Take the 2-minute tour ×
Personal Finance & Money Stack Exchange is a question and answer site for people who want to be financially literate. It's 100% free, no registration required.

When money is withdrawn from a traditional IRA account, why is the money taxed at the rate same as for ordinary income, instead of capital gain tax rate? In other words, what is the rationale for it?

Is the tax rate for ordinary income higher or lower than the tax rate on (long term and short term) capital gain?

Thanks and regards!

share|improve this question
6  
Tax laws, marginal tax rates, etc are not required to have a rationale, only a Congress that has read Article I, Section 8, of the US Constitution, and an Internal Revenue Service that carries out the laws. –  Dilip Sarwate Jun 9 '12 at 2:06
    
True, the laws are not required to have a rationale. However, pretty well everything other than basic tax rates are fiscal policy decisions. Consequently, there likely is a policy rationale. –  Chris Cudmore Jun 11 '12 at 19:43

6 Answers 6

up vote 8 down vote accepted

You are missing something very significant.

The money in a traditional IRA (specifically, a deductible traditional IRA; there is not really any reason to keep a nondeductible traditional IRA anymore) is pre-tax. That means when you pay tax on it when you take it out, you are paying tax on it for the first time.

If you take ordinary money to invest it in stocks, and then pay capital gains tax on it when you take it out, that is post-tax money to begin with -- meaning that you have already paid (income) tax on it once. Then you have to pay tax again on the time-value growth of that money (i.e. that growth is earned from money that is already taxed). That means you are effectively paying tax twice on part of that money.

If that doesn't make sense to you, and you think that interest, capital gains, etc. is the first time you're paying tax on the money because it's growth, then you have a very simplistic view of money. There's something called time value of money, which means that a certain amount of money is equivalent to a greater amount of money in the future. If you invest $100 now and end up with $150 in the future, that $150 in the future is effectively the same money as the $100 now.

Let's consider a few examples. Let's say you have $1000 of pre-tax income you want to invest and withdraw a certain period of time later in retirement. Let's say you have an investment that grows 100% over this period of time. And let's say that your tax rate now and in the future is 25% (and for simplicity, assume that all income is taxed at that rate instead of the tax bracket system). And capital gains tax is 15%.

  • Put it in a Traditional IRA and withdraw it: $1000 grows to $2000, you pay 25% taxes, end up with $1500
  • Take it in your paycheck, and then invest it in the stock, and withdraw it at the end: $1000, you pay 25% income tax to $750, the investment grows to $1500, but then you pay capital gains tax of 15% x $750 = $112.50. You end up with $1387.50
  • Put it in a Roth IRA and withdraw it: $1000, you pay 25% income tax on it to $750; it then grows to $1500; you pay no taxes on that

You see a few things: Traditional IRA and Roth IRA are equivalent if the tax rates are the same. This is because, in both cases, you pay tax one time on the money (the only difference between paying tax now and later is the tax rate). It doesn't matter that you're paying tax only on the principal for the Roth and on the principal plus earnings for Traditional, because the principal now is equivalent to the principal plus earnings in the future.

And you also see that investing money outside fares worse than both of them. That is because you are paying tax on the money once plus some more. When you compare it against the Roth IRA, the disadvantage is obvious -- in both cases you pay income tax on the principal, but for Roth IRA you pay nothing on the earnings, whereas for the outside stock, you pay some tax on the earnings. What may be less obvious is it is equally disadvantageous compared to a Traditional IRA; Traditional and Roth IRA are equivalent in this comparison.

401(k)s and IRAs have a fundamental tax benefit compared to normal money investment, because they allow money to be taxed only one time. No matter how low the capital gains tax rate it, it is still worse because it is a tax on time-value growth from money that is already taxed.

share|improve this answer
    
Most of this is correct, however capital gains taxes are charged on exactly that; capital gains. Scenario; you have $1000 sitting in a savings account basically losing value (interest isn't matching inflation). You take that money and put it in the stock market, where the value of your stocks increases to $1500. You then cash out the whole thing. On the return for that year, you would list the $500 as capital gains income and pay the capital gains rate. You would NOT list the $1000 you invested because that money was already taxed as income when you earned it as wages (or however you got it) –  KeithS Jun 11 '12 at 20:20
    
This means that outside investing at current rates will beat a traditional IRA, because the capital gains tax rate is only about 15% while the average wage earner's somewhere near 26%. A traditional IRA instead provides simplicity; as you're cashing out the IRA it's taxed at one rate (basically as if you were still earning it as a paycheck). A Roth IRA provides a hedge; you pay the rates now on what you put in on the (probably accurate) belief that individual tax rates will increase. Individual investing is somewhere in between; you pay the taxes when you cash out, but that can be at any time. –  KeithS Jun 11 '12 at 20:29

In a Traditional IRA contributions are often tax-deductible. For instance, if a taxpayer contributes $4,000 to a traditional IRA and is in the twenty-five percent marginal tax bracket, then a $1,000 benefit ($1,000 reduced tax liability) will be realized for the year. So that's why they tax you as income, because they didn't tax that income before.

If a taxpayer expects to be in a lower tax bracket in retirement than during the working years, then this is one advantage for using a Traditional IRA vs a Roth.

Distributions are taxed as ordinary income. So it depends on your tax bracket

UPDATE FOR COMMENT:

Currently you may have heard on the news about "the fiscal cliff" - CNBC at the end of the year. This is due to the fact that the Bush tax-cuts are set to expire and if they expire. Many tax rates will change. But here is the info as of right now:

Dividends: From 2003 to 2007, qualified dividends were taxed at 15% or 5% depending on the individual's ordinary income tax bracket, and from 2008 to 2012, the tax rate on qualified dividends was reduced to 0% for taxpayers in the 10% and 15% ordinary income tax brackets.

After 2012, dividends will be taxed at the taxpayer's ordinary income tax rate, regardless of his or her tax bracket. - If the Bush tax cuts are allowed to expire. - Reference - Wikipedia

Capital Gains tax rates can be seen here - the Capital Gains tax rate is relative to your Ordinary Income tax rate For Example: this year long term gains will be 0% if you fall in the 15% ordinary tax bracket.

NOTE: These rates can change every year so any future rates might be different from the current year.

share|improve this answer
    
Thanks! Is there something to say in general about the tax rate on (long term or short term) capital gain compared to the tax rate on ordinary income, although I know the tax rate on ordinary income depends on a person's tax bracket? –  Tim Jun 9 '12 at 2:26
    
Long term capital gains is taxed at a smaller rate then short term gains. –  Kirill Fuchs Jun 9 '12 at 2:54
    
How is tax rate on ordinary income compared to the tax rate on (long or short term) capital gain? –  Tim Jun 9 '12 at 2:58
    
I have updated my answer to include this information –  Kirill Fuchs Jun 9 '12 at 3:16

The simplest explanation is that a traditional IRA is a method of deferring taxes. That is, normally you pay taxes on money you earn at the ordinary rate then invest the rest and only pay the capital gains rate.

However, with a traditional IRA you don't pay taxes on the money when you earn it, you defer the payment of those taxes until you retire. So in the end it ends up being treated the same. That said, if you are strategic about it you can wind up paying less taxes with this type of account.

share|improve this answer

This is actually (to me) an interesting point to note. While the answer is "that's what Congress wrote," there are implications to note. First, for many, the goal of tax deferral is to shift 25% or 28% income to 15% income at retirement. With long term gains at 15%, simply investing long term post tax can accomplish a similar goal, where all gain is taxed at 15%. Looking at this from another angle, an IRA (or 401(k) for that matter) effectively turns long term gains into ordinary income. It's a good observation, and shouldn't be ignored.

share|improve this answer

Basically, the idea of an IRA is that the money is earned by you and would normally be taxed at the individual rate, but the government is allowing you to avoid paying the taxes on it now by instead putting it in the account. This "tax deferral" encourages retirement savings by reducing your current taxable income (providing a short-term "carrot").

However, the government will want their cut; specifically, when you begin withdrawing from that account, the principal which wasn't taxed when you put it in will be taxed at the current individual rate when you take it out. When you think about it, that's only fair; you didn't pay taxes on it when it came out of your paycheck, so you should pay that tax once you're withdrawing it to live on. Here's the rub; the interest is also taxed at the individual rate. At the time, that was a good thing; the capital gains rate in 1976 (when the Regular IRA was established) was 35%, the highest it's ever been. Now, that's not looking so good because the current cap gains rate is only 15%. However, these rates rise and fall, cap gains more than individual rates, and so by contributing to a Traditional IRA you simplify your tax bill; the principal and interest is taxed at the individual rate as if you were still making a paycheck.

A Roth IRA is basically the government trying to get money now by giving up money later. You pay the marginal individual rate on the contributions as you earn them (it becomes a "post-tax deduction") but then that money is completely yours, and the kicker is that the government won't tax the interest on it if you don't withdraw it before retirement age. This makes Roths very attractive to retirement investors as a hedge against higher overall tax rates later in life. If you think that, for any reason, you'll be paying more taxes in 30 years than you would be paying for the same money now, you should be investing in a Roth.

A normal (non-IRA) investment account, at first, seems to be the worst of both worlds; you pay individual tax on all earned wages that you invest, then capital gains on the money your investment earns (stock gains and dividends, bond interest, etc) whenever you cash out. However, a traditional account has the most flexibility; you can keep your money in and take your money out on a timeline you choose. This means you can react both to market moves AND to tax changes; when a conservative administration slashes tax rates on capital gains, you can cash out, pay that low rate on the money you made from your account, and then the money's yours to spend or to reinvest.

You can, if you're market- and tax-savvy, use all three of these instruments to your overall advantage. When tax rates are high now, contribute to a traditional IRA, and then withdraw the money during your retirement in times where individual tax rates are low. When tax rates are low (like right now), max out your Roth contributions, and use that money after retirement when tax rates are high. Use a regular investment account as an overage to Roth contributions when taxes are low; contribute when the individual rate is low, then capitalize and reinvest during times when capital gains taxes are low (perhaps replacing a paycheck deduction in annual contributions to a Roth, or you can simply fold it back into the investment account). This isn't as good as a Roth but is better than a Traditional; by capitalizing at an advantageous time, you turn interest earned into principal invested and pay a low tax on it at that time to avoid a higher tax later. However, the market and the tax structure have to coincide to make ordinary investing pay off; you may have bought in in the early 90s, taking advantage of the lowest individual rates since the Great Depression. While now, capital gains taxes are the lowest they've ever been, if you cash out you may not be realizing much of a gain in the first place.

share|improve this answer

It would be fairer to the average person if we paid our normal tax rate on the amount we contributed to the IRA and paid at the capital gains rate for the difference. The same as people that invest outside of the IRA. Most IRAs aren't that large and most people are going to have a rough time living on the reduced social security. It seems like we are taxing the average Joe at a higher rate than the rich.

share|improve this answer
    
+1 although, this is more of a comment than answer. You not one of the issues inherent to the pre-tax IRA, that it converts capital gain to ordinary income making matters worse for some investors. Welcome to SE. –  JoeTaxpayer Mar 17 '13 at 21:22

Your Answer

 
discard

By posting your answer, you agree to the privacy policy and terms of service.

Not the answer you're looking for? Browse other questions tagged or ask your own question.