The clock is ticking down to the tax filing deadline. The good news: There may still be an opportunity to save on your tax bill from last year. If you qualify, you can make a deductible contribution to a traditional IRA right up until the April 15, 2013 filing date and still benefit from the resulting tax savings on your 2012 return.
Small business owners can set up and contribute to a Simplified Employee Pension (SEP) plan up until the due date for their returns, including extensions.
You also have until Monday, April 15, to make a contribution to a Roth IRA.
Here are the main differences between a traditional IRA and a Roth:
Below is a chart with all the details for this filing season. (Note: These figures are for 2012. They increased for 2013).
An Option for High Wage Earners
Let's say you can't qualify for IRA deductions because you actively participate in an employer-sponsored retirement plan and your adjusted gross income exceeds the level allowed.
Fortunately, highly paid wage earners aren't completely closed out of the IRA market. Even if you can't deduct IRA contributions or contribute to a Roth IRA, you're still permitted to make nondeductible contributions to a traditional IRA. As with regular IRA or Roth IRA contributions, the limit for 2012 is $5,000, plus a "catch-up contribution" of $1,000 if you were age 50 or older on December 31, 2012.
Contributions to a nondeductible IRA allow you to build up tax-deferred earnings, just like a regular IRA, until distributions are made. This allows you to save more for retirement. The portion of your IRA distributions representing nondeductible contributions is tax-free.
Important: When making a deductible or nondeductible contribution, be sure to tell the IRA trustee that the contribution is for 2012. Otherwise, the trustee may report it as being for 2013.
Working Teens Can Also Have IRAs
Did your children or grandchildren earn some money working last year? If so, they also have time to make a 2012 IRA contribution. As you'll see, the IRA contribution strategy is a terrific idea because the children can potentially accumulate a truly amazing amount by retirement age.
Specifically, your child can contribute the lesser of earned income or $5,000 for the 2012 tax year.
Children with earned income have the option of contributing to either a traditional deductible IRA or a tax-free Roth IRA. The contribution limits are the same for both. Having your child contribute to a Roth account is usually the best alternative, even though it doesn't create a tax deduction. Why? Your child can later withdraw all or part of his or her Roth IRA contributions -- without any federal income tax or penalty -- to pay for college, buy a car, put a down payment on a new house or for any other reason. (However, he or she generally cannot withdraw any Roth account earnings tax-free before age 59 1/2.)
Of course, even though the child will have the right to withdraw Roth IRA contributions without any adverse federal income tax consequences, the best strategy is to leave as much of the account balance as possible untouched until retirement age.
Example: Let's say your child contributes $1,000 to a Roth account this year. After 45 years, the account would be worth $31,920 assuming an 8 percent annual return. Say your kid contributes another $1,000 next year and lets the money ride. The Roth IRA would be worth $61,475 after 45 years. As you can see, the numbers really start adding up. After age 59 1/2, your child can begin taking federal-income-tax-free withdrawals. In other words, your child will never owe any federal income tax on the accumulated Roth IRA earnings. In contrast, if your child contributes to a traditional deductible IRA, all subsequent withdrawals will be taxable income. Payouts before age 59 1/2 are also hit with a 10 percent penalty tax, unless they are used for certain IRS-approved reasons (including paying for college or a first home).
Here's another big reason for the Roth IRA alternative: Your child may not actually save any taxes by contributing to a traditional deductible IRA. Why? Because an unmarried dependent taxpayer's standard deduction amount automatically shelters up to $5,950 of earned income for 2012 from the federal income tax. (For 2013, the standard deduction increases to $6,100.) Therefore, contributing to a traditional IRA won't necessarily create any current tax savings unless your child has a fairly substantial amount of income. So a Roth IRA is generally the best move.
One more plus: Owning a Roth IRA (or a traditional IRA for that matter) generally won't cost your child any financial aid dollars at college time (at least not under the current guidelines). This is because the financial aid calculations generally don't count IRAs as assets.
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