The Tax Benefits of Starting an IRA

The Tax Benefits of Starting an IRA
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Opening a traditional individual retirement account or a Roth IRA provides a great way to save for the future. An IRA also provides tax advantages for most investors, and an Roth IRA can provide even more advantages. You must understand how you can benefit from tax savings to maximize your savings potential. With some careful preparation, you can save thousands of dollars through tax benefits available to those who save money with an IRA.

Tax Deduction

When you deposit money into an IRA, you protect that money from immediate taxation. It becomes tax-deferred. This means that you will not pay tax on it during the year in which you earned the income. Instead, you will pay tax on the money when you withdraw it. The federal tax law allows you to deduct the amount of your deposit on your federal tax return in the year the money was deposited. Individuals who earn more than a certain amount in a tax year cannot claim any deduction for that tax year. For 2011, a taxpayer married and filing jointly can claim a deduction for IRA deposits only if his income totals no more than $179,000.

Deduction Limits

Federal tax law limits the amount that you claim as a tax deduction for IRA deposits. Most taxpayers can claim a deduction equal to the amount that they deposited up to $5,000. If you are 50 or older, you can claim up to $6,000. The deduction limit is an annual limit. You can claim the maximum deduction amount each year, and most taxpayers try to put the maximum amount into an IRA.

Withdrawal Taxation

You must pay tax when you withdraw money from your IRA. If you claimed a tax deduction for your IRA deposits, you must pay tax on all of what you withdraw. If you did not claim a deduction for your IRA deposits, you only need to pay tax on what you earned through your investment. You would not pay tax on the contributions because you were already taxed for that income. Some IRAs feature different rules. For example, you do not pay any tax on a Roth IRA withdrawal if you are 59 1/2 years of age or older and have had the Roth IRA account for at least five years.

Early Withdrawal

If you withdraw money from your IRA before you reach age 59-1/2, you not only pay any income taxes that are due but also a 10-percent penalty tax for the early withdrawal. The IRA, though, allows some penalty-free early withdrawals. If you withdraw money that you use to pay school costs, the IRS does not penalize you. With a traditional IRA, you still pay tax on the withdrawal, however. With a Roth IRA, you do not pay tax on the withdrawal, as long as it does not exceed the contributions you have made. The school costs can be for yourself, a spouse or children or grandchildren. The student must attend an IRS-approved institution. You also can use up to $10,000 in IRA funds toward the purchase of your first home. A married couple can use up to $20,000. The first-time homebuyer rule, in IRS terms, only requires that you did not own a home within the past two years.

Tax Rate

When you withdraw money from your IRA, the federal government taxes you. If you invested in your IRA with pre-tax dollars, the government considers the entire amount as part of your income for the year in which you withdraw the money. If you invested with deposits that were taxed during the year they money was deposited, the IRS only counts your earnings as a portion of your income during the withdrawal year. Since the withdrawal factors into your income, it can affect your tax rate for that year by increasing your rate from what you would otherwise pay.