An individual retirement account (IRA) provides benefits for savings or investing. The money deposited in an IRA grows tax deferred until withdrawals are made in retirement. An IRA can also provide current tax benefits with a deduction of the amount of deposit made during the current tax year.
Maximum IRA Contribution
The first step to calculating tax savings from an IRA contribution is to determine how much money you will deposit in an IRA for the year. As of 2011, the maximum annual IRA contribution is $5,000. If you are age 50 or over you can deposit an additional $1,000 for a total IRA contribution of $6,000. You can elect to deposit less money in your IRA and the tax savings will be calculated on your actual deposit amount.
Not every taxpayer can deduct an IRA contribution. If neither you nor your spouse is covered by a qualified retirement plan at work, you can contribute and deduct up to the maximum annual IRA limit. If you are covered by a retirement plan at work and your income exceeds certain limits, the amount of IRA contributions you can deduct may be limited. A single tax payer covered at work and earning less than $56,000 could still make the full deduction. If married filing jointly, the deductions starts to reduce at an income of $90,000. If your income exceeds these levels check the IRS Publication 590 for the deductible IRA limits for your income and tax filing status.
Your Tax Bracket
To calculate the tax savings from an IRA contribution you need to know your marginal tax bracket. The U.S. tax code has six tax income levels that are taxed rates of 10, 15, 25, 28, 33 and 35 percent. Your marginal tax bracket is the percentage you pay in taxes for the last dollar of income you earned for the year. The bracket is based on your taxable income -- after deductions -- and tax filing status. For example, if you are a single filer with a taxable income of $60,000, you would be in the 25 percent tax bracket.
The tax savings from making an IRA contribution is the deductible contribution amount times your marginal tax bracket. For example, assume you have determined you can deduct the full $5,000 annual contribution limit and have determined you are in the 25 percent tax bracket. Multiply $5,000 time 0.25 for a result of $1,250. If you make an IRA contribution in this amount, your federal income tax bill will be reduced by $1,250.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.