Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It may not have been previewed, commissioned or otherwise endorsed by any of our network partners.
Updated on Monday, February 29, 2016
Many people invest in traditional individual retirement accounts (IRAs) because they’re told these accounts offer a good way to save for retirement. And it’s true!
One of the biggest reasons why? You get to invest money in an account that can grow tax deferred until retirement. In other words, you can save money now and take advantage of the fact that you won’t be on the hook to pay taxes on investment returns (interest, dividends and capital gains) until you take the money out later in life.
What is it about tax deferral that’s so great when it comes to saving for your financial future? Essentially, this is a legitimate, legal way to avoid paying taxes if you use your traditional IRA in the right way.
Here are the specific types of tax deferral you can take advantage of when you save for retirement in an IRA – along with why they make a powerful impact on your nest egg.
Example 1: No Taxes on Investment Returns
As mentioned above, the money you invest in your IRA can grow and you don’t have to pay taxes on interest, dividends, and capital gains that you earn by investing in stocks, bonds, mutual funds and exchange-traded funds.
That means you can buy and sell investments and not worry about the tax consequences as long as you keep that money in the IRA account.
Not having to pay taxes right away benefits you because it may boost your ability to save. If you have to account for taxes on your investment returns, which may cut into the amount you can actually contribute to your account. But since taxes are deferred, you can take advantage and save more right now – and allow compound interest more time to go to work for you and your investments.
Example 2: No Taxes on Current Income
An even better benefit comes in the form of income tax deferral. In certain situations, you may be able to avoid paying taxes on a portion of the income you earn in any given year by contributing to an IRA.
Here’s an example: Let’s assume you’re eligible for tax deferral and you’re in the 25% marginal tax bracket. (Without getting into too much detail, this means you make between $37,450 and $90,750 if you’re single and between $74,900 and $151,200 if you’re married and choose to file taxes jointly with your spouse.)
If you contribute $5,500 into your IRA this year, you’ll receive a deduction on your tax return in the amount of $1,375. Put another way, it feels like you only invested $4,125, which your wallet will appreciate. This is because you don’t actually pay ANY income taxes on the $5,500 until later (typically in retirement).
Since you don’t pay taxes on that money, that means you get to invest the full $5,500 – rather than just $4,125. That’s the amount you would have had to invest in a normal brokerage account if you actually had to pay $1,375 in taxes to the IRS. Thanks to the deduction, you don’t have to.
Over time, this can add up to a significant amount of investment growth in your IRA making tax deferral a very powerful factor. Just think about the amount you can save in taxes over your working years if you continue to invest $5,500 into your IRA every year. (That’s the maximum amount you can contribute to an IRA in 2015 if you’re under 50. The amount rises to – $6,500 for anyone over age 50.).
Make Sure You Take Advantage of Tax Deferrals
So, how do you take advantage of tax deferral inside an IRA? Well, to receive the benefit of the example number one above, you simply have to earn an income. If you do, then you can open an IRA and begin investing up to $5,500 every year that you earn a wage.
Once you hit 50 years old, you can then contribute another $1,000 per year. (These limits will continue to increase with cost of living adjustments.)
Example number two is a little tougher to qualify for. In order to deduct the amount of money you contribute to your IRA, you must not have access to another retirement plan elsewhere, typically through work. If, for example, your company offers a 401(k), then you have access to another plan. And if you do have that access, you cannot deduct your IRA contributions (there is an exception noted below).
The key phrase here is “have access to” because it doesn’t matter if you actually contribute to the employer plan or not. You are still not eligible for a tax deduction on IRA contributions because you could have contributed to that 401(k). Before you get too bummed out, know that, you do get the same tax benefit explained in example two by contributing to your employer’s retirement plan so you’re still in good shape. Plus, you may even get a matching contribution from your employer, which is something you won’t get in an IRA.
There is one exception to this rule. If you make less than $61,000 in any one year, you can deduct your IRA contributions even if you have access to another retirement plan at work ($98,000 if married filing jointly and $10,000 if married filing separately). You may also be eligible for a partial deduction depending onyou modified adjusted gross income. Find the IRS chart here.
One More Tax Advantage to Use in Your Favor
If you’re not excited about the opportunities to take advantage of saving on your taxes now while simultaneously saving for your financial future, here’s a bonus for you: if you haven’t contributed the maximum amount to an IRA for the 2015 tax year (or even opened up an IRA yet), you have until you file your taxes or the April 15 deadline to contribute for last year!
Why would you do this? Well, the more money you get into your IRA, the more money you have working for you for retirement on a tax-deferred basis. If you have the funds available, it’s a great opportunity to increase your retirement nest egg.
Plus, if you just realized that you owe taxes for 2015 and you are eligible to receive a tax deduction by contributing (see rules above), you can reduce a percentage of the taxes owed so you don’t have to pay as much.
It’s yet another win-win situation offered by contributing to your IRA!