With less than two weeks left before the tax filing deadline, many of us are scrambling to find last-minute deductions. Most tax-savings strategies must be implemented during the previous calendar year, but one popular strategy is still in play even though many other rules changed significantly under the 2017 Tax Cuts and Jobs Act. Contributions to an Individual Retirement Arrangement (IRA) are tax deductible and can be made right up until April 15. Save for your future and save on taxes now — it's a win-win situation.
Why an IRA?
Company-sponsored retirement accounts such as the 401(k) and 403(b) are offered to many full-time employees. These are tax-deferred accounts in which money is invested before taxes are taken out. This means the contributions are deducted from income and no taxes are paid on that portion of income. However, employees have to pay taxes on the money when it's withdrawn at a later point, usually in retirement.
Traditional IRAs have the same deferred-tax advantage and, like a 401(k), the money is intended to be used during retirement. It's a good option for the many workers who don't have access to employer-sponsored plans. There is a limitation on how much money can be put into the account each year, though. For 2018, the limit is $5,500; those over 50 years old can contribute an extra $1,000 each year. For 2019, the basic limit will rise $500 to $6,000, and taxpayers over 50 will still be able to contribute an extra $1,000.
You can open an IRA through most large financial institutions such as banks and brokerage firms. As with a 401(k), once the money is deposited in an IRA, you need to choose where to invest it. While a 401(k) account usually offers a limited number of investment choices, with an IRA you can invest in any publically traded company, exchange traded fund, or mutual fund. The access to more investment options and the lack of administrative fees make IRAs a popular retirement savings option. However, many employers match employee contributions to retirement accounts, often paying 50 cents for every dollar the employee saves, up to a set amount. If this is the case, it's best to fund your 401(k) to maximize your match before funding an IRA.
If you're able to max out the employer match and have more money to put away, you can also open an IRA. You'll receive a tax deduction for the total amount contributed (by you) to both your 401(k) and IRA. However, the annual IRA deduction has limits that vary with income levels, so check with the IRS for the details. If you're looking for a last-minute tax break, 401(k) contributions won't help you, since the funds must come out of your paycheck and can't be applied to a previous year. But an IRA contribution can help up to the April 15 deadline.
What If I Need My Money?
What happens if there's an emergency, you decide to go back to school, or you're finally ready to buy a house but all your money is locked up in an IRA?
When you withdraw money from a traditional IRA you have to pay taxes as if it's ordinary income. If you do so before age 59½, there's also a 10 percent penalty. Together, that can amount to almost half of your withdrawal! The good news is that although you'll still need to pay the taxes, there are exceptions that allow you to make penalty-free withdrawals. You may pay for medical expenses or health insurance premiums, higher education expenses, and take out $10,000 toward buying, building, or rebuilding your first house without penalty. There are several other penalty-free scenarios as well.
What Is a Roth IRA?
A Roth IRA is similar to a regular IRA but the contributions are made post-tax, meaning you won't get a tax deduction. Roth IRAs are a little more flexible, since the contributions can be withdrawn at any time without paying a penalty or extra taxes. Some earnings from your investments may be withdrawn early without penalty as well, depending on how the money is spent.
Roth IRAs aren't available to high-income earners, but they're a good option if you want to open a retirement account, have easy access to your money, and don't need the tax deduction this year. They're very popular among younger investors because the earnings can be withdrawn tax-free in retirement, as long as you follow the rules about age and account duration. With a traditional IRA, income tax must be paid eventually on the contributions and earnings.
Remember, with both a traditional and Roth IRA you can contribute toward the previous year's current $5,500 limit all the way through April 15. However, only the traditional IRA results in a deduction.