Monday, November 3, 2014

Current Tax Benefits for IRA Contributions

As an incentive to promote personal investing, the IRS allows individuals with earned income to deduct contributions made to a traditional Individual Retirement Account (IRA) in calculating adjusted gross income. There are certain limits to deductibility of contributions for those who are active in an employer sponsored retirement plan, such as a 401(k). However, those not considered active can contribute $5,500 per person or $6,500 for those 50 years old and over (see for deduction qualifications and contribution limits). Contributions must be made by the due date of your income tax return, excluding extensions, which means April 15.

Many couples are unaware that a spouse who does not have earned income can still receive a deduction provided the couple files a married filing joint return and meets certain requirements. This can be especially beneficial to couples in high tax rate brackets that are looking to reduce current tax liability by deferring it through traditional IRAs. It doesn't seem like much, but can start to add up if you consider the long term effects.

The 28% and 33% tax rate tables in 2014 for a joint return start at $148,850 and $226,850 for taxable income, respectively. If a couple under the age of 50 years old has $11,000 or more of taxable income over these thresholds, then the tax deferred savings will be maximized based on their marginal rate. Assume, for example, that a couple has taxable income of $159,850 ($148,850 + S11,000) and they do not have the option to defer income through employment. The deferred tax savings by each spouse contributing $5,500 would be $3,080 ($11,000*28%). The same would apply for those in the 33% bracket. If taxable income was $11,000 or more over the $226,850 threshold, then deferred tax savings would be $3,630 ($11,000*33%).

Now suppose the couple in the 28% bracket were 35 years old and made $11,000 ($5,500 each)of deductible contributions each year for 30 years and earned a compounded annual rate of 5% each year through investing the deferred tax savings amount. The potential future value just in the deferred tax savings of $3,080 each year could be up to $215,000 in 30 years from the initial payment. A more impressive figure is that your $11,000 annual investment for 30 years at 5% will have grown to approximately $767,000.

For those in higher tax brackets, the future value with equivalent assumptions would potentially yield an even higher amount. Keep in mind that withdrawals from one's traditional IRA will be taxable, so typically those who expect to have a lower taxable income rate at retirement or prefer more growth during investing years should consider this strategy.

Jon Holcomb