How Much Is Your IRA or Qualified Plan Deduction Worth To You?
by Shane Flait (2010)

 

Government-regulated retirement plans – such as your IRA or your company plan at work – offer you tax-deductible contributions as an incentive to use them to save for your retirement. But how much is that tax-deductible contribution really worth to you? That’s what this article is all about.

 

Both your company plan and your IRA come it two versions: a tax-deductible contribution version or a non tax-deductible contribution version, the latter referred to as a Roth plan. It the tax-deductible contribution plan that can help you put more into your plan right off the bat.

 

Getting a tax-deduction allows your contribution to be subtracted of your taxable income. A lower taxable income means you pay less income tax in the year you contribute to your IRA. So you end up with more in your IRA and with less loss in your pocket than your contribution.

 

So just how big is the break I get?

The more you earn, the higher is the tax rate on what you earn. In 2010—you have six tax brackets: 10%, 15%, 25%, 28%, 33%, and 35% - each assigned to a bracket of taxable income.

 

But your income isn’t taxed at all until you’ve exceeded an income tax-threshold. That tax threshold is made up of an exemption for yourself and a standard deduction. A single person under 65 has a tax threshold of $9,350; a married filing jointly couple (both under 65) has a tax threshold of $18,700. It’s only income they earn above these tax thresholds that are subject to the income tax brackets – higher brackets for higher income.

 

So for the single person the first $8,375 earned beyond his $9,350 threshold is taxed at 10%, then at 15% until $34,000 at which it’s taxed at 25%, then at 28% beyond $82,400.

 

For example, a single person earning $17,725 (= $9,350 + $8,375) will have all his income from $9350 to $17,725 taxed at 10%. A reduction in his income of $1,000 is within the 10% tax bracket so it’ll save him $100 (10% of $1,000).   

 

Because of the increasing tax rate of higher brackets, a reduction of taxable income at a higher bracket saves you more tax than the same reduction at a lower bracket. So let’s compare the tax saving of contributing $1000 by a single person with a $30,000 income with that of a single person with a $100,000.

 

Subtracting the tax threshold (see table) of $9,350 from each of their incomes leaves their taxable incomes at $20,650 and $90,650 respectively which are within their 15% and 28% marginal tax bracket rates.

 

Contributing a deductible $1,000 will lower the taxable income of the $30,000 per year person from $20,650 to $19,650 and save taxes of $150 (=15% of $1000). For the $100,000 per year person, his taxable income decreases from $90,650 to $89,650 and saves him $280 (=28% of $1000) – almost twice as much!

 

What’s the benefit?

If the $30,000 a year person did not contribute to his IRA, he’d end up with $850 more in his pocket than if he contributed. But, having contributed, he’s got $1,000 more in his IRA and $150, rather than $850, in his pocket. So he’s got $300 ($150+$1000 less $850) more to his name for having contributed.

 

If the $100,000 a year person didn’t contribute, he’d end up $720 more in his pocket. But, having contributed, he’s got $1,000 more in his IRA and $280 – rather than $720 - in his pocket. So he’s got $560 ($280+$1000 less $720) more to his name. Wow!

 

If you are eligible to make a tax deductible contribution to a plan, do so if you’re in a tax-bracket higher than 10%.

 

Otherwise contribute to the Roth version. You get no deduction for contributing but you’re never tax again on that money – as it earns and when you withdraw it from the plan. That’s a lot of benefit too.

 

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com