Many Americans are confused about which tax-saving strategies are actually legal, according to NerdWallet’s 2018 Tax Study. As a result, millions of people filing taxes could be missing out on money-saving deductions.
One such strategy is to fund an IRA after December 31 but before the tax deadline, yet “75 percent of Americans think contributing to or opening an IRA after the end of the year to reduce their taxable income is illegal,” the personal finance site reports.
It’s perfectly legal. You have until the April 17 tax deadline to contribute to an IRA for the previous tax year.
The reason this particular strategy can save you money is because “when you contribute to an IRA, that amount goes toward reducing your taxable income,” Andrea Coombes, tax specialist at NerdWallet, tells CNBC Make It.
“Say your income is $45,000, and you contribute the maximum $5,500 to an IRA. That reduces your taxable income to $39,500. Put another way, if your marginal tax rate is 25 percent, a $5,500 IRA contribution reduces your tax bill by $1,375.”
Keep in mind that this strategy only applies to a traditional IRA, not a Roth IRA. “A Roth can be a fantastic savings vehicle, but it doesn’t reduce your current tax bill,” says Coombes. “With a Roth, you put money in after you’ve paid tax on it, but then the money grows tax-free.”
While anyone can contribute to a traditional IRA, “for that contribution to be deductible, there are specific rules to keep in mind,” says Coombes. “If you (and your spouse, if you’re married) don’t have a retirement plan at work, then there are no income limits — you can deduct up to $5,500 in IRA contributions. But if you or your spouse has a retirement plan at work, then the maximum amount that you can deduct starts to phase out at certain incomes.”
To see if you qualify for tax savings by contributing to an IRA, check out NerdWallet’s handy chart, which breaks down the deduction limits.
A few other general rules that apply to IRAs: You need to have taxable compensation to contribute; the maximum yearly contribution is $5,500, or $6,500 for people age 50 or older; and if you’re contributing to both a traditional IRA and a Roth IRA, the maximum contribution limit applies to both accounts combined.
Finally, “you must specify whether you want your contribution to apply to your 2017 taxes or your 2018 taxes,” Coombes notes. So if you want to take advantage of this tax-reduction strategy this year, specify that you are making a tax-year 2017 contribution.