Traditional IRA or Roth IRA?

George Saenzq_v2.gifDear 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

a_v2.gifDear 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.


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