Tax Savings With IRAs

Everyone is looking for tax savings at this time of year. One of the best things you can do is contribute to an IRA. It might reduce your taxes this year, and the money will grow tax free. There is still time to do it and have it apply to the 2010 tax year. You and your spouse can each contribute up to $5,000 a year ($6,000 if you are 50 or older). This amount may be less if you are already investing in a 401K at your workplace.

If you are a retiree, but have part-time employment, you can continue to contribute to an IRA up until the age of 70, although the amount is dependent upon your earnings. It’s an easy way to save money if you don’t need the cash right away. If it turns out that you do need the money, you have the option of beginning withdrawals from your IRA at age 59½.

What is best for you is an individual matter, but for most people, a traditional IRA works better than a Roth IRA. With a traditional IRA, your money is deducted from your income and deposited tax free. You pay taxes on it when you begin withdrawing it. At that time, since you would no longer be employed, you would probably be in a lower tax bracket. With a Roth IRA, you pay taxes now, the money grows tax sheltered, and you withdraw it tax free.

Should I Get a Roth IRA or a Traditional IRA?

The big difference between a traditional IRA and a Roth IRA is the way that income taxes are handled. With a traditional IRA, you don’t pay taxes on the money you put in since your IRA contribution is tax deductible. Instead, you pay your income taxes when you take the money out in retirement. With a Roth IRA, you pay your income taxes on your contribution before putting it in the Roth IRA, but it is all tax free when you take it out in retirement.

For example, let’s say you put $5,000 in a traditional IRA. You get a tax break now because you can deduct the entire $5,000. Your $5,000 grows tax free within your traditional IRA. You have to leave the money in the IRA until at least age 59.5, and then you can begin withdrawing the money. As you take the money out, you declare it on your tax return and pay your income taxes at that time. Presumably you will be in a lower tax bracket in your old age, so your tax bill will be lower.

Now let’s say you put $5,000 into a Roth IRA. You cannot deduct this amount on your tax returns, so you pay your regular income tax on the full $5,000. Then your $5,000 grows tax free within your Roth IRA. When you begin taking money out of your Roth IRA, it all comes out tax free.

There are other differences. Not everyone can deduct their traditional IRA contribution because there are income limitations. The traditional IRA has mandatory withdrawals after age 70.5, but there are no such mandatory withdrawals from a Roth IRA. Also, you can leave your money in a Roth IRA longer, and you can withdraw your contributions any time without taxes, but not the investment proceeds.

How Much Can I contribute to My IRA?

The maximum contribution is $5,000 a year ($6,000 if you are 50 or older). Same for your spouse. However, you cannot contribute more than your taxable compensation for the year. If you were part of a 401k retirement plan that went bankrupt, you may qualify to contribute more if you meet all the requirements. You may not be able to deduct the full amount if you or your spouse is covered by a retirement plan at work.

More details can be found at http://www.irs.gov/pub/irs-pdf/p590.pdf

How Does a Roth Ira Work?

A Roth IRA works like this: First you earn wages, then you pay tax on your wages, then you deposit some of your wages into a Roth IRA. Your money grows tax free inside the Roth IRA and after five years and age 59.5 you can withdraw it tax free. In other words, you pay your tax when you earn the money, but not again. If your Roth IRA increases in value, all the increase as well as the original principal can be withdrawn tax free.

A traditional IRA can be converted to a Roth IRA but you must pay taxes on this amount at the time of conversion. There are also slightly different rules for a Roth IRA. For example, you can make contributions to a Roth IRA even after age 70.5 and there are no required withdrawals. Leave it in as long as you live.

There is a wealth of information about IRA’s here: http://www.irs.gov/pub/irs-pdf/p590.pdf