I usually advise my clients against making IRA contributions for the prior year after the year has ended.
Let’s back up. What are we even talking about here?
IRA Contributions After Year-End
A taxpayer who qualifies to make a deductible IRA contribution (WARNING: not everyone does qualify!) can make a contribution up to the due date of their tax return and have it count for the prior year.
Example: your 2020 return is due April 15th, 2021. You can make an IRA contribution up to April 15th, 2021, and take a deduction on your 2020 taxes.
But is this a good idea?
I don’t like doing this. Now, with business clients making contributions into a retirement account it’s different. It’s also different if you have the money available and want to make a contribution into your IRA.
But usually what happens is this: I prepare the return, and let’s say you end up owing $1,000, and you’re in the 22% tax bracket. “I’ll just make an IRA contribution,” people think.
If you are going to eliminate a $1,000 tax liability and are in the 22% tax bracket, you need to come up with $4,545 of additional deductions. (Take $1,000 / .22.)
So to wipe out a $1,000 tax liability you would need to put $4,545 into your IRA. Do you have $4,545?
Let’s look at the cash flow here:
Option 1: Do Nothing
You owe $1,000. That’s a cash flow of a negative $1,000.
Option 2: Put Money in Your IRA
Let’s say you decide to put $4,545 into your IRA. Great! Now your tax liability is $0.
YEAH, TAKE THAT STUPID IRS!!!!! YEE HAW!!!!
But is it so great? You must SPEND $4,545 to save $1,000. You haven’t “saved” $1,000, you have SPENT a net of $3,545.
This is only a good exchange if you have the money to do this and this is what you want to do with the money.
Otherwise — and hold onto your hats for what I am about to say — you will be better off just paying the tax.
Yes yes I can hear some readers now. “IT’S MY MONEY GOD###NM IT AND I AIN’T GIVING A CENT TO THE GOD###NMED GOVERNMENT!!!!!!!!!!!!!!!! I AM PUTTING THE MONEY IN THE IRA BECAUSE IT’S MINE ALL MINE!!!!!!!!!!! FREEEEEDDDDDOOOOMMMMM!!!!!!! ARGLE BARGLE EEEEEEEFEJLAKJJIOEWARJOIFA”
And my standard response to the “it’s my money argle bargle” rant is, I agree that taxes are annoying, but taxes exist and always will, so grow up and learn to deal with them and make smart moves.
Putting money into an IRA in this instance may be a smart move, but only if you have the money and this is what you want to do with the money. And usually, with the average client, they see this math laid out and decide to just pay the $1,000 of tax and be done with it, because paying $1,000 is more feasible than paying $4,545 into an IRA.
What might be a smart move is, in our example, starting to make an IRA contribution in 2021, for 2021. That way you’re not chasing your tail trying to eliminate a prior-year tax liability. (Because unless something changes, you’re going to have another $1,000 tax bill on your 2021 return.) If you can swing it, make the IRA contributions in 2021 to reduce your tax liability on your 2021 taxes.
But again, it comes back to: how much money do you have, in the here and now, and what do you want to do with it?