What Are the Tax Advantages of an IRA?

Everyone wants to find ways to save on taxes and most people want to have money for retirement. There are plans that offer both opportunities in one vehicle. These plans are IRA's. They come in several forms and each type of IRA works for different situations. No matter which one you choose, there are tax-advantages to each type of IRA.

History

Understand that individual retirement accounts, IRA's, started back in 1974. They were limited to self employed individuals and those not covered by a corporate pension plan. You could only put as much as you earned up to $1,500 into the account. In 1981, changes made it available to all taxpayers. There were changes in the contribution limits for nonworking spouses. By 1986, tax deductibility phase out limits passed. Changes in the 1990's increased contribution limits for all and created the Roth IRA. In 2001, "catch up" contributions were created for those 50 and older.

Function

Remember that the function of the IRA is to encourage investors to save for retirement by using tax incentives. There are varieties of tax advantages that vary with the type of IRA. The traditional tax deductible IRA offers the investor the right to remove the income they invested from their taxable income. This can substantially lower their taxes.

Effects

Understand that no matter what IRA you use, the funds grow tax-free. Money that grows tax-free grows faster because the whole amount compounds without removing the cost of the taxes.

Size

Note the size of the income you make before you deduct the money off your taxes from a traditional IRA deposit. The more income you have, the less you can invest and deduct if you can participate in another plan. In 2008, phase out began at $50,000 and is completely non-deductible at $60,000 for single people. If one spouse works where there's a plan but the other spouse doesn't, then the income limits for phase out are $150,000 to $160,000. For those that are married and both have a plan then phase out of deductibility is $80,000 to $100,000. Married people filing separately can't make over $100,000 if the two live together.

Types

Try a Roth IRA before you put money into a non-deductible traditional IRA. If you can't deduct the money from your income, then use a Roth IRA instead. The IRS taxes the growth of non-deductible traditional IRAs when you remove it, there's no tax on the Roth growth. You have to remove the money from a traditional IRA after you reach 70 1/2, you don't with a Roth. Consider the tax advantages of the Roth over the traditional IRA if up if you can't tax deduct the deposit. There are phase out limits for the Roth. If you are single, they are between $101,000 and $116,000. Married people phase out between $159,000 and $169,000. Married filing separately can't make over $100,000 if the two live together.

Warning

Mix the non-deductible money with deductible IRA money and you'll be sorry. When you put money into a non-deductible traditional IRA, make sure you don't mix it with money that you can deduct. When you remove money from a traditional IRA, you pay taxes on all of it. When you deducted the amount from your taxable income, in effect, you never paid taxes on the money. If you mix the two, there's no way to isolate the money you didn't deduct.