If you have a big income tax bill due in April 2017, there might be a way to reduce it, if you are willing to set some cash aside for retirement. It’s not too late to make an individual retirement account contribution that will decrease your 2016 tax bill or even boost your refund. Here’s why you should save in an IRA before the April 18, 2017 deadline.
[See: How to Reduce Your Tax Bill by Saving for Retirement.]
You can reduce your 2016 tax bill. As you prepare your tax return you can plug in an IRA contribution and see exactly how much your tax bill will decline. For example, a worker in the 25 percent tax bracket who contributes $5,500 to an IRA will pay $1,375 less in federal income tax. Taxes won’t be due on that money until it is withdrawn from the account. You can defer paying income tax on up to $5,500 that you contribute to an IRA, or $6,500 if you are age 50 or older in 2016. Married couples can open an account in each of their names for double the tax break. If you have access to a 401(k) plan at work, the IRA tax deduction is phased out for those with a modified adjusted gross income between $61,000 and $71,000 as an individual and $98,000 to $118,000 for married couples in tax-year 2016. If only one member of the married couple has a 401(k) account, the income limits climb to $184,000 to $194,000 for 2016. However, once you turn age 70 1/2, you won’t be able to claim a tax deduction for new IRA contributions and will instead be required to take money out of the account and pay the resulting tax bill.
You won’t owe annual income tax on the investment gains. You don’t have to pay income tax on the investment growth in your IRA each year. Taxes won’t be due on the retirement savings in an IRA until you withdraw the money from the account. If you drop into a lower tax bracket in retirement, you will pay less tax on your retirement savings and reduce your lifetime tax bill by saving in an IRA. For example, a worker in the 25 percent tax bracket would pay $1,250 for income tax on $5,000 worth of income. However, if he saves that $5,000 in an IRA and then withdraws it in retirement, after he has dropped into the 15 percent tax bracket, he will pay only $750 for income tax on the IRA distribution.
[See: 10 Tips to Boost Your IRA Balance.]
You can use your tax refund to fund an IRA. IRS form 8888 allows you to directly deposit part or all of your tax refund in an IRA. You can file a tax return claiming a tax deduction for an IRA deposit before the money is in the account as long as you make the contribution by April 18, 2017. Take care to specify that you want the contribution to be applied to your 2016 tax return, because IRA providers are allowed to automatically apply the deposit to the calendar year in which it is received unless you indicate otherwise.
You will be less tempted to spend the money on an immediate need. An IRA makes it a little more difficult to spend your nest egg before retirement. If you take a withdrawal before age 59 1/2, there’s typically a 10 percent early withdrawal penalty, and you will have to pay income tax on the distribution. A $1,000 early withdrawal could result in $350 in taxes and penalties for someone in the 25 percent tax bracket. However, there are a variety of exceptions to the early withdrawal penalty that include many serious needs for the money such as large medical bills, health insurance after a layoff, college costs and a first home purchase.
[Read: 5 New 401(k) and IRA Rules for 2017.]
You might qualify for the saver’s credit. If you save in an IRA and you have a 2016 adjusted gross income of less than $30,750 as an individual, $46,125 has a head of household or $61,500 as part of a married couple, you might be eligible for the saver’s credit. The saver’s credit is worth between 10 and 50 percent of your IRA contribution of up to $2,000 for an individual and $4,000 for a couple, with bigger credits going to savers with lower incomes. The saver’s credit can be claimed in addition to the tax deduction for contributing to a retirement account.
Emily Brandon is the author of “Pensionless: The 10-Step Solution for a Stress-Free Retirement.”
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5 Reasons to Make a Last-Minute IRA Contribution originally appeared on usnews.com
