Broadly speaking, retirement accounts can offer some sort of tax benefit—whether it’s during the year that contributions are made or when distributions take place after retiring. But, not all retirement accounts are taxed the same. For example, Traditional IRA accounts and Roth IRA accounts adhere to different rules. (Hence why they are two different entities).
As complicated as taxes can seem, there are some strategies that can shave off some liability from one’s income—including, IRA contribution deductions (for eligible accounts and qualifying individuals).
With a traditional IRA, it’s possible for certain individuals to both invest for their future and reduce their present tax liability. Here’s the IRS’ summary of IRA contribution and deduction limits . (Different limits apply to retirement plans, like an SEP, that are generally used by self-employed people).
To maximize deductions in a given year, investors might want to understand how IRA tax deductions work. Practically speaking, a good place to start is the differences between common retirement accounts—and their taxation. Since each individual financial situation is different, readers
may want to speak with a tax professional to share specific tax questions.
Here’s a look at IRA tax deductions, including a deeper dive into how both Traditional and Roth IRA accounts are taxed in the US.
What is a Tax Deduction?
First, here’s a quick refresher on tax deductions. It’s helpful to understand that this article is discussing income taxes—or, the tax owed/paid on a person’s paycheck, bonuses, tips, and any other wages made through work. “Taxable income” could also include interest earned on some types of investments.
Tax deductions are subtracted from a person’s total taxable income. After deductions, taxes are paid on the difference—the amount of taxable income that remains. Eligible deductions can allow qualifying individuals to reduce their overall tax liability to the US government.
Let’s turn to an example to clarify. Person X earns $70,000 per year. They qualify for a total of $10,000 in income tax deductions. When calculating their income tax liability, the allowable deductions would be subtracted from their income—leaving $60,000 in taxable income. Person X then would need to pay income taxes on the remaining $60,000—not the $70,000 in income that they’d originally earned.
In 2022, 22% is the highest federal income tax rate for a person earning $70,000. By deducting $10,000 from their taxable income, they are able to lower their federal total tax bill by $2,200, which is 22% of the $10,000 deduction. (There may be additional state income tax deductions.)
A tax deduction is not to be confused with a tax credit. Tax credits provide a dollar-for-dollar reduction on a person’s actual tax bill—not their taxable income. For example, a $3,000 tax credit would eliminate $3,000 in taxes owed.
Putting the IRA Tax Deduction to Use
Traditional IRA tax deductions are quite simple. If a qualifying individual contributes the full $6,000 maximum allowed to a Traditional IRA in a year, they can deduct the contribution from their taxable income.
It’s worth noting that 2022 deductions may be phased out if a tax filer is:
• Single (and covered by a workplace retirement account)
• Married (filing jointly or separately)
• Covered by a work 401(k) plan (if they make more than $78,000 as an individual or more than $129,000 for married folks filing jointly)
• Earning above specific income levels (i.e., more than $68,000 for individuals and more than $109,000 for married people filing jointly)
Different restrictions apply to married couples where one person is not covered by a workplace plan but their spouse is covered through work. Contributions to Roth IRAs are not tax deductible.
401(k), 403(b), and other non-Roth workplace retirement plans work in a similar way. In 2022, the contribution maximum for a 401k is $20,500. A person who contributes the full amount could then deduct $20,500 from their taxable income, potentially reducing their highest marginal tax rate(s).
One common source of confusion: The tax deduction for an IRA will reduce the amount a person owes in federal and state income taxes, but will not circumvent payroll taxes, which fund Social Security and Medicare. Also known as Federal Insurance Contributions Act (FICA) taxes, these are assessed on a person’s gross income. Both the employer and the employee pay FICA taxes at a rate of 7.65% each.
Understanding Tax-Deferred Accounts
Traditional IRA, 401(k), and other non-Roth retirement accounts are deemed “tax-deferred.” Money that enters into one of these accounts is deducted from an eligible person’s total income tax bill. In this way, qualifying individuals do not pay income taxes on that invested income.
a Roth retirement account? All retirement accounts provide an additional type of tax benefit as compared to a non-retirement investment account: There are no taxes on interest or capital gains, which is money earned via the sale of an investment. Retirement accounts provide a “tax shelter” for investment growth.
Someone might choose a Roth over a tax-deferred retirement account because they prefer to pay the income taxes up front, instead of in retirement. For example, imagine a person who earned $30,000 this year. They pay a relatively low income tax rate, so they simply may prefer to pay the income taxes now. That way, the taxes are potentially less of a burden come retirement age.
Not everyone qualifies for a Roth IRA. There are limits to how much a person can earn. For a single filer, the ability to contribute to a Roth IRA begins to phase out when a person earns more than $129,000, and is completely phased out at an income level of $144,000. For a person that is married and filing jointly, the phase-out begins at $204,000, ending at $214,000.
Deduction and Contribution Limits
The maximum amount a person is able to deduct from their taxes by contributing to a retirement account may correspond to an account’s contribution limits.
Here’s how much money can be put into an IRA this year:
• Traditional IRA: $6,000 contribution limit, deductibility depends on whether the person is covered by a workplace retirement plan
• 401(k): $20,500
• 403(b): $20,500
• 457(b): $20,500
• Thrift Savings Plan (TSP): $20,500
• Simple IRA or 401(K): $14,000
• SEP IRA: The lower of 25% of an employee’s income, or $61,000
• Solo 401(k): Either $20,500 or up to 100% of total earned income as employee, additional opportunity to contribute as the employer
The above list is only meant as a guide and does not take into account all factors that could impact contribution or deduction limits—such as catch-up contributions. Anyone with questions about what accounts they qualify for should consult a certified tax professional.
Investing for Retirement
Different types of retirement accounts come with distinct tax benefits and, for eligible investors, IRA tax deductions. Contributing to certain tax-deferred accounts may affect how much a person owes in income taxes in a given year. Roth accounts can provide tax-free withdrawals later on.
After deciding which retirement account makes most sense (given a person’s unique tax situation), some folks opt to open an investment account. This can be done at an online brokerage platform like SoFi Invest®, where both opening an account and buying investments come with no fees.
One other option is to use a portfolio-building tool that takes into account an investor’s individual financial goals, preferred timeline, and risk tolerance. SoFi Invest’s easy-to-use app can help members to set up an IRA.
Curious about investing for tomorrow? Check out SoFi Invest.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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Source: sofi.com