How Much of My IRA Investment Can I Deduct From Taxes?

by Cindy Quarters

The purpose of creating an independent retirement account (IRA) is to save a portion of your earnings from your working life so that they can be used once you retire. To encourage people to save for retirement, the government offers incentives in the form of tax breaks for people who contribute to their retirement funds. There are also significant tax consequences for those who remove funds early, which provides another reason to leave your money in your retirement funds.

Traditional IRAs

A traditional IRA is funded with pretax dollars. This means that all contributions to your IRA fund do not count as income for the year. If your IRA is through an employer, the money will be taken out prior to your withholding, and no taxes will be taken from the contributions. If you have your IRA someplace other than work, the money that you place in it will have already been counted as regular income and will have already been taxed.

Deductions

Since the money placed in an IRA through paycheck withdrawals is not counted as income, you are not able to deduct those contributions again when you file your taxes for the year. If you have an IRA that is separate from your employment, however, you most likely have already paid taxes on any contributions you make. At tax time you can deduct all of those contributions from your gross income. If you are paid as a contractor, are self-employed, or otherwise do not have taxes taken out of your income, you can do the same thing and deduct the IRA contributions from your gross pay.

Roth IRAs

With a Roth IRA, money contributed to it consists completely of after-tax dollars, meaning that the funds in a Roth IRA have already had the taxes paid on them. Unlike any taxed funds contributed to a regular IRA, those in a Roth IRA count as regular income for the year in which you received them. You cannot deduct Roth contributions from your wages or from your taxes at any point.

Distributions

An important tax difference occurs when you begin to take distributions from your IRA account. If you take distribution from any IRA prior to reaching age 59 1/2, you will be penalized an extra 10 percent on top of any taxes you may owe, although there are a few exceptions. If you have reached 59 1/2, you can take money from your IRA. If it is a traditional IRA, you will have to pay taxes on any money you receive for the year in which you get it. Both your contributions and any money your IRA investments have made are taxed as regular earnings. When you reach retirement age and remove funds from a Roth IRA, there are no taxes due on either the contributions or the earnings.

Photo Credits

  • Photodisc/Photodisc/Getty Images