Question about IRA's:

[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
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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.
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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:
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Option 1 (do nothing): $1,655
Option 2 (contribute to IRA): $1,783
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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.

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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
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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.
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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:
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Option 1 (do nothing): $5,112
Option 2 (contribute to IRA): $6,485
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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).

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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
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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.
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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