Contributing to an IRA may qualify you to receive tax deductions every year. Here are 5 ways to get the potential tax benefits of an IRA with more investment flexibility.
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Your individual retirement accounts (IRAs) can be useful investment tools to help you save money for retirement. But did you know they may also help save you money on taxes?
The potential tax perks vary depending on a variety of scenarios, such as the type of IRA, current and future tax laws, and your personal tax status now and at the time you plan to take money out of your IRA. By understanding and taking advantage of how IRAs work, and their unique tax treatments, you may be able to cut your IRS bill down now and in the future.
But First, Some IRA Basics
Before getting into IRAs’ tax-saving benefits, it helps to understand how different IRA accounts work.
The two main types of IRAs are traditional and Roth accounts, both of which allow you to invest in a range of financial products, including stocks, bonds, exchange-traded funds (ETFs) and mutual funds.
But, that’s about where their similarities end, and it helps to understand their differences, especially how they can offer tax advantages now and in the future.
Traditional IRAs: Contributions to a traditional IRA are typically with before-tax dollars, which can result in a tax deduction now (reducing your annual income amount for tax purposes). Because you haven’t paid any income tax on it, your money grows tax-deferred, meaning you don’t have to pay taxes until you begin withdrawing money from your account later, say in retirement, when the money will be taxed at your future, marginal rate. If you choose to make contributions to a traditional IRA with after-tax dollars, then that money wouldn’t be tax deductible, so you would document such contributions with IRS Form 8606.
Roth IRAs: Any money that you contribute into a Roth IRA is with after-tax dollars. After-tax income is your final net income after the deduction of all federal, state, and withholding taxes. Also called “income after taxes,” this money represents the amount of disposable income that you have available to spend after you’ve already paid applicable income taxes on it.
Unlike any before-tax money that goes into your traditional IRA, there is no tax deduction for your Roth IRA contribution.
Your Roth IRA money grows tax-free, so when you withdraw the money close to or in your retirement years, you won’t have to pay any taxes again on it.
There are camps that argue which IRA is better; for example some investors prefer the tax deduction that may come with a traditional IRA because they believe they’ll fall into a lower tax bracket in their retirement years. And then there are those who champion a Roth IRA, and are happy forgoing a tax deduction now to be certain they won’t have to pay income taxes on any future withdrawals in retirement.
But for other investors, a downside of traditional and Roth IRAs may simply be that they don’t provide access to certain types of investments, such as real estate, private companies, art, farmland and other real assets.
Self-directed IRAs (SDIRAs), on the other hand, give you more investment flexibility while providing the same tax benefits as traditional and Roth IRAs.
SDIRAs can be structured like a traditional or Roth IRA, with the same contribution limits and potential tax benefits.
All funds are held by a qualified third party, such as a bank, trust company, or other authorized custodian. A custodian performs all administrative duties, including maintaining compliance with IRS requirements; processing contributions, transfers and rollovers; executing your orders to buy and sell assets; receiving and distributing investment income; and tax reporting.
By taking advantage of the different IRAs available, you may diversify your retirement investments and cut your tax bill at the same time. Now that you know the basics about different types of IRAs, here are five ways they may be able to help you save money on taxes.
#1: Tap into Immediate Tax Deductions Using a Traditional IRA
As mentioned, traditional IRAs may be funded with pre-tax contributions. In 2021, you can contribute up to $6,000 per year (or $7,000 if you’re older than 50). Any money you add to your IRA for the year may allow you to decrease your taxable income for that same year.
For instance, if you invest the maximum amount of $6,000, your taxable income would be reduced by $6,000 for the year.
If you’re on the border between two tax brackets, making a contribution to a traditional IRA could knock you down to the lower tax bracket, too. Not only does this mean your income may be taxed at a lower rate, but it may also help you to qualify for other tax incentives.
#2: Avoid Taxes on Distributions Later
Unlike traditional IRAs where you generally contribute before-tax dollars, Roth IRAs don’t provide an immediate tax deduction — your contributions are taxed before they’re added to your account. While that may seem like a missed opportunity to save on your tax bill now, when you’re ready to withdraw your money, you won’t be taxed again. This means you won’t have to pay taxes on your investment gains.
For example, say you invest $5,000 into a Roth IRA early in your career, then earn an average 8% return on this money over the next 25 years, until you retire at 65. Even if you never add another dime, you’ll end up with $34,242 in your Roth IRA. You’ll have paid taxes on the initial contribution of $5,000 the year you made it, but you won’t be required to pay taxes on the remaining $29,242 in investment earnings.
Note that you’re generally required to hold your Roth IRA for at least five years and be age 59½ to qualify for these free distributions to avoid a 10% penalty.
#3: Boost Your Investments with Tax-Deferred Compounding
In both traditional and Roth IRAs, you pay no taxes on gains as your investments grow. That means no capital gains tax or taxes on dividends, as long as you keep your money in the IRA.
You get to keep 100% of the return you earn every year, reinvesting it instead of giving up a portion of your money to taxes. This process, known as tax-deferred compounding, can considerably boost your ability to accumulate assets over time.
For instance, say you start with $10,000 and earn a return of 8% per year. Here’s how much taxes could impact your investment after 30 years:
#4: Access Additional Tax Savings through the Retirement Savings Contribution Credit
You may further reduce your income tax bill by making a retirement contribution through the Retirement Savings Contributions Credit. According to the IRS, the credit amount you may receive can range from zero to $2,000 ($4,000 if married filing jointly), depending on factors, such as how much money you make, your filing status and the size of your retirement plan contribution.
This credit is generally limited to low- and moderate-income earners. For instance, in 2021, the credit is limited to joint filers with less than $66,000 in adjusted gross income, single filers under $33,000, and heads of households less than $49,500.
Your contribution can’t be a rollover from another investment account; it must come from current income. Unlike a tax deduction — which reduces your taxable income — a tax credit subtracts money directly from your tax liability, so a $500 tax credit would mean you pay $500 less in income taxes.
#5: Save on Taxes While Giving to Charity
What can be better than giving to a cause that’s close to your heart? Answer: Reducing your taxes at the same time.
After age 70 ½, the IRS allows you to contribute up to $100,000 from a traditional IRA to a qualified charity without it being considered a taxable distribution.
That means you may pay no income taxes on your IRA distribution, and you may deduct your charitable gift from your taxable income in the year when you make it. This can be a beneficial strategy if you want to reduce your income so you’ll fall into a lower tax bracket or qualify for income-based government benefits.
Get the tax benefits of an IRA with more investment flexibility
If you’ve been thinking about investing in commercial real estate assets that offer the tax benefits of an IRA, a self-directed IRA may be the ticket. As mentioned earlier, unlike traditional and Roth IRAs, SDRIAs allow you to hold certain real estate investments as part of your retirement portfolio, using tax-advantaged dollars to optimize your investment.
Not all custodians offer self-directed IRAs, so you’ll likely have to find one that specializes in them.
Before getting started, there are some basics you should know. Otherwise, the IRS could rule your SDIRA invalid, and you may have to pay back taxes and penalties.
Here are several important guidelines:
- No self-dealing: In general, you must have a hands-off relationship with the properties in which you invest. That means you can’t live in your property, use it to house your business, rent it to relatives or friends, or pay yourself for making improvements on it.
- The custodian acts as an intermediary: All of the money you invest and earn in the form of rental income or dividends must flow through your custodian. If you sell the property, the proceeds also will go to the custodian and into your account.
- Limited tax write-offs: The IRS doesn’t permit investors to take advantage of tax reduction through depreciation or interest write-offs within the SDIRA structure.
SDIRAs generally charge annual fees, but some providers may wave them to start.
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