Last year, I was in danger of moving up a tax bracket. We were pretty close to the line between the two, and the accountant recommended that we open an IRA in order to, perhaps, drop us down a tax bracket. We already had a Roth IRA, but the contributions to a Roth IRA aren’t tax deductible, so the accountant thought that if we opened a traditional IRA, we could squeak by, remaining in the same tax bracket. He quickly whipped up an alternative calculation, assuming that we opened a traditional IRA with $2,500. It was enough to reduce our taxable income to a degree that we managed to stay in the same tax bracket for another year. And the cool thing was that we did this after the first of the year.
You Have Until Tax Day To Open An IRA
One of the great things about opening an IRA is that you can do so after the first of the year. You usually have until Tax Day (which is usually April 15) to open an IRA and add funds. This means that, as you prepare your taxes, and you discover that another deduction would be helpful, you can get that deduction without too much trouble. As long as you have enough to open an IRA with an amount that will be of benefit to you.
If you do decide to open an IRA in order to get the tax deduction, you will need to make sure you designate which tax year it is being used for. If you open an IRA in 2011, before the deadline, you will need to specify that your contribution is for tax year 2010. You will not be able to use the deduction again for 2011. You have to choose which year you want it to count for. A knowledgeable tax professional, or an IRS representative, can help you figure out the best way to go about getting your deduction.
Coming Up With The Contribution
Of course, the next issue is how you are going to come up with the IRA contribution. You can open your IRA with a smaller amount, and then figure out how much you need to put in until April rolls around. If you need $2,000 to achieve your goals, and you open an account in February, it is possible to open the account with $750. Then, during March and at the beginning of April, you will need to put in $625 to total $2,000. Others might consider dipping into an emergency fund to come up with the money all at once. If you do this, though, you need a plan for properly replacing the money as quickly as possible.
For us, the difference was about $637 in taxes. It may seem strange to open an IRA with $2,500 to avoid paying $637 in taxes. However, that $2,500 is working for us (tax deferred), rather than us giving away more than $600 to the government. The situation kicked us into gear, putting more toward retirement. On top of that, having that lower amount in taxes means that our quarterly taxes didn’t change. Do your own cost and benefit analysis, and decide whether it’s worth it to you to save some money in taxes by opening an IRA that will work on your behalf.
My wife and I will probably be using the IRA tax deduction next year to lower our income. Most of our contributions this year were ROTH. We’ll probably have a mix of both depending on our tax situation.
Nice article. Your accountant’s understanding of tax brackets seems a bit off, though. “Moving up” a tax bracket is not really a big deal because the higher tax rate only applies to the income above the lower tax brackets. So if you go $1 into a higher bracket, only that $1 is taxed at a higher rate. The exception to this is the dreaded AMT, but that is more like a different set of rules rather than a different tax bracket.
Also, you should max out your Roth IRA for 2010! And consider opening up one for 2011, just to get a head start.
One other option for reducing taxes, for those who have self-employment income, is to open a SEP-IRA. I have one of these, and once I figure my taxes, I always try to make a contribution, to see if I can reduce amount going to Uncle Sam.
-NCN