THE 35% BRACKET
From Jim Maloney: “In writing about the Roth IRA, you discuss the situation of currently being in a 35% tax bracket. You say, ‘In that case, taking the deduction now would save $700 on your taxes today (35% of the $2,000 contribution).’ I think I’m missing something. If you are currently being taxed at the 35% tax rate aren’t you, in all likelihood, making too much to take advantage of the IRA tax deduction?”
Yes, but only if you are covered by a retirement plan at work. If not, there’s no limit on how much you can earn and still take the IRA deduction with a traditional IRA. (It used to be that having either spouse covered by a plan at work disqualified you. But I believe that starting in 1998, spouses’ IRAs have become “delinked.”)
Note also that there is no 35% federal tax bracket as such. The relevant number here is your combined marginal tax rate, including state income tax. I was just using it as an example.
NAMING CHARITIES THE BENEFICIARY OF YOUR IRA
From Bill Jones: “If you plan on leaving money in your will to charity, a far better thing than to give appreciated securities is to give deductible IRAs. The charity avoids ALL taxes, and those gifts do not count for estate taxes. This is the simplest, cheapest, and most efficient estate planning available.”
As I have written before, if you have an IRA and plan to leave money to charity when you die, the best way, as Bill and I agree, is simply to designate the charity or charities as beneficiaries of a percentage of your IRA (or even the whole thing). But what if you want to be charitable before you die — perhaps even this month? That was what I was writing about in listing the reasons to keep your most speculative investments outside an IRA. If one of them hits big, you can use it, instead of cash, to do your giving. (Meanwhile, those that lose big outside an IRA provide a tax loss.)
The one new twist to consider is that with a Roth IRA, since withdrawals are already free of tax, there’s no special advantage to designating a charity the beneficiary; i.e., if charities are the beneficiaries of your IRA, there’s less reason to move from a traditional IRA to a Roth IRA and incur the tax to do so.
There’s still some reason, to be sure: With any luck, you’ll be withdrawing cash from your IRA for many years before the charities get to celebrate your demise. Better to withdraw that cash tax-free from a Roth IRA than taxably from a traditional one. But the case becomes a little less compelling — and, as we’ve discussed, wasn’t in all situations that compelling to begin with. (For help deciding whether it makes sense for you to transfer your IRA to a new Roth IRA, click here.)
So this is a very good time to think about whether you do plan to leave some money to charity . . . and, if so, whether you might not want to do it simply by naming that charity/those charities as beneficiary/ies of the IRA.
NOT SO HARD EARNING 7% OUTSIDE AN IRA — VARIABLE ANNUITIES
His comment on charitable giving was really just an afterthought. Here’s what really got Bill Jones writing in:
You missed a key point in your discussion of a Roth IRA. In your example, you assumed 9% tax-free growth within the IRA but indicated it would “not be easy” to make your $700 tax saving (from the traditional-IRA deduction) grow outside the IRA at 7% after taxes.
It is actually very easy. Consider this: Put the $700 tax rebate in EXACTLY THE SAME 9% investment as the IRA, but within a Vanguard variable annuity. The effect is that you only earn 8.5% (because the annuity charges a 0.5% annual management and expense fee). And you have to pay 15% tax at the end. But that still comes out to $25,370, which is far larger than the $16,000 you thought would “not be easy” to match.
The apparently paradoxical result is that a 9% pre-tax and pre-expense growth rate [over the 46 years in my example] is equivalent to an 8.1% post-tax growth rate in a variable annuity. Odd, isn’t it!
Note that I can actually do much better; as a teacher, I qualify for TIAA’s variable annuity with an 0.2% annual charge.
Bill is right — and I’m not just saying that to curry favor with the teacher (though good teachers should be honored at every opportunity). I’d just add two thoughts.
First, as a general proposition, I’m leery of variable annuities. Those that are most heavily promoted have high sales and expense charges. And all are in effect a mechanism for transforming what would be lightly taxed long-term capital gains (if you invested outside the annuity) into more heavily taxed ordinary income when you withdraw it. Not to mention that you lose flexibility once you take the plunge — it can be hard or expensive to switch managers.
Second, if tax rates at withdrawal turned out to be higher than 15%, as they certainly might — no one can know — then our 24-year-old is hit with a double whammy. The taxes turn out to be steeper than planned on both the traditional IRA withdrawals and from the annuity whose growth was meant to make up for those taxes.
Still, Bill’s math is right and his perspective, valuable. And if one does choose the traditional IRA . . . and does lock up one’s $700 tax-saving from a $2,000 deductible IRA contribution in a variable annuity (as per this example) . . . at least one is likely to avoid the other pitfall I referred to: squandering that $700 someplace along the way.
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