How does an IRA save you money on taxes?

Want to learn how you could possibly save over $1000 on your taxes this year?

If you live and work in the United States, your taxes are due in just under a week. One common strategy for saving money on your taxes is to use a tax-deferred retirement savings account. Most companies that employ more than a few dozen people will offer a 401(k) retirement savings plan to their employees, sometimes with a company match. However, this is only available to employees of that company. A spouse is not eligible, nor is someone who left the company. The tax code offers every citizen the option of opening an IRA, or Individual Retirement Arrangement (the “A” doesn’t stand for account, believe it or not).

There are two flavors of IRA: Roth and Traditional. The big difference between the two is that your money that goes into a Roth gets taxed before you contribute, while the money that goes into a Traditional gets taxed in retirement. Both allow you gains to grow tax free each year. The only way to save money on this year’s taxes is to contribute to a Traditional IRA. If you are reading this on or before April 12^th, 2018, you are not too late to make a contribution towards your 2017 taxes!

Other countries besides the United States offer similar programs. There is the Individual Savings Account in the United Kingdom, which functions a lot like a Roth IRA in that you contribute money after taxes. Switzerland has restricted pension plan accounts which function a lot like a Traditional IRA. Plenty of other countries have plans that are somewhat similar to a 401(k) or an IRA, like Poland, New Zealand, and Australia.

Let’s talk about a Traditional IRA. How can putting money in this account fatten your tax refund or reduce what you owe? How much money did you make last year, total? Imagine you took all of those dollars, turned them into bills, and stacked them on top of each other. Now slide that stack next to a ladder. You should have something that looks like this:

 (not to scale)

The United States has a progressive tax system, which basically means that the more money you make, the higher your earnings are taxed. This is somewhat hard to understand intuitively for some people, so here I have grossly over-simplified to illustrate what this looks like in practice. The red portion of each dollar is the number of cents you owe in taxes.

(definitely not to scale)

So to use some actual numbers, if you are single, you pay nothing on the first $10,040 of money you earned. Then on the next $9,325 you earned, you’d pay 10% of that. Then on the next $28,625 you earn, you’d pay 15%. Then on amounts between there and $101,940 you’d pay 25%. There are more brackets the higher you earn, but I’m going to assume you make $60,000 a year for this exercise and stop there. (I also oversimplified and assumed you just took the standard deduction and an exemption for yourself and didn’t qualify for any other credits or deductions or taxes.)

So if you imagine each of your dollar bills stacking up during the year, you pay nothing on the first ten thousand or so at the bottom. Then you start forking over ten cents for each dollar, for bill after bill. Then you hit fifteen-cent land. Then you finally make it to the twenty-five cent territory, where for every dollar you earned, you give Uncle Sam a shiny quarter. Your $59,999^th dollar bill? Another quarter. And one more quarter for 60K and you’re done. What’s your tax bill? It’s $8,228.75. Here you go, picture time again:

(not a round number)

So even though you are in the “25% tax bracket”, we’re only talking about your top dollars. So you didn’t owe $15,000, you owed roughly half that. You actually paid an effective tax rate of just 13.7%. Now here is where the IRA can come in to save you a ton of money. Uncle Sam treats the dollars you put into an IRA like they are invisible when it comes to taxes for that year. And not only that, they also assume you are putting the dollars at the top of the ladder in your IRA first. In 2017 the IRS lets you put up to $5,500 into an IRA. Since those dollars come off of the top of the ladder, that would save you $1,375 in taxes. You’d owe that much less, or get that much more as a refund. My final picture:

(sweet sweet green)

Now your tax liability goes down to $6,853.75, or 11.4%. Yay keeping your money. Except 20 or 30 something you doesn’t really get to keep it anymore… you pay a penalty if you touch that money again before you turn 59 ½. There are some exceptions to this rule, but you generally want to just write that money off until retirement.

That being said, if you have an extra couple grand laying around that you don’t need, this is great way to get a jump start on your retirement and save a bunch of money in taxes. Convinced? Then you’re going to need to make two decisions. First, where to open the IRA. Second, what to invest in. Since I’m already to a thousand words here, I’ll save topic number two for another day. You don’t technically have to do anything at all with the money in the IRA in order to qualify for the tax savings, so I’ll write about picking investments another time. But bottom line, I recommend index tracking ETFs. These are ticker symbols like QQQ and SPY. If you put a couple grand in there, you could do a lot worse than going 50-50 into those two ETFs right there and calling it a day. It can really be that simple.

As to where you open an account, it doesn’t really matter too much, to be honest. If they are coming up in the first two pages of a Google search for “open an IRA”, then they’re almost definitely a trustworthy company. I would scout out offers for new accounts, like a cash bonus or referral bonus. The only thing that would really matter to me about where to open an IRA would be if I wanted access to that company’s mutual funds. But I think mutual funds are kind of crappy ways to invest, so it wouldn’t make a difference to me.

There are dozens of caveats and other things I haven’t covered, so if you’re interested in this I’d encourage you to do some more research or ask me questions and I’ll do what I can to help. One of the biggest questions/gotchas would be if you already contribute to your employer’s 401(k), should you put extra contributions there instead. I would say yes, but only if you are happy with the options available in your 401(k). I know I only have a couple dozen options available to me in my employer-sponsored plan, so I couldn’t take my own advice and buy a bunch of my beloved QQQ. The other consideration is annual limits. You can contribute to both an IRA and a 401(k), but if you make over a certain amount, you can’t deduct the IRA contributions (they still grow tax free). That threshold for single people is $62,000 MAGI, and for married it is $99,000 MAGI. MAGI is your modified income, so it’s the number after you take all your deductions and exemptions. In our example above, you are well under the threshold at 60k a year. Bottom line – if you have a 401(k) at work and made a lot more than these cutoffs, your best bet is to add more to your 401(k). You can still do this and tag it for last year. The annual limit is $18,000, which leaves plenty of room for most people to play tax time games. Don’t forget your spouse gets their own separate limit too if you are married. A few grand chipped into your 401(k) now for last year will do the exact same thing for your taxes as the pictures above show.

So there you have it! A Traditional IRA will let you save money on your taxes. It’s very similar to a 401(k), but generally allows you a lot more freedom in how you allocate your money. It’s also completely unrelated to your employer or your current job. If you have any questions, send them my way!