Last Minute Tax Moves

The deadline for filing your 2020 tax return is about two months away, but there are still some moves you can make that can impact your taxes, as well as your retirement income.

Most importantly, if you haven’t yet made an Individual Retirement Account (IRA) contribution for 2020, you can do that right up until April 15. But, there are two types of IRAs, a traditional IRA and a Roth IRA. Which one is right for you?

Which IRA?

The traditional IRA reduces your taxable income today, but then you pay taxes on it when you make withdrawals later. If you withdraw it after the age of 59 ½, the withdrawals are taxed as regular income. Early withdrawals, before age 59 ½, from any type of qualified retirement account, come with a 10% penalty plus any income taxes due. There are some exceptions to this rule, but in general you should only take an early distribution as a matter of last resort.

The Roth IRA contributions are not tax deductible, but withdrawals of earnings are tax-free as long as the owner has had the Roth IRA account for at least five years and they are at least age 59 ½. However, because the original contributions weren’t tax deductible, you are allowed to withdraw those contributions at any time for any reason without penalty.

Which type of IRA you choose mostly comes down to your tax situation. If your tax rate is high right now and you expect it to be lower in retirement, then a traditional IRA may be best, assuming you meet the eligibility requirements. More on that below. Further, if you live in a state that allows you to avoid state income taxes on your IRA contribution, but you expect to live in a state with a lower (or zero) state income tax rate in retirement, the best tax strategy may be to take the traditional IRA contribution.

I would add a caveat that many people expect their tax rate to be lower in retirement, but that may not be true. If you have a large traditional IRA, the Required Minimum Distribution (RMD) rules of the IRS may force you to withdraw more from the IRA than you really need. These rules specify that you generally have to start taking withdrawals from your IRA, SEP (self-employment) IRA, SIMPLE IRA, or retirement plan account when you reach age 72 (70 ½ if you reach 70 ½ before January 1, 2020). Roth IRAs do not require withdrawals until after the death of the owner.

If, on the other hand, you expect your tax rate to be higher in retirement, the Roth IRA may make the most sense. You pay the taxes now, and all withdrawals in retirement are tax free. This is my personal preference, assuming you are eligible to contribute.

Income Limits

The annual contribution limit for both types of IRA is $6,000. If you’re age 50 or older, you can contribute an additional $1,000 annually. The contribution must come from taxable earned income of at least your contribution amount.

If you’re single and not covered by a retirement plan at work, your traditional IRA contribution is tax-deductible for 2020 up to $6,000 ($7,000 if you’re 50 or older) regardless of your income. If you are married and filing jointly, and your spouse is covered by a workplace-based retirement plan but you are not, your deduction may be limited. You can still deduct the full IRA contribution as long as your joint adjusted gross income (AGI) isn’t over $196,000 for 2020. You can take a partial tax deduction If your combined income is between $196,000 and $206,000.

The same amounts can be contributed to a Roth IRA, as long as your income is not above the limits: The ability to contribute to a Roth IRA starts to phase out at $196,000 (as defined by modified adjusted gross income, or MAGI) in 2020, if you are married and file a joint return. If you are a single filer, the phase-out begins at $124,000 in 2020.

But don’t wait too long. Once April 15 arrives, you will no longer be able to make a contribution for 2020.

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