The 2 primary schools of thought:
When it comes to choosing how to invest for retirement, the 401(k) and IRA are still among the most popular options for most Americans. Within the IRA, you can choose between tradition or Roth. The choice between these two rests largely on the difference between 2 major schools of thought: (1) The one that calculates the greatest overall gains, and (2) the one that is most practical based on human nature.
From my personal experience in doing taxes for people in retirement, the most common complaint I hear from retirees is having to pay federal and state taxes on retirement distributions, reported on Form 1099-R. Most of the time, the companies holding the money DO NOT withhold tax on the distribution, resulting in taxes owed when filing. This has surprised and frustrated many people, especially in their first year of retirement. So let me break it down for you with a simple example:
Simple Example – Traditional IRA
If you contribute $5,000 to a traditional IRA, you will get a $5,000 tax deduction when you file your taxes. Depending on your income level, it might be around $600-$1,000 for most people. That $5,000 then, will go into whichever investment(s) you choose and hopefully stay there until you retire. Capital gains/losses on that money are NOT taxable events and NOT reported on your taxes. For example, you gain 8% interest in the first year, you will NOT receive a 1099-INT to report on your taxes. It is a tax-free event, which goes on from year to year until you finally decide to withdraw money from the account.
Let’s say your money doubles to $10,000 and you pull it all out when you’re 58 years old. Because you withdraw it before you reach 59.5 yrs old, you would pay a 10% or $1,000 early withdrawal penalty that year, AND receive a 1099-R, which would be reported as income on your taxes. This would increase your taxable income which increases your federal and state tax for that year. Utah is currently around 4.95% (ignoring the retirement credit) and the current federal rate is usually between 10-12% for most people. So, you might expect to pay approx $1,600 in taxes and $1,000 in early withdrawal penalties, netting approx $7,400. If you withdraw after reaching age 59.5, you would NOT pay the 10% or early withdrawal penalty and, in this example, net approx $8,400. So now, let’s look at how the Roth would work.
Simple Example – Roth IRA
If you contribute $5,000 to a Roth IRA, you will NOT get a tax deduction when you file your taxes. That $5,000 will then go into whichever investment(s) you choose and hopefully stay there until you retire. Same as the traditional IRA, your capital gains/losses on that money are NOT taxable events and NOT reported on your taxes. As above, let’s say your money doubles to $10,000 and you pull it out before you’re 59.5 years old. You would NOT pay a 10% early withdrawal penalty. You would ALSO NOT pay federal or state taxes on the money. You would, therefore, net the full $10,000 in that year “tax-free.”
Why the Roth IRA is more practical
Many people in retirement feel like they’re living on low income. So, the thought of having to shrink that amount even further by paying federal and state taxes on it, can be frustrating and discouraging. Being able to withdraw that money during retirement “tax-free” is a nice way to help boost that limited income.
There are 2 main benefits to the traditional IRA not found in the Roth. First, the 10% early withdrawal penalty might help people discipline themselves to leave the money in there until retirement. (However, there are people who don’t seem to mind the penalty, when they need the money). Second, the traditional IRA provides a tax deduction in the year the money is put in the account.
Important note: Unless you’re in a high income tax bracket when you make a contribution to a Traditional IRA, the savings is kind of small. In the example above, the $5,000 saved about $600-1,000 in taxes, but caused a higher amount of tax to be paid out when withdrawn.
It is possible to convert from one type of IRA to another. There are some rules and tax consequences that apply. To help you find what’s right for you, consult a tax professional or certified financial advisor who can help.