How to Reduce Tax Bills With an IRA Contribution

by Leslie McClintock

The tax breaks associated with individual retirement arrangements, or IRAs, are designed to encourage taxpayers to set aside money on their own to provide for their incomes in retirement. For this reason, Congress has allowed investors to deduct contributions they make to an IRA, provided they meet certain income criteria. People who make more than the threshold income can still contribute to an IRA, but they cannot deduct their contributions, lowering their tax bill in the current year.

Establish a SEP-IRA (simplified employee pension IRA) account and contribute to it first. A SEP-IRA is a special type of retirement plan available to certain small-business owners. Like traditional IRA contributions, SEP-IRA contributions are "above-the-line" deductions. This means you do not have to itemize in order to deduct the contribution. You may be able to deduct a greater amount contributed to a SEP-IRA than to a traditional IRA.

Establish a traditional IRA. You can do this directly with most mutual fund companies, brokerage firms, banks and some life insurance companies that sell annuities. Mutual funds and brokerages tend to sell riskier products with higher potential rates of return, while insurance companies and banks tend to sell safer investments and guaranteed vehicles, but with somewhat lower expected rates of return. Neither approach is better, but one approach may be a better fit for your personal circumstances than another. Contact the company you want to do business with for specific details.

Contribute to the IRA. This can be done over the web, by mailing in a check, by wiring money or by handing a check to a broker or agent.

Deduct the contribution on your personal income-tax return. You need to file an IRS Form 1040 to benefit from this deduction, but you do not have to itemize your returns by turning in a Schedule A. Depending on your income, you may only be able to take a partial deduction. To calculate your allowable deduction, fill out the worksheet the IRS provides in Publication 590. Enter the allowable deduction on line 32 of your IRS Form 1040. There is no line for deducting IRA contributions on the 1040EZ.

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