Deductions Allowed for Contributions to a Traditional IRA
Updated for Tax Year 2016
The contributions you make to a traditional IRA account may entitle you to a tax deduction each year.
Traditional individual retirement accounts, or IRAs, are tax-deferred, meaning that you don’t have to pay tax on any interest or other gains the account earns until you withdrawal the money. Additionally, the contributions you make to the account may entitle you to a tax deduction each year. However, the Internal Revenue Service (IRS) restricts who can claim a tax deduction for contributions to traditional IRAs based on various factors.
Everyone is eligible to make contributions to a traditional IRA, but a tax deduction for those contributions may not always be available. If you or your spouse contributes to an employer-sponsored retirement plan, such as a 401(k) or 403(b), and your Modified Adjusted Gross Income (MAGI) exceeds annual limits, you may need to reduce or entirely eliminate your IRA deduction. If you and your spouse are not eligible to contribute to an employer plan, you can deduct your contribution as long as you earn income during the year. For purposes of the IRA deduction, earned income excludes interest, dividends and similar types of investment income.
The IRS limits the amount you can deduct each year. However, this amount is subject to change each tax year. This maximum tax deduction may also be subject to a reduction when your MAGI is too high. The IRS provides a worksheet with your tax return instructions to help you calculate your deduction.
If you use tax software, such as TurboTax, you can avoid tedious calculations and let your computer calculate the deduction for you. TurboTax can help you determine whether your IRA contributions are deductible and will calculate exactly how much you can deduct.
You must file your tax return on Form 1040 or 1040A to claim a deduction for your traditional IRA contributions. The IRS categorizes it as an above-the-line deduction, meaning you can take it regardless of whether you itemize or claim the standard deduction. This deduction reduces your taxable income for the year, which ultimately reduces the amount of income tax you pay.
If you cannot make a tax-deductible contribution to a traditional IRA, consider several alternatives. First, maximize your contributions to the retirement plans that your employer offers. Contributions to 401(k) plans and 403(b) plans have the same effect on your taxes as a contribution to a traditional IRA. Also, if your MAGI does not exceed the IRS limits for contributing to a Roth IRA, consider putting the money into this type of account instead of a traditional IRA.
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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.
Reporting the ROTH IRA Conversion on your Tax Return
Retirement by Scott Wills
It might have seemed like a simply marvelous idea at the time, but lots of people who did the ROTH IRA conversion are having a bear of a time getting it all sorted out on their income tax returns. If you’re one of those people, hopefully this will help.
I’m going to tell you where the numbers should show up on the form. If you know where things are supposed to go, then you’ll know if it’s right or not. Quite frankly, the most difficult part for me has been using the computer software to get the numbers to go in the right place.
Let’s run a few different scenarios, all using a rollover of $15,000. In all of the scenarios, you’re going to use form 8606 to let the IRS know that you did a ROTH conversion instead of just taking the money out and spending it. This will keep you from being charged the 10% penalty for early withdrawal.
In our first example, you’re rolling over $15,000 from a traditional IRA and you have no basis (meaning you didn’t pay taxes on any of the $15,000.) Down near the bottom of the first page of the 8606 is Part II, the section about ROTH IRA conversions. Question 16 wants to know the amount that you converted: that’s $15,000. Line 17 will be blank, line 18 will be the taxable amount of $15,000. Lines 19 and 20 are based upon if you’re paying the tax in 2010 or if you’re splitting it between 2011 and 2012. If you’re paying the tax this year, then you’ll have the number 15,000 on line 15b of your 1040 form. If you’re putting off paying until next year, then that line will be blank.
One of the questions I’ve been asked is, “If I don’t pay the tax this year, how does the IRS know that I’m supposed to pay it next year?” Line 20. Rest assured, anyone with numbers in lines 20a and 20b will have their returns looked at during the next two years to see if they remembered to pay the tax. I guarantee it.
Our second example still has you rolling over $15,000 and that’s all the money you have in your IRA. What’s different is that you paid taxes on $5000 of that money. Just like before you put 15,000 on line 16, but now you put $5000 basis on line 17. That makes the taxable amount only $10,000. You decide about whether to pay now or later.
Our third scenario is a little trickier. You’re still rolling over $15,000 and your basis is $5,000—the difference this time is that you have a total of $60,000 total in your IRA. Unlike the above example, you can’t just deduct the $5,000 of basis from what you rollover, it has to be proportional to your total IRA amount. 5000/60,000 equals 8.33%. That percentage of 5000 is $417. You’ll put $15,000 on line 16 for the rollover, $417 on line 17 for the basis. That means that the taxable amount on line 18 will be $14,583. (I know, it doesn’t sound as good as the other scenarios does it?) Don’t forget that you still have $4,583 in basis to use if you do any conversions in the future.
And our last scenario, you have $5,000 in basis from before and you made a $5000 non-deductible IRA contribution this year. The $15,000 is your entire IRA. This time, you also have to fill out Part 1 of form 8606. On line 1 you will put $5,000—the contribution you made this year. On line 2 you will put $5,000 the basis you had before. One line 3 your add them together for $10,000. Then you’re going to skip down to Part 2 (unless you had SEP and SIMPLE IRAs) and put $15,000 on line 16. Your total basis will be $10,000 on line 17, and your taxable conversion will be $5,000.
Knowing what form you need and where the numbers go is only half the battle. Getting the numbers to go where they’re supposed to go using computer software can be more challenging than doing it by hand. If you’re using brand name software like Turbo Tax, you can call their expert hotline for help.
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You are missing something very significant.
The money in a traditional IRA (specifically, a deductible traditional IRA; there is not really any reason to keep a nondeductible traditional IRA anymore) is pre-tax. That means when you pay tax on it when you take it out, you are paying tax on it for the first time.
If you take ordinary money to invest it in stocks, and then pay capital gains tax on it when you take it out, that is post-tax money to begin with -- meaning that you have already paid (income) tax on it once. Then you have to pay tax again on the time-value growth of that money (i.e. that growth is earned from money that is already taxed). That means you are effectively paying tax twice on part of that money.
If that doesn't make sense to you, and you think that interest, capital gains, etc. is the first time you're paying tax on the money because it's growth, then you have a very simplistic view of money. There's something called time value of money, which means that a certain amount of money is equivalent to a greater amount of money in the future. If you invest $100 now and end up with $150 in the future, that $150 in the future is effectively the same money as the $100 now.
Let's consider a few examples. Let's say you have $1000 of pre-tax income you want to invest and withdraw a certain period of time later in retirement. Let's say you have an investment that grows 100% over this period of time. And let's say that your tax rate now and in the future is 25% (and for simplicity, assume that all income is taxed at that rate instead of the tax bracket system). And capital gains tax is 15%.
- Put it in a Traditional IRA and withdraw it: $1000 grows to $2000, you pay 25% taxes, end up with $1500
- Take it in your paycheck, and then invest it in the stock, and withdraw it at the end: $1000, you pay 25% income tax to $750, the investment grows to $1500, but then you pay capital gains tax of 15% x $750 = $112.50. You end up with $1387.50
- Put it in a Roth IRA and withdraw it: $1000, you pay 25% income tax on it to $750; it then grows to $1500; you pay no taxes on that
You see a few things: Traditional IRA and Roth IRA are equivalent if the tax rates are the same. This is because, in both cases, you pay tax one time on the money (the only difference between paying tax now and later is the tax rate). It doesn't matter that you're paying tax only on the principal for the Roth and on the principal plus earnings for Traditional, because the principal now is equivalent to the principal plus earnings in the future.
And you also see that investing money outside fares worse than both of them. That is because you are paying tax on the money once plus some more. When you compare it against the Roth IRA, the disadvantage is obvious -- in both cases you pay income tax on the principal, but for Roth IRA you pay nothing on the earnings, whereas for the outside stock, you pay some tax on the earnings. What may be less obvious is it is equally disadvantageous compared to a Traditional IRA; Traditional and Roth IRA are equivalent in this comparison.
401(k)s and IRAs have a fundamental tax benefit compared to normal money investment, because they allow money to be taxed only one time. No matter how low the capital gains tax rate it, it is still worse because it is a tax on time-value growth from money that is already taxed.
In a Traditional IRA contributions are often tax-deductible. For instance, if a taxpayer contributes $4,000 to a traditional IRA and is in the twenty-five percent marginal tax bracket, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. So that's why they tax you as income, because they didn't tax that income before.
If a taxpayer expects to be in a lower tax bracket in retirement than during the working years, then this is one advantage for using a Traditional IRA vs a Roth.
Distributions are taxed as ordinary income. So it depends on your tax bracket
UPDATE FOR COMMENT:
Currently you may have heard on the news about "the fiscal cliff" - CNBC at the end of the year. This is due to the fact that the Bush tax-cuts are set to expire and if they expire. Many tax rates will change. But here is the info as of right now:
Dividends: From 2003 to 2007, qualified dividends were taxed at 15% or 5% depending on the individual's ordinary income tax bracket, and from 2008 to 2012, the tax rate on qualified dividends was reduced to 0% for taxpayers in the 10% and 15% ordinary income tax brackets.
After 2012, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket. - If the Bush tax cuts are allowed to expire. - Reference - Wikipedia
Capital Gains tax rates can be seen here - the Capital Gains tax rate is relative to your Ordinary Income tax rate For Example: this year long term gains will be 0% if you fall in the 15% ordinary tax bracket.
NOTE: These rates can change every year so any future rates might be different from the current year.
The simplest explanation is that a traditional IRA is a method of deferring taxes. That is, normally you pay taxes on money you earn at the ordinary rate then invest the rest and only pay the capital gains rate.
However, with a traditional IRA you don't pay taxes on the money when you earn it, you defer the payment of those taxes until you retire. So in the end it ends up being treated the same. That said, if you are strategic about it you can wind up paying less taxes with this type of account.
This is actually (to me) an interesting point to note. While the answer is "that's what Congress wrote," there are implications to note. First, for many, the goal of tax deferral is to shift 25% or 28% income to 15% income at retirement. With long term gains at 15%, simply investing long term post tax can accomplish a similar goal, where all gain is taxed at 15%. Looking at this from another angle, an IRA (or 401(k) for that matter) effectively turns long term gains into ordinary income. It's a good observation, and shouldn't be ignored.
Basically, the idea of an IRA is that the money is earned by you and would normally be taxed at the individual rate, but the government is allowing you to avoid paying the taxes on it now by instead putting it in the account. This "tax deferral" encourages retirement savings by reducing your current taxable income (providing a short-term "carrot").
However, the government will want their cut; specifically, when you begin withdrawing from that account, the principal which wasn't taxed when you put it in will be taxed at the current individual rate when you take it out. When you think about it, that's only fair; you didn't pay taxes on it when it came out of your paycheck, so you should pay that tax once you're withdrawing it to live on. Here's the rub; the interest is also taxed at the individual rate. At the time, that was a good thing; the capital gains rate in 1976 (when the Regular IRA was established) was 35%, the highest it's ever been. Now, that's not looking so good because the current cap gains rate is only 15%. However, these rates rise and fall, cap gains more than individual rates, and so by contributing to a Traditional IRA you simplify your tax bill; the principal and interest is taxed at the individual rate as if you were still making a paycheck.
A Roth IRA is basically the government trying to get money now by giving up money later. You pay the marginal individual rate on the contributions as you earn them (it becomes a "post-tax deduction") but then that money is completely yours, and the kicker is that the government won't tax the interest on it if you don't withdraw it before retirement age. This makes Roths very attractive to retirement investors as a hedge against higher overall tax rates later in life. If you think that, for any reason, you'll be paying more taxes in 30 years than you would be paying for the same money now, you should be investing in a Roth.
A normal (non-IRA) investment account, at first, seems to be the worst of both worlds; you pay individual tax on all earned wages that you invest, then capital gains on the money your investment earns (stock gains and dividends, bond interest, etc) whenever you cash out. However, a traditional account has the most flexibility; you can keep your money in and take your money out on a timeline you choose. This means you can react both to market moves AND to tax changes; when a conservative administration slashes tax rates on capital gains, you can cash out, pay that low rate on the money you made from your account, and then the money's yours to spend or to reinvest.
You can, if you're market- and tax-savvy, use all three of these instruments to your overall advantage. When tax rates are high now, contribute to a traditional IRA, and then withdraw the money during your retirement in times where individual tax rates are low. When tax rates are low (like right now), max out your Roth contributions, and use that money after retirement when tax rates are high. Use a regular investment account as an overage to Roth contributions when taxes are low; contribute when the individual rate is low, then capitalize and reinvest during times when capital gains taxes are low (perhaps replacing a paycheck deduction in annual contributions to a Roth, or you can simply fold it back into the investment account). This isn't as good as a Roth but is better than a Traditional; by capitalizing at an advantageous time, you turn interest earned into principal invested and pay a low tax on it at that time to avoid a higher tax later. However, the market and the tax structure have to coincide to make ordinary investing pay off; you may have bought in in the early 90s, taking advantage of the lowest individual rates since the Great Depression. While now, capital gains taxes are the lowest they've ever been, if you cash out you may not be realizing much of a gain in the first place.
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Non-Deductible IRA Contributions Could Leave You Taxed Twice
If you’re ineligible to make tax-deductible contributions to a traditional IRA, and you make too much money to contribute to a Roth IRA, you have another option: making non-deductible (that is, after-tax) contributions to a traditional IRA. It seems like a smart decision: Why not take advantage of the government’s offer to let your contributions grow tax-deferred until withdrawal many years in the future? The problem is, you could end up paying taxes twice on some of the money you contribute — especially if you neglect to file a tax form that you might not even know exists.
With all traditional IRAs, you can begin making withdrawals, or distributions, at age 59½ — and once you reach 70½, you’re required to take distributions if you haven’t yet started them (see IRS Publication 590). Your IRA custodian (the bank, brokerage or other institution where you have the account) reports the full amount of the distribution to the IRS using Form 1099-R.
In theory, you will owe federal income tax only on the portion of the distribution that is attributable to tax-deferred growth, while the portion attributable to after-tax contributions would not be taxed.
In practice, for many who have made non-deductible IRA contributions, your reward for saving is a tax-reporting nightmare when distributions begin.
One common, unpleasant surprise that befalls some non-deductible IRA owners is that IRA custodians do not automatically keep track of your after-tax contributions. You’re supposed to report those contributions to the IRS yourself using Form 8606, which you file with your tax return for each year in which you made non-deductible contributions. The trouble is that many taxpayers — particularly those who prepare their own returns — are unaware of this form. Without this form, the IRS has no record of how much after-tax contributions you have made, and the burden is on you to prove that you made them.
Even for those who were savvy enough to file Form 8606 and who have maintained meticulous records of after-tax contributions, teasing out your after-tax contributions is still not as simple as you would think.
Many investors mistakenly believe that, as long as they have maintained their non-deductible IRAs separate from their pre-tax IRAs, the money they withdraw from their non-deductible IRAs will be taxed according to the ratio of contributions to the value of the account. For example, if they made $25,000 in after-tax contributions to an account now worth $100,000, they assume that only three-quarters of their distributions from that account would be taxable.
In reality, however, the IRS requires you to consider the after-tax contributions in relation to the total value of all IRAs you own. For investors with considerable IRA holdings, this often means that only a very small percentage of the distributions from a non-deductible IRA may be exempt from taxation.
As this point, some astute investors may say: “Aha! I have a solution! Why not convert the entire value of the non-deductible contributions to a Roth IRA?” Bad news, my friends — Uncle Sam is one step ahead. While it is certainly permissible to convert after-tax IRA contributions to a Roth IRA, the conversion amount is still taxable in proportion to the amount of total combined IRA holdings.
For example, say an IRA holder made five years of $2,000 annual non-deductible IRA contributions in the 1990s ($10,000 total), and the total value of all of his IRAs (including rollover IRAs, SEPs and SIMPLE IRAs, but excluding Roth IRAs) is now $500,000. If he elects to convert $10,000 to a Roth IRA, only 2% ($10,000/$500,000) of the conversion amount, or $200, will be exempt from taxation.
In summary, while the concept of making non-deductible IRA contributions may be sound, the bitter pill for many taxpayers may be double taxation on the money they have contributed. It could potentially take decades to get the after-tax money returned, and the odds of beneficiaries who may eventually inherit the residual IRA avoiding the taxation on the original contributions are slim to none.