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How a Traditional IRA Reduces Tax

Traditional IRA Basics

With all the different types of retirement investments to choose from, including the traditional IRA, it’s easy to get confused. If you are considering putting money into a traditional IRA, you should understand how your contributions can reduce the income tax you pay each year – including during those retirement years when you begin making withdrawals from the account. In the years you make contributions to the account, the IRS allows you to deduct them on your tax return. However, there are some limitations on your annual IRA contribution deduction. Each year, the federal government determines the maximum deduction and sets a fixed dollar amount. But you also need to consider the “taxable compensation” you receive – which is generally all income you receive from employment and self-employment – but it doesn’t include other types of income such as rental income. After a quick comparison of the two numbers, the maximum deduction you can possibly take is the smaller of the two. But there are other factors to consider as well, such as your filing status and age.

Tax on Traditional IRA Withdrawals

Traditional IRAs aren’t tax-exempt, but are tax deferred investments. This means that eventually you’ll need to pay tax on those deductible contributions. The IRS will force you to begin taking taxable withdrawals from your traditional IRA no later than the year after you turn 70 ½; otherwise, you’ll face expensive penalties that will more than offset any taxes you’ve saved. Your annual withdrawals must be reported on your tax return. But for the entire period prior to the time you start taking money from your traditional IRA account, your investment will grow without any income tax due on those gains each year. But when you reach retirement age, your taxable income each year is likely to be less than those years you make contributions to the IRA account. One common reason for this is because the Social Security benefits you receive at the same time aren’t taxable if your other income doesn’t exceed certain thresholds. And even if your Social Security benefits are subject to tax, usually no more than 50% of it is. This helps to keep most of your taxable income, including your traditional IRA withdrawals, in lower tax brackets.

The Roth IRA

Investing in a Roth IRA can certainly reduce your taxes too, but it works a bit differently than a traditional IRA. With a Roth IRA, your contributions to the account aren’t deductible; however, when you begin taking distributions from the IRA at retirement, all payments are tax free and aren’t reported on your tax returns.

Reference: Individual Retirement Arrangements (IRAs)