Saturday, January 22, 2011

Viewer Mail - IRA to offset tax bill?

Amounts contributed to an IRA, 401(k), SEP, ThriftSavings, or other pre-tax savings plan will offset your tax bill.  That is the entire point of these plans!

A viewer asks (via Google):

"can i open an ira instead of paying tax bill?"

Yes, Virginia, there is a Santa Claus.  And that is the whole point of these tax-deferred plans.

As a salary slave, you might not appreciate this, as every week, your pay is deducted for taxes and your 401(k), etc.

But once you are self-employed, it becomes abundantly clear around tax time, particularly if you are in higher income brackets.

Every April 15th, my late Accountant would call me and say "Well, you owe the IRS X dollars, but if you put Y dollars in your 401(k) plan, you will owe a lot less, or maybe nothing."

The amount of savings depends on what tax bracket you are in.  And one great thing about online tax calculation programs like is that you can play with contribution numbers and see how it affects your tax bill.

Say, for example, you are in the 25% marginal rate bracket.  You calculate your taxes and realize that you owe the IRS $1000.  You can pay the IRS that $1000 on April 15th, or you can contribute $4000 to a qualified pre-tax savings plan and owe the IRS nothing.

In effect, the IRS is subsidizing your savings by 25%.  Or look at it another way, you are getting a 25% return on your investment immediately.  And yet some people still under-fund their retirement savings!  Go Figure!

There are a lot of caveats, of course, and you should consult your tax adviser accordingly:

1.  There are limits on how much you can contribute to a plan - whether it is a 401(k), IRA, SEP, CSEP, or whatever.   Some limits are dollar amount only, others are percentage of income and dollar amount.  Consult your tax adviser for more details.  If you owe $500,000 in taxes, chances are, you can't get out of it through an IRA deduction.

2.  The higher your bracket, the better this works.  If you are in the 10% or 15% bracket, the savings are pretty small.  Real savings only kick in when you get into the 25% bracket and above.

3. If you ain't got the money, the point is moot.  If you owe the IRS $1000 and can get out of it by putting $4000 into your IRA - but you only have $1000 in your checking account - your options are limited.

4.  There are deadlines for contributions, so consult your tax adviser as to which tax year contributions are credited for.

 In most cases, putting money in an IRA or 401(k) will merely reduce your tax bill.  But in terms of "return on investment" it does illustrate how lucrative these plans can be.  Again, I would suggest using to play with various contribution strategies and see how they play out.  Note that you can enter data in turbotax all day long and play with the numbers and not pay a cent to use it!  They only charge you (a nominal fee) to file when you are done.  And the fee is so nominal that it makes sense, once you have all the data entered, to just click "finish and pay".

Good Luck!