How can IRA contributions help with your taxes?
IRA contributions generally affect your current taxes in a positive way. It’s basically a way to save money for your retirement now tax-free (in other words, you don’t pay taxes on the income you put into an IRA until you withdraw it), so you’ll have something to live on after you retire and no longer have earned income. In addition to the traditional IRA, there are also other IRA structures, such as the Roth IRA. However, for the purposes of this article, we are going to talk about traditional IRAs.
How do IRAs affect your taxes?
Traditional IRAs are the IRAs most of us think about what we think about retirement, IRA contributions, and taxes. An IRA, also known as an individual retirement account, is a way to save money tax-deferred for retirement. Traditional IRAs have some restrictions (just like Roth IRAs).
However, there are great ways to save money for retirement, and they’ll generally save you money in the long run, too, since you won’t pay taxes on IRA outlays until you actually withdraw the money.
When you contribute to an IRA
Your contributions to a traditional IRA generally lower your tax bill, because they lower your adjusted gross income. In general, there are limitations on how much you can contribute to your IRA in any given year. Exceeding these contribution limits will generally result in an IRS penalty, so you must be careful not to exceed these limits. You are also limited in how much you can contribute to an IRA if you participate in another retirement plan with your employer, receive Social Security benefits, have any foreign-earned income, have student loans, tuition and fee deductions, exclusion or housing deductions, or deductions for domestic production activities.
The benefit to IRAs is that, in addition to being able to avoid income tax on the set amount you can contribute for a particular year, your IRA itself can grow and the tax on the interest is also deferred until withdraws. For traditional IRAs, you can start spending at age 59 1/2, and you MUST start spending on April 1 of the year after you turn 70 1/2.
Once you start receiving IRA distributions
Once you start taking distributions from your IRA, you’ll pay income taxes on those disbursements at the time you take them, as long as you’re at least 59 1/2 when you start taking them. (Taking disbursements from your IRA before you turn 59 1/2 will result in you having to pay income tax on that money when you withdraw the disbursements, and you’ll also have to pay a 10% penalty to the IRS on top of that.) At least Theoretically, you reduce your tax by “deferring” your tax at the time of distributions; because your income tax bracket is likely to be lower at that time, so you pay less tax overall.
Yes, you MUST receive distributions at 70 1/2
If you decide not to take distributions by the time you’re 70½ (or, for that matter, April 1 of the following year), the IRS will sanction and sign off on you. So you have to take these distributions and you can’t just decide not to.