IRAs are one of the best tools you can use to save and invest for retirement. When used the right way, the tax benefits can save you lots of money and put you in a better position to financially flourish in retirement. Here are five things everyone should know about IRAs.
1. Your tax bracket matters
Both Roth IRAs and traditional IRAs have great tax benefits, but what separates them is when you receive the tax break. With a Roth IRA, you contribute after-tax money, so your investments get to grow tax-deferred, and you get to take tax-free withdrawals in retirement. You technically contribute after-tax money in a traditional IRA, but you may be eligible to deduct your contribution, so your tax break is still on the front end. When deciding which account you should choose, it should come down to your current tax bracket versus your likely tax bracket in retirement.
If your current tax bracket is likely lower than what your tax bracket will be in retirement, it makes sense to go with a Roth IRA because you get to pay money on the taxes now, instead of later when it’ll be more expensive. If your current tax bracket is likely higher than what it’ll be in retirement, you should go with a traditional IRA because it makes sense to take the tax break now when it could be more helpful.
2. You can use a backdoor Roth IRA if you make too much money to contribute directly
There is an income limit to be eligible to contribute to a Roth IRA. For tax year 2022, it’s $144,000 if you’re single and $214,000 if you’re married and filing jointly. If you’re above the income limit, you can still use a Roth IRA by using the “backdoor Roth IRA” method. To create a backdoor Roth IRA, you first contribute to a traditional IRA. Once you do that, you’ll convert the traditional IRA to a Roth IRA.
Since you received your tax break on the front end with a traditional IRA, you’ll owe income taxes on the amount you convert to a Roth IRA. This is the IRS’ way of making sure you don’t contribute to a traditional IRA, take the deduction, and then convert to a Roth IRA and receive tax-free retirement withdrawals.
3. There are exceptions to the early withdrawal rule
Generally, taking withdrawals from a retirement account before you’re 59 1/2 years old is considered an early withdrawal and will result in income taxes owed, as well as a 10% early withdrawal penalty. However, there are some exceptions to the early withdrawal rule for IRAs:
Qualified education expenses
First-time home purchase (up to $10,000)
Unreimbursed medical expenses over a certain amount
Making an early withdrawal from a retirement account should be one of your last options because it’s a costly move, but in some cases — such as the first-time homebuyer perk — it may make sense to utilize your retirement account funds if it’s not going to resort in taxes or a penalty.
4. Contributions can be made after year end
For 2022, the maximum amount you can contribute to an IRA is $6,000 for those younger than 50. This includes both Roth IRAs and traditional IRAs; you can only contribute $6,000 combined, not for each. Although contributions are based on a specific year, you don’t have to make your contributions by the end of that year. You have until April 15 (Tax Day) of the following year. Note, however, that if you’re making contributions for tax year 2022, you have until April 18, 2023, to contribute up to $6,000 because the 15th is on a weekend and April 17 is Emancipation Day in Washington, D.C.
5. You can contribute to a spouse’s IRA
Part of the stipulation with IRAs is that you can only contribute earned income. Normally, if you don’t work, you can’t contribute to one — even if you technically have the money. There is an exception, though: If you and your spouse file a joint return, you can contribute to their IRA if they didn’t have any earned income, as long as you did. You can contribute up to $12,000 per year ($13,000 if one of you is 50 or older; $14,000 if both of you are 50 or older).
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