Question about IRA's:

[ret5hd]

If a person is in the lowest tax bracket, of what use is it (in the long run) to use an IRA to defer taxes?

My thinking is:

1) the lowest tax rate probably will never be lower than now. So, even if the tax rates stay the same you are only delaying taxes on that money till a later date (when it is eventually withdrawn).

2) if the lowest tax rates rise in the future, you would end up paying more in taxes than if you paid the taxes now.

Is there something I am missing? Or my thinking muddled?

[mobeau69]

1. Tax rates are based on income. After you retire you will

Be in a lower bracket and depending on your SS and how much additional you’ll need to withdraw yearly, you may end up paying no income tax at all. You might want to look at a Roth IRA also.

[ret5hd]

2. But I am already in the lowest bracket...

Let’s assume the tax rates/brackets stay exactly the same...I deposit $1000 in an IRA today and therefore defer the taxes on that $1000, then withdraw the $1000 five years from now and pay the taxes on the money at that point...but it is the same amount of tax on the $1000...right? Or no?

[Salviati]

3. With your assumptions, yes. There's not really any benefit to an IRA as far as I know.

Other than locking it away where it's less accessible to make sure it's around for later. As mentioned above a Roth IRA might have more advantages. You'd pay taxes on the $1000 now, but when you withdraw the money, and any gains that it's made in the future, it's all tax free. There are limits to how much you can put in a Roth IRA each year though.

[progree]

7. "a Roth IRA might have more advantages. You'd pay taxes on the $1000 now,"

If a person decides to contribute to a Roth IRA, he/she doesn't pay any taxes. One just writes a check or transfers money from their regular checking account or other regular account to the IRA custodian to set up or contribute to a Roth IRA (its been years since I contributed to any IRA). One's taxes will be completely unaffected by this. And one will never pay taxes on any of it in the future, not even on withdrawal.

Contributing to a Roth is a no-brainer, other than I'm pretty sure there is a 10% penalty for withdrawing before age 59 1/2, and there's some 5 year rule, where one must pay taxes on the earnings (but not on the original contribution) if withdrawing during the first 5 years or setting up the account, or before age 59 1/2. Something like that anyway.

Otherwise, it's just turning taxable money in a regular taxable account to a tax free forever account.

Edited: contributing to a traditional IRA may be a better move in some circumstances. There are Roth calculators out there (ones that compare contributing to a traditional IRA vs. a Roth IRA, or ones that analyze a Roth conversion), but be wary, particularly of financial planners' advice, most of whom have more bias than analytical skills https://www.democraticunderground.com/11212619

[Salviati]

8. The money you put into a Roth IRA is post tax money.

You've paid taxes on that money before you put it into the Roth.

[progree]

9. I know. So?

The choice is put the $1,000 in a Roth IRA or just keep the $1,000 in a taxable account.

The money that's in the taxable account is also after-tax money.

EDITED: now if you are comparing contributing to a traditional IRA vs. contributing to a Roth IRA, then it definitely a different story. With the traditional IRA, one gets a tax deduction up front. Not so with the Roth IRA.

[mobeau69]

5. Not necessarily. You could withdraw it without paying any tax at all.

[zipplewrath]

4. Hides your capital gains

If you have the kinds of IRA's that allows you to do trading, you don't have to declare the capital gains each year. But you are kind of on to something. The assumption on IRAs is that you'll be in a lower tax bracket than you are now (or at various times in your future). I didn't really work with IRA's, I had a 401K which is similar (only better if you have company matching). The other thing to consider is whether you intend to "spend" the whole IRA. You might end up giving it to heirs before you ever "remove" it from there. The other thing to consider is whether you have a stable employment environment. If you ever find yourself seriously unemployed, you may be able to take hardship withdrawals without penalty and you may be in a "no tax" bracket.

There are professionals that will discuss this with you for little to no cost.

[gibraltar72]

6. Having some knowledge on this

Anything that is accessible is in danger. I saw it many times in my career. There is always an "emergency" that requires you to tap funds. Maybe you are different than 99% of the people I dealt with. The early withdrawal plus tax deferred growth have saved many of my clients.

[doc03]

10. Invest in a Roth while tax rates are low nt

[progree]

12. Or high, or in between. When one contributes to a Roth (compared to doing nothing), one is in

effect converting taxable money in a regular taxable account into tax-free money in the Roth account.

One always comes out ahead, as long as one doesn't run afoul of the 5 year rule or withdraw before age 59 1/2 in which case i'd have to brush up on that and do the math.

EDIT: good point though -- compared to a traditional IRA, the Roth IRA always does best when tax rates in the year of contribution are low compared to later years.

[doc03]

13. I am 72 and have no idea where to park my RMDs from my traditional IRA. The banks and

MM funds pay next to nothing in interest. The market is at all time highs I don't feel safe to invest
in Mutual Funds. I was thinking of cannabis stocks but they have never taken off. On the Roth after I take out
my RMDs from my IRA I convert as much as I can to my Roth without going into the higher 22% bracket.
Since I am losing money with my savings I did buy a new car last year and gave some money to my nieces.

[progree]

15. I'm 69, so am also not looking at a very long time frame for compounding my money!

nor do we have a lot of years for recovering from a big stock market crash.

Right now, as far as investable assets, I'm maybe 55% in equities (mostly index funds) and 45% in bond funds.

On the equities, I believe the long-term historic results are so much superior to bonds or other fixed income. I recognize that valuations are way high compared to historic, but a lot of that is because interest rates are so low low, so people looking for any kind of return above nominal are forced to invest in stocks, thus the high P/E ratios. So I think they might not be overvalued much, at current interest rates.

But if interest rates go up in a serious and sustained way, than the above justification for the high equity P/E ratio dwindles. So that's very scary.

Post WWII, U.S. stock market has crashed a number of times, but has gotten back to where it was in like 8 years or less. I think people are seeing it as a safe buy-and-hold investment if they can hold on for 8 or so years, and that is helping to cause the high valuations. I am mindful though that it took the Dow about 16 years to regain its 1966 peak.

And the Nikkei was 38,916 at the end of 1989 and 7,055 in 2009, and about 28,000 now, so they haven't fully recovered their losses 30+ years later. And pity the poor person who needed their money in 2009.

My bond funds are yielding between 1.5% to 2.2%. It's sad to see such a weak return on 45% of my investable assets. But I just don't have the stomach to have it all in equities, and risk losing it all

I've written in a couple of posts that contributing to a Roth IRA -- compared to doing nothing and letting the money sit in a taxable account -- is a no-brainer if one doesn't run afoul of the early withdrawal rules.

But the decision to convert traditional IRA money to a Roth IRA is a different thing entirely, definitely NOT a no-brainer. But I tend to believe that if one's tax rate in the year of conversion is lower or the same as in the year of withdrawal, that the Roth usually comes out better.

[doc03]

17. I am in 42% equites and 58% fixed income in my IRAs and Roth. I started withdrawing from my IRAs at

65 instead of waiting until I was 70 1/2 and have done very well. Even after withdrawing for 8 years my retirement
balance is 37% higher now. I have converted a good portion to a Roth over the years which will be tax free. But what I don't spend out of my withdrawals there is nowhere to park it short term and at my age I am not worried about long term investments.
I wish I would have bought a condo down south back in 2009 when they were dirt cheap.

[progree]

11. The tax-deferral advantage of traditional IRAs

Last edited Thu Feb 4, 2021, 02:08 AM - Edit history (2)

Say your combined tax rate is just 15%. Say its 15% throughout -- when contributing, and in the years following, including the withdrawal year.

You have $1000 in a regular taxable account.

Option 1: Do nothing, keep your money in a regular taxable account
===================================================================

If the rate of return is 3% (e.g. the interest rate on a bond fund), then the after-tax rate of return is (100%-15%) * 3% = 85% * 3% = 2.55%.

Over 20 years, that $1000 grows to $1,000 * 1.0255^20 = $1,655

Option 2: Contribute the $1000 to a traditional IRA.
==============================================

First you get a $1,000 tax deduction (not subject to the standard deduction) for an initial tax savings of 15% * 1,000 = $150. That ends up in your regular taxable account

Over 20 years, that $150 grows to $150 * 1.0255^20 = $248

The $1,000 in the IRA earns 3% tax free until time of withdrawal.

Over 20 years, that $1000 grows to 1,000 * 1.03^20 = $1,806.

On withdrawal, one must pay taxes on the whole amount: Tax = 15% * 1,806 = $271.

Leaving: $1,806 - 271 = $1,535.

Adding it all up: $248 + 1,535 = $1,783

Summarizing:
==============
Option 1 (do nothing): $1,655
Option 2 (contribute to IRA): $1,783
------------------------------
Difference: $128

Anyway, this weakly shows the power of tax-deferred compounding, though at a very weak rate of return and low tax rate, so its not that wildly impressive.

====####################################====

Back in the early days of IRA's, it was easy to get a 10% bond or CD, and it was much more advantageous:


Option 1: Do nothing, keep your money in a regular taxable account
===================================================================

If the rate of return is 10% (e.g. the interest rate of a bond fund), then the after-tax rate of return is (100%-15%) * 10% = 85% * 10% = 8.5%.

Over 20 years, that $1000 grows to 1.085^20 = $5,112

Option 2: Contribute the $1000 to a traditional IRA.
==============================================

First you get a $1,000 tax deduction (not subject to the standard deduction) for an initial tax savings of 15% * 1,000 = $150. That ends up in your regular taxable account

Over 20 years, that $150 grows to $150 * 1.085^20 = $767

The $1,000 in the IRA earns 10% tax free until time of withdrawal.

Over 20 years, that $1000 grows to 1,000 * 1.10^20 = $6,727

On withdrawal, one must pay taxes on the whole amount: Tax = 15% * 6727 = $1,009.

Leaving: $6,727 - 1,009 = $5,718.

Adding it all up: $767 + 5,718 = $6,485

Summarizing:
==============
Option 1 (do nothing): $5,112
Option 2 (contribute to IRA): $6,485
------------------------------
Difference: $1,373

It would be even bigger at a higher tax rate (in most cases one should use their combined federal and state tax rate).

====####################################====

It gets complicated when considering equity investing and capital gains. For example if one is a buy-and-hold stock investor:

Option 1: Do nothing, keep your money (invested in the stock(s) ) in a regular taxable account. Sell the stock after 20 years
===================================================================

One pays no taxes on the capital gains until one sells it 20 years later. (So in effect you have a 20 year tax deferral).

When one does sell, the capital gains tax rate is 0% or 15% or a mix of that for most people

If the stock earns qualified dividends, one pays taxes on those each year at the low capital gains tax rate.

Option 2: Contribute the $1000 to a traditional IRA holding stocks.
==============================================

One still gets the $150 tax break up front to invest (see option 1 for it's treatment)

As for the $1,000 in the traditional IRA, it grows tax deferred and the dividends are untaxed prior to withdrawal

But on withdrawal, the entire traditional IRA is taxed at one's ordinary tax rate which is almost certain to be higher than one's capital gains tax rate.

In conclusion, the traditional IRA option is not likely to work out well because of the big difference for most people in their ordinary tax rate and their capital gains tax rate.

But if one contributes to a Roth, it will always be better so long as you don't withdraw prematurely -- see Post #7

EDITED TO ADD: Although the way one would contribute to an IRA would be to transfer money from one's checking account to one's IRA account via writing a check or electronic transfer directly or indirectly or something like that, or otherwise moving money from some taxable account to the IRA in the proper way (I haven't contributed to an IRA for decades, back then I went to a bank and filled out a form and wrote a check to go with it, saying what it was for in the memo line), the reason for this edit is to stress that, in order to contribute $1,000 to an IRA in a given year, one must have $1,000 or more of earned income in that year -- what one earns from salary or wages or from self-employment.

And there are limits to what one can contribute to an IRA in a given year, currently (2021) $6,000 ($7,000 if you are age 50 and over). The same as in 2019 and 2020. It is indexed for inflation, but they change it in increments.

More on contribution limits and some other IRA minutae: https://www.kiplinger.com/retirement/retirement-plans/601632/bad-news-on-ira-and-401k-contribution-limits-for-2021

[ret5hd]

14. Thank you! Exactly the kind of info l thought may be out there.

So I was missing something...even if the difference is slight, it is still there!

[progree]

16. If you put that $1,000 in a Roth instead:

Summarizing, for the 3% interest rate case:
==============
Option 1 (do nothing): $1,655
Option 2 (contribute to Traditional IRA): $1,783
Option 3 (contribute to Roth IRA): $1,806

Summarizing for the 10% interest rate case:
==============
Option 1 (do nothing): $5,112
Option 2 (contribute to Traditional IRA): $6,485
Option 3 (contribute to Roth IRA): $6,727

Edited - a few edits, hopefully this is right now.

[UrbScotty]

18. If you're in a low tax bracket, the only reason I can think of to open a traditional IRA

(i.e. not Roth) is if you want to roll over your 401(k) or other retirement plan assets from a previous job (which is allowed). That could give you more control over your investments than a workplace retirement plan provides (i.e. allowing you to invest in individual stocks, or in funds that the other plan doesn't offer).

Even then, there can be downsides to that kind of rollover. Many 401(k)/403/457 plans allow you to take money out of your plan (as taxable income) after you've left that employer - even if you're not 59 1/2 yet. If you rolled that over into an IRA, you'd have to wait until you're 59 1/2 or pay a penalty on top of whatever other tax.

I think a traditional IRA makes the most sense if you're in a higher tax bracket and your employer does not offer you a retirement plan. In that case, you can deduct your contributions now, with a view toward taking the money out when you're retired (and presumably in a lower tax bracket). (If your employer did offer a retirement plan, then it's probably better to just contribute to that, given the phase-out rule for IRA deductions and the higher contribution limits for employer plans versus IRAs.)