What Are the Tax Benefits to Opening an IRA Account?
One of the greatest advantages to saving for retirement is the tax benefits you get when investing in an IRA or other qualified retirement account. Most people know there are tax benefits to opening an IRA account, but few understand how many benefits there are, and how powerful they can be in the cause of saving money for retirement. Did you know there are at least six tax benefits to opening an IRA account?
We discuss these benefits more in-depth below, and how you can leverage them for your own retirement savings.
1. Annual Contribution Tax Deduction (in Most Cases)
If you don't participate in an employer-sponsored retirement plan, you can contribute up to $6,500 per year to an IRA ($7,500 if you’re age 50 or older) and deduct the amount of the contribution from your income when you file your federal income tax return (usually state as well).
Here's an example: if you're in the 28% federal income tax bracket, you'll save $1,820 in income taxes with an annual $6,500 IRA contribution.
You may also be able to make a tax-deductible contribution even if you participate in an employer-sponsored plan.
Single taxpayers can take a full deduction for a traditional IRA with an income up to $73,000 for 2023 and a partial deduction up to $83,000. Married couples who file jointly can take a full deduction on an income up to $116,000 and a partial deduction up to $136,000.
2. Investment Earnings Tax Deferral
Whether or not your IRA contribution is tax-deductible in the year it's made, any earnings that accumulate in your account will be fully tax-deferred until they're withdrawn. This can result in a significant improvement in the investment performance of your retirement portfolio.
The difference between a taxable investment and a tax-deferred investment can be substantial. If you're in a combined federal and state income tax bracket of 35%, a 10% average rate of return on your investment portfolio will be reduced to just 6.5% in a taxable account.
With $100,000 invested in a taxable account for 30 years, at effectively 6.5% your investment will grow to $661,436. But $100,000 invested in a tax-deferred account for 30 years at the full 10% return will grow to $1,744,940.
That’s a difference of well over $1 million! That’s the power of tax deferral.
3. Lower Adjusted Gross Income (AGI)
The IRA tax benefit here is not nearly as impressive as the tax deferral demonstrated above, but it works in your favor nonetheless.
A tax-deductible IRA contribution lowers your adjusted gross income (AGI), which is used to calculate certain itemized tax deductions, as well as your tax rate.
For example; in order to deduct medical expenses, those expenses must exceed 7.5% of your AGI. A $6,000 IRA deduction will lower that threshold by $600, which is to say that an additional $600 in medical expenses will be deductible on Schedule A of your Form 1040.
4. Tax-Deferred Investment Income Up to Age 72
Though most people are concerned primarily with taking IRA withdrawals when they retire, or as early as age 59 ½, the reality is that you don’t need to begin taking withdrawals until you turn 72 (the required minimum distribution age).
This means that if you retire at 65, you don’t need to begin taking withdrawals from your IRA account. You can allow the money in the IRA to continue accumulating tax-deferred investment income right up to age 72. This gives you extra seven years of investment accumulation and compounding interest. This will make a big difference when you finally do begin taking withdrawals.
Let’s say you have $200,000 in your IRA at age 65 when you retire. Instead of taking withdrawals immediately, you delay tapping the account until you turn 72. If you are earning an average of 10% per year, your account will grow to $389,743.42 during the extra deferral period.
This can be an excellent strategy to ensure your retirement assets are able to last throughout your entire retired life.
5. Additional Tax-Deferred Retirement Savings
An IRA enables you to make additional retirement savings contributions, even if you're covered by an employer-sponsored plan. You can contribute up to $6,500 (or $7,500 if you're 50 or older) in addition to the funds you’re putting into your 401(k).
You get the match from your employer (which is essentially like getting free money) and are able to contribute your own savings to an IRA at the same time. This will have the effect of multiplying your retirement savings considerably.
And even if your income exceeds the contribution limits, you can always make a nondeductible contribution that will still earn and accumulate tax-deferred investment income. Learn how to max out your 401(k) with Blooom.
6. A Catch-All Fund for Other Accounts
Sooner or later you will leave every employer you've worked for, and in most cases that will happen well before you reach retirement age. If you already have an IRA account established, you'll have an account you can roll your employer-sponsored plan over into. This allows the employer plan to continue growing — on a tax-deferred basis — until you're ready to begin taking withdrawals.
While you typically do have the option to either keep an employer-sponsored plan where it is or even to roll it over into the plan of your next employer, there are certain advantages to putting it into a self-directed IRA account.
IRAs typically have more investment options than employer-sponsored plans. Those additional investment opportunities are a chance to earn even higher investment returns, which will allow your retirement money to grow even bigger versus just sitting in an employer plan.
As you can see, IRAs have too many tax advantages to ever be without one. Even if you have a retirement plan through your employer, you should still have a self-directed IRA account that will enable you to take advantage of all of the additional tax benefits it provides.
Readers: Do you have an IRA on top of your employer-sponsored plan? Why or why not? What benefits have you received?
I thought it was interesting when you explained that one of the advantages of an IRA plan is that it allows people to make additional retirement contributions. It seems like this kind of retirement plan acts as a great backup just in case something goes wrong with the first one. My parents are planning on retiring in a couple of years, and it seems like it would be a good idea for them to look getting into an IRA account.
Hello, I am 20 and know very little about IRA and retirement plans. What would be YOUR first plan of action to get started?