A week ago I sat down at my computer to do my duty as a patriotic, slightly irritated, American and file my taxes. Filing my taxes always leaves me feeling a little like Oliver Twist begging for more. My first experience with income tax occurred in college — while my parents still lived overseas — so I didn’t even have parental guidance to lean on. I picked up the paper forms from the campus post office and proceeded to pull my hair out for several hours whilst trying to figure out what all the boxes and numbers meant. I couldn’t tell you if I got much back, it would’ve probably been in the ballpark of $150, but the experience left me admiring those who understand tax code and know how to find loop holes.
Five years later and I’m still searching for ways to keep my hard-earned dollars away from the clutches of Uncle Sam, all while doing my own taxes of course.
This year, I finally did something I should’ve done long ago that made the difference between owing my State and Country nearly $650 verse having them pay me just over $800. What happened this year you ask?
I fully funded a traditional IRA.
Yes, TRADITIONAL IRA.
Overwhelming, the advice is for young investors to throw their excess cash towards a Roth IRA. I’m down with Roth. In fact, my 401(k) is a Roth account, but that does diddly-squat (self-five for using that term) when it comes to helping with taxes. Why, you ask? Well, let’s break down the difference quickly.
Roth pay taxes now. Traditional pay taxes later.
Okay, that’s the most simplified version possible, but it’s the most relevant factor when it comes to utilizing an IRA to get a tax break.
If you fund a Roth IRA then your contributions aren’t tax deductible, so it doesn’t lower your taxable income. The upside is that you aren’t taxed when you start making withdraws after you turn 59 ½ . Roth accounts are often viewed as a win in the long-term, however, I needed a win in the short-term.
I don’t want to owe money
For the first time I was looking at owing money to New York State and the Federal Government. Frankly, it was a bit asinine in my opinion. I already make less than $40,000 a year, which I pay taxes on all year (perhaps I should be waiting to owe taxes at the end of the year but that’s an entirely separate post). I had less than $2,000 of income in a 1099-MISC from freelance work and made a paltry sum in dividends from a mutual fund. But because of my freelance work, I was looking at owing over $600 (according to that fun little ticker on the left-hand side of TurboTax)?
Fortunately, I’d anticipated owing which is why I’d a) already saved up spare cash just in case I did have to cut a check to Uncle Sam and b) investigated my options for lowering my taxable income.
Even though I contribute to a retirement plan at work, I am legally allowed to fully contribute to an IRA because I’m a single individual with a modified AGI of $59,000 (in 2013, it will be $60,000 in 2014).
In order to drop my taxable income by $5,500 — which I fortunately had access to without killing my emergency fund — I went to Vanguard [nope, not a referral link]. Even though this act transpired in 2014, it counts for my 2013 taxes because you can fully fund an IRA for 2013 until April 15.
The process of setting up my IRA took all of an hour and it took that long because I put a little more research into picking my funds than the average millennial and called up a representative at Vanguard to answer a few questions. An hour well-spent because it made the difference between owing money and receiving a tax refund.
This method isn’t magic for all
The method to my tax-filing-madness certainly isn’t for everyone. If you don’t have the funds to contribute to both a Roth and traditional accounts then you should seriously consider which will serve you better in the long-run.* While I’ve always favored Roth, Matt Becker over at Mom and Dad Money has an excellent breakdown of why Roth isn’t always the best for young investors.
It also isn’t a legal tactic for everyone depending on your level of income and whether you (and/or a spouse) contributes to a retirement plan through work.
For those who are with me on the lower-end of the income spectrum and who also happen to be diligent savers with some money saved up, then going the traditional IRA track might be right for you. Or, if you’re like me then you might be running a very long experiment about which investment was indeed better: Roth or Traditional? We can discuss the results in 35 years!
Did you open a traditional IRA for tax purposes? What legal loopholes have you found?
*As a point of clarification, I was referring to contributing to a company retirement plan and a separate IRA. I personally have a Roth 401(k), so I’m contributing to both Roth and traditional funds. You can’t fully fund two separate IRAs each tax season. Thanks for asking for clarification, Mr. DonebyForty!