Traditional individual retirement accounts, or IRAs, are tax-deferred, meaning that you don’t have to pay tax on any interest or other gains the account earns until you withdrawal the money. Additionally, the contributions you make to the account may entitle you to a tax deduction each year. However, the Internal Revenue Service (IRS) restricts who can claim a tax deduction for contributions to traditional IRAs based on various factors.
Are you eligible for a tax deduction?
Everyone is eligible to make contributions to a traditional IRA, but a tax deduction for those contributions may not always be available. If you or your spouse contributes to an employer-sponsored retirement plan, such as a 401(k) or 403(b), and your Modified Adjusted Gross Income (MAGI) exceeds annual limits, you may need to reduce or entirely eliminate your IRA deduction. If you and your spouse are not eligible to contribute to an employer plan, you can deduct your contribution as long as you earn income during the year. For purposes of the IRA deduction, earned income excludes interest, dividends and similar types of investment income.
Income and tax deduction limitations
The IRS limits the amount you can deduct each year. However, this amount is subject to change each tax year. This maximum tax deduction may also be subject to a reduction when your MAGI is too high. The IRS provides a worksheet with your tax return instructions to help you calculate your deduction.
If you use tax software, such as TurboTax, you can avoid tedious calculations and let your computer calculate the deduction for you. TurboTax can help you determine whether your IRA contributions are deductible and will calculate exactly how much you can deduct.
Reporting your IRA deduction
You must file your tax return on Form 1040 or 1040A to claim a deduction for your traditional IRA contributions. The IRS categorizes it as an above-the-line deduction, meaning you can take it regardless of whether you itemize or claim the standard deduction. This deduction reduces your taxable income for the year, which ultimately reduces the amount of income tax you pay.
Alternatives to traditional IRAs
If you cannot make a tax-deductible contribution to a traditional IRA, consider several alternatives. First, maximize your contributions to the retirement plans that your employer offers. Contributions to 401(k) plans and 403(b) plans have the same effect on your taxes as a contribution to a traditional IRA. Also, if your MAGI does not exceed the IRS limits for contributing to a Roth IRA, consider putting the money into this type of account instead of a traditional IRA.