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 2020, 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 2021 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 $76,000 as an individual or more than $125,000 for married folks filing jointly)
• Earning above specific income levels (i.e., more than $66,000 for individuals and more than $105,000 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 2020, the contribution maximum for a 401k is $19,500. A person who contributes the full amount could then deduct $19,500 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.
But, Uncle Sam can’t be avoided forever. Because these taxes are simply deferred until later, money that leaves an account will usually be taxed at the point of withdrawal.
Let’s look at an example of this. Having reached retirement age, a person chooses to withdraw $30,000 per year from a traditional IRA plan. As far as the IRS is concerned, this withdrawal is taxable income. The traditional IRA money will be taxed as the income.
So, what’s the point of deferring taxes? Generally speaking, people may be in a higher marginal tax bracket earning as a working person than they are spending as a retired person. Therefore, the idea is to defer taxes until a time when an individual may pay proportionally less in taxes.
Tax Brackets and IRA Deductions
Income tax brackets can work in a stair-step fashion. Each bracket reveals what a person owes at that level of income. Still, when a person is “in” a certain tax bracket, they do not pay that tax rate on their entire income.
For instance, single filers pay a 12% federal income tax rate for the income earned between $9,875 and $40,125. Then, the tax rate “steps up,” and they pay a 22% tax on the income earned that falls in the range of $40,126 and $85,525. Even if a person is a high-earner and “in” the 37% tax bracket, they still pay the lower rates on their lower levels of income.
Why is this worth noting? Because tax deductions reduce a person’s taxable income at a person’s highest marginal rate (their highest “stair-step”). Using 2020 tax rates, the above-mentioned person with $70,000 in taxable income would be taxed like this:
• 10% up to $9875 ($60,125 remaining)
• 12% up to $40,125 ($20,000 remaining)
• 22% on the remaining $20,000
However, if that same person contributes the maximum to their tax-deferred retirement account, they would be taxed 22% on the top amount minus what’s deductible. In other words, they wouldn’t be taxed 22% on the full $20,000.
401k Withdrawals and Taxation
Now, let’s compare with the taxation on a $30,000 withdrawal from a 401k. Assuming 2020 income tax rates, a $10,000 withdrawal would be taxed at a 10% rate up to $9,875 and then a 12% rate for the remaining $20,000.
Taxes are assessed at a person’s “effective,” or average, tax rate. This is another reason that some folks prefer to defer their taxes until later, when they can pay a hypothetically lower effective tax rate on their withdrawals, rather than taxes at their highest marginal rate.
But, here’s why it’s not so simple: All of the above assumes that income tax rates remain the same over time. And, income tax rates (and eligible deductions) can change with federal legislation.
Still, plenty of earners opt to reduce their tax bill at their highest rate in the current year—and a tax deduction via an eligible retirement contribution can do just that.
For individual tax questions, it’s a good idea to consult a certified tax professional with questions about specific scenarios.
What About Roth IRAs and Taxes?
Simply put, there are no tax deductions for Roth retirement accounts. Both Roth IRA and Roth 401k account contributions are not tax-deductible.
The trade-off is that Roth money is not taxed when it is withdrawn in retirement, as is the case with tax-deferred accounts like a 401(k) and Traditional IRA. In fact, this is the primary difference between Roth and non-Roth retirement accounts. With Roth accounts, taxes are already paid on money that is contributed, whereas income taxes on a non-Roth 401k are deferred until later.
So, then, what are some advantages of 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 $124,000, and is completely phased out at an income level of $139,000. For a person that is married and filing jointly, the phase-out begins at $196,000, ending at $206,000.
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): $19,500
• 403(b): $19,500
• 457(b): $19,500
• Thrift Savings Plan (TSP): $19,500
• Simple IRA or 401(K): $13,500
• SEP IRA: The lower of 25% of an employee’s income, or $57,000
• Solo 401(k): Either $19,500 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.
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