Traditional IRA or Roth IRA?
|  Dear
Tax Talk,
I'm trying to decide between an IRA and a Roth IRA. I know
the advantages and disadvantages of both. However, how is the tax bracket calculated
at retirement? Is it based on the amount in your accounts at the time of retirement,
or your tax bracket the year you retire from a full-time job?
Is
it possible to get a part-time, lower paying job a few years before I officially
retire and therefore lower my tax bracket, resulting in lower taxes for IRA distributions?
I'm just trying to understand how the tax bracket at retirement is determined
so I can decide which IRA is right for me. I'm currently 26-years-old and in the
25 percent bracket and have no idea where I'll be in the future.
--
Shannon
Dear Shannon,
A bird in the hand is worth two in
the bush. Although a tax-free retirement sounds good, saving taxes today sounds
better. Using your 25 percent tax bracket as an example, in order to put $4,000
into a Roth IRA today, you would have to earn $5,333 and give the IRS $1,333 to
keep the full $4,000 in your retirement account.
To put $4,000
into a traditional deductible IRA, you only need to part with $3,000 because,
in a sense, the IRS is giving you $1,000. Remember that by contributing $4,000
to your IRA pretax, you are lowering your income by $4,000 for income tax purposes.
So you're not paying 25 percent of that in taxes. In both situations,
you still have $4,000 in savings but it cost you $2,333 to get the Roth. It sounds
like better business for the IRS than for you. By making the traditional deductible
IRA, you're getting a 58 percent return on your investment of $4,000. It's better
than the bank will return in the first several years. I may be double dipping
in my calculation on the savings, as you're only really getting the 25 percent
return when you make the deductible IRA, but the spread in taxes is still $2,333. Your
tax bracket at any time, including at retirement, is determined
by your earnings in a given calendar year, including what taxable funds you
take from your retirement accounts. It has nothing to do with how much you have
in those accounts or how much you earned in previous years. But the tax brackets
are not carved in stone, and they can change along with Congressional priorities,
so there's no way of knowing what they'll be in 40 years. At
age 26 you have a long time to grow your retirement savings, and whether it is
tax-free or not at retirement will not affect its growth over the years. That
is, both accounts grow tax-free; the only difference is how much remains when
you retire. Circumstances beyond your control will affect the tax you pay at the
time of withdrawal. In the intervening years you may have
an opportunity to convert the traditional IRA to a Roth at less than a 25 percent
tax cost. The rules are always changing. We could have a flat tax in the future
combined with a Value Added Tax. Of course, the ultimate shame would be if you
die before you get to laugh at the tax collector. Since we
already have had two Bushes, I would take the $1,000 in hand. To
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