So you chose an individual retirement arrangement (IRA) to save for your future. This choice can be beneficial at tax time, as contributions to a traditional IRA may be deductible at tax time. There are several different types of IRA plans, including a traditional and Roth IRA, and are set up through a financial institution, bank, or insurance agent.
If you have a traditional IRA, you may be eligible for a tax credit equal to a percentage of your contribution. Normally, traditional IRAs aren’t taxed until they are distributed. IRAs are individually owned, though a beneficiary can be named.
You can only make contributions to a traditional IRA if you are under the age of 70 ½ by the year end. You have to have taxable income as well, including wages, salaries, tips, bonuses, or commissions. Income can also include money earned from self-employment. Certain compensation payments, like alimony, are considered taxable income.
Income that is not included:
- Rental income
- Interest/dividend income
- Pensions and annuities
- Deferred compensation
You can calculate your deduction by using Form 1040 worksheets, and attach Form 8606, Nondeductible IRAs if you determine you cannot deduct any of your contributions. You cannot use a Form 1040-EZ, but Form 8880, Credit for Qualified Retirement Savings Contributions, will help you figure out whether or not you qualify for a tax credit.
Traditional IRAs are fully or partially taxed when distributions begin. If you fully deducted your contributions, then distributions are fully taxed. If you receive distributions from a traditional IRA before age 59 ½, you may have to pay an additional 10% tax. At age 70 ½ you should begin receiving minimum distributions, which help you avoid excise penalties and taxes.
Roth IRAs, which are designated at setup, vary from traditional IRAs by:
- Contributions are NOT deductible
- Qualified distributions are not taxed
- There is no age limit for contributing