The Individual Retirement Arrangement was established in 1974 under the Employee Retirement Income Security Act (ERISA).
Deductible contributions and their value
One tax advantage of Traditional IRAs that Roth IRAs do not possess is the ability for certain taxpayers to claim an up-front tax deduction. Taxpayers can deduct the value of their contribution to the Traditional IRA against their gross income to owe less in taxes. This deduction is reported on line 20 of the 1040, schedule 1 part 2.
To illustrate, when your $100,000 gross earning family goes to file their taxes you would claim the $25,900 standard deduction. In addition, you would get to deduct your $6,000 (2022) max Traditional IRA contribution.
$100,000 – $24,000 – $6,000 = $70,000 Taxable Income
$70,000 places you in the 12% marginal tax bracket for a Married Filing Jointly Taxpayer.
The first $20,550 of income had $2,055 worth of tax liability as you stepped through the 0% & 10% marginal tax brackets.
The remaining $49,450 ($70,000 – $20,550) is subject to the 12% marginal tax bracket.
$49,550 * .12 = $5,946 tax liability from the 12% marginal tax bracket.
This means your total tax liability for the calendar year 2022 is $2,055 + $5,946 = $8,001.
If you decided you wanted to make a Roth IRA contribution instead of a Traditional IRA contribution your tax liability would look as follows:
$100,000 – $24,000 = $76,000 Taxable Income
You are still in the 12% marginal tax bracket.
The remaining $ ($76,000 – $20,550) is subject to the 12% marginal tax bracket.
The first $20,550 of income had $2,055 worth of tax liability as you stepped through the 0% & 10% marginal tax brackets.
The remaining $55,450 ($76,000 – $20,550) is subject to the 12% marginal tax bracket.
$50,450 * .12 = $6,654 tax liability from the 12% marginal tax bracket.
You owe Uncle Sam $708 more for 2022 because you decided to save to a Roth IRA
The value of this deduction increases the higher your taxable income levels get. The irony is that high-earners lose the ability to take this deduction against their taxable income because of deductibility phaseouts (see this table).
Deductibility phase-outs do not remove one’s ability to contribute to a Traditional IRA. It simply removes the ability to take the deduction. Taxpayers can continue to make nondeductible contributions.
⚠️Two Rules of the Road ⚠️
The IRA Aggregation Rule
IRC Section 408(d)(2), stipulates that when determining the tax consequences of an IRA distribution – particularly the “pro-rata” rule under IRC Section 72(e)(8) and also the early withdrawal penalty under IRC Section 72(t)(1) – the value of all Non-Roth & Non-Inherited IRA accounts will be aggregated together for any tax calculations. No IRA stands alone.
Aggregating the IRA values together brings a total IRA value of $72,000 ($67,000 SEP IRA + $5,000 nondeductible IRA). The after-tax percentage is 6.94% ($5,000/$72,000). The $5,000 withdrawal is deemed to be a return of $347 (6.94% of $5,000) after-tax basis. The remaining $4,653 will be taxable income potentially subject to an early withdrawal penalty (if under 59.5). Further still, $4,653 ($5,000 nondeductible contribution – $347 basis recovery) of after-tax basis remains in your SEP IRA.