Farm and ranch income often varies from year to year. The tax code has some options that allow variable income to be balanced somewhat from year to year. A producer may also adjust the timing of sales and expenses to manage income taxes. Even utilizing these tools, taxable income may vary. The Montana and federal income tax systems are progressive, meaning that as taxable income increases the marginal tax rate increases. At the federal level, income tax rates start at 10% and move up to 15%, 25% and eventually to nearly 40%. Montana has a similar structure however the top rate is 6.9% and it is reached a much lower income level. As a result of this, a producer in a high income year might pay a marginal tax rate of 33% (25% federal plus 6.9% state). In a lower income year the marginal rate might be closer to 23% (15% federal plus 6.9% state). These variations in marginal income tax rates can play a factor in how to maximize the tax advantages of contributing to an Individual Retirement Account (IRA).
Traditional IRA contributions are made on a “pre-tax” basis. If you contribute to a traditional IRA your taxable income is reduced by the amount of your contribution on your current year’s tax return. If you contribute $1,000 and are in the 28% federal tax bracket and 6.9% state income tax bracket; then your taxes will be reduced by $280 and $69. If you were in the 15% tax bracket and the 6.9% state tax bracket your savings would be $150 and $69. The same $1,000 contribution with different marginal tax rates yields $130 higher income tax savings ($349 vs. $219) in high marginal tax rate versus the low marginal tax rate. All withdrawals from a traditional IRA are taxable in the year in which you withdrawal them.
Roth IRA contributions are made on a “post-tax” basis. If you contribute $1,000 to a Roth, your current year income taxes are unaffected. Withdrawals from a Roth IRA are not included in your taxable income. Regardless of whether you have a high or low marginal tax rate when you make Roth IRA contribution, the current year tax benefits are similar.
To maximize the income tax savings from an IRA contribution you’ll want to keep in mind your current marginal tax rate. A traditional IRA will likely provide a greater income tax reduction than a Roth IRA if you are currently in a high marginal income tax situation. A Roth IRA will be more attractive if you are currently in a low marginal income tax situation. There are other reasons to save for retirement beyond income tax minimization that should be considered but don’t overlook the opportunities presented by variable marginal income tax rates.
(Photo by 401(K) 2013 is licensed under CC BY 4.0)
