Dear Carrie,
How much can a person who is 55 invest yearly in an IRA that is tax-deductible?
--A Reader
Dear Reader,
It seems like such a simple question. But the answer is anything but, thanks to the complex web of rules and regulations surrounding the whole range of retirement investment options. Still, it's an important question, because the need to build capital for retirement is the most critical financial challenge for most Americans - regardless of their age.
Despite its complexity, the tax code can help you. So you owe it to yourself to take full advantage of what's available. In a nutshell, here's how IRA deductibility works.
What's tax deductible
Anyone with earned income (i.e., wages or self-employment income) can open an IRA and contribute to it annually based on certain maximums and income limits, which I'll discuss. But whether those contributions are deductible depends on two things: 1) whether you (or your spouse) participate in a company retirement plan; and 2) your income level.
- If you (and your spouse) are not active participants in a qualified workplace retirement plan such as a 401(k), 403(b) or a traditional defined benefit plan, in both 2015 and 2016 at age 55 you can deduct annual IRA contributions of up to6,500. That figure includes the basic maximum of5,500 for people under 50, PLUS a "catch-up" contribution of a1,000 for those 50 and over.
- If you are an active participant in a company-sponsored plan, then an IRA is deductible only if your income is below certain thresholds: in both 2015 and 2016 these numbers are61,000 to71,000 for single taxpayers;98,000 to118,000 for married filing jointly;0 to10,000 if you're married filing separately. Deductibility is phased out between those limits.
- If your spouse is an active participant in a plan but you're not, for your 2015 return you can contribute and deduct the full6,500 if your income is below183,000. Deductibility gets phased out between183,000 and193,000. (These numbers change to184,000 and194,000 for 2016.)
Even if you (or your spouse) don't have any earned income, either of you may be able to contribute to what is known as a spousal IRA--provided the other spouse has sufficient earned income. Contributions limits are the same as any other IRA. That contribution may also be tax-deductible, again depending on the above scenarios.
Definition of "active participant"
It may seem obvious that if you're contributing to a 401(k) plan, you're an "active participant." But there's a bit of nuance that you need to consider because, even if you don't participate through payroll deductions, you might be an active participant according to IRS rules.
For instance, if your company has a traditional pension plan, you are probably considered an active participant as long as you're eligible--even if no contributions are being made at the moment. If you're unsure where you stand, check with your human resources department.
Two steps to maximize financial security
The first step is to determine your status in terms of what you can contribute and what's tax deductible for you.
Step two is to put as much as you can into the right vehicle. A 401(k) plan has much higher annual contribution limits than an IRA, in both 2015 and 2016 up to $18,000 plus an additional $6,000 for those over 50. Since contributions are made with pretax dollars, it's essentially the same as tax deductibility for an IRA contribution. Contribute the max if you can, but at the very least, contribute enough to get any company match.
If neither you nor your spouse has a 401(k), contribute the maximum to an IRA, including the catch-up contribution. That will shave $6,500 off your income and save you taxes. If you were in the 35 percent tax bracket, you'd reduce your taxes by $2,275.
Beyond a deductible IRA contribution
- Invest that money in a traditional taxable brokerage account. You give up tax-deferred growth, but in return you'll be able to take advantage of long-term capital gain rates (withdrawals from traditional IRAs are taxed at ordinary income rates). Plus, taxable accounts are more flexible, with no rules about early withdrawals or minimum distributions.
Looking for answers to your retirement questions? Check out Carrie's new book, "The Charles Schwab Guide to Finances After Fifty: Answers to Your Most Important Money Questions."
This article originally appeared on Schwab.com. You can e-mail Carrie at askcarrie@schwab.com, or click here for additional Ask Carrie columns. This column is no substitute for an individualized recommendation, tax, legal or personalized investment advice. Asset allocation and diversification cannot ensure a profit or eliminate the risk of investment losses. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. Diversification cannot ensure a profit or eliminate the risk of investment losses.
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