IRAs and Your Taxes

Apr 13, 2015 by

clock approaching tax deadlineYou have until midnight Wednesday (April 15) to make a contribution to an IRA for the 2014 tax year. If you’ve not yet done so, get on the IRA contribution stick!

2014 IRA Contribution Limits

Because Uncle Sam can’t afford to give away much money, the two main IRA species (not counting the new myRA), called Traditional and Roth, have contribution limits.

For the 2014 tax year, you can contribute up to $5,500 to both types of IRA combined. So $2,000 to a Traditional IRA + $3,500 to a Roth IRA for example, or any other combination that adds up to $5,500 in total IRA contributions.

Bonus if you were 50 or older before 01 January 2015: you can contribute an extra $1,000, so a maximum of $6,500.

How Federal Tax Brackets Work

As a bit of an aside but also as a prelude to outlining the tax benefits of IRAs, let’s understand how tax brackets work.

You’ve heard someone say that, for example, they are “in the 15% tax bracket,” which is where most Americans are pegged. Many people think this means that 15% of the individual’s or family’s income is siphoned off for taxes. Not so!

For 2014, here is 10% and 15% tax bracket info:

tax brackets

How much tax would a married couple filing jointly pay on $50,000 of taxable income?

Answer:

→ 10% of $18,149 = $1,815
plus
→ 15% of ($50,000 minus $18,149) = $4,778
equals a total of
→ $6,593 in tax due

What portion of their $50,000 in taxable income would the couple pay in federal income tax?

$6,593 / $50,000 = 13.2%

This couple in the 15% tax bracket owed Uncle Same 13.2% of their taxable income. Of course taxable income means what’s left after all sorts of potential deductions, allowances, and credits. A typical couple likely would pay something like 10% of their gross income in federal tax, depending on a huge host of factors specific to their circumstances. Good to keep in mind the next time you hear some wealthy person whining about their “tax bracket.” (Read “U.S. Income Tax Rate History” for an eye-opening look at the effective tax rate on $200,000 in income over the past 50 years.)

IRA Tax Benefits

Now back to IRAs. Let’s first review how each of the two IRA varieties cut your taxes.

Traditional IRA

If you qualify, you can deduct on your tax return contributions you make to a Traditional IRA.

For our fictitious couple, if they each contributed $5,500 and they qualified for the full deduction, they’d knock $1,650 off their tax bill.

→ 15% x $11,000 = $1,650

That’s a huge, 25% tax cut whuppin’ they’d be putting on Uncle Sam!

However, Uncle Sam’s not going away. When the couple withdraws money from their Traditional IRA they will have to pay tax on all withdrawals at the prevailing tax rates for the year of withdrawal. The earnings within their IRA accounts grow tax-free until withdrawal—no tax on earnings in an IRA account.

Roth IRA

Roth IRA contributions produce no tax benefit for the year of contribution.

BUT, all withdrawals from a Roth IRA are 100% tax-free!

That future tax benefit can’t be quantified because it’s speculative—who knows what your tax rate will be when you withdraw your Roth IRA cash—but the benefit surely could be huge!

Growth of Untaxed Earnings

The earnings you are able to muster in either type of IRA accounts are not taxed when you earn them (and are never taxed if they accumulate in a Roth IRA). How does this benefit translate to dollars? Here’s an example.

ira tax benefts

This chart shows the difference in growth between two investment accounts. The red line is like an IRA—earnings are not taxed (until withdrawn, if a Traditional IRA). The green line is a normal, taxable investment account. I assumed earnings are taxed annually at a 7.5% rate.

It may not look like there’s a lot of separation between the two lines, but after 30 years the IRA account balance (red line) is $33,000 more than the taxable account balance. That’s real money, and a powerful incentive to feed your IRA!

But check out the Big Picture: Just from contributing $5,500 annually to an IRA over your career, you could nearly be a half-millionaire!

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