Many investors are better off paying more in taxes now, when they at least know how much they’ll be paying.
There’s no denying it — paying taxes just plain stinks! Even if the money is being used for the common good, it’s still a big chunk of your hard-earned dollars being spent by someone else. It’s understandable that people seek to minimize their annual tax bills.
Before contributing to a traditional IRA (individual retirement account) simply to reduce your current taxable income, however, you might want to take a step back and consider a Roth IRA instead. Although it doesn’t provide any sort of tax break right now, it does offer a huge break once you start taking money out of Roth accounts when you retire. A little personalized number-crunching may be in order.
It’s just a matter of when
You’re probably familiar with traditional IRAs. Introduced in 1974, these accounts not only facilitate untaxed gains within the account itself, but your contributions to them are also tax-deductible. Assuming you’re eligible to make this year’s maximum contribution to a traditional IRA, you could reduce your taxable income by up to $6,500 (or $7,500 if you’re 50 years old, or older).
The catch? Withdrawals from this type of retirement account are typically taxed in full as ordinary income in the year in which they’re taken out. If your withdrawals are going to be sizable, your corresponding tax bills could be big as well.
Roth IRAs are taxed in the exact opposite way. If you’re eligible to contribute to one (and most people are), your current taxable income isn’t lowered, so there is no immediate tax benefit. But future withdrawals from Roth accounts aren’t taxed at all. Neither are any gains they achieve between now and then.
Said more plainly, both types of IRAs provide a tax-savings benefit. They just do so at a different time. Most traditional IRA contributors enjoy their tax break here and now. Most of these same investors could enjoy a bigger tax break in retirement, though, by foregoing the current tax-deductible contributions to a traditional IRA and putting that money into a Roth IRA instead.
But which makes the most sense for you? Keep reading.
Think strategically when choosing a traditional or Roth IRA
Broadly speaking, you’ll want to pay whatever income taxes are due with your IRAs when your income and your income-based tax rates are at their lowest. For many of us — although not all — that will be in retirement.
There are noteworthy potential exceptions to this likelihood, though. A relatively modest earner (but good saver) in their mid-20s is one such exception. If this individual is earning on the order of $40,000 per year, they’re already paying a minimal amount of taxes after standard deductions. A tax break right now doesn’t necessarily do this individual a great deal of extra good.
Moreover, if this person is able to contribute even just $5,000 to a Roth every year and invest that money in stocks for 40 years, the retirement account could be worth over $2.4 million at the end of the four-decade stretch, assuming a 10% average annual return. The required taxable withdrawals from a traditional IRA this big would incur a major tax bill just because such a big sum would be taken out. The minimum distribution for the first year of required withdrawals from a $2.4 million traditional IRA would be nearly $100,000.
A Roth makes far more long-term sense in this scenario, particularly given that there are no required distributions for these accounts as long as their owner is alive.
On the flipside, a relatively high earner in their latter working years might be better off using a traditional IRA to bolster their retirement nest egg. Someone in a top tax bracket now might be in at least a slightly lower bracket in retirement, making it prudent to look for ways to pay less tax now.
But you’re somewhere in between these two scenarios? Most people are. Your situation likely isn’t as cut-and-dried as these examples. You’ll want to think carefully about which option makes the most sense for you right now. It may even require putting some pencil to paper, and forming a long-term savings plan and budget.
The X-factor: You don’t know what tax rates will be in the future. Even if it seems to make financial sense to forego the tax break now and pay taxes on this money later, the math could change in the interim.
On balance, the Roth IRA often wins
There is no absolute right or wrong choice, for the record. Each type of retirement account comes with its unique upsides and downsides. Also keep in mind that most people can contribute to both a Roth and a traditional IRA for the same tax year, as long as you don’t contribute a total amount that exceeds your age-based and income-based limits. This possibility might allow you to fine-tune your total tax savings.
However, bear in mind that — depending on your income and whether or not you and/or your spouse have access to a work-based retirement plan — you may or may not be allowed to contribute to a Roth IRA, or even deduct your traditional IRA contributions from your taxable income. Be sure to familiarize yourself with the IRS’s rules regarding these limitations.
Assuming there’s no such contribution or participation restriction for you, however, many people are usually better served by funding a Roth IRA. This gives you a means of avoiding paying taxes on what’s (hopefully) a fortune at a time when tax rates might be much higher than they are now.
