As tax day approaches each April, tax experts roll out innumerable methods to reduce your year-end taxes. While you can claim plenty of deductions and credits, one of the most effective ways to lower your tax bill is to plan for retirement with an IRA. Money you place in an IRA is a direct deduction on your taxes, allowing you to save significant amounts of taxes in April.
Any time you place money into an IRA, the Internal Revenue Service considers it a pre-tax contribution to your retirement. This means that within contribution limits, the money you place in an IRA isn’t counted as income by the IRS and is effectively ignored on this year’s taxes. You can make a qualifying contribution at any point in the year and apply it as an above-the-line deduction when you figure your tax bill, providing you with tax-free income for the year.
Don’t make plans to pull out your checkbook and sink 60 percent of your income into an IRA, as the IRS places limits on the amount any taxpayer can contribute to an IRA. You may contribute only if you earned income this year -- investment income doesn’t apply -- and can’t contribute more than you received in earned wages in the year to an IRA. Finally, the IRS limits annual contributions to IRAs to $5,000 per year. If you’re 50 or older, that limit increases to $6,000.
While you effectively don’t pay income taxes on the money you place into an IRA because of their above-the-line deduction status, you don’t forever dodge the taxman. You merely defer those taxes until you take the money out of the retirement account: The IRS treats distributions from an IRA as ordinary income, and the money you receive from it is subject to income tax withholding. It’s likely you’ll be in a lower tax bracket after retirement than you are now, so you may be taxed at a lower rate on the distribution than you would be today. In addition, pre-tax contributions allow you to invest a larger portion of your income, thereby reaping larger returns.
Don’t think you can sock away a few thousand in an IRA this year and dodge taxes, then empty the account next year. If you put money into an IRA, consider it there for the long haul. The IRS doesn’t allow you to access funds in an IRA until you turn 59 1/2 without paying a 10 percent penalty on early distributions. The IRS assesses this penalty in addition to normal income taxes you pay as the funds leave the tax-deferred account.
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