Individual retirement arrangements, or IRAs, provide tax incentives for saving for retirement. If you can afford it, I strongly encourage everybody to contribute at least a little bit to a Roth IRA every year, even if you have a 401(k) or other retirement plan at work. And among the many benefits of IRAs is the fact that you can make prior year IRA contributions up until April 15 each year.
What are prior year IRA contributions?
Ok, so every year you file your tax returns on or around April 15. As you prepare your tax return, you collect deductible expenses (like student loan or mortgage interest) that you paid last year, before December 31. If you determine in April that you didn’t pay enough tax last year and will owe the IRS, you can’t write a check to charity and count it for last year to reduce your taxable income – it’s too late.
Fortunately, however, you can make prior year IRA contributions up until the tax filing date. So if you meant to start an IRA last year but forgot, you can still open an account, fund it, and count the contributions for the prior tax year.
Why would you want make prior year IRA contributions?
Maybe you forgot to open an IRA last year, or you only contributed a little bit and realize you have more money to save up until the annual limit.
Perhaps you discovered that you’re going to owe the IRS some money and you want to reduce your tax bill. If you haven’t already maxed out your IRA for last year, you can make traditional IRA contributions that are tax deductible. (For example, if you contribute $5,000 to a traditional IRA before April 15 you can reduce last year’s taxable income by $5,000 and reduce the amount you owe by some percentage).
Note that this only works with traditional IRAs. You cannot deduct contributions to a Roth IRA because the money can be withdrawn tax-free during retirement. In general, I recommend young people open Roth IRAs instead of traditional IRAs because, in most cases, your tax rate will be higher in 30 or 40 years than it is now. That said, reducing an unexpected tax bill would be a good reason to put some cash into a traditional IRA.