IRA contributions usually affect your current taxes in positive ways. It’s basically a way to save money for your retirement on a tax-free basis now (in other words, you don’t pay tax on the income you plop into an IRA until you take it out), so that you’ll have something to live on after you retire and no longer have an earned income. In addition to the traditional IRA, there are other IRA structures, too, such as the Roth IRA. For the purposes of this article, though, we’re going talk about traditional IRAs.
How do IRAs affect your taxes?
Traditional IRAs are the IRAs most of us think about what we think of retirement, IRA contributions, and taxes. An IRA, also known as an individual retirement account, is a way for you to save money on a tax-deferred basis for retirement. Traditional IRAs do have some restrictions (as to Roth IRAs).
Nonetheless, there are great way to sock away money for retirement and in general, they’ll save you money over the long term as well, since you won’t pay tax on any IRA disbursements until you actually take the money out.
When you contribute to an IRA
Your contributions to a traditional IRA generally lower your tax bill, because they reduce your adjusted gross income. In general, there are limitations as to what you can contribute to your IRA in a given year. Exceeding these contribution limits will usually result in a penalty from the IRS, so you do need to be careful not to exceed these limits. You’re also limited as to what you can contribute to an IRA if you participate in another retirement plan with your employer, receive Social Security benefits, have any foreign earned income, have student loan, tuition and fees deductions, housing exclusion or deductions, or domestic production activities deductions.
The benefit to IRAs is that in addition to being able to avoid income tax on the given amount you can contribute for a particular year, your IRA itself can grow, and the tax on the interest is also deferred until you withdraw. For traditional IRAs, you can begin taking disbursements at the age of 59 1/2, and you MUST begin taking disbursements on April 1 of the year after you turn 70 1/2.
Once you begin taking IRA distributions
Once you begin taking distributions from your IRA, you going to pay income tax on those disbursements at the time you take them, as long as you are at least 59 1/2 years old when you begin taking them. (Taking disbursements from your IRA before you turn 59 1/2 will result in your having to pay the income tax on that money when you take out the disbursements, and you’ll also have to pay a 10% penalty to the IRS in addition.) At least theoretically, you reduce your tax by "deferring" your tax to the time of the distributions; because your income tax bracket is likely to be lower at that time, so that you pay fewer taxes overall.
Yes, you HAVE to take distributions at 70 1/2
If you decide not to take distributions by the time you’re 70 1/2 (or actually, April 1 of the following year), you’ll be penalized and signed by the IRS. Therefore, you do have to take these distributions and can’t simply decide not to.