With tax filing season upon us, most of us are looking for ways to either reduce the taxes we’ll owe, or increase the refund we’ll receive.
One way to do this is to make a contribution to a Traditional IRA.
Contributing To An IRA
Making a contribution to a Traditional IRA is an excellent way to accomplish two goals. First, as long as your income and situation permits, you can claim a deduction for the contribution. The deduction ultimately reduces your adjusted gross income (AGI). This in turn lowers the amount you’ll be responsible to pay taxes on.
Second, you are putting funds away for your retirement. By making the contribution, it forces you dump money into an account that is a little difficult to access. That’s because once the funds are in a Traditional IRA, distributions from the account may result in taxes and penalties.
For instance, making a withdrawal from the account before reaching 59 ½ years of age (or without qualifying for an exception) will trigger a 10% penalty on the amount taken. It will also require you to report the funds as income. Basically, you decrease your income with a contribution, and increase with a distribution.
Since you received a tax break when you made the contribution (i.e. lowering your income by the contribution amount), now you have to claim the distribution as income, and Uncle Sam wants his cut.
You Can Use Your Refund As Your Contribution
Many think the contribution must be made before they hit the send button on their return. That is not the case-
You can actually use your refund as your contribution. Just make sure to have the funds into a qualified account by the filing deadline (this year it’s April 18th). Using tax filing software makes this a lot easier, but you can figure it with pen and paper as well. Here’s how it works...
Let’s say you have an extra $2,500 bucks sitting in your checking account that you plan on contributing to an IRA. Let’s also say that by making that $2,500 contribution you’ll end up getting a refund of $1,500. By lumping the refund amount as part of your contribution, for a total of $4,000, you’ll reduce your AGI even more. By reducing your AGI, it reduces your tax responsibility, which could ultimately increase your refunded amount more. For this example, let’s assume it increased your refund to $2,000...
Instead of making a $2,500 contribution, by re-routing your refund you could end up with a contribution of $4,500. A much better investment for your retirement funds...
Roth Contribution Illusion
What if you’d rather contribute to a Roth account, but your income is too high? There’s a fix for that as well...
Anyone with income can contribute funds to a Traditional IRA. You may not be able to use a deduction, but you can still contribute.
A Roth Conversion allows for funds already in a Traditional IRA to be moved into a Roth account penalty free. By making your contribution to the Traditional, then sliding it over to a Roth via a Roth Conversion, you end up with the same outcome.
It’s a roundabout way of making a Roth contribution, and there will most likely be some additional paperwork needed on your part, so make sure to consult a tax professional for your individual situation.
Michelle Kuehner is a Registered Investment Advisor Representative and Managing Director for Personal Money Planning. She is also a Certified Credit Counselor, Certified Financial Health Counselor, writes Fix Our Budget blog, and has over 24 years of experience in the financial industry.
Photo by Stuart Miles. Published on 13 August 2014Stock photo - Image ID: 100282003