We Asked an Expert: Who Gets an IRA Tax Deduction?
Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)
One important decision point when you choose between a traditional IRA and a Roth IRA is whether you prefer a potential tax break now or later. For some investors, traditional IRA contributions are tax deductible right away. But not everyone qualifies, and some investors can only deduct a portion of what they put into their IRA.
We asked Hayden Adams, CPA, CFP, and director of tax planning and wealth management at the Schwab Center for Financial Research, to help explain the rules.
Q: Why might someone choose the tax benefits of a traditional IRA over those of a Roth IRA?
Hayden: You're going to pay some taxes with either type of IRA—so it's really a question of whether paying taxes now or later makes the most sense for you. With a Roth IRA, you'll pay taxes on your contributions now but you can usually take tax-free withdrawals in retirement. If you think you'll be in a higher tax bracket in retirement, a Roth could give you significant tax savings down the road. But you won't get a tax deduction up front.
Traditional IRA contributions, on the other hand, may be tax deductible. This allows you to delay taxes on your contributions until you take money out in retirement, which may make saving a little easier. But you must meet certain requirements to get the tax deduction. Keep in mind that both types of IRAs can make sense depending on your goals, so many investors use both in their portfolio.
Q: When are contributions to a traditional IRA not tax deductible?
Hayden: In general, eligibility for the IRA tax deduction hinges on whether you—or if you're married, your spouse—are covered by a retirement plan at work. But the rules may also vary, depending on your tax filing status and income.
Let's start with single filers. If you're single and have a retirement plan at work, you'll need a modified adjusted gross income (MAGI) of less than $78,000 to take a full or partial IRA deduction in 2022 (see IRS deduction limits for exact cut-offs for 2022 and 2023). If your MAGI is $78,000 or more, your IRA contributions are not tax deductible.
If you're married filing jointly, the rules are a little more complex. In that case, if you—as the owner of the IRA—have a retirement plan at work, your MAGI must be less than $129,000 to take a full or partial deduction in 2022. Once your MAGI reaches $129,000 or more, you're no longer eligible for the deduction.
On the other hand, if you're married filing jointly and you don't have a plan at work but your spouse does, you must have a MAGI of less than $214,000 to qualify for a full or partial IRA deduction. And once your MAGI rises to $214,000 or more, you can no longer deduct your IRA contributions.
One more thing to consider—if you're married filing separately in 2022, you won't be eligible for a full deduction, and you can only take a partial deduction if your MAGI is less than $10,000.
Q: What if no one in your household is covered by a retirement plan at work?
Hayden: Single filers and married couples filing jointly who aren't covered by a retirement plan at work can usually deduct the full amount of their traditional IRA contributions, regardless of how high their income is.
As a general rule, you have until the tax filing deadline to make IRA contributions for the prior year and still take the deduction. For 2022, you and your spouse can each contribute up to $6,000 to a traditional IRA and deduct it from your taxes—plus, another $1,000 starting the year you turn 50.1
Q: Does it make sense to contribute to a traditional IRA even if you won't qualify for a tax deduction?
Hayden: It's safe to say that not getting the up-front tax deduction takes away one of the most appealing features of a traditional IRA. But you can still take advantage of the potential for tax-deferred growth that it offers.
If you contribute to a traditional IRA without receiving a deduction, your contributions will be made on an "after-tax" basis. This means you'll contribute dollars you've already paid taxes on, which is similar to the way Roth contributions work.
When you eventually take money out of your IRA, you won't owe taxes on your contributions since they were already taxed. But you will owe ordinary income tax when you withdraw any earnings (growth on investments) from the account.
Without a tax deduction, it could make more sense to contribute to a Roth IRA, if you meet the IRS income requirements. If you can't contribute to a Roth IRA, you could also consider saving in a taxable brokerage account with a focus on tax-efficient investing.
1 In general, your IRA contributions cannot exceed your earned income for the year.
Depending on the type of IRA account you have, there are different rules for withdrawals, penalties, and distributions. Please understand these before opening your account.
Traditional IRA withdrawals are subject to ordinary income tax and prior to age 59½ may be subject to a 10% federal tax penalty.
Roth IRA earnings can be withdrawn tax-free after age 59½, if you've held the account for at least five years. If you take a distribution of Roth IRA earnings before you reach age 59½ and before the account is five years old, the earnings may be subject to taxes and a 10% federal tax penalty.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for their own particular situation before making any investment decision.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.1122-21DW