What if I told you there's a legal way to shield more of your hard-earned cash from the IRS, and the government might actually reward you for taking advantage of it?
Well, there is. If you have a little extra cash you won't need anytime soon, you can make a prior-year traditional IRA contribution and reap the benefits now and in retirement. Here's a closer look at how it works and what kind of a difference it can make for your taxes.
What's a prior-year IRA contribution?
A prior-year IRA contribution is a contribution you make to your IRA for the previous year -- in this case, 2020. You can do this at any point up until the April 15 tax-filing deadline, although if you've already filed your taxes and then decide you'd like to make a prior-year contribution, you must file an amended tax return, or the government won't give you the tax break you deserve.
A traditional IRA contribution makes the most sense if you want a tax break this year because these contributions reduce your taxable income. You could also put money into a Roth IRA if you prefer. These accounts are usually better if you believe you're in a lower tax bracket now than you will be in retirement. But you pay taxes on these contributions now in exchange for tax-free distributions later, so Roth IRA contributions won't help you save any money this year.
Making a prior-year contribution isn't much different from making an IRA contribution for the current year, though some IRA providers automatically default to current-year contributions, so you may have to notify your broker that you want your contribution applied to the 2020 tax year.
You must also make sure your contribution doesn't exceed what you earned in income in 2020 or the contribution limit for the year, which is $6,000 (or $7,000 if you're 50 or older). Excess contributions could lead to problems with the IRS. Only income you earned from a regular job or side hustle you've reported to the government counts. Unemployment benefits do not.
How does a traditional IRA contribution save me money?
Traditional IRA contributions reduce your taxable income for the year. For example, if you earned $44,000 in 2020 and you put $5,000 of that into a traditional IRA, the federal government ignores that $5,000 for now and only taxes you as if you earned $39,000.
In this particular example using the single filing status tax rules, your traditional IRA contribution would also knock you down from the 22% tax bracket to the 12% bracket for single filers. Assuming you qualify for no other tax deductions or credits, that would save you $987.50 in taxes for the year. Not bad, right?
And you could be even better off if you qualify for the Saver's Tax Credit. This is a tax credit available to adults 18 or older who aren't students or listed as dependents on anyone else's tax return. Tax credits give you a dollar-for-dollar reduction of your tax bill. So if you qualify for a $1,000 tax credit, that's $1,000 less you owe the government.
The Saver's Tax Credit is worth up to 50% of your retirement contributions during the year, depending on your adjusted gross income (AGI) and tax filing status. Those with lower AGIs receive a larger tax credit. In 2020, the maximum credit is $1,000 for individuals or $2,000 for married couples filing jointly. To get this, you'd have to put aside $2,000 or more ($4,000 or more for married couples) in a traditional IRA or other retirement plan.
But this credit isn't available to everyone. It's meant to incentivize low-income households to save more for retirement, so those who earn too much can't take advantage of it. In 2020, married couples filing jointly with AGIs exceeding $65,000, heads of households with AGIs exceeding $48,750, and other filers with AGIs exceeding $32,500 won't qualify for the Saver's Tax Credit. But they can still get the tax deduction that comes with making a traditional IRA contribution.
Locking money away in a retirement account might seem counterintuitive right now when money is tight for a lot of people. But if you choose to make a prior-year traditional IRA contribution, some of that money will come back to you in the form of a smaller tax bill or a larger tax refund. Plus, the money you'll be stashing away for retirement will have years and possibly even decades to grow before you need to use it, at which point it'll be worth a lot more than a few thousand dollars.
It may not make sense for everyone, but a prior-year IRA contribution is worth considering if you want to save a little cash this year and be better prepared for retirement.
10 stocks we like better than Walmart
When investing geniuses David and Tom Gardner have an investing tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*