Tax Impact of an IRA Contribution

by Matt Petryni

Saving for retirement is generally a wise investment -- if not immediately, certainly in the long run. Some taxpayers may not be aware of the ways retirement savings contributions -- in an individual retirement arrangement (IRA), for instance -- may offer tax advantages in the shorter term. Individual taxpayers can benefit considerably from understanding some of the income tax savings that come along with an IRA contribution.

Basics of an IRA

An individual retirement arrangement is a kind of retirement plan where an individual can set up a long-term savings account and enjoy certain tax advantages. In many cases, most of a taxpayer's income is subject to taxes, no matter whether they choose to spend or save it. With an IRA, income taxes are essentially deferred until retirement, according to the Internal Revenue Service, and "amounts in your traditional IRA, including earnings, generally are not taxed until distributed to you." Using an IRA in this way, taxpayers can commit savings without having to first pay the same tax rate that is applied to regular income.

Deducting IRA Contributions

One of the features of a traditional IRA is that contributions are tax deductible. As a result, making contributions to an IRA during the tax year often has the effect of increasing tax refunds or reducing tax liability. This option is available to a wide number of taxpayers -- anyone with earned income, according to financial writer Jim Wang for U.S. News & World Report.

Limits and Conditions

As with most tax savings, contributions to an IRA are not guaranteed to result in a tax deduction. There are limits to the amount that an individual can contribute in a year -- $5,000 for filers 49 and younger, $6,000 for those older than 50. Income limits also apply. Single filers making less than $55,000 per year and joint filers making less than $89,000 are allowed to deduct 100% of their IRA contribution. Above this level, part of the contribution might be deductible, though single filers making more than $66,000 and joint filers making more than $109,000 per year cannot deduct their IRA contributions.

Taxes on Distributions From an IRA

It is important to remember that the tax impact of an IRA contribution is a deferral, not an exemption. Income from an IRA after retirement is still taxable at the time of distribution. In addition, a penalty tax of 10 percent may apply if the taxpayer chooses to tax distributions from his IRA before age 59 1/2. Additionally, the taxpayer may incur an excise tax unless he begins to take minimum distributions from his IRA before age 70 1/2. Nondeductible contributions will count against any taxes paid on IRA distributions -- a taxpayer will not be taxed twice if he reports the nondeductible contributions to his account.

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