Yes, you can lower your taxable income and your tax bill by opening and contributing to an individual retirement account (IRA). But it depends, first and foremost, on the type of IRA you have.1
Let’s look at those and some other ways to reduce your gross income, freeing up funds to contribute to an IRA for the maximum advantage.
- Contributions to a traditional IRA can reduce your adjusted gross income (AGI) for that year by a dollar-for-dollar amount.
- If you have a traditional IRA, your income and any workplace retirement plan you own may limit the amount by which your AGI can be reduced.2
- Contributions to a Roth IRA do not lower your adjusted gross income.3
The 2 Types of IRAs
If you contribute to a traditional IRA, it can definitely reduce your taxable income; however, some individuals may be ineligible to deduct these contributions based on their income level.4
The money deposited into a traditional IRA reduces your adjusted gross income (AGI) for that tax year on a dollar-for-dollar basis, assuming it is within the annual contribution limits (see below). So a qualifying contribution of, say, $2,000 could reduce your AGI by $2,000, giving you a tax break for that year. This move is what is known as contributing with pretax dollars.5
A contribution to a Roth IRA does not reduce your AGI in the tax year you make it. Roth contributions are funded with after-tax dollars, meaning there’s no deduction at the time of your deposit; however, when the money is withdrawn from the account (presumably after you retire), no income tax is due on it.1
But you do pay taxes on distributions—the sums you withdraw—from your traditional IRA in the year you take them. They count as taxable income. As a result, they may significantly boost the amount of tax you owe.1
Of course, your funds grow tax-free while in the account with both types of IRAs.1
IRA Contribution Limits
The Internal Revenue Service (IRS) places limits on the amount you can invest annually in an IRA, whether you choose to go down the Roth or traditional IRA path. For 2022, the IRA limit for contributors is $6,000 plus a $1,000 catch-up contribution for taxpayers who are 50 and over. For 2023, the limit is $6,500 plus a $1,000 catch-up contribution for taxpayers who are 50 and over. The contribution maximums apply collectively to all your IRAs, which means they are not per account.6
Traditional IRA Limits
The IRS allows deductions on contributions to a traditional IRA, but the deduction may be reduced or phased out if you (or your spouse, if you file jointly) are covered by a retirement plan at work.8
For the 2022 tax year, a single filer covered by a workplace plan can take a full deduction if their AGI is under $68,000 ($73,000 for 2023) or a partial one if they make between $68,000 and $78,000 ($73,000 and $83,000 for 2023). The deduction is eliminated above that amount.6
A married couple in which the IRA-contributing spouse is covered by a workplace retirement plan can take a full deduction if their AGI is below $109,000 annually ($116,000 for 2023), a partial one if it’s between $109,000 and $129,000 ($116,000 and $136,000 for 2023), and none if their AGI is above that amount. If the other spouse has the workplace plan, the phase-out applies to a joint income between $204,000 and $214,000 ($218,000 and $228,000 for 2023).6
Roth IRA Limits
Your participation in a workplace plan doesn’t affect your Roth IRA contributions. Your income, on the other hand, does. Specifically, your modified adjusted gross income (MAGI) determines whether or not you can contribute to a Roth IRA and how much you can contribute.9
Single taxpayers are good to go until their MAGI hits $129,000 ($138,000 for 2023). If it falls between $129,000 and $144,000 ($138,000 and $153,000 for 2023), they face a gradual reduction in the amount they can contribute. For joint filers, the phase-out applies to incomes between $204,000 to $214,000 ($218,000 to $228,000 for 2023). Exceed those outer limits and you can’t fund a Roth IRA at all.6
Modified adjusted gross income (MAGI) is your AGI with certain tax deductions added back in, including those for traditional IRA contributions, interest on bonds and student loans, self-employment taxes, and foreign income.8
How to Reduce Your MAGI
Here are some ways to reduce your income so you may contribute to a Roth IRA.
Contribute at Work
Pretax contributions you make to a workplace retirement plan such as a 401(k), 403(b), 457 retirement plan, or Thrift Savings Plan are deducted from your taxable income.10,11,12 The contribution limit for employees who participate in 401(k), 403(b), most 457 retirement plans, and the federal government’s Thrift Savings Plan is $20,500 for 2022 ($22,500 for 2023). The catch-up contribution limit for employees aged 50 and over who participate in these plans is $6,500 for 2022 and $7,500 for 2023.6
Contribute to an HSA
In 2022, if your health insurance policy has a deductible of at least $1,400 (single) or $2,800 (family), you may qualify to make pretax contributions to a health savings account (HSA).13 For 2023, these amounts are $1,500 and $3,000, respectively.14
There are limits to how much you can contribute in one year. In 2022, the maximum for HSAs is $3,650 for individual coverage and $7,300 for family coverage.15 For 2023, the amounts are $3,850 and $7,750.16
TIP: Individuals aged 55 and older can make an additional $1,000 in catch-up contributions to their HSAs each year.17
Contribute to an FSA
A variation on the HSA is called a flexible spending account (FSA), which some employers offer. The contribution limit for 2022 is $2,850 to a healthcare FSA or limited-purpose FSA ($3,050 for 2023).18,19
Typically, there’s an open-enrollment period in the fall, during which you must sign up. Normally, you can’t contribute to both an FSA and HSA in the same year, though there are some exceptions.20
Contribute to a Dependent Care FSA
If you pay for childcare or adult daycare, you can contribute up to $5,000 in pretax earnings to a dependent care flexible spending account.21
Like a regular FSA, this one typically requires you to sign up during an open enrollment period, unless you have a qualifying event (such as the birth of a child).22,23
Lower Your Schedule C Income
Self-employment income claimed on Schedule C is another area where you may be able to find deductions that lower your MAGI.24 In addition to normal business-related deductions, consider contributions to a simplified employee pension (SEP), solo 401(k), or some other tax-deductible retirement plan, if appropriate.25,26 While you’re at it, check for nonbusiness deductions, as well.27
Claim Capital Losses
If you have capital losses that exceed capital gains, you can apply up to $3,000 against ordinary income. This strategy is often overlooked as a way to reduce MAGI. Claiming capital losses is complex, and the IRS has rules that you must follow. Consult your tax advisor to make sure you comply.28
How Does an IRA Affect My Taxes?
With a traditional IRA, you can make contributions with pre-tax dollars, thereby reducing your taxable income. Your investments will grow tax-free until you take distributions at the age of 59½, where you will then be taxed on the amount distributed. Roth IRAs are different in that they are funded with after-tax dollars, meaning they don’t have any impact on your taxes and you will not pay taxes on the amount when taking distributions.1
What Are the IRA Contribution Limits for 2022 and 2023?
The contribution limit for both traditional IRAs and Roth IRAs is $6,000, or $7,000 if you are age 50 and over in 2022. For 2023, the amounts are $6,500 and $7,500, respectively.6
Which Is Better, a 401(k) or an IRA?
Deciding which retirement account is better, either a 401(k) or an IRA, will depend on the individual and their specific needs. A 401(k) allows for more contributions to be made than an IRA.6 Additionally, 401(k)s can be easier to manage, since participants generally have a range of target-date funds (TDFs) to choose from, which lets an investor put investing on autopilot. Many plans are designed to opt participants into a qualified default investment alternative so that their contributions are automatically invested rather than sitting in cash.
The Bottom Line
Individual retirement accounts are a great way to reduce your tax liability. But keep in mind, there are restrictions on which accounts you can own and how much you can contribute. You can also look at other options to reduce your taxable income, including HSAs and FSAs. When in doubt, always check with a financial professional in order to avoid making any mistakes.
This article was originally published in Investopedia on January 11, 2023, and written by Troy Segal.
2. Image courtesy of iStock
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1. Internal Revenue Service. “Traditional and Roth IRAs.”
2. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Pages 11-13.
3. Internal Revenue Service. “IRA Deduction Limits.”
4. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Page 13.
5. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Page 11.
6. Internal Revenue Service. “401(k) Limit Increases to $22,500 for 2023, IRA Limit Rises to $6,500.”
7. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Page 33.
8. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Pages 12-13.
9. Internal Revenue Service. “Publication 590-A: Contributions to Individual Retirement Arrangements (IRAs),” Pages 41-42.
10. Internal Revenue Service. “401(k) Plan Overview.”
11. Internal Revenue Service. “Publication 571 (01/2022), Tax-Sheltered Annuity Plans (403(b) Plans).”
12. Internal Revenue Service. “IRC 457(b) Deferred Compensation Plans.”
13. Internal Revenue Service. “Rev. Proc. 2021-25,” Page 2.
14. Internal Revenue Service. “Rev. Proc. 2022-24,” Page 2.
15. Internal Revenue Service. “Rev. Proc. 2021-25,” Page 1.
16. Internal Revenue Service. “Rev. Proc. 2022-24,” Page 1.
17. Internal Revenue Service. “Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans.”
18. Internal Revenue Service. “Rev. Proc. 2021-45,” Page 14.
19. Internal Revenue Service. “Rev. Proc. 2022-38,” Page 14.
20. Internal Revenue Service. “Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans,” Page 5.
21. U.S. Office of Personnel Management. “My Spouse Has an FSA Program Offered by Their Employer. Can I still Contribute the Full $5,000 to the DCFSA Even if My Spouse Is Contributing to a DCFSA as Well?”
22. U.S. Office of Personnel Management. “Dependent Care FSA.”
23. U.S. Office of Personnel Management. “What Is a Qualifying Life Event?”
24. Internal Revenue Service. “About Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship).”
25. Internal Revenue Service. “Simplified Employee Pension Plan (SEP).”
26. Internal Revenue Service. “One-Participant 401(k) Plans.”
27. Internal Revenue Service. “Publication 536 (2021), Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.”
28. Internal Revenue Service. “Helpful Facts to Know About Capital Gains and Losses.”
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