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An IRA Is a Legal, Last-Minute Way to Lower Your Taxes

Feb. 21, 2018
IRA, Personal Taxes, Taxes
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Saving for retirement is one of the best gifts you can give your future self — and it’s not too late to claim a deduction on your 2017 taxes for doing so.

A recent NerdWallet study showed that 3 in 4 Americans think it’s illegal to claim a deduction for contributions made to a traditional IRA after Dec. 31 but before the April tax deadline (April 17 this year). But eligible savers can claim a deduction of up to $5,500 for contributions made to an IRA after the start of the year but before the tax deadline. That amount jumps to $6,500 if you’re 50 or older.

Need more convincing? Here’s why you might want to open an IRA before April 17.

Last-minute way to lower taxable income

Most tax-saving activities can only be done within the tax year you’re filing for — in other words, the window for most deductions closes Dec. 31. But contributing to an IRA is a rare exception, and it can save you a chunk of cash you might otherwise have to pay this April.

Let’s say you’re a single person who makes $50,000 per year. With the standard deduction, your taxes due would be about $5,645. But if you max out a traditional IRA by contributing $5,500, your taxes due drop to about $4,652, for a savings of nearly $1,000.

It’s generally not good financially to sacrifice $5,500 for $1,000, but this case is an exception. In addition to having money set aside for retirement, the earlier you save this money, the more it will grow. Because the next best thing to saving money is giving it time to multiply.

Compound interest is your friend

Investing is key to reaching your retirement goals. It’s the difference between ending up with $480,000 after 40 years of saving $12,000 per year, the sum you’ll get with a 0% return, and ending up with roughly $2 million, the same amount invested at a 6% annual return, compounded monthly.

The longer you invest, the longer compound interest has to work its magic. Let’s say you max out your traditional IRA just once. You put $5,500 in an account and leave it there without ever contributing more. At an interest rate of 6%, compounded monthly, that $5,500 would grow to $7,419 in five years. In 40 years, the $5,500 would turn into $60,282.

In short, compound interest supercharges your retirement savings. You may already know this if you have a 401(k) or other workplace savings plan, but if an IRA would be your first foray into retirement saving, it’s a powerful lesson to note.

You can explore more of the possibilities here with a retirement calculator.

Even a year can make a big difference

You could just forget about saving money in your IRA for 2017 and only focus on maxing it out for 2018. But several thousand dollars invested over the long term can add a lot to your retirement savings.

Let’s say you want to retire in 40 years and you earn 6% on your savings. If you decide not to save for 2017 and you start with $0, you will have $892,000 in retirement savings if you put $5,500 in your savings each year going forward. However, if you max out your IRA for 2017 and continue to max it out until you hit retirement, you’ll have $949,000 saved by age 65. That’s a difference of $57,000, or more than 10 times your 2017 contribution of $5,500.

Not sure how to start an IRA of your own? This guide can help take you through the basics of setting up your first IRA and choosing a provider.

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