The Impact of Retirement Taxes on IRAs and Roth IRAs
In the following commentary, I will provide a comparison between Roth IRAs and traditional IRAs in the hope of answering which one of these tools is best for you. While no one can accurately predict upcoming tax rates, numerous scenarios show the traditional IRA is not as good as the Roth IRA in terms of providing retirement income.
Before I can get into the meat of that discussion, I need to explain a blemish with the traditional IRA, which is generally praised for its tax-deductible contributions. The problem with a traditional IRA is when you have it without tax-deductible contributions. The misunderstood benefit of tax-deferred growth is offered by both IRA versions. There is no tax advantage on your contribution to the less popular tax-deductible IRA upfront, but you can still benefit from your earnings from the tax deferral. That particular benefit is generally lost on people who are unfamiliar with investing outside of their retirement plan. You will be subjected to capital gains taxes each year on your earnings if you invest outside of your retirement account.
The non-tax-deductible, traditional IRA is similar to the tax-deductible, traditional IRA in that it has required minimum distributions at 70 ½ years old. However, when it comes to taxes when you withdraw your money, the two IRAs differ. When you withdraw money or when you are required to take out money from a non-tax-deductible, traditional IRA, your contributions are not taxed since you already paid taxes on the contributions. When phased out of contributing to a Roth IRA or traditional IRA, this non-tax-deductible, traditional IRA can become an option for you.
The impact of taxes on IRAs
Numerous people, including you, may assume that their tax rate during retirement will significantly decrease from their current tax rate. However, even though it is natural to be hopeful about this, it is not necessarily true. The effect of taxes can be significant. Think about the 2018 federal tax rates, which are scheduled to expire in 2025 and increase to their previous marginal tax rates. Now, think about the effect of tax rates within states. As of now, the state of Illinois does not tax retirement accounts. However, will this be maintained in the future?
Using Money Guide Pro’s IRA Contributions Calculator, I have created some hypothetical cases to explain the effects of taxes, whether you are participating in a 401(k), ERISA 403(B), or an Employee Retirement Income Security Plan (ERISA) through your place of employment. MoneyGuidePro is a software package used by a plethora of Certified Financial Planners. The 2025 income tax rate can be used to predict what will happen with tax rates in the future. The cases below are sectioned by income and active participant status in an ERISA retirement plan that demonstrates the effects that phase-outs have on your overall options. These are then broken down further into scheduled 2025 rates and current ones. Lastly, I will demonstrate how deep of a tax rate cut would be necessary in order to favor the traditional IRA.
Basic scenario assumptions
A man who lives in the state of Illinois who is beginning to save at 45 years old. He makes $6,000 in yearly contributions into his savings account until he hits retirement. His hypothetical return rate is 7%. His distributions would begin at 65 years old and end at 94 years old. He makes a total adjusted gross income of $50,000 and is not currently participating in a retirement plan sponsored by his employer. His current state tax rate is 4.95%, and his federal tax rate is 22%. For the year of 2025, the scheduled retirement federal tax rate is 25%, and the state tax rate is 0%.
Due to the income being less than the phase-out amounts for the traditional IRA and the Roth IRA with tax-deductible contributions, there is a possibility for both types of IRAs. He could withdraw $21,693 yearly between the ages of 65 and 94 using the Roth IRA. Using the assumptions we’ve previously talked about, that withdrawal amount would lessen to $20,179 if he saved the exact same amount in a traditional IRA. This means that the total traditional IRA withdrawals would be $605,378, and the Roth IRA retirement withdrawals would be $650,794. Take note that if he had used a taxable savings instrument and not one of the tax-advantaged retirement accounts we have discussed, he would have only amassed $435,184 based on current capital gains tax rates.
Both the state and federal rate drop that is needed in retirement for Roth and IRA is 8.95%. The tax rates would need to be reduced to this amount before the traditional, tax-deductible IRA would be more beneficial over the Roth IRA. He could withdraw $21,896 per year from a traditional, tax-deductible IRA between the ages of 65 to 94 if that reduction was to happen.
Current State Tax Rate: 4.95%; Federal: 24%
Total Adjusted Gross Income: $100,000
2025 Scheduled Retirement State Tax Rate: 0%; Federal: 28%
In this scenario, all the IRA options remain open to use. The traditional IRA would only allow for annual withdrawals of $18,440, totaling a final withdrawal amount of $553,207 due to the higher marginal tax bracket. However, the Roth IRA results stay the same with annual withdrawals of $21,693 for a total withdrawal amount of $650,794.
Necessary drop rate needed both federally and statewide for retirement for both the Best Roth and IRA: 9.95%. Using this figure, the joint tax rate would need to decrease to 19% from 28.95% before the traditional tax-deductible IRA would have an advantage over the Roth IRA.
Current State Tax Rate: 4.95%; Federal: 24%
Total Adjusted Gross Income of $150,000
2025 Scheduled Retirement State Tax Rate: 0%; Federal: 28%
He is no longer allowed to contribute to a Roth IRA at this income level. At this point, he only has a choice between a taxable account and a non-tax-deductible IRA. The non-tax-deductible IRA would allow him to withdraw $589,770, where a taxable investment would only pay out $418,645. The IRA choice would give him $19,659 per year. If he elected to use a taxable investment instead, this number would drop dramatically to $13,955. The taxable account using the current tax rate on earnings is nowhere near as beneficial as the traditional IRA with non-deductible contributions.
Total Adjusted Gross Income of $50,000
Current Federal Tax Rate: 22%; State: 4.95%
Scheduled 2025 Retirement Federal Tax Rate: 25%; State: 0%
Participating in an Employer-Sponsored Retirement Plan
For a person earning this income, the results are the same as someone not participating in a retirement plan sponsored by their employer.
Total Adjusted Gross Income of $100,000
Current State Tax Rate: 4.95%; Federal: 24%
Scheduled 2025 Retirement Federal Tax Rate: 28%; State: 0%
For this scenario, the Roth IRA is still an option. For someone at this income level who is not participating in a retirement plan sponsored by their employer, the results would be the same as someone using the Roth IRA. They would get withdrawals of $21,693 per year from ages 65 to 94. His income is now above the income phase-out amount of $74,000 for a tax-deductible IRA. Because of this, he is now eligible for a non-tax-deductible IRA. Sadly, he can only withdraw $18,276 per year using the non-tax-deductible IRA. This ends up being a total of $503,852 for withdrawals from a traditional, non-tax-deductible IRA. For a total Roth IRA, the retirement withdrawals would be $650,794.
Total needed in state and federal rate drop in retirement for the IRA to Best Roth: 28.95%
Unfortunately, the tax rate would need to become 0%, which is highly unlikely to happen as that would mean a 28.95 percent drop. If it were, then her traditional, non-deductible IRA withdrawals would equal her Roth withdrawals of $21,693.
Total Adjusted Gross Income of $150,000
Current State Tax Rate: 4.95%; Federal: 24%
Retirement State Tax Rate Scheduled for 2025: 0%; Federal: 28%
For contributing to a Roth IRA, his income is now above the $137,000 phase out income amount. He will remain qualified for the non-tax-deductible IRA. Using this IRA, he could withdraw up to $18,276 per year. His withdrawal amount would drastically decrease to $13,955 if he were to go past this option and go down the taxable route. Theoretically, he could withdraw from his taxable account $418,645, whereas he could gain more from his traditional, non-tax-deductible IRA account. To reiterate, a traditional IRA with non-tax-deductible contribution is a better route to go down than the taxable account that uses current tax rates on earnings, such as capital gains taxes.
Are your current hopes about retirement tax rates realistic?
In conclusion, the aforementioned analysis shows that there would have to be serious tax reductions for a traditional IRA to beat out a Roth IRA. Due to phase-outs, you cannot always contribute to a Roth IRA. Leaving a traditional IRA may be your only option. If you have already created a workplace plan, it might be a beneficial idea to ask your employer about adding on the Roth IRA feature. Active participants in retirement plans sponsored by their employers do not always have the option of a tax-deductible IRA. When this happens, the only IRA option is the non-tax-deductible, traditional IRA. This might appear to be a downside, but it still offers tax deferral on earnings, which is significantly better than a taxable investment due to not having to face capital gains taxes every year.
A final option you may have for investing and saving is opening a health savings account. If the money is used in retirement for healthcare expenses, then there are no taxes or phase-outs. It is natural when you are in retirement to face healthcare-related expenses, which is why it becomes a triple tax-free option for paying those expenses. Check out articles on discounts regarding retirement healthcare to learn more.
It is my hope that this information has given you a greater appreciation of available IRA options and the benefit of tax deferral. Use this information to help make better money-making decisions to go down the life path you want the most.
