Contributing to an IRA (Individual Retirement Account) each year is a valuable way to save for retirement and reduce your lifetime tax bill. But should you contribute to a Roth IRA or a traditional IRA? If you qualify for both, the decision is up to you, and here are a few steps to decide which to add to.
1. Complete Your Taxes
First, complete your income tax Form 1040 without the contribution in question. Include all your other deductions and credits so the only variable remaining is your IRA contribution.
2. Calculate Your Deduction Savings
With your taxes in hand, calculate how much would be saved if you contribute to a traditional IRA. Generally, multiply the amount of your deduction by your marginal tax rate. This is your highest tax rate, and it's applied to the last amount of income earned (and therefore the first income deducted). If your marginal tax rate, for instance, is 22%, you will likely save 22 cents for every dollar deducted.
If your marginal tax rate is high, a traditional IRA can benefit you. Many retirees have a lower tax rate in retirement, making it better to put off that tax bill until later. Someone with a low marginal tax rate, though, should consider a Roth IRA deduction instead since the benefit to current taxes may be minimal.
3. Consider Your Effective Tax Rate
Look at your effective tax rate as well. This is the actual percentage paid for the year in taxes. This rate will generally be lower than your marginal rate — sometimes by a significant amount. This is because the percentage of tax increases as you earn more. Some taxpayers may have much more of their income taxed at a lower rate than at a higher one.
If your effective tax rate ends up being a lot lower than your marginal rate, it may also behoove you to contribute to a Roth IRA and pay the taxes this year. Why? Your overall current tax hit may be low anyway.
4. Look At Income-Based Credits
Your tax rate isn't the only number to crunch. In addition, look at any credits and deductions that change based on income. These include the Saver's Credit, Earned Income Credit, Child Tax Credit, education credits, and student loan interest. If your income is near any threshold — either to qualify or to be disqualified — you may want to choose the IRA option that preserves these deductions.
5. Make Your Contribution
Once you decide whether to fund your traditional IRA or a Roth IRA, be sure you make this contribution before the deadline (usually April 15). Follow your IRA account provider's instructions to mark the contribution for the preceding year. And keep a record of the contribution with your tax forms.
Where to Start
Want to know more about IRA contributions, tax rates, or income-based deductions? Start by meeting with an accounting company, such as Hough & Co CPA.