I usually try to steer clients away from making contributions to a retirement account after the year ends, even if they might get a deduction in that prior year. Example: an individual has until April 15, 2022, to put money into an IRA and count it (and take a deduction for it) as a 2021 item on their 2021 tax return.
Do note that I am referring in this post to IRA contributions of individuals, not retirement-plan contributions by businesses. But the same logic applies to businesses doing contributions after the year ends (SEP contributions by a sole proprietor, for example). If you have the money, it makes sense. Otherwise it doesn’t make sense.
Chasing Your Tail: Cash Flow
Let’s say it’s late March and you’re finishing up your tax return. You discover that you owe $1,000 to the IRS. You’re in the 22% tax bracket, so a contribution to an IRA of $4,545 by April 15th would eliminate this liability ($1,000 tax liability / .22 = $4,545). (Let’s assume you meet all the qualifications and so the IRA contributions would be fully deductible.)
When you think about doing this, you need to look at cash flow, not just “hey, let’s do the IRA so I can keep the government from getting MY MONEY! MY MONEY! AHHAAAAAHHAAAAAHAAA!”
In this example, you’re not really “saving” $1,000 of taxes by putting money into the IRA — you’re SPENDING $3,545.
So you need to look at it this way:
- Your cash outflow if you did nothing would be $1,000 to the IRS.
- If you put $4,545 into the IRA, you’ll save $1,000 in taxes, your tax return will come down to $0 — but you still need to come up with $4,545 to put into the IRA. This is real money you’d need to spend in order to save $1,000 on your taxes. $4,545 – $1,000 = $3,545 net cash outflow.
- Do you have $4,545 sitting around to put in an IRA? If yes, then this is an excellent thing to do. If no, then — GASP — you should just pay the taxes because it’s a much smaller cash outflow.
Example of it making sense:
You have $5,000 available to spend. You can either pay $1,000 to the feds with your tax return and have $4,000 left. Or, you can put all $5,000 into the IRA, which would generate a small refund on your tax return. If putting the money into a retirement account is what you want to do with this $5,000, then this is an excellent idea, and the tax savings are a nice bonus. But it’s only a good idea if you have the $5,000 available to do something with.
The point is, if you’re making an IRA contribution because you have the money available and it’s what you want to do with the money, then great. But if you’re making the contribution because you’re just trying to get extra deductions, it’s a horrible idea.