Individual retirement accounts encourage you to save up while you're still working by offering tax incentives. Traditional IRAs offer tax-deferred growth, which offers better saving if you expect to pay a lower tax rate in retirement. Roth IRAs, on the other hand, offer after-tax savings, which gives more savings if you expect to pay a higher rate in retirement. The earnings in the Roth IRA will never show up on your tax return, because the profits are sheltered from tax.
Your traditional IRA contributions must be reported on your tax return using either Form 1040 or Form 1040A. You're always eligible to deduct your traditional IRA contributions, which reduces your taxable income, if neither you nor your spouse participates in an employer-sponsored retirement plan. If either of you does, you can still deduct your contribution if your modified adjusted gross income falls below the annual limits. These limits adjust each year and differ depending on your filing status. If in 2012 you are covered, the modified adjusted gross income limits are $68,000 if you're single, $112,000 if you're married filing jointly and $10,000 if you're married filing separately. If only your spouse is covered and you file jointly, you can't deduct any of your contribution if your modified adjusted gross income exceeds $183,000. If you file separately, it's $10,000. If you're not sure if you're a plan participant, look at the "Retirement Plan" box on your Form W-2: If the box is checked, you're covered. Roth IRA contributions aren't deductible, nor are they reported on your tax return.
Retirement Savings Credit
Both traditional and Roth IRA contributions can qualify for the retirement savings credit. The credit is on top of any deduction you get for contributing and can be as high as 50 percent of up to $2,000 of contributions, but your modified adjusted gross income must fall below the annual limits. For example, in 2012 you can claim a credit if you are single and your modified adjusted gross income is less than $57,500, if you're married filing jointly and your modified adjusted gross income falls below $28,750, or if you're head of household and your modified adjusted gross income falls below $43,125. In addition, you won't get the credit if you're a full-time student during any five months of the year, someone else claims you as their dependent or if you're not at least 19 years old at the end of the year. If you qualify, you must file Form 8880 to claim the credit and the credit lowers your tax liability.
Traditional IRA Distributions
Traditional IRA distributions count as ordinary income when you take distributions, which must be included on your tax return, typically increaseing your taxable income. It's all taxable unless you've made nondeductible contributions. If you've made nondeductible contributions to your traditional IRA, you'll get a portion of your distribution out tax-free. The portion equals the percentage of nondeductible contributions in your account. For example, if 28 percent of your traditional IRA value is from nondeductible contributions and you withdraw $10,000, $2,800 comes out tax-free. If you do have nondeductible contributions, you must file Form 8606 to figure the taxable portion. If you're taking a withdrawal before you turn 59-1/2-years-old, you'll also owe a 10 percent early withdrawal penalty on top of the ordinary income taxes. If an exception applies, you get out of the penalty, but not the income taxes. Either way, you have to file Form 5329 for any early traditional IRA distribution.
Roth IRA Distributions
Roth IRA distributions work a little differently on your taxes. If you take a qualified distribution, you still must report it on your tax return, but it won't increase your taxes. Qualified Roth IRA distributions occur after the account has been open for five years and you are either 59-1/2-years-old, permanently disabled or taking out up to $10,000 as a first-time homebuyer. Early Roth IRA distributions take out all your contributions first. Early withdrawals of contributions aren't taxed or penalized, but must be reported on your tax return. Once you take out all your contributions, you start taking out earnings. Earnings count as taxable income and, unless an exception applies, you'll also owe the 10 percent early withdrawal penalty. If you take an early distribution, you must include Form 8606. If any of the withdrawal includes earnings, you also must file Form 5329 to figure the penalty or report your exception.
- Internal Revenue Service: Publication 590 -- Individual Retirement Arrangements (IRAs)
- Internal Revenue Service: Retirement Topics -- Retirement Savings Contributions Credit (Saver’s Credit)
- Internal Revenue Service: 2012 IRA Contribution and Deduction Limits - Effect of Modified AGI on Deductible Contributions If You ARE Covered by a Retirement Plan at Work
- Internal Revenue Service: 2012 IRA Contribution and Deduction Limits - Effect of Modified AGI on Deductible Contributions if You are NOT Covered by a Retirement Plan at Work
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."