The federal government gives tax incentives to people who contribute to Individual Retirement Accounts (IRAs). The amount varies depending on the type of IRA to which you make your contribution. When thinking about how much an IRA contribution can save you on your income taxes, think beyond the year of the contribution because some IRAs offer significant tax savings when you take distributions.
Traditional IRA Contributions
If you are not covered by a retirement plan at work, and your spouse is not either, you can deduct your traditional IRA contribution from your taxes. If you are covered, you may still be able to claim a deduction if your modified adjusted gross income falls below the limits, which change each year. To figure how much can be saved on your taxes in the current year with a contribution, multiply your deductible traditional IRA contribution amount by your tax bracket. For example, if you fall in the 23 percent tax bracket, a $5,000 traditional IRA contribution would save you $1,150.
Retirement Savings Credit Tax Savings
In addition to the tax deduction for a traditional IRA credit, you can also use the same contribution to calculate your Retirement Savings Credit. Roth IRA contribution also count for this credit even though you cannot deduct them from your income taxes. The credit can be up to $1,000 ($2,000 for joint filers) depending on your income level, filing status and size of your contribution. Since this is a credit, it directly reduces your taxable income.
Remember Tax-Free Growth
While the money is in the IRA account, you do not pay income taxes on any growth in your investments. This allows your account to grow at a faster rate because you do not lose any of your returns to income taxes. For example, if you fall in the 20 percent tax bracket and you have $3,000 in returns in an IRA, you save yourself $600 on taxes that year. That means that extra $600 is not earning more returns the next year than you otherwise would have had in a taxable account.
Tax-Free Qualified Distributions for Roth IRAs
Unless you qualify for the Retirement Savings Credit, a contribution to a Roth IRA does not save you on your taxes in the year you make the contribution. Instead, when you meet the qualified-distribution requirements -- your account being at least five tax-years old and you being at least 59 1/2 -- your money, including returns on your investments, comes out tax-free. You can estimate your tax savings by multiplying your expected marginal tax rate in retirement by the amount you plan to withdraw.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."