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How Contributing to an IRA Can Help You Save on Taxes

Retirement planning is crucial to a person’s financial well-being. Contributing to a retirement account as early and often as possible can offer peace of mind, with the knowledge that many years of hard work will pay off. Certain types of retirement accounts can also offer tax benefits, either now or in the future. Starting in the early 1970s, Congress authorized favorable tax treatment for employee contributions to individual retirement accounts (IRAs). Our Los Angeles tax professionals can advise you on the benefits that each type of IRA may provide.

What Is an IRA?

An IRA is a type of financial account that offer tax advantages as a way to encourage people to save for retirement. Many employers include IRAs as a benefit for their employees. Individuals may also open IRAs on their own. The IRS refers to these accounts as “individual retirement arrangements.”

The two most well-known IRAs are:

Traditional IRA: Congress established the tax benefits of a traditional IRA in the Employee Retirement Income Security Act (ERISA) of 1974.
Roth IRA: The Taxpayer Relief Act of 1997 created this type of account, named for Senator William V. Roth, Jr. (R-DE).

Tax Benefits of a Traditional IRA

Individuals may make pre-tax contributions to a traditional IRA up to a maximum amount set each year by the IRS. For 2020, the annual contribution limit is $6,000 for people under the age of fifty, and $7,000 for people age fifty or older. For a married couple, the contribution limit is still the same for each individual in most situations.

The amount contributed to a traditional IRA up to the annual limit is not included in taxable income. If a forty-year-old taxpayer has a gross income of $40,000 in 2020 and makes the maximum contribution of $6,000 to their traditional IRA, they will only owe federal income tax on $34,000.

When the person retires, withdrawals from their traditional IRA are taxed as regular income. This essentially defers the tax they would have paid on that $6,000 until retirement. Traditional IRAs are subject to an early-withdrawal penalty for withdrawals made before the age of 59½.

Traditional IRAs include a required minimum distribution (RMD) by a certain date. Under current IRS regulations, a traditional IRA account holder must receive a distribution by April 1 of the year after they turn 70½ years old. This can be confusing. If a person’s 70th birthday is on June 1, 2020, they will turn 70½ on December 1, 2020, and must receive an RMD by April 1, 2021. If they turn 70 on September 1, 2020, however, they will turn 70½ on March 1, 2021. Their RMD date will not be until the following year, on April 1, 2022.

Tax Benefits of a Roth IRA

Contributions to a Roth IRA are not tax-deductible, meaning that the account holder pays tax on the amount of the contribution for the same year they make the contribution. Withdrawals of the account’s principal balance, however, are tax-free, and gains in the account are taxed at the capital gains rate instead of the higher income tax rate.

Roth IRAs are subject to the same annual contribution limit as traditional IRAs, but they do not have an RMD. As long as the account holder only withdraws from the principal balance, they are not subject to an early-withdrawal penalty. In order to take advantage of the capital gains tax rate, dividends and other gains must remain in the account for at least one year.

If you have questions about tax problems in California, the Enterprise Consultants Group’s tax advisors are available to assist you. Please contact us today online or at (800) 575-9284 to discuss your case.

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