If you have an IRA, you will be able to make your 1997 contribution as late as April 15 next year, just as you always could. My advice: do this as soon as you can. The earlier you fund any kind of IRA, the longer your money has to work for you.

For your 1998 contribution, and from then on, you will have a choice: Continue with your old IRA, as before, or set up a new one, called a Roth IRA, after William Roth, the senior senator from Delaware, who hatched it. In that case, the old one would continue to grow, but from then on you could split your maximum $2,000 contribution each year over the two of them any way you wanted.

If you have no IRA currently, this is a good time to consider whether you should start one — of either variety. (Or perhaps start yet another new kind of IRA, the education IRA, where the “R” stands not for retirement but for Education. But the limits and laws on that are independent of those for the two retirement IRAs, so let’s just ignore that for now.) Both are great, and there’s no telling for sure which will be better for most people, so don’t let indecision keep you from contributing to one of them. The examples that follow should give you a pretty good idea how to think about this.

The basic difference between the traditional IRA and the new Roth IRA is simple. With the traditional IRA, you get a tax break for your contribution today, but pay taxes on everything you withdraw. With the Roth IRA, you get no tax break now, but so long as it’s been in existence for at least 5 years, every penny you withdraw after age 59-1/2 (and even before 59-1/2 in limited circumstances, such as purchase of a first home) will be tax-free.

Advantages of the Roth IRA:

  • Withdrawals are completely tax-free.
  • Easier to qualify to contribute to it (see tomorrow’s comment: Who Qualifies).
  • You can continue to contribute even after age 70-1/2, if you have earned income, and you need not begin withdrawing money until you’re good and ready — and then, according to any schedule you please. (With a traditional IRA, you must begin withdrawing by April 1 of the year after you reached 70-1/2, and minimums are prescribed by law.) For someone who’s going to live to 100 or beyond, and who may not need the cash right now — or may not even be retired at 70-1/2 (Ronald Reagan certainly wasn’t) — this is welcome flexibility.

Disadvantage of the Roth IRA:

  • You don’t get a tax deduction (technically, an “adjustment,” which lowers your taxable income whether you itemize or not) for your contribution.

Basically, which IRA to contribute to in any given year depends on your assumptions about tax rates. If all income were always taxed the same, then a Roth IRA would always make more sense than a traditional one. To see why, let’s pretend all income were always taxed at 50% and all investments grew at 10% a year. Neither is true, but it makes the math easy.

You could put $2,000 into a traditional IRA and get $1,000 “back” in the sense that doing so would lower your tax bill by $1,000.

So now you have both the $2,000 in the IRA and the $1,000 you got back via the tax break, and both are growing at 10% a year . . . except wait! The $1,000 is growing in a regular, taxable account someplace, so it’s really only growing at 5% a year after tax.

After one year, the $2,000 has grown to $2,200 and the tax if you withdrew it would be $1,100. Right? Fifty percent of $2,200. The $1,000 “tax break” money, meanwhile, would have grown at 5% after tax to $1,050 — $50 short of what you need to pay the $1,100 tax. And year after year it gets worse. What you can earn on your “tax break” money, because it’s subject to tax, is always likely to fall short of the rate at which your IRA — and thus your tax bill when you withdraw it — is likely to grow.

Now, you might say: well, what if I could earn 15% on that $1,000 tax break money instead of 10%? And I’d say two things: First, 15% is still only 7.5% after tax in this silly example, so you’d still fall short. Second: if it’s so easy to earn 15% outside of an IRA, why wouldn’t you be earning it inside the IRA as well?

In other words, however fast or slow you can make your money grow, it will always grow faster tax-free than taxable. The “tax break” you get from the traditional IRA will either be frittered away (in which case you really come out behind), or else it will be invested subject to tax, which over the long run will almost surely amount to less than if it had been invested free of tax.

In the real world, though, tax rates are not all the same, and that’s where it gets tricky. Here are two general rules:

  • The lower your tax bracket today, the more likely a Roth IRA will be to your advantage.
  • The younger you are, the more likely a Roth IRA will be to your advantage.

Say you’re 24, that you qualify to contribute $2,000 to an IRA, and that you can compound your IRA money over a lifetime at 9%. You don’t plan to withdraw the money until age 70. (In the real world, of course, there would be other $2,000s from other years, and you wouldn’t withdraw all the money at once. But let’s just follow this one $2,000 chunk.)

If you are in the 15% bracket today, because you’re a 24-year-old starting out, and you expect to be in more like the 35% bracket when you retire, then the case for the Roth IRA is overwhelming. By foregoing a tiny tax break today — $300 in the case of 15% on a $2,000 contribution — you would save $37,000 in taxes when you went to withdraw that $2,000 — now grown to $105,000 — at age 70. For $300 today to be worth so much — $37,000 — 46 years from now is for it to compound at 11%; i.e., if you had chosen the traditional IRA and gotten your $300 tax break, you’d have had to find a way to make that $300 grow at 11% a year after tax just to break even versus the Roth IRA. And trust me: It is very hard to grow money at 11% after tax. (If it is easy for you, then surely you could also have been growing the IRA at 11% also — in which case your $2,000 would have grown to $243,000 instead of $105,000, and the 35% tax would be $85,000 instead of $37,000, and your pathetic little $300 would have had to grow at 13% after tax, not 11%, to keep pace.)

So if you’re in a low tax bracket now with the prospect of a higher one when you retire, it’s a no-brainer.

But what if you are in the 35% bracket now, between federal and local income taxes, and expect to be in the 15% bracket in retirement? In that case, taking the deduction now would save $700 on your taxes today (35% of the $2,000 contribution). When you withdraw that $2,000 at age 70, it will again have grown to $105,000 using the 9% assumption. Paying 15% of that in tax will cost you $16,000. So which is better: $700 now or $16,000 in 46 years? Well, that $700 would have to grow at 7%, after tax, for it to produce $16,000 after 46 years. So you have to think what you’d do with that $700 today. If you’d spend it on a new suit, forget it! You don’t need a new suit. Or, if you do, you can get a perfectly good one for a heck of a lot less than $700. In any event, a new suit is not going to produce $16,000 for you by the time you turn 70. But even if you were very disciplined and earmarked that $700 specifically to grow to pay taxes on your traditional IRA, the fact is, it’s not easy to beat 7% after taxes over a long period of time. So even in this scenario, the Roth IRA doesn’t look bad.

Now what if we kept everything the same as above but made you 64 instead of 24? You’re still in the 35% bracket, but expect to be in the 15% bracket when you withdraw the money at age 70 (because you’ll be retiring, moving to a no-income-tax state, and getting by on a very low taxable income). In this case, it would be smart to use the traditional IRA rather than a Roth IRA. Why? You save $700 on your 1998 taxes, and six years later, when you withdraw your $3,354 (it’s grown by 9% a year), your tax on it at 15% will only be $503. That $700, meanwhile, has grown to around $1,100 if its growth was subject to just 15% in taxes (or even less if it was all capital gain and thus entirely shielded from tax, and subject to a very light tax when the gain was realized). So why give up what could be $1,100 to save $503 in taxes? You’ve shifted income that would otherwise have been taxed at 35% into income taxed at 15%.

Even if you were 44, given these same assumptions, the Roth IRA doesn’t look great. By age 70, the $2,000 has grown to $18,800 so the 15% tax you avoid is worth $2,800. The $700 you could have saved today with the tax break from the traditional IRA would have had to grow, after tax, at just 5.5% to match that same value. And if you could have found some nice growth stock that rose at 9% a year, you’d be sitting with $6,579, and very nearly that much even after you paid some tiny long-term capital gain tax on it when you sold it. Still: the Roth IRA does at least relieve you of the concern that tax rates will be a lot higher when you withdraw the money. And it also provides you the flexibility and easier accounting referred to above.

It’s easy to see that the Roth IRA will not always make sense. The lower you expect your tax bracket to be at retirement, the less enticing it is. Still, there sure is something nice about “paying” a few hundred bucks (by not getting the tax break) in order to know your $2,000 will grow completely tax-free for decades to come.

Nuances:

  • Note the distinction between your marginal tax bracket and your average tax rate. If I pay zero tax on my first $10,000 of income, 15% on my next $10,000, and 35% on my third $10,000 — to take a simple hypothetical example — then my marginal tax bracket is 35%, because on the last dollars I earn, I’m paying 35% in tax. But all told, I’ve earned $30,000 on which my total tax was $5,000, so my average tax rate is 16.7% ($5,000 divided by $30,000). See the difference?
  • In most financial decisions — should I buy $25,000 of taxable or tax-free bonds? what does this $1,000 gift to the Salvation Army really cost me after tax? — it’s the marginal tax bracket you should look at. What’s under consideration are relatively few dollars at the margin of your finances: a little more taxable interest income, perhaps; a little more in the way of itemized deductions. And indeed, when you look at the impact of the $2,000 IRA contributions many of us make each year, it’s the marginal tax rate that determines just how big a break we get.
  • But when the dollars grow large . . . when it’s not just a small difference at the margin of your finances but a huge chunk of your income that’s at stake, as a $105,000 withdrawal from your retirement plan is likely to seem large 46 years from now . . . you should think more in terms of what you expect your average tax rate to be by then. Sure, some of that $105,000 will be taxed at the top bracket. But much of it may be taxed at a lower bracket or not taxed at all. So even if you expect today’s brackets to remain unchanged (for 46 years? hah!), your average tax rate on withdrawals from your IRA may be a lot lower.
  • This distinction further moderates one’s enthusiasm for the Roth IRA. For people with relatively little taxable income at retirement, the savings from the Roth IRA may be quite modest.
  • Leave your riskiest investments outside the IRA (of whichever variety). You do that for three reasons. First, some risky investments bomb. Outside an IRA — but not inside — you can take a tax write-off on the clinkers. Second, on the risks that do pay off, taxes can be light anyway because of the favorable long-term capital gains treatment. Third, you’ll have the flexibility to do your charitable giving with appreciated securities instead of cash.
  • Ain’t Congress grand? This is the perfect tax break. It actually gets people to pay more tax now, decreasing the deficit, by getting them to forego the traditional $2,000 IRA adjustment . . . and shifts the cost decades into the future, when there will be that much less income available to be taxed . . . leading one to wonder whether tax brackets in the distant future, on the money that is available to be taxed, will be so low after all. This is an argument for choosing the Roth IRA. But . . .
  • What if Congress one day abolishes the income tax altogether in favor of, say, a national sales tax? Well then, the traditional IRA might prove to have been the wiser choice after all. You got the tax deduction now and had no tax due on the withdrawals. Personally, I don’t see it happening. But there are going to be an awful lot of retiree voters in a few decades. Maybe they’ll get Congress to abolish the tax on all retirement income.
  • What if, strapped for funds, Congress finds some back-door way to tax Roth IRA withdrawals — say, by adding that income into the mix in calculating some modified Alternative Minimum Tax? Well, then, again the Roth folks would have gotten the shaft. They’d have foregone today’s tax break, yet been hit up for taxes tomorrow anyway. I don’t think this is likely either.

For most people, especially today’s low-bracket taxpayers — as well as those likely to spend rather than invest their tax breaks — the Roth IRA is likely to be a good deal.

Tomorrow: Who Does Qualify — and Should You Switch?

 

 

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