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“To Deduct, or Not To Deduct”? That is the question

Tax time is nearly here again, so it’s time to start getting organized. Many of us will be looking to put more money into a 401k, IRA, or SEP plan, all with the intention of trying to lower our taxable income this year. However, is this what you should be doing? Let’s explore why sometimes it can be good to get a deduction, and other times it is just kicking the can down the road.

IRAs are attractive to many because people often feel that they are in a higher tax bracket while they are working than they will be when they are retired. While this may be true for those in the top bracket (33%-35%), it may not apply to the typical taxpayer. Remember, our tax brackets have gotten much bigger over the past 3 decades; they are now separated by $50,000-$75,000. http://www.taxbrackets2012.com/  Many Americans may never leave their current bracket, even in retirement. 

If this is the case, would it make more sense to pay taxes now while you are working or wait until retirement when you will be living on a fixed income?

To answer this, consider that these are the lowest taxes many of us have seen in our working lives. Remember that from the 1940s through the 1960s our top tax bracket was at or above 90%!  Additionally, our national debt is over $15 trillion, and that must be paid at some point in the future. This adds up to the possibility of higher taxes down the road. If this comes to bear, does it still make sense to put off paying those taxes now?

If this is making you think twice about taking that deduction now, there is an option out there for you. You may be able toput your retirement dollars into a Roth IRA this year, rather than a traditional IRA. A Roth allows you to pay your taxes now, and if handled correctly, all the growth on the money can be taken out tax-free at retirement. So no matter what tax bracket you find yourself in during retirement, you will not pay taxes on the money you pull out of your Roth (provided you follow the IRS guidelines for Roth IRAs). 

No matter how much money you make, you still may be able to take advantage of a Roth account. While it’s true the IRS imposes income phase-outs to Roth contributions (referred to as the Phase-Out Income Limit), there’s a way to get around this restriction if you exceed the limit; simply make a non-deductible contribution to another IRA, and then convert it to a Roth within the same calendar year.

So while you’re scheduling your appointment with your tax preparer or accountant, consider meeting with your Financial Adviser as well to do some year-end planning to discuss which options makes the most sense for your personal situation.