In the last few months, one hit that has directed a lot of people to this blog is the query "use IRA or 401(k) contribution to offset or lower tax bill?"
And enough people have made this query to warrant a a more thorough discussion of it.
How do you lower your tax bill by contributing to an IRA? The concept is simple, but you have to contribute a lot to your IRA or 401(k) in comparison to your tax bill.
Note: Talk to your tax adviser for specific advice. As I noted in a previous posting, you can simulate the effects of an IRA or 401(k) contribution on your taxes by using Turbotax online. I highly recommend TurboTax online, just for this reason.
So how can you lower your tax bill by contributing to a tax-deferred savings plan? Well, the idea is something called "salary reduction".
In effect, when you contribute to an IRA, a 401(k), or SEP plan, TSP, SIMPLE IRA or other tax-deferred plan (which does NOT include a Roth IRA, by the way) you are effectively reducing your salary by that amount.
So, your taxes are assessed on your lower salary - that is to say, your INCOME taxes. They still nick you with the Social Security, Medicare and other taxes.
And the benefit to you will depend on which marginal tax bracket your are in. If you are in the 15% bracket, this isn't going to save you a lot of money - unless you contribute a lot.
So, for example, suppose you owe the IRS $1000 in taxes and you are in the 25% marginal rate bracket. You could write a check to the IRS for $1000 and call it a day. Or, you could contribute $4000 to your IRA for this taxable year, and end up owing the IRS nothing.
Pay the IRS $1000 or pay your IRA $4000. For many of us, it is a simple choice - unless we don't have $4000 laying around.
And this example illustrates the advantage of tax-deferred plans - you get an effective "gain" of 25% (or whatever your marginal rate is) almost right away.
There are, of course, some caveats, which is why I say "consult your tax adviser" for more details:
1. There are limits on how much you can contribute to these plans - total amounts and/or percentage of income. For an IRA, for example, the limit is $5000 unless you are over 50, in which case it is $6000. And these limits change from year to year. Consult your tax adviser.
2. There are deadlines for contributions. Generally, you can contribute to a plan before April 15th, and designate the money for the previous tax year. Consult your tax adviser for more details.
3. There are more esoteric limits, such as phase-outs, in case you are covered by a retirement plan at work - which may limit your ability to contribute.
4. Again, it all depends on your marginal rate. If you are in the 15% bracket and owe the IRS $1000 you'd have to put in $6,666 to offset this tax bill - and that is $666 more than the over-50 limit for an IRA. And bear in mind that such contributions may push you into a lower bracket as well, making the savings less effective.
5. Tax-deferred accounts have severe tax penalties for early withdrawal, so don't contribute money you might need in the next few years into your tax-deferred savings.
But overall, this is a good strategy for lowering your taxes. If you have $5000 sitting around invested in after-tax investments, it makes more sense to transfer that money to a pre-tax investment and lower your tax bill. The net effect is to take money from one pocket and put it in the other, at little or no cost to you, but at a large cost to Uncle Sam.