In our Ask an Advisor series, members of Grow’s Financial Advisor Panel answer your money questions each week. Today, CFP Michael Kitces, co-founder of XY Planning Network, partner and director of wealth management for Pinnacle Advisory Group and publisher of Nerd’s Eye View, shares his #1 recommendation for shaving money off your tax bill.
Q: What’s the most effective year-end strategy for lowering my tax bill?
In addition to giving money to your favorite charity or donating unwanted household items to a nonprofit—both tax-deductible strategies that are likely top of mind this time of year—there’s another smart strategy that can lower your tax bill: contributing to your Individual Retirement Account (IRA).
You can save up to $5,500 this year, so long as you earned at least that much. And there’s still plenty of time to max it out if you’re behind: You have until April 17, 2017 to contribute for tax year 2016.
When you’re preparing your tax return next year, you may be able to deduct the amount you contributed from your income. For instance, if you saved $1,000, your taxable income is reduced by $1,000. If you’re in the 15 percent tax bracket, that can increase your refund—or the amount you owe—by $150.
Note that if you (or your spouse, if you’re married) are covered by an employer-sponsored plan at work, like a 401(k), your ability to deduct your IRA contributions phases out at higher income levels. Those earning less than $30,750 (and married couples earning less than $61,500), however, can not only deduct the contribution, but also claim a bonus tax credit for another 10 to 50 percent of their IRA contributions.
On the other hand, for those who want to save for retirement, but don’t want or need the tax deduction right away—perhaps because your tax rates are still fairly low early in your career—the better option is to contribute to a Roth IRA instead. There’s no tax deduction now, but all the growth can be tax-free for retirement in the future.
In fact, even those who earn more than the income limits allow for tax-deductible IRA contributions should look to a Roth IRA—either contributing to the account directly, or contributing to a non-deductible IRA with the plan to convert it to a Roth later (the so-called “back door Roth” contribution strategy).
Just don’t forget: The money you contribute to a traditional or Roth IRA is meant to be there long-term. If you withdraw it before age 59 ½, you’ll owe a 10 percent penalty, plus ordinary income taxes.