Good morning & happy Monday!
“The nation ought to have a tax system which looks like someone designed it on purpose.”
– William E Simon, 1927-2000, former US Secretary of the Treasury
Unfortunately, I’m afraid our tax system oftentimes does not seem to be designed on purpose. But today I would like to discuss one of the tax provisions that was designed with purpose and can make a meaningful difference in your savings strategy: tax-deductible / tax-deferred accounts and tax-free accounts.
Tax-deductible / tax-deferred accounts include traditional IRAs, traditional 401(k), and traditional 403(b) accounts. These types of accounts you can deduct the contributions on your taxes and the growth is tax-deferred. Upon withdraw the entire amount of the withdraw is fully taxable at regular income tax brackets.
Tax-free vehicles will be anything with the word Roth in it (Roth IRA, Roth 401(k), Roth 403(b), etc.). These accounts do not provide any tax deduction upon contribution, but all the growth is tax-free upon distribution.
These are overly simplistic definitions and there are many caveats that I will skip so as to not get too caught up in the weeds. As always, please feel free to reach out with any questions.
As is the case with many financial concepts, I think examples might be the best way to illustrate the difference between these different ways to save / invest.
Let’s say these are the base facts of this hypothetical:
- I am 40 years old
- I make $100,000/year
- I save $5,000/year for 25 years (age 40-65) into an IRA (either traditional IRA or Roth IRA)
- My compound rate of return is 7% (just math, no product recommendation here).
After 25 years I have $326,837 ($125,000 of contributions and $201,837 of growth). That is going to be the same under either tax-deductible / tax-deferred or tax-free (Roth). What is different is the tax treatment.
Traditional IRA
My contributions are tax-deductible each year I make the contribution. So, in this example my taxable income goes from $100,000 to $95,000 ($5,000 less because of my traditional IRA contribution). This saves me taxes each year I make a contribution. Yeah! Less taxes!
But … there is a price to pay …
Upon distribution of my account, $326,837 at age 65 in this example, 100% of those funds are taxed at my regular tax bracket. What will my tax bracket be in 25 years when I go to take the funds out? Who knows? (The current tax brackets are set to expire in 2025)
If I’m in a high tax bracket in my working years, say 32%, and a low tax bracket in retirement (age 65 in this example), say 12%, then this was a good deal for me because I was able to deduct income at 32% and then pay taxes at 12%. But, I am paying taxes on a bigger pot of money. I deducted from my income $125,000 ($5,000/year for 25 years), but I now must pay taxes on $326,837 which is the contributions plus all the growth. Even if I am in a lower tax bracket in retirement this may not be the best option, it depends on a lot of different factors.
Taxes will need to be paid on every penny in the traditional IRA … even if I die my beneficiaries will need to pay taxes on all of those funds.
Roth IRA
No immediate tax benefit. I made $100,00, put $5,000 into a Roth IRA, my taxable income is still $100,000. Lame!
But … now comes the benefit …
That $326,837 Roth IRA balance at age 65 … 100% of that is mine … the IRS get zero, zip, zilch, nada! So, I paid the price early on by not writing any of my contributions off on my taxes, but now I get the benefit of not having to split my IRA proceeds with the IRS.
Upon my death the Roth IRA funds are also tax-free to my beneficiaries too.
I always like to summarize the difference between traditional IRAs and Roth IRAs by asking: Would you rather tax the harvest (traditional IRA) or would you rather tax the seed (Roth IRA)?
I do have a personal bias: I love Roth accounts, but that is not always the best solution.
As is true for each of our precious clients, we evaluate these decisions on an individual basis factoring in objectives, income, assets, projected retirement income, projected growth rate, age, legacy desires, risk profile and other factors before determining the specific recommendation on the traditional IRA vs. Roth IRA.
I hope this helicopter view was helpful, please let me know if you would like further information or any other way my team and I can support you on your journey.
Have a wonderful week ahead!