An IRA is one of the easiest ways to reduce your taxable income since anyone with earned income can open and contribute to an account. The full amount of your contribution to a traditional IRA is tax deductible, which in 2023, can be up to $6,500 if you’re under 50 years old, and up to $7,500 if you’re 50 years of age or older. However, there are some instances where your contributions may not be tax deductible, if you also participate in an employer-sponsored plan like a 401k.
In this article, we’ll look at how to maximize your tax deduction with an IRA, eligibility rules around taking a tax deduction, and how it compares with other retirement accounts.
Tax deductions from an IRA
In 2023, the contribution limit for an IRA is $6,500 if you’re under 50 years of age, and $7,500 if you’re 50 years of age or older. If you contribute the maximum amount to your IRA, you can get a tax deduction up to the IRA contribution limit.
It’s important to note that only contributions to a traditional IRA are tax deductible. Contributions to your Roth IRA are not deductible from your taxable income. Because contribution limits for both are aggregated, to get the full $6,500 (or $7,500 if age 50+) tax deduction, you must make the full contribution to your traditional IRA for the year, and not to your Roth IRA.
Traditional vs Roth IRA
Contributions to a traditional IRA are made with pre-tax income and deductible from your taxable income. For example, if you made $30,000 this year and contribute $5,000 to your traditional IRA, your taxable income would now be $25,000. However, withdrawals from your traditional IRA in retirement are taxed as regular income.
Contributions to a Roth IRA are made with after-tax income and are not deductible from your taxable income. If you made $30,000 this year, you would pay taxes on the entire amount of income, and then contribute after-tax money to your Roth IRA. The advantage of a Roth IRA is that your withdrawals in retirement are completely tax-free.
Also read: Roth vs Traditional IRA
Contribution limits are aggregated
The IRA contribution limit is aggregated across all of your IRAs, meaning the total contributions to all of your IRAs must not exceed the annual IRA contribution limit, which is $6,500 for 2023 ($7,500 if age 50+). For example, if you’re under 50 years of age and have already contributed $2,000 to your Roth IRA this year, you would only have $4,500 in contribution room remaining for your traditional IRA. If you want to receive the full IRA tax deduction, you must make your full IRA contribution into a traditional IRA.
Instances when you cannot get a tax deduction from an IRA
With a Roth IRA, you cannot make any contributions at all if your income is too high. A traditional IRA does not have an income limit that restricts contributions. However, it does have a tax deduction limit. You could still make contributions with a high income, but your tax deduction may get reduced to zero.
IRA tax deduction limit
The traditional IRA tax deduction limit gets applied if you also participate in an employer-sponsored plan at work, like a 401k. And it’s determined by your modified adjusted gross income (MAGI), which is your adjusted gross income with some deductions and exclusions added back in.
Traditional IRA tax deduction limits for 2023
- If your MAGI is $73,000 or less, you get get a tax deduction up to the maximum traditional IRA contribution limit of $6,500 ($7,500 if age 50+).
- If your MAGI is over $73,000 but less than $83,000, you’ll get a partial tax deduction.
- If your MAGI is over $83,000, you get no tax deduction.
To be able to get the full tax-deduction on your contributions for 2023, your MAGI must be under $73,000. You can view IRS Publication 590-A Worksheet 1-1 for calculating MAGI for a traditional IRA.
How much do I need to make in order to max out my IRA contribution?
You can contribute up to 100% of your earned income into a traditional IRA, up to the contribution limit.
For 2023, since the contribution limit is $6,500 ($7,500 if age 50+), you would need to make at least $6,500 in order to contribute the maximum amount into your traditional IRA.
How to report IRA tax deductions to the IRS
If you’re eligible to take a tax deduction on your IRA contribution, you would need to report the deduction on Line 32 of Form 1040.
If you’re not eligible to take a tax deduction, but still have made a contribution to your IRA, you would need to report non-deductible IRA contributions using Form 8606.
When can I take money out of my traditional IRA?
You can start to take qualified distributions from your traditional IRA when you reach the age of 59½. Qualified withdrawals have no penalties but are taxed as regular income according to your tax bracket and tax rates at the time of withdrawal.
If you make an early withdrawal before the age of 59½, you’ll be hit with a 10% early distribution penalty plus income taxes on the withdrawn amount.
With a traditional IRA, you’re not required to start taking distributions until the age of 73, which is the age when RMD kicks in. That means that even though you’re eligible for qualified withdrawals at 59½ years of age, you could choose to keep your money compounding until you’re 73 years old.
The IRS requires that you start taking required minimum distributions (RMD) every year starting from the age of 73 until your account is emptied.
What retirement plans offer larger tax deductions than an IRA?
An employer-sponsored 401k offers employees up to $22,500 in tax deductions for 2023 if you’re under 50 years of age, and up to $30,000 if you’re 50 years of age or older.
If you own your own business, you could also set up a solo 401k, which could give you a $66,000 tax deduction for 2023 if you’re under 50 years of age, and up to $73,500 if you’re 50 years of age or older.
Also read: IRA vs Solo 401k