How to Reduce Your Taxes with Eleventh Hour IRA Contributions
Tax savings and retirement planning go hand in hand. As you navigate your journey towards securing your future through retirement funds, it is equally imperative to mitigate the burden of taxes in the present. Even though the tax year has drawn to a close, the window for strategic financial maneuvers remains open. One such avenue worth exploring is the eleventh-hour Individual Retirement Account (IRA) contributions. These strategic adjustments offer a prudent means to fortify your financial standing and secure your retirement future.
A financial advisor can help you understand how a traditional or Roth IRA reduces taxable income and serves as a potent tool for minimizing your tax burden while simultaneously bolstering your retirement savings. This article will also discuss how IRA contributions affect taxes and the best strategies to use your account to save tax.
How can last-minute IRA contributions be used to lower taxes?
An IRA serves as a potent vehicle for accumulating retirement funds while enjoying tax advantages. Beyond its primary function of saving for retirement, an IRA can be used strategically to mitigate last-minute tax burdens.
Traditional IRAs offer tax-deferred growth, making them a popular choice for retirement savings. Contributions to a traditional IRA can significantly reduce your taxable income, translating into substantial tax savings. For example, a $6,500 contribution for the tax year 2023 can potentially yield a tax savings of $1,560 for an individual in the 24% income tax bracket.
A Simplified Employee Pension (SEP) IRA, tailored for small businesses and self-employed individuals, is another option that provides generous contribution limits compared to standard IRAs. Making last-minute contributions to a SEP IRA can further enhance tax savings. Additionally, taxpayers can contribute to both a SEP IRA and a normal IRA to maximize their retirement savings potential. Filing an extension also grants additional time to make SEP IRA contributions, providing added flexibility.
It is important to note that taxpayers can enjoy significant tax deductions based on their income and filing status. For instance:
- Single taxpayers without workplace plans can deduct the full amount of their IRA contributions.
- Single taxpayers with workplace plans can receive a full deduction with an Adjusted Gross Income (AGI) of $73,000 or less in 2023.
- Both spouses can deduct the full amount of IRA contributions for married couples filing jointly if neither has a workplace plan. However, if one spouse has a workplace plan, the other can receive a full deduction if their joint income is $218,000 or less in 2023.
While anyone with earned income can open a traditional IRA and contribute the maximum allowable amount, eligibility for tax deductions hinges on various factors. Individuals not covered by a workplace-defined contribution plan, such as a 401(k), can deduct all traditional IRA contributions from their taxes. However, eligibility becomes more nuanced for those covered by workplace retirement plans.
You can make contributions to an IRA until the income tax filing deadline. The last day to max out the Roth IRA is fixed as per the federal tax deadline, which typically falls around mid-April, usually on April 15th. This deadline is crucial for making contributions to an IRA for the previous tax year. However, it is essential to note that the deadline can be extended due to holidays or in cases where certain areas are declared federal disaster zones. These extensions can provide you with additional time to contribute to your IRAs and reap the associated tax benefits.
Before you use your IRA to claim a tax deduction, here are some things to know about this account:
- Contribution limits and eligibility: Taxpayers can contribute up to $6,500 to their IRA for the tax year 2023, provided they had earned income during that year. The limit is $7,500 for individuals aged 50 or older. Contributions cannot exceed the annual limit or 100% of taxable compensation, whichever is less. Additionally, individuals may also make contributions to an IRA on behalf of their spouse for the previous tax year, even if the spouse had no earned income.
- Tax deductibility and Roth IRA considerations: Traditional IRA contributions offer potential tax deductions, particularly for those not covered by a work-based retirement plan or within certain income thresholds. If eligibility criteria are met, contributions may be fully or partially tax-deductible. On the other hand, Roth IRA contributions are not tax-deductible, but qualified distributions are tax-free. Understanding your eligibility and weighing the benefits of each option is crucial in maximizing tax savings.
- Backdoor Roth IRA: For individuals ineligible to contribute directly to a Roth IRA due to income limits, a backdoor Roth IRA presents an alternative avenue. This involves making non-deductible contributions to a traditional IRA and subsequently converting them to a Roth IRA. While this strategy helps you circumvent income limitations otherwise associated with an IRA, careful consideration of tax implications and aggregation rules for traditional IRAs is imperative.
- Five-year holding period and qualified distributions: When it comes to Roth IRAs, the timing of contributions holds a lot of significance. A qualified distribution from a Roth IRA can be made after the account has been held for at least five years and the account owner meets certain conditions, such as reaching the age of 59.5 years or becoming disabled. Initiating Roth IRA contributions by the tax return due date can expedite the commencement of this five-year holding period and potentially unlock tax-free distributions sooner.
IRA deduction limits
| Income tax filing status | Deduction limit |
| Single or Head of Household | Full deduction up to contribution limit |
| Single or Head of Household | Partial deduction |
| Single or Head of Household | No deduction |
| Married Filing Jointly or Qualifying Widow(er) | Full deduction up to contribution limit |
| Married Filing Jointly or Qualifying Widow(er) | Partial deduction |
| Married Filing Jointly or Qualifying Widow(er) | No deduction |
| Married Filing Separately | Partial deduction |
| Married Filing Separately | No deduction |
Traditional IRA income limits for 2023 and 2024 to make a tax deduction
| Income tax filing status | MAGI (2023) | MAGI (2024) |
| Single or Head of Household | $73,000 or less | Less than $77,000 |
| Single or Head of Household | More than $73,000 but less than $83,000 | $77,000 to $87,000 |
| Single or Head of Household | $83,000 or more | More than $87,000 |
| Married Filing Jointly or Qualifying Widow(er) | $116,000 or less | Less than $123,000 |
| Married Filing Jointly or Qualifying Widow(er) | More than $116,000 but less than $136,000 | $123,000 to $143,000 |
| Married Filing Jointly or Qualifying Widow(er) | $136,000 or more | More than $143,000 |
| Married Filing Separately | Less than $10,000 | Less than $10,000 |
| Married Filing Separately | $10,000 or more | More than $10,000 |
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Roth IRA income limits for 2023 and 2024
| Income tax filing status | MAGI (2023) | MAGI (2024) |
| Single or Head of Household | Less than $138,000 | Less than $146,000 |
| Single or Head of Household | $138,000 to $153,000 | $146,000 to $161,000 |
| Single or Head of Household | More than $153,000 | More than $161,000 |
| Married Filing Jointly or Qualifying Widow(er) | Less than $218,000 | Less than $230,000 |
| Married Filing Jointly or Qualifying Widow(er) | $218,000 to $228,000 | $230,000 to $240,000 |
| Married Filing Jointly or Qualifying Widow(er) | More than $228,000 | More than $240,000 |
| Married Filing Separately | Less than $10,000 | Less than $10,000 |
| Married Filing Separately | More than $10,000 | More than $10,000 |
When considering last-minute ways to reduce taxable income through IRA contributions, it is crucial to explore potential additional tax benefits, such as the saver’s credit. This credit, officially known as the Retirement Savings Contributions Credit, is designed to incentivize retirement savings for low to moderate-income individuals and families. The saver’s credit offers a tax credit based on specific income thresholds. For instance, in 2023, married couples filing jointly with an AGI between $47,501 and $73,000 are eligible for a credit worth 10% of their contribution up to $2,000. However, surpassing the $73,000 threshold means missing out on this credit.
Making a last-minute contribution to an IRA not only reduces potential income tax liability through deductions but also aids in qualifying for the saver’s credit by lowering the AGI. For example, contributing $4,000 to an IRA could decrease income tax liability by $480 and enable eligibility for a $400 bonus from the savings credit.
Remaining informed about alterations in eligibility criteria for the saver’s credit is essential. For married joint filers, the eligibility cutoff is now set at $76,500, meaning if their combined income exceeds this amount, they will not be eligible for the saver’s credit in 2024. For singles and married individuals filing separately, the income limit for eligibility has been raised to $38,250 in 2024, up from $36,500 in 2023. This means if their income surpasses $38,250, they will no longer qualify for the saver’s credit.
When should you opt for a last-minute IRA contribution?
Making a last-minute contribution to your IRA can be a tempting option, especially if you are looking to maximize your tax benefits for the previous year. However, it is essential to consider whether this strategy aligns with your overall financial goals and circumstances. Here are some things to consider when opting for a last-minute IRA contribution:
1. Suitable for high earners and tax benefits
High earners who are eligible for a full or partial deduction can benefit from making an IRA contribution. Depending on your income level and whether you or your spouse are financially covered by a company-sponsored retirement plan, you may be eligible for a deduction on your IRA contributions. Lowering your taxable income through an IRA contribution can result in a lower tax liability for the previous year. This can be especially advantageous for high earners who are subject to higher tax rates. Even if you have not contributed to your IRA throughout the year, you still have the opportunity to make a contribution and potentially reap the tax benefits.
2. Consider your current tax bracket
How much an IRA will reduce your taxes will depend on your current tax bracket. If you are in one of the lower tax brackets, the potential tax savings may not be as significant compared to those in higher tax brackets. For instance, someone in the 12% tax bracket might save less compared to someone in the 22% or 24% tax brackets. While this is a helpful tax break, it might not represent substantial savings compared to higher earners who could save thousands of dollars through their IRA deduction.
It is essential to evaluate whether the tax savings from contributing to a traditional IRA align with your overall financial goals and priorities. If the potential tax savings are relatively modest, you might consider other investment options or financial strategies that offer greater long-term benefits.
3. Evaluate your long-term financial goals
Evaluating your long-term financial goals is crucial when considering whether to make a last-minute IRA contribution. Assess your current tax bracket to determine the potential tax savings from making an IRA contribution. If you are in a higher tax bracket, the tax deduction from a traditional IRA contribution may offer significant immediate benefits. Conversely, if you are in a lower tax bracket, the tax advantages of a Roth IRA may be more appealing.
Consider your expectations for future tax rates, both during your working years and in retirement. If you anticipate being in a higher tax bracket in retirement or if tax rates are expected to increase in the future, contributing to a Roth IRA may be advantageous for tax-free withdrawals in retirement. Remember to take a holistic approach to your financial strategy, considering factors beyond retirement savings. You must assess your debt management, emergency savings, investment portfolio diversification, and other financial priorities. Determine how making an IRA contribution fits into your broader financial plan and whether it complements other financial goals.
Consulting with a financial advisor can also help as it provides you with personalized guidance and assistance in retirement planning and IRA contributions.
To conclude
Last-minute IRA contributions present a valuable opportunity for taxpayers to both reduce their tax burdens and bolster their retirement savings. Seizing these opportunities not only allows you to maximize your potential tax savings but also reinforces your long-term financial security. However, you must have a thorough and clear comprehension of contribution deadlines, eligibility criteria, and due dates for tax filing to enhance your tax planning strategies effectively. Taking proactive steps to capitalize on these avenues can pave the way towards a more stable and prosperous financial future.
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