Ask the Readers: Have you ever opened a retirement account to reduce your taxes?
As we finished up our tax return this year, it turned out that we owed. Great. We don’t have to scrape the money together. We had planned for the extra liability when an unexpected consulting gig came together for my husband at the end of 2014. But nonetheless, it stings when you have to write a check to the Internal Revenue Service. (And besides, you just want to keep your hard-earned money for yourself!) But I was astonished with what happened next — because the solution came from yours truly and not my MBA-husband.
“You know, we can open an individual retirement account (IRA) and potentially reduce our liability,” I said. I practically turned my head around to see who uttered the words. (I think he actually did too!) My husband and I are newly married and our joint tax life is still pretty new. Last year when he prepared our first joint tax return, I happily checked out of the process leaving it entirely to his capable hands.
So what was different? About two years of reading personal finance articles day in and day out — total immersion. This year, I didn’t check out of the process. I participated in a supportive kind of way (meaning I was there to provide sustenance, moral support, hand over the appropriate paperwork at the appropriate time, and listen to his mutterings. Doesn’t everyone mutter as they prepare their taxes?) But even though we knew we would owe going into it, when he came to the end and it became clear we owed that much, we were crestfallen.
“Really?”
“Really.” Ugh.
So after I suggested the retirement account, I could see the wheels turning. Within a couple seconds, he was tapping the keys to get back to the section in the software where you enter the amount you added (or intend to add) to your retirement account in 2014. He put in the full amount, made his way through the software again and — voila! — our tax liability was less by about $1,400. I felt smug. But that wasn’t all. I noticed that it also doubled the refund we were expecting from the state! Jubilation ensued.
What do you need to pursue this strategy?
Once you determine the specifics of your tax liability, your eligibility, and which type of retirement account is appropriate for your circumstances, there is one critical element you need to be able to participate: liquid assets (as in the kind you would keep available in an online savings account).
To participate in this strategy, you need to be able to fund the account — AND pay whatever your tax liability ends up being — by the date you are required to pay (usually April 15).
This means you would need to deposit up to $5,500 to fully fund your retirement account if you are under 50; if you are over 50, the maximum you can deposit is $6,500. So in our case, it was the tax liability plus the $6,500 for his account.
If you have sufficient savings to participate in this strategy, remember to tell the institution that you are making the contribution for tax year 2014 when you open the account. (Otherwise, they will attribute the deposit to the year in which they receive the funds, which could actually be deposited up until April 15, 2015.)
The amount you save in taxes depends on your income, your filing status, tax bracket and the amount you are willing to deposit into your IRA. So it is best to consult your tax professional, but we found the tax software to be more than capable of providing the correct guidance.
So, have you ever opened an IRA to reduce your taxes? Do you plan to do this every year, or do you have a different strategy?
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There are 40 comments to "Ask the Readers: Have you ever opened a retirement account to reduce your taxes?".
I did this in graduate school. Back then the maximum contribution was $2000. Now we have employee sponsored plans at work, so we aren’t eligible. One time when I hadn’t maxed out for the year, I was not allowed to make a 401K contribution before April for the previous year.
I did this in my early 30s. We’ve funded Roth IRAs that last couple of years, but mostly to sock away a bit more for retirement, tax free instead of deferred. Of course, a Roth isn’t going to affect current tax liability, but it will help later on.
I wish I could open a traditional IRA but I’m phased out. Living in NYC my state/local tax rate is approximately 10%, therefore I defer my taxes as much as possible through maxing out my pre-tax 401k and HSA.
Not knowing your specifics, but you can probably open an IRA, it just won’t be deductible if you have access to a 401k. http://adventures-of-sam.blogspot.com/2013/10/2013-ira.html Then you can convert to a Roth IRA. See the link in my blog post for more information.
It won’t lower your taxes now, but it will in the future since Roth distributions are tax free.
Yeap we did that. As we live in Europe the details are different but the overall principle is the more or less the same: Save now, get half back from the state and enjoy a better, but taxable, retirement later.
Come back in 20 years or so and I will tell you whether it was worth it! 🙂
My story may only be somewhat related but I figure it might be helpful to at least someone, hopefully 🙂
My husband and I ended up owing on our 2013 taxes so we figured, instead of increasing withholding and getting less in our paychecks we decided to contribute more (substantially more) to our 401ks through work. That way we lower our taxable income without sacrificing the size of our paychecks, win-win, right? Well, it backfired, and when we filed our 2014 taxes we owed even more! We didn’t account for the fact that our workplaces would be taking less taxes throughout the year since the taxable income in our paychecks was smaller… ugh. It probably would have helped more to open a separate account and do it that way — lesson learned I suppose.
Since we’ve owed two years in a row now I’ve gained a new perspective on it — people always say to try and break even with your taxes so that you’re not giving the government an interest free loan, right? Well I’ve decided that if you owe on your taxes that just means that YOU’VE gotten the interest free loan – take that IRS! While it may not be healthy or accurate, at least this viewpoint helps with my stress levels related to paying taxes, sigh…
Just make sure you don’t owe so much that you’re paying penalties. You can have your employer adjust your withholdings or you can independently pay estimated taxes to avoid penalties on tax day.
I’m highly considering depositing some of my self-employment income into my IRA this year to help reduce my tax liability. I’ve already earned more in the first quarter of 2015 than I did in half the year of 2014, so I’m worried I’m going to have to pay in quite a bit this year if I don’t get creative.
Do you already have a solo 401K? If you don’t then you may want to look into it.
It depends on your AGI whether you can fund an IRA and have a workplace pre-tax plan (401k, 403b, etc). It is not true that you cannot do both – it depends on your circumstances. Yes, I have contributed to IRA’s to reduce tax liability. This year I just don’t want to spend the cash since it will take a large IRA contribution for small reduction in federal tax. We have no state tax and a small mortgage at 2.75% so we can no longer benefit from itemizing. (Children are grown-up, too.)The truth is the dollars I put in a 401k and now have moved to an IRA from my early years of work (in my 20’s), work much harder than any new money I contribute for the few years left before retirement. Yes more is always more, but my financial advisor says I am set so I’d rather kill my mortgage fast.
Even if your AGI is above the limit to fund both, you can often fund a non-deductible IRA which you then can back door into a Roth. We’ve been doing it since the income limits were lifted in 2010 permitting this maneuver.
We don’t save on taxes now, but will save later since we now have a good chunk in a ROTH IRA.
Hey Sam,
If your AGI is above the limit, why put it into an IRA and then “back-door” it into a Roth IRA; why not just put it into a Roth IRA to begin with? I’m sure I’m missing something, please fill me in.
Thanks!
Roth IRAs also have limits based on your MAGI: http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2015
I started doing this probably 8 years ago. This was the first year that my husband & I maxed out the annual contribution, so I’m proud that we’ve reached that threshold.
Nearing retirement age, but not retirement (for lack of funds and interest), my accountant recently advised me that putting 6500 into a traditional IRA to reduce taxes – would also reduce my AGI (and therefore s/e?) – most meaningfully, by reducing my taxable income it will also reduce the Social Security I will receive. Who knew? Why did they wait till now to tell me? How do you read this on the 1040? And is it so? If correct, I’ve never read about this before and it’s quite important information to have. Anyone know about this ?
I would suggest you find another accountant who specializes in taxes. Medical FSA contribution amounts and health insurance premiums deducted from your paycheck reduce your SS income, but 401(k) & traditional IRA contributions do not. Check your W-2 to see the difference in income reported if your insurance premiums are pre-tax deductions.
I don’t believe this is quite accurate. Social Security gets its numbers from the W2 your employer submits, which does not reflect any IRA contributions you make. If you contribute to a 401K at work, you will see that there are two different numbers reported, taxable income and social security income.
Tangentially, when my husband retired from the IRS, the retirement expert who gave the seminar said that your social security amount was set at 62 (the first age that you can receive it), and that later earnings do not increase the amount you receive (other than the increase due to delaying the start date.) I haven’t been able to confirm this anywhere, but that woman knew an awful lot of answers to questions I hadn’t been able to find anywhere else about social security.
I hope that’s not true. Those years from 62 to 66 can be some of the highest earning years.
Re the expert who knew the answers: but were her answers correct?
I believe that if you keep working after 62, your SS benefit will increase. If a person’s full retirement age is 66, they get an 8% increase in their benefit for every year (up to age 70) they delay their retirement.
The woman was wrong and should be slapped upside the head for spreading BS.
From the SS website, FAQs, Retirement, Question “What happens if I work and get Social Security retirement benefits?”:
“As long as you continue to work, even if you are receiving benefits, you will continue to pay Social Security taxes on your earnings. However, we will check your record every year to see whether the additional earnings you had will increase your monthly benefit. If there is an increase, we will send you a letter telling you of your new benefit amount.”
The Social Security formula is based on your highest 35 years of annual earned income prior to filing for Social Security, regardless of when earned.
Sorry, minor correction to my last point, your SS is based on highest 35 years of annual earnings regardless of when earned. Meant to say “…whether before filling or not.”
are you going to continue working while receiving social security? If so, he could have meant that contributing to a traditional IRA would lower your AGI and help to lower the amount of social security that would be subject to tax. The taxable amount of social security is on a sliding scale subject to income, but maxes out at 85% at $44,000. It is a bit tricky if you do your taxes yourself though. First you compute the taxable amount of social security if there is no IRA deduction. Then you compute the allowed IRA deduction using the taxable SS you just calculated. Last you recompute the taxable social security income using the IRA deduction allowed. Like I said earlier, it can be tricky if you are doing your return yourself.
Yes, definitely have funded a traditional IRA to reduce taxes. I did this while I worked at Jackson Hewitt for a season, saw the benefit in doing it as I filled out other people’s tax forms. And I had access to a 401K at the time — as a single Mom my income was low enough to be able to qualify for at least a portion of a deduction (see Sam’s comment above).
As to the social security impact question from Diane — I guess that makes sense. Your SS is figured based on an average of 35 years of earnings. So if you pay SS on $79K a year versus $85K a year, I guess there is some impact. But it’s gotta’ be pretty minimal compared to the multiple benefits of socking away money pre-tax. (Medicare deduction is also less, State taxes are less, etc).
I have a 401k with employer match, so I don’t keep a traditional IRA. However I did the same research described in this article but was not able to take advantage of this. Why? Depending on income, you can get PENALIZED come tax time if you “over contribute” to IRAs. I have a Roth that I max out every year – If I was to fund another traditional IRA, I would take a hit for that amount. Beware.
We usually make the Roth/Traditional decision before we’ve done our taxes, but our final tax bill is part of that decision. (This is true for the 401K/403b as well as the IRA.)
We always use the IRA calculations to figure out ROTH/Traditional breaks. I also highly recommend it for those couples with incomes in the 50k range (median household income in the nation) since the size of the saver’s credit can be influenced by your T-IRA contribution. EX. 11k contribution gives you $800 in a tax credit while a 10k contribution results in a $400 credit.
Of course if their income was 40k and they contributes $2,001 each to their T-IRAs then they would have a $1570 credit (plus they reduced their tax by an additional $400)
Here is a simplified, yet detailed description table of the income limits for deducting traditional IRA contributions, regardless of workplace 403b, 401k plan availability.
https://www.fidelity.com/retirement-ira/contribution-limits-deadlines
For years, until the Roth came along. One of the biggest reasons we are able to retire early.
We each deposit the max to our 401k to be eligible for our Roth IRA’S. With $18,000 to my 401k and $24,000 for my wife who will be 50 this year were eligible to deposit $6,500 in her IRA and $5,500 into mine. With about $7,500 in employer contributions that’s $61,500 in new money invested tax deferred annual.
Pretty sweet!
I went into my credit union a few weeks ago to do that very thing. 🙂 It works out beautifully: depositing $2,000 into a spousal IRA for me will A) reduce our taxable income, B) bump us below the threshold so we can claim the Retirement Saver’s Credit for the IRA – & my husband’s Roth 401k contributions too! – and C) allow us to take advantage of the Additional Child tax credit for a $300 bonus from the government. All told, investing that $2,000 in the IRA means instead of still owing $200, we will receive a $500 refund – that’s a $700 difference! A risk-free 35% ROI? Yes please!!!
I’ve only done this once. The key is having the available cash.
Honestly, if “Bad Money Advice” were still an active blog, I would nominate this post. Ms. Vergon needs to check her logic. You should never base money decisions on the amount of your income tax refund, and suggesting it’s a good idea, reinforces it with people who don’t know better. You need to consider total tax liability including estimated taxes and withholdings you’ve paid throughout the year. You also need to consider your average and marginal tax rates.
While paying attention to the size of your refund/net liability at tax time is good, it should never be the driving factor in financial decisions except for adjustments to estimated tax payments and withholdings to bring it close to 0. It usually does not reflect your whole tax bill.
I didn’t really take this as advice. Notice the title is a question–this is about seeing whether readers have ever done this. From what I’ve read above it seems like it’s a strategy that is rarely a viable option, best implemented when you’re right on the line between one tax bracket and another and have plenty of cash on hand that you don’t need for anything else. That combination of circumstances is unlikely to occur for people on a regular basis, more likely it might occur once or twice in a lifetime.
The IRS Credit for Qualified Retirement Savings Contributions (Form 8880) should be reason enough to open a retirement account. My wife and i make $400 a year because of this simple form.
And our retirement account doubles as an emergency fund because we choose a Roth IRA. We can withdraw our contributions any time. It’s when you withdraw the investment earnings that you get the big tax penalty.
Ditto on Form 8880. If you’re close to the boundary, it can pay off big. If you were $1 over the cutoff, then a $1 contribution to a pre-tax IRA would net you as much as $400 in tax savings (this is for a married couple, saving $200 each).
I’m fairly close to that boundary, so each year I optimize my pre-tax vs. Roth savings by getting below that cutoff.
Yep, I contributed to a traditional IRA until my AGI & 401(k) participation took away the deduction. I did it part to get the deduction and to save for retirement.
Now I max out my 401(k) contribution. It took me a while to do it – psychologically it was hard to lose the immediate benefit of that money.
Yep! Totally did this. I use the Betterment platform and was also encouraged to signup there. Win win.
Yep! We did that this year. Only put in $1500 but it definitely helped our tax situation.
we must have some very high earners on this blog because i earn just over 80k gross as a single and i still can make a max contribution to my traditional IRA because my AGI is under 60k after maxing the 401k contribution and HSA. So i am awfully confused as to why people dont do both if they can afford it. Even over 61k AGI you can sometimes get a partial deduction.
I did this for the first time this year. I’m a stay-at-home dad, and I did some odd at-home jobs to make about a thousand dollars. Because I would have owed self-employment taxes, after some research, I put the entire amount in a traditional IRA.
I was able to put everything I personally earned into savings, while avoiding having to pay any tax on it…until retirement.