maximum and deduct the full amount, regardless of your income. If you are married, you may make the full deductible contribution if your joint income is $169,000 or less. Above that your allowable deduction decreases, until it vanishes when your income reaches $179,000. You can still make contributions on a non-deductible basis, but it will not affect your current year's tax bill.
Claiming the Adjustment
To claim deductible IRA contributions, you must file an IRS Form 1040, Individual Income Tax Return; or a 1040A form, also called the "short form." As of 2011, you would fill in your IRA deduction on Line 32 of your Form 1040, or on Line 17 of your Form 1040A. This amount is subtracted from your taxable income for the year. You cannot use a Form 1040EZ and claim the adjustment to income.
Although a fully or partly deductible traditional IRA contribution will reduce your tax bill in the current year, it is not the only consideration. A Roth IRA does not offer a current-year deduction on contributions, but withdrawals are not taxed at all if they have been in the account at least five years. A 10 percent penalty may apply to earnings if the account holder is younger than 59 1/2, but that is also true of traditional IRAs. You might be better off choosing the Roth IRA over the traditional IRA if you cannot qualify for a current year deduction because to your income, or if you believe that when you take out the money you'll be in a higher income tax bracket than you are now. You also might be better off holding long-term investments with low dividends in a taxable account, where they will be subject to the long-term capital gains tax, which as of 2011 was much lower that the top brackets on income tax.
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