The impact of IRA contributions on your tax liability depends on how much you contribute, whether the contributions are deductible and how much you earn. When money you contribute is deductible, it is not taxed until the year it is withdrawn from the account. When withdrawn, deductible contributions and earnings become taxable at ordinary income tax rates.
You can contribute up to $5,000 a year to an individual retirement account or $6,000 if you are age 50 or older, as of 2012. You must have earned income at least as great as the contributed amount. If you are married and file a joint return, each spouse may make contributions to IRAs as long as one has earned income. Normally these contributions may be taken as a tax deduction on your income tax return, which reduces the amount of tax you owe. Because Roth IRA contributions are not tax deductible, they have no effect on your tax liability.
Unless some of your traditional IRA contributions are considered nondeductible, the tax deduction you get is equal to the amount of your contribution. To calculate the effect of the deduction on you tax liability, multiply the deductible contribution amount by your marginal tax rate. This is the highest percentage tax rate that applies to your income. For example, if your marginal tax rate is 28 percent and you contribute $5,000 to a traditional IRA, the amount of income tax you owe for the year is reduced by $1,400.
When you or your spouse is covered by a retirement plan at work, the Internal Revenue Service sets income limits on deductible traditional IRA contributions. These limits are adjusted annually to allow for inflation. As of 2012, a single person starts to lose the deduction when her adjusted gross income reaches $58,000; the deduction is eliminated at $68,000. If you are married, file a joint return and are covered by a workplace retirement plan, your phase-out limits are $92,000 to $112,000. If you are not covered but your spouse is, the phase-out range is $173,000 to $183,000. You can still make the maximum yearly contribution amount. The nondeductible part won’t have an impact on how much income tax you owe.
SEP and SIMPLE IRAs
Simplified employee pension plans and savings incentive match plans for employees are IRA accounts provided by employers. SEP an d SIMPLE IRAs operate under the same contribution and deduction rules as traditional IRAs, so the effect on your tax liability is figured the same way. However, the contribution limits are higher, and there is no income limitation. Your employer may contribute 25 percent of your salary, up to $51,000 to a SEP IRA. If you are self-employed, you can contribute up to 20 percent of your net earnings, up to the same dollar limit. Employees and employers can each add up to $11,500 to a SIMPLE IRA.