How do IRA deductions work?

[dan45066]

I'm self employed and have an SEP IRA that I want to contribute to with the goal of lowering my taxes, but I'm not really sure how this works.

I've asked several people (included cpas) but haven't received a clean explanation yet.. so I'm hoping someone here can help me using this example:

If I have $100k profit, and lets say my tax bracket is 10%. If I do nothing, then I would be taxed $10k.

But, if I contribute $10k to my sep ira, then here's where I don't fully understand.

Do I subtract the $10k from the tax bill making it where I owe $0 in total?

Or does the contribution subtract from my profit - making my taxable income $90k and thus my tax bill $9k?

I'm really confused with how all this works.. because if throwing $10k into an ira only gets me a $1k tax break, then I'd rather just keep the $9k in my pocket.

[Critter · Accepted solution]

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 Ok ... The SEP contribution will only reduce your federal taxable income (not the profit)  ... it is NOT a $ for  $ reduction in your tax bill and has NO effect on the SE taxes you will pay on the profit on the Sch C.  

So in your flawed example the $10K  SEP will only reduce your federal taxes by $1K.   The best way to see how this works is to complete the entire return without the SEP (save a PDF) then add the SEP and save the return again ... then compare both returns side by side.  

[dan45066]

Awe man, that really sucks. I guess I'll just keep the cash and not mess with the ira in this case.

Well thanks for the response though, I really appreciate the help!

[dmertz]

"I guess I'll just keep the cash and not mess with the ira in this case."

The SEP contribution is more about saving for retirement than the immediate tax deduction.  Even if you made a SEP contribution that lowered your present tax liability, the amount contributed and any investment gains would be taxable income when distributed from the IRA.  It's possible that your marginal tax rate will be lower when eventually distributed, but it's not uncommon for one's tax rate to be the same or higher in retirement.  If your present marginal tax rate is relatively low and you have no need for the money for at least 5 years it would make a great deal of sense to make the SEP contribution and immediately convert to a Roth IRA.  While you'll have no immediate tax savings, you'll be able to get the converted amount back out tax and penalty free after 5 years and and distributions of earnings from the Roth IRA will be entirely tax and penalty free once the requirements are met (5 years and age 59½).

If you choose not to make the SEP IRA contribution and convert to Roth it would probably be better to just invest in capital investments where long-term capital gains are taxed at a lower tax rate than is ordinary income.

[Carl]

If your primary reason for doing "any" kind of deferred tax retirement account is to lower your current taxes, then you're doing it for all the wrong reasons. The "primary" reason for establishing any retirement account is to maintain an acceptable standard of living once you retire, for the rest of your living years. Doing this for any other primary reason is flawed.

I myself have and prefer a ROTH account. That's where I pay taxes on the money "before" I contribute it to the ROTH account. Then when I retire all withdrawals "including" the earnings are all tax exempt and tax free.  So I have two primary reasons for my ROTH retirement account.

 - To maintain my same (or acceptable) standard of living upon retirement

 - To not pay "any" taxes on my retirement contributions when the time comes I need to use them to maintain the same or acceptable standard of living I enjoy in my working years.