An IRA is an easy and critical tool for growing wealth and reducing taxes. Everyone needs one but you need to choose whether a traditional IRA or a Roth IRA is right for you.
You may not have a choice between Roth and traditional since Roth contributions are limited by income. For the 2021 tax year, only individuals with modified adjusted gross income (MAGI) less than $125,000 or couples filing jointly with MAGI less than $198,000 can contribute the maximum amount of $6000 per year ($7000 for ages 50 and older) to a Roth. Anyone with earned income above or below these limits can contribute to a traditional IRA.
MAGI is not your salary. Your salary adjusted for various deductions equals your adjusted gross income (AGI) which, for 2020, can be found on line 11 of Form 1040. Per the IRS, “For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return before subtracting any deduction for student loan interest.” You can find MAGI calculators online but for most people it is enough to know that MAGI is close to AGI and much less than your salary.
The other main difference between a Roth and Traditional IRA is when you get a tax break. Contributions to a traditional IRA are tax deductible in the contribution year which could reduce your taxable income that year. Contribute $6000 (the 2021 maximum for people under 50) and pay taxes on $6000 less income. If you are in the 20% tax bracket you save $1200 per year in taxes. However, if you contribute $6000 every year ($500/month) for 30 years you would have $930,662 (assuming 9% annual return). All of it, the principle and growth, would be taxed as ordinary income upon withdrawal when you retire. At a 20% tax rate, that represents a tax burden of $186,132. It’s actually more because as you withdraw over time the balance continues growing but who can calculate that? Withdrawals also increase your income in retirement, possibly your tax bracket, and the taxes you will pay on other income.
Contributions to a Roth IRA are not tax deductible. You contribute after-tax money but when you retire all contributions and growth are withdrawn tax-free! Of course in a 20% tax bracket you have to earn $7500 to have $6000 to contribute. So over 30 years you pay $45,000 ($1500*30 years) in taxes on your contributions but then you are done. This is a far-cry from the overall tax burden in a traditional IRA.
The IRA Tax-Bracket Fallacy
The Tax-Bracket Fallacy is what I call the standard advice about whether to contribute to a Roth or Traditional IRA. It goes like this:
You should use a traditional IRA if you expect to be in a lower tax bracket in retirement than you are now. This way you get a higher tax break now and pay taxes at a lower rate in retirement. Likewise, the argument goes, if you expect to be in a higher tax-bracket in retirement you should use the Roth so you pay low taxes now and no taxes later.
This is crazy for several reasons and a Roth is generally better for most people. Let's review the differences between Roth and traditional IRAs. This will help you decide which is better for your situation and expose the Tax-Bracket Fallacy.
So, why is the conventional advice wrong? I learned a lot from a Motley Fool Answers podcast on IRAs and one with an interview with Ed Slott. You should check them out. Here are three reasons Roth is better in most cases and why the tax-bracket argument is whack.
1) There is no way to know what tax rates will be in the future. What we do know is that they are historically low now. Advantage Roth.
2) There is no way to know what your taxable income will be when you retire. People are living longer and are more active in retirement. People who retire at 65 could be retired for over 30 years. Maybe you will start a business or write a book or have income from sources other than social security like interest and dividends. You cannot predict your future sources of income. But with a Roth, IRA distributions will not be one of them. Better to pay low taxes now and have lower taxable income and flexibility in the future. Advantage Roth.
3) The math just doesn’t work. A $6000 investment in a Roth costs $7500 but you keep all the growth tax free. The total transaction cost for a traditional IRA is actually $7200 because you contribute $6000 but save $1200. These transactions and subsequent growth are unequal because the $1200 tax-break disappears from your retirement savings whereas the $1500 taxes paid on a Roth contribution are included in your retirement savings as pre-paid taxes.
Thus, the returns and wealth generated from a traditional IRA will only equal those of a Roth if you also invest your tax savings. You cannot contribute more than $6000 per year to an IRA so the extra $1200 per year would have to go in a separate taxable account. However, $1200 deposited as $100/month for 30 years (9% annual return) = $186,132, the exact tax burden of the traditional IRA. Unfortunately you would eventually have to pay taxes on this also. Advantage Roth.
There are other benefits to Roth IRAs and there are obviously details and nuances I cannot include here. For example, the tax break captured by traditional IRA contributions decreases if you also have an employer sponsored retirement plan. Also, since you have already paid taxes on your Roth contributions they can be withdrawn tax and penalty free though any growth on those contributions cannot.
If your income is so high that a traditional IRA is your only choice this is a good problem to have. You may be able to reduce your taxable income with contributions to a 401(k), 403b, or 457 account. There are also ways to convert traditional IRAs to Roth IRAs but these are complex and you should consult a tax professional. For the rest of us, if you want tax-free investment returns and low retirement income, Roth has the advantage.
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