The Incentives of IRAs
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The U.S. tax code incentivizes us in many ways. Most importantly, the tax code incentivizes us to save for retirement through IRAs. Here are some of the incentives of IRAs.
No doubt you’ve encountered decisions where you have to weigh if something is “worth it” or not. Measuring the pros and cons of a certain move, particularly if it has big impact on your life is rarely black or white. More than likely you have evaluated the incentives, meaning the little things that motivate or encourage you to take action. When it comes to evaluating the best ways to save for retirement, there are accounts that provide noteworthy incentives.
Sometimes incentives come in the form of rewards (or penalties) through the tax code. The U.S. tax code incentivizes us to give to charity through deductions. To pay our taxes on time through penalties and interests. And most importantly, the tax code incentivizes us to save for retirement.
In a recent survey, 53% of Americans stated they feel confident they will reach their desired goal by retirement. And while this tends to be the #1 savings goal for people, it is also in the IRS’s best interest to help us. One way this happens is through individual retirement accounts.
Everything About Individual Retirement Accounts (IRA)
An IRA is an account you save money in that is specific for retirement. Of course, the habit of saving is a very healthy financial discipline because it can reward you in the future. But when you save for retirement, you’re not only rewarding yourself, the IRS rewards you too!
This prize comes in the form of special tax treatment on all the money saved in an IRA.
For example, if you save $1,000 in a savings account, the IRS is indifferent. You are taxed regularly for this money. But if you save $1,000 in an IRA (meaning you promise to use that money for retirement,) the IRS says ‘Wow! Great decision, now you can have a tax break.’
An IRA seems like the way to go in order to make sure you are saving as much as you can, but it’s not unlimited and there has to be a cap. The best practice is to take advantage of this account until you reach that cap.
The Limits of IRAs
We all want to pay less in taxes if given the chance, but the IRS still has to make money in some way. To balance the tax break reward you’re getting, they place a limit on how much you can put into an IRA account per year. Giving you the chance to save on taxes, but not to the point where the IRS loses.
As of 2022, you can put up to $6,000 in an IRA per year. BUT, as you get closer to retirement (age 50+) the IRS encourages you to prepare more, so at that age you can start putting up to $7,000 per year.
Our motivations to save for retirement vary. Primarily, it’s to cover our expenses when we stop working. But whether you’re retiring in your dream destination, or simply want to keep supporting your family, everyone has a personal goal number they want to hit before they retire.
What most don’t realize is that the IRS has a motivation too! They encourage us to save for retirement because as we get older, we might not have the physical or mental ability to keep working in the same fashion.
This means we have a higher likelihood to rely on the government to take care of us throughout retirement. While there are some systems in place to make that happen, it’s not sustainable if 100% of the population uses that as their retirement plan.
To help encourage us to prepare in advance, the IRS gives us tax incentives to persuade ‘good behavior’ and reduce their risk and expenses.
The Tax Benefits
To understand the tax benefits of these accounts a little better, we need to look at them in two steps.
1. The Contribution. When you save money in an IRA, there is a tax deduction available for us to take advantage of. So instead of having $6,000 of income reported on your taxes, you get to reduce the income number by the amount contributed. Of course, there are some additional eligibility requirements, but generally speaking, this is how it works.
2. The Growth. After the money is in an IRA, it can be invested beyond just cash. As the investment increases in value, there isn’t tax due each year! For comparison, if you have a regular investment account, you’d pay tax on the gains and income each year. But if you have the same investments in an IRA account, all the gains and income are tax-deferred. And they’re deferred until you turn 72, so if you contribute when you’re 22, that would be 50 years of tax savings!
The Side Benefits
It gets better… there are so many more incentives offered by the IRS for these accounts. Including buying a home, getting a college degree, or paying health insurance premiums while unemployed. You would think that a retirement account can be used for retirement only, but with IRAs it’s not the case.
These incentivizers are displayed through penalty exceptions.
To put it in simple terms: You may have promised to use the money in an IRA exclusively for retirement, but if years go by and you decide to use it for other qualified expenses, you can get a pass.
But if you decide to use your IRA money for a dream vacation in Bali, then the IRS will come back with penalties… Making your dream vacation the most expensive one too!
The Right Moment
There is a limit to a lot of the contributions you’re able to make when it comes to taxes. And taking advantage of those limits can be extremely beneficial. When it comes to IRAs, maximizing the tax benefits can help you a lot while you’re trying to meet your retirement goals.
Typically, money timelines work off the calendar year. So if you want to donate to charity, you must do so before 12/31 to be able to take it as a tax deduction.
For IRA contributions, we get a little extra time. The IRS is so excited for us to save that we get an extra 4 months to make a contribution. So if you forgot to put money in an IRA last year, you have until you file your taxes the following April to make it up.
IRAs in Summary
It’s worth looking into the many tax incentives available to us… Especially as they can help our money grow faster!
For retirement, IRAs are one of the most helpful accounts in that sense. Most importantly, IRAs can give you second chances with everything. Whether it’s wanting to put the money there into something meaningful like buying a home or giving you extra time to actually put in the money.
There are tax incentives everywhere that are beneficial to growing your wealth. Regardless of if you’re just starting your savings or getting close to that retirement market, utilizing an IRA account will be beneficial.
You absolutely want to take advantage of any incentives the IRS has to offer, especially as they’re targeted to help you meet your financial goals!
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