Employees often have the ability to contribute to an employer sponsored retirement plan (typically a 401(k) plan) – also known as a Traditional IRA. To contribute to this plan, the employee selects a percentage of income to contribute each pay period and this amount is taken out of their paycheck and sent directly to the plan administrator to be deposited in the individual’s IRA account. When contributing to a Traditional IRA no taxes are due at contribution. When the funds are distributed in the future, typically during retirement, income taxes will be due on the full amount distributed – both the earnings growth and the initial contributions.
Separately from a Traditional IRA, workers can on their own open and contribute to a Roth IRA (subject to income limitations). In 2019 an individual earning less than $122,000 can contribute up to $6,000 to a Roth IRA. With a Roth the individual pays taxes up front, when the money is earned, and then contributes the money after taxes have been paid. When funds are distributed in the future, typically during retirement, there are no taxes on the distributions.
Deciding between contributing to a Traditional IRA or a Roth IRA, or the relative amounts to each, is a frequent topic on personal finance blogs and talk shows. An important bit that doesn’t get enough coverage is this:
** Income Tax Rate Changes Are What Really Matters **
The are other factors to consider between these types of IRAs outside of tax treatment. A couple of factors, among others, include:
- Employer contributions – Traditional IRAs often include employer-matching of employee contributions.
- Liquidity – Ability to access contributions differ, with Roth contributions being accessible without penalty in some situations.
However, the biggest impact is made by the change in income tax rates between contribution and distribution. If tax rates are higher in the future at distribution, a Roth IRA is better – you paid at a lower rate when contributing and get to withdraw and avoid taxes at a higher rate. The converse is also true – lower rates at distribution favor a Traditional IRA. You avoid higher taxes at contribution and then they are applied at lower rates at distribution. Let’s repeat and then look at a few simple example calculations.
- Higher income tax rates in future = Roth IRA better
- Lower income tax rates in future = Traditional IRA better
If there are no changes in income tax rates, there’s no difference between the two types of IRA. Here’s a calculation example showing the net total distribution is the same if there are no changes in tax rates.
If tax rates are lower in the future than now (lower at distribution) then the Traditional IRA is better and yields a higher total distribution. Here’s the same example, with only the future tax rates decreasing.
If tax rates are higher in the future than now (higher at distribution) then the Roth IRA is better and yields a higher total distribution. Here’s the same scenario again, but with higher future tax rates.
There are two primary reasons for a change in income tax rates, both of which are difficult to predict over a long-term period.
- Changes in Tax Law – changes to the rates and brackets in the IRS Code enacted by Congress
- Changes in Income – changes in individual earnings resulting in a change in the applicable tax bracket (whether or not the tax brackets are changed by law)
Planning for the long-term is difficult but remember the impact that tax rate changes can have should be a prominent consideration.
Note: The content of this post is for informational and discussion purposes and is not financial or tax advice. Consult with an advisor before relying on this or any information.
Like this:
Like Loading...
