IRA Tax Deduction: Know Your IRA Types & Tax Considerations

Learn the rules around IRA deductions for this year. What are the different types of IRAs, and how can you choose the best one for you?

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Key Takeaways

  • For the 2019 tax season, contribute funds to a tax-advantaged IRA up until April 15

  • Consider taking a tax deduction against your IRA contributions 

  • Withdraw Roth IRA contributions and their gains as nontaxable income during retirement

Stashing money away for your retirement is a wise, even necessary, thing to do. So as you consider saving for your future, you might want to take a look at retirement vehicles that offer tax advantages. Some accounts offer tax advantages for the year that you make your contributions; others offer tax breaks much later, when it’s time to withdraw the funds.

One of the simplest ways to potentially benefit from tax advantages is to contribute to an Individual Retirement Account (IRA), which can provide an IRA tax deduction or tax-exempt retirement income. However, there are different kinds of IRAs to choose from, each with different tax benefits, rules, and limitations.

What differentiates these account types, and which one might be right for you? Let’s dive in and take a closer look.

Traditional IRA

A traditional IRA allows you to make annual contributions that you can claim as an IRA tax deduction. Instead of paying taxes on the money you contribute now, you defer those tax payments until retirement, at which point you pay taxes on your withdrawals.

As long as your contributions don’t exceed your annual earned income, the amount you can contribute to your traditional IRA is as follows:

  • If you’re under the age of 50, you can contribute as much as $6,000 in 2019 and 2020.
  • If you’re 50 or older, you can benefit from the $1,000 IRA “catch-up” rule, which allows you to contribute as much as $7,000 for 2019 and 2020.

You can contribute to a traditional account for an IRA tax deduction up until the filing deadline, which this year is April 15, 2020, for the 2019 tax year. Traditional IRA tax deductions can reduce your tax bill for your filing year, with your total contribution being fully deductible if neither you nor your spouse is covered by a workplace retirement plan.

If you’re covered by a workplace retirement plan, then your contribution may be fully or partially deductible depending on your modified adjusted gross income, which is your gross income minus any deductions. Once your modified adjusted gross income exceeds a certain amount, the amount of deductions you can take for IRA contributions begins to reduce. Here’s how the phaseout works:

  • If you’re a single filer, your phaseout range for tax year 2019 was $64,000 to $74,000; for 2020, it’s $65,000 to $75,000.
  • If you’re a joint filer, your phaseout range for 2019 was $103,000 to $123,000; for 2020, it’s $104,000 to $124,000.

Each type of IRA has different benefits, rules, and limitations. Which one might be right for you?

It’s important to be aware of the changes to the required minimum distributions, or RMDs, for traditional IRAs under the SECURE Act. Previously, RMDs had to begin in the year you turn 70 1/2, but the SECURE Act increases the age to 72. (Note that the age limit for making contributions has been removed starting in 2020.) There are steep penalties you could incur if you fail to make the required withdrawals from your traditional IRA—as much as 50% of the amount you should have withdrawn. In addition, if you withdraw funds from a traditional IRA before the age of 59 1/2, you’ll be subject to a 10% early withdrawal penalty. Plus, your funds will be taxed as regular income.

(If you happen to be a small business owner or self-employed, you can use a SIMPLE IRA plan or Simplified Employee Pension (SEP) to save up for retirement. There are also plenty of other retirement plans available for self-employed entrepreneurs.)

Roth IRA

A Roth IRA has many features that are similar to a traditional IRA, but its tax advantages are different. Essentially, contributions to a Roth IRA are not tax deductible when you file taxes for the year. Instead, the contributions provide tax-free income on all your withdrawals and earnings once you’re in retirement.

So, when choosing between a traditional or Roth IRA, it’s a matter of deciding whether you think it’s best to pay taxes now, at your current tax rate, or later when you’re retired. Keep in mind that under the current law, your taxable income during retirement can affect a number of expenses, such as your Medicare premium. So a Roth IRA, by providing nontaxable income, has the advantage of not increasing expenses such as your Medicare premium, whereas distributions from your traditional IRA might.

Also, a Roth IRA does not carry a required minimum distribution for withdrawal, as a traditional IRA does. However, like a traditional IRA, you’ll incur a 10% penalty for early withdrawal of earnings (contributions can be taken out anytime), or before age 59 1/2.

Your contribution limits for a Roth IRA tax deduction are the same as those for a traditional IRA. But the amount you can contribute will begin to phase out once you reach a certain income. Here are the phaseout limits:

  • For single filers, contributions for tax year 2019 begin phasing out at $122,000 and are ineligible at $137,00; for tax year 2020, phaseout begins at $124,000, ineligible at $139,000.
  • For joint filers, contributions for 2019 begin phasing out at $193,000, ineligible at $203,000; for tax year 2020, phaseout begins at $196,000, ineligible at $206,000.

If you’ve made the transition from being employed to self-employed, or if you’ve experienced a significant drop in income and hence a drop in tax rates, you might want to consider how converting to a Roth IRA could benefit you, because you’d likely pay lower taxes up front.

Keep in mind that under these tax laws, you may no longer reverse a rollover into a Roth IRA. So if you made a conversion or rollover into a Roth IRA after January 1, 2018, you’re stuck with it. 

Note that there are a few more rules that apply to the phasing out of both your contribution and deductibility. To learn more, you can visit the IRS.gov page on 2019 IRA deduction limits, the IRS.gov page for 2020, the TD Ameritrade page on IRA and Roth IRA rules, or contact a tax consultant.

Want more detailed information about IRAs? The TD Ameritrade IRA Guide offers plenty of useful information to help you decide what’s best for your retirement goals.

TD Ameritrade does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances.

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Key Takeaways

  • For the 2019 tax season, contribute funds to a tax-advantaged IRA up until April 15

  • Consider taking a tax deduction against your IRA contributions 

  • Withdraw Roth IRA contributions and their gains as nontaxable income during retirement

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