Individual retirement accounts (IRAs) are tax-favored vehicles, designed for long-term savings and investments – to build a nest egg for professional life. While some IRAs are available in the workplace, the two most popular are for investors for independent use: the traditional IRA, founded in 1974, and its younger cousin, Roth IRA, introduced in 1997, and named after the sponsor Sen, William Roth. Are Roth contributions tax deductible?
What type of IRA do you have?
Contributions to traditional IRAs, which are the most common choice, are deductible in the tax year in which they are paid. You will not owe taxes on contributions or their returns on investment until you retire.
Contribution to the Roth IRA is not tax deductible. You pay full income tax on money deposited into your account. However, once you retire and start withdrawing money, you will not owe any premium taxes or investment returns.
Retirement plan at work: Your deduction may be limited if you (or your spouse if you are married) are in a retirement scheme at work and your income exceeds certain levels.
No retirement plan at work: Your deduction is allowed in full if you (and the spouse if you are married) are not covered by the retirement plan at work.
Although there is no upfront tax deduction for Roth IRAs, as is the case with traditional IRAs, Roth withdrawals are tax free if you comply with certain conditions. Because the funds in the Roth IRA come from your contributions, not from tax subsidized income, you can use your contributions (but not your earnings) without tax and without penalties at any time you want to do so. Roth IRAs are often an attractive savings tool for people who expect their tax rate to be higher during retirement than they are today. Roth IRAs allow you to pay taxes on money deposited into your account, then all future withdrawals are tax free. Roth IRA contributions are not taxed because the contributions you make to them are usually made from post-tax money and you cannot deduct them. Earnings on your Roth account can be tax-exempt, not deferred. So you can’t deduct contributions to your Roth IRA account. However, payments made during retirement may be exempt. These must be qualified distributions.
Special notes for Roth and traditional IRAs
The key issue when deciding between traditional and Roth IRAs is how you think your future income – and hence the income tax range – will be compared to your current situation. As a result, you must determine whether the tax rate you pay today on Roth IRA contributions will be higher or lower than the rate you will pay for withdrawals from a traditional IRA later.
Although conventional wisdom suggests that gross income decreases in retirement, taxable income is sometimes not. Think about it. You will collect (and possibly taxes due) social security benefits and you can get investment income. You can opt for consulting or self-employment, for which you will have to pay self-employment tax.