April 15 is approaching fast, but it’s not too late to reduce your tax bill if you happen to have a little extra money in your budget.
Here’s how: a last-minute contribution to your IRA, or individual retirement account. Not only can that move help with your current tax situation, it’s also powerful for your future.
“A $500 [IRA] contribution each year for someone starting at age 25 can be an extra $114,000 by the time they reach retirement,” says Maura Cassidy, vice president of retirement at Fidelity Investments.
“It sounds small, but if you can put that away every year until you’re 65, that’s a good amount of money,” she says. “Those types of small steps can really pay off in the long run.”
First, let’s recap some basics on IRAs. There are two main kinds: Roth IRAs and traditional IRAs. (Check out our primer here.) The big difference is in taxes. You may be able to deduct contributions to traditional IRAs, with the funds growing tax-free. With a Roth IRA, you’re making after-tax contributions, which then grow tax-free and can be withdrawn tax-free.
There’s a limit as to how much you can contribute to an IRA each year. For the 2018 tax year, the limit is $5,500, or $6,500 for those over 50. For 2019, those maximums are $6,000 and $7,000, respectively.
And you can actually make IRA contributions for the previous year up until this year’s tax filing deadline. So, even though it’s 2019, you can still make contributions to an IRA that count toward 2018.
So if you have extra cash you want to contribute to an IRA, is it best to contribute for this year (2019) or last year (2018)? There are a few things to consider.
Cassidy says that if you haven’t contributed anything for 2018, or are just now starting an IRA account, you should contribute for last year. “If you haven’t contributed to 2018, you may as well take advantage of that,” she says.
There are other reasons why earmarking your contribution for 2018 may be a good idea, too.
Julie Welch, a tax partner at Kansas-based accounting firm Meara Welch Browne and member of the American Institute of Certified Public Accountants (AICPA) executive committee, says some taxpayers may qualify for the Retirement Savings Contributions Credit (Saver’s Credit), which in some cases allows you to deduct up to 50% of your contribution.
But Welch says that you may be better off contributing posttax dollars to a Roth IRA instead, especially if you think you’ll be in a higher tax bracket later in life—which is likely for many young savers.
“If you’re in a low bracket now, yeah, you might save a little bit of tax if you make the contribution and deduct it now,” she says. “But you might be a lot better off not deducting it. [Then] when you pull that money out in retirement, you don’t have taxes due on anything.”
In other words, you can effectively pay a lower tax rate now by contributing to a Roth IRA than you would when you withdraw the funds at retirement, when you’ll probably be earning more.
“It’s not just a one-year decision,” Welch says.
If you decide to make a contribution for the 2018 tax year, be sure you tell your financial institution that that’s what you’re doing—so they can correctly report the transaction to the IRS. (If you’ve already filed, you’ll likely need to amend your return.)
“If you want to make an IRA contribution,” Welch says, “and if you want it to be for 2018, for the tax return you’re working on, you have to specifically tell [your financial institution] that you want it to be for 2018.
“The money has to go in, and you have to make it clear.”
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