Knowing whether you should fund a Roth IRA or a traditional retirement account can be a difficult choice. Money goes into a Roth IRA after taxes. Your money grows tax-free and is tax-free when withdrawn. You get a tax deduction when you put money into a “traditional” retirement plan. Money grows tax-deferred and is taxed when withdrawn.
Why Tax Rates Are Very Important
Let’s assume you own a home with a mortgage and you itemize your tax deductions every year. Let’s say you typically have around $18,000 in itemized deductions annually. Using the 2022 tax rates for married couples filing jointly, this means:
– You won’t pay any federal taxes on the first $25,900 of taxable income. A 10% tax is applied to the next $20,550 of taxable income. A 12% tax is applied to income over $20,550 and up to $83,550.
Now let’s say you and your spouse earn a combined $72,000 annually:
– You won’t pay taxes on the first $25,900 of income due to the standard deduction for 2022, so you have $46,100 of taxable income. A 10% tax is applied to $20,550 of taxable income, and a 12% tax is applied to the next $20,550.
You would save $600 in federal income tax at a 12% rate if you contributed $5,000 to a traditional retirement account or 401(k). But what is your tax rate when you withdraw that money in the future? You might be in a 22% or 24% tax bracket in retirement, so you would pay $1,100 or $1,200 in taxes on that $5,000 when you withdraw it at that time.
Note: Deductible contributions to retirement plans may not be the right way if you believe your tax rate may be higher in the future. You might save 15% in taxes when putting in the money, but pay 25% in taxes when withdrawing it.
Tax Planning Helps: Example
Simple tax planning each year can help you determine which type of contributions are best.
Let’s say you are a real estate agent and you are 54 years old. Your income varies from year to year. You fund a traditional retirement account each year (deductible contribution) so you can save as much on taxes as possible… or so you think.
Your income becomes lower than it was when you started funding your regular retirement account when the economy slows down. You decide to do some tax planning and run tax projections. You have many deductible business expenses, and you can itemize your deductions. Estimating, you pay no federal income tax for the year, only self-employment tax. So the deductible contribution to a traditional retirement account won’t provide you with a significant tax benefit.
During your low-income years, the best option would be to fund a Roth IRA or Roth 401(k), which doesn’t provide any tax deduction either. But all earned investment income is tax-free, now and in the future. And the Roth IRA has a unique advantage in retirement: the income you withdraw from a Roth IRA is not included in the formula that determines the amount of your social security tax benefits.
Having Roth IRA funds to withdraw in retirement will help reduce the amount of taxes you will pay. You will need to run tax projections each year so you can estimate the important tax bracket and determine which type of account is most beneficial for you to use. This strategy will add thousands of additional after-tax dollars available to you once retired.
Let’s assume
You have five years of low income where it makes sense to contribute to a Roth, as you won’t be able to take the deduction if you contribute to a traditional retirement account. You will accumulate $25,000 in your Roth account, plus earn $5,000 in interest over 10 years. You are still in the 12% federal tax bracket at retirement, so you will save an estimated 12% on $30,000, or $3,600, when withdrawing the full balance of the Roth IRA.
Note: You must have taxable compensation to contribute to a traditional or Roth IRA.
You will have an accumulated interest of $3,000. Contributions to the traditional retirement account at the 12% federal tax rate over five years will amount to $600. The difference will be a tax savings of $600.
Withdrawals over decades in retirement can lead to tax savings of thousands of dollars.
Source: https://www.thebalancemoney.com/traditional-vs-roth-ira-2388698
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