Yes, you can lower your taxable income—and hence, your tax bill—by contributing to an individual retirement account (IRA). But it depends, first of all, on the type of IRA you have.
With a Traditional IRA
If you are contributing to a traditional IRA, the answer is definitely yes (unless your income and having a retirement plan at work makes you ineligible to deduct these contributions).
The money that is deposited into a traditional IRA reduces your adjusted gross income (AGI) for that tax year dollar-for-dollar, assuming it is within the annual contribution limits (see below). So a qualifying contribution of, say, $2,000 could reduce your AGI by $2,000, giving you, the account holder, a tax break for that year. This move is what is known as making a contribution with pre-tax dollars.
With a Roth IRA
On the other hand, a contribution to a Roth IRA does not reduce your AGI in the tax year you make it. Roth contributions are funded with after-tax dollars, meaning there's no deduction at the time of your deposit. However, when the money is withdrawn from the account (presumably after you retire), no income tax is due on it.
In contrast, you do pay taxes on distributions from your traditional IRA in the year you take them—that is, the sums you withdraw count as taxable income, and may significantly boost the amount of tax you owe.
Of course, with both types of IRAs, your funds grow tax-free while in the account.
- Contributions to a traditional IRA can reduce your adjusted gross income (AGI) for that year by a dollar-for-dollar amount.
- If you have a traditional IRA, your income and whether or not you have a workplace retirement plan may limit the amount by which your AGI can be reduced.
- Contributions to a Roth IRA do not lower your adjusted gross income.
IRA Contribution Limits
The Internal Revenue Service (IRS) places limits on the amount you can invest annually in an IRA, whether Roth or traditional. For 2019 and 2020, the IRA limit for contributors is $6,000 plus a $1,000 catch-up contribution for taxpayers who are ages 50 and over. The contribution maximums apply collectively to all your IRAs; they are not per account.
The IRS imposes penalties if you contribute more than the allowable annual amount to an IRA.
Traditional IRA Limits
The IRS allows deductions on contributions to a traditional IRA, but the deduction may be reduced or phased out if you (or your spouse, if you are married and filing jointly) are covered by a retirement plan at work.
For the 2019 tax year, a single filer covered by a workplace plan can take a full deduction if their AGI is under $64,000 or a partial one if they make between $64,000 and $74,000; above that amount, the deduction is eliminated.
A married couple in which the IRA-contributing spouse is covered by a workplace retirement plan can take a full deduction if their AGI is below $103,000 annually, a partial one if it's between $103,000 and $123,000, and none if their AGI above that amount. If the other spouse has the workplace plan, the phase-out applies to a joint income between $193,000 and $203,000.
Roth IRA Limits
Your participation in a workplace plan doesn't affect your Roth IRA contributions. Your income, on the other hand, does. Specifically, your modified adjusted gross income (MAGI) determines whether or not you can contribute to a Roth IRA and how much you can contribute.
Single taxpayers are good to go until their MAGI hits $122,000; if it's between $122,000 and $137,000, they face a gradual reduction of the amount they can contribute. For joint filers, the phase-out applies to incomes between $193,000 to $203,000. Exceed those outer limits and you can't fund a Roth IRA at all.
Modified adjusted gross income (MAGI) is your AGI with certain tax deductions added back in, including those for traditional IRA contributions, interest on bonds and student loans, self-employment taxes, and foreign income. IRS Publication 590A lists them all.
How to Reduce Your MAGI
Here are some ways to reduce your income so you may contribute to a Roth IRA.
Contribute at Work
Pre-tax contributions you make to a workplace retirement plan such as a 401(k), 403(b), 457 retirement plan, or thrift savings plan are deducted from your taxable income. In 2020, the IRS increased the contribution limit for employees who participate in 401(k), 403(b), most 457 retirement plans, and the federal government's thrift savings plan from $19,000 to $19,500. The catch-up contribution limit for employees ages 50 and over who participate in these plans is increased from $6,000 to $6,500.
Contribute to an HSA
If your health insurance policy has a deductible of at least $1,350 (single) or $2,700 (family), you may qualify to make pretax contributions to a health savings account (HSA).
In 2020, the new IRS limits for HSAs rose $50 for individual coverage and $100 for family coverage, bringing them to $3,550 and $7,100, respectively. The catch-up contribution limit for those older than age 55 will remain at $1,000. Money in your HSA doesn’t expire at year-end. It’s yours even if you switch your employer or health insurance policy.
Contribute to an FSA
A variation on the HSA is called a flexible spending account (FSA), which some employers offer. For the 2020 calendar year, an individual can contribute up to $2,750 to a health care FSA or limited purpose FSA (an increase of $50 from 2019).
Typically, there’s an open-enrollment period in the fall, during which you must sign up. Normally, you can’t contribute to both an FSA and HSA in the same year, though there are some exceptions.
Contribute to a Dependent Care FSA
If you pay for childcare or adult daycare, you may be able to contribute up to $5,000 pretax to a dependent care flexible spending account. Like a regular FSA, this one typically requires you to sign up during an open enrollment period, unless you have a qualifying event (such as the birth of a child).
Lower Your Schedule C Income
Self-employment income claimed on Schedule C is another area where you may be able to find deductions that lower your MAGI. In addition to normal business-related deductions, consider contributions to a simplified employee pension (SEP), solo 401(k), or some other tax-deductible retirement plan, if appropriate. While you’re at it, check for nonbusiness deductions, as well.
Claim Capital Losses
If you have capital losses that exceed capital gains, you can apply up to $3,000 against ordinary income. This strategy is often overlooked as a way to reduce MAGI. Claiming capital losses is complex, and the IRS has rules that you must follow. Consult your tax advisor to make sure you’re in compliance.