An individual retirement account, or IRA, gives you more control over your retirement savings investments than the typical employer-sponsored retirement plan. Just opening an IRA will not reduce your federal income taxes, but making contributions will if you meet the qualifications and contribute to a traditional IRA rather than a Roth IRA.
Why a Tradtional IRA?
The federal government structured traditional IRAs as tax-deferred accounts. This means that contributions to the account can be deducted from your taxable income, but you must pay taxes when you take distributions from the account. While the money sits in your traditional IRA you do not pay taxes on it. A Roth IRA also offers tax-sheltered growth, but it works in reverse: You pay taxes up-front on your contributions, then make withdrawals tax-free in retirement.
Traditional IRA Eligibility
Only people under age 70 1/2 at the conclusion of the calendar year can open and contribute to a traditional IRA. For example, even if you do not turn 70 1/2 until December, you cannot open or make a traditional IRA contribution earlier in the year. In addition, you must have earned compensation during the year. Compensation, for the purposes of contributing to a traditional IRA, include wages, salaries, self-employment income and bonuses.
To qualify for the deductions, you must either have no access to an employer plan or your modified adjusted gross income must not exceed the annual limits. The modified adjusted gross income limits differ depending on your tax filing status. In addition, the Internal Revenue Service updates the limits annually to account for inflation changes. For example, in 2011, if you are covered and are single, you cannot deduct any of your contribution if your modified adjusted gross income exceeds $66,000. But if you are married filing jointly the limit increases to $110,000.
IRA Tax Savings
If you are eligible to deduct your traditional IRA contribution, you can calculate the amount by which it will reduce your federal income tax by figuring the product of your tax rate and your contribution amount. You can find your tax rate by looking up the tax tables published each year by the IRS in Publication 17. For example, if you pay 30 percent in taxes and claim a $3,330 deduction for a traditional IRA contribution, multiply 0.3 by $3,330 to find your federal taxes are reduced by $999.