Contributions to individual retirement accounts, or IRAs, can help reduce your gross income and either maximize your refund or chip away at your tax bill. Although IRA contributions don’t reduce your tax bill on a dollar-for-dollar basis, investors who make contributions can expect tax savings based on their tax rate -- and possibly savings in the future when they receive distributions.
IRA Contribution Deductions
Unlike many other deductions, contributions you make to your IRA are considered “above the line” deductions that directly reduce your adjusted gross income on a dollar-for-dollar basis. If you contribute $5,000 to an IRA and earn $45,000 annually, you’re taxed as if you earned only $40,000. In addition, because of its above-the-line status, you don’t need to itemize to claim your IRA contribution as a deduction, and may claim the deduction alongside the standard deduction.
Savings in Current Tax Year
Because contributions to your IRA directly reduce your adjusted gross income, lowering your taxable income, you can easily determine the bottom-line tax savings they provide. The tax savings value of a contribution varies between tax brackets -- the more you earn, the more taxes your contribution saves -- and can be calculated by multiplying your marginal tax rate by your contribution amount. For example, if you’re in the 25 percent bracket and make the maximum $5,000 annual contribution, you save $1,250 -- or $5,000 x 0.25 -- from your total tax bill this year.
Potential Savings in Future Tax Years
When you make a contribution to an IRA, you don’t completely avoid paying taxes on that income. Instead, you defer it to a later date. When you receive a distribution from the IRA, you must pay income taxes on the distribution. However, because many retirees have limited earned incomes when they begin to access their retirement funds, they’re in a much lower tax bracket than when they were working. If you’re completely retired and in the 10 percent bracket when you receive your distribution, you’ll owe only $500 on the $5,000 you invested when you were at the 25 percent bracket, a net tax savings of $750 -- even if your IRA doesn’t report any returns on your investment.
The long-term tax impact of investing in IRAs is easiest to understand when comparing two example investors in the 25-percent bracket who budget to place $5,000 of their before-tax earnings into investments into accounts with identical returns. John plans to invest in bonds, a post-tax investment, that pay 5 percent annually and mature after 20 years. After taxes, he has $3,750 to invest, which after simple interest compounds, is worth $9,375. He doesn’t pay taxes when he sells this investment, resulting in a total post-tax yield of $8,125. Steve, on the other hand, invests $5,000 pre-tax -- a post-tax value of $3,750 -- in a traditional IRA that earns 5 percent compounded simply for 20 years, which is worth $10,000 after 20 years. If he takes a lump-sum distribution and receives the entire amount, and has no other income, he’s taxed at the 15 percent rate, and receives a post-tax yield of $8,500.
- IRS.gov: Publication 590 - Individual Retirement Arrangements (IRAs)
- Smart Money; Four Things You Can Stil Do to Lower Your 2010 Tax Bill; February 2011
- Bankrate; Traditional IRAs Make Tax Sense for Some Filers; Kay Bell; March 2008
- "U.S. News and World Report"; Reasons to Spend Your Tax Refund; Kimberly Palmer; March 2011