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Before taxes, I make $16k a year, which is not much of an income. I've been told that people who have low incomes should get a Roth IRA since they won't make much money off of tax deductions, so I got a Roth IRA at my local bank and deposit a little money into it every month.

I pay around $1,800 a year in taxes. If invested in a traditional IRA, could I get all or most of the money I pay in taxes back to re-invest? Would you recommend someone who makes $16k a year getting a traditional or Roth IRA?

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    How do you pay $4k / yr in taxes on an income of $16k / yr? No state tax is that high. Do you own property, and pay property tax? Do you have interest income? – WetlabStudent Jan 8 at 5:03
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    @WetlabStudent the standard deduction in 2018 is now 12K. That makes the taxable income at the federal level of 4K. – mhoran_psprep Jan 8 at 10:58
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    Please clarify your tax situation. If you're paying an effective 25% tax rate (which seems wrong unless you have other income you haven't disclosed) it will change the correct answer. – D Stanley Jan 8 at 14:36
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    @thinksinbinary for tax year 2018, I still find it hard to believe your tax bill will be $2220. You'll get a standard deduction of $12k, so your taxable income would only be $4000, which should get taxed at the 10% bracket, leading to a tax of only $400, not $2200. Unless you are in a very atypical income situation, which i can't begin to imagine. – jaypops96 Jan 9 at 22:06
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    @thinksinbinary well the type of income and your age could matter in the calculation. But in your numbers above you aren't claiming any standard deduction! you should be deducting $12k from your taxable income. 16k-12k = only $4k in taxable income. that would be taxed 10% for only $400 in taxes. What are we missing? Are you not allowed to claim the standard deduction because of some unusual situation? – jaypops96 Jan 10 at 1:04
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Assume you make 16k/yr for 45 yrs of your working life. You put $4k in an IRA each year with a 7% interest rate. You can also make 7% interest outside your IRA. Let's assume you live an extra 20 years after retirement and withdraw everything in your IRA to use for the remaining 20 years of your life. In this case, your IRA would contain roughly 1.22 million $ when you retire. Of this 180k is principle and 1.04 million is interest.

Scenario 1: You choose a Roth IRA, and pay $400/year in taxes while working. But in retirement, you pay zero tax. In this case, you paid a total of 18k in taxes.

Scenario 2: You invested in a regular IRA. Here you saved 18k in taxes over the 45 years of working due to deductions. And if you were continually reinvesting this income, at 7% interest rate (and but deducting the 15% tax the gov takes on interest income), you would turn the tax savings into 89k.

So which is better scenario 1 or scenario 2? Well, if you divided the 1.04 million interest income in your IRA by 20 (years of withdrawals), you get 52k in interest income / yr. Now subtract the standard deduction and you have 40k per year of taxable income. So you'd pay around 5k per year in taxes on that income. That is about 100k saved in taxes over the 20 years.

IRA: money saved 89k (investing saved taxes) Roth IRA: money saved 100k (taxes you don't have to pay when you retire)

Roth wins in the above scenario. There are a ton of assumptions in this calculation to make the math easier, and I'm guessing you could construct scenarios where the regular IRA wins. One assumption is that interest making stops once you start retirement, another is that you only live 20 yrs past retirement. The 7% interest rate is also uncertain. I assumed the Roth IRA would be favored by a ton, but when doing the math it appears that both retirement options save you similar amounts of money.

One reason to choose the Roth is that tax rates are currently at historic lows. If they were to raise in the future, your interest income would be exempt from these raises, because you pay no taxes on interest income in a roth.

  • I appreciate going to all the calculations, i'll have to do that considering the actual number of taxes i pay a year. It might make sense to have both a traditional and roth ira and split the money i put in them. I don't know. Is it possible to put money into a traditional and put the bigger tax refund into the roth to avoid paying taxes on those funds? I know there is a limit to how much you can put in iras during the year but with my current plan i only put $1200 into the roth a year...if i got some more tax returns back i could put them into the roth ira to avoid future taxes – thinksinbinary Jan 8 at 16:21
  • i talked to my accountant about this, i was confused a little about what a tax deduction would mean: it means you get money back on the taxes that you would pay on the amount that you put in, not on the amount of taxes you pay, so in other words roth ira is definetly the better choice. I would only be getting back a small fraction of what i put into a traditional ira, traditional ira's of course make since if your not in the lowest tax bracket like i am – thinksinbinary Jan 8 at 17:40
  • @thinksinbinary Yep, that is why in the calculation you only saved $400 / yr and not the full $4,000 you deducted from your income. It was interesting though when going through the math with this assumption the Roth only beat the traditional IRA by about 10%. I would have guessed a much bigger difference. – WetlabStudent Jan 9 at 0:09
  • @WetlabStudent If the tax rate you pay on withdrawls from a trad in retirement is the same as your marginal tax rate when you contribute then the trad and roth work out exactly the same. The difference is only the difference between these two tax rates when contributing vs in retirement, so about 10% makes sense. – Matt Jan 10 at 0:52
  • @matt I think it's actually more complicated than that because the OP is investing the tax savings they take when using the trad. If there were no capital gains tax on those invested tax savings then the traditional IRA actually works better! And I'm not so sure there actually would be capitol gains taxes on those investments since the OP makes so little money. That's even in this scenario where the OP pays about 10% more taxes on the withdraws due to the increased budget. Of course this all assumes the OP is diligent enough to always invest the tax savings. – WetlabStudent Jan 10 at 3:31
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The main difference between a traditional and Roth IRA (assuming equal contributions) is the timing of taxes. You want to avoid taxes when the rates will be highest, so since your income is low now and presumably will be higher in the future, you would probably be better off investing in a Roth, paying the tax now, and avoiding tax in the future.

Yes, it would be nice to have a little bit more of a refund, but you'd be saving about 10% in tax now in exchange for possibly paying around 25% in tax in the future.

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    "Plus, you'd be paying tax on a higher amount since the investment should be expected to grow." you would, but you would be able to invest more in the traditional, so overall that is a wash. – Peter Green Jan 8 at 14:34
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    If you invest the tax savings, yes. I suspect many just spend it... – D Stanley Jan 8 at 14:35
  • @PeterGreen exactly! It's much more of a wash than I would have expected, even when there is a large difference in current and future tax brackets (see my calculation in my answer for details) – WetlabStudent Jan 10 at 3:33
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As I understand it.

Your aim is to maximise your effective after-tax return. The US government gives you two choices for your tax-advantaged retirement accounts, you can pay tax up-front "roth" or pay tax when you take the money out "traditional".

If your effective tax rate is the same at contribution time as withdrawl time then it doesn't matter which you go for. Your after-tax return is the same (in the traditional case you pay more tax, but you also make more money from your investments).

So the big question you need to ask yourself is what do you expect to happen to your income over time? Unless you never plan to retire or you have other significant passive sources of income you want to have at least some money in a traditional IRA/401K to use up your tax allowances in retirement. On the other hand if you expect to earn significantly more money in the future than now then it makes sense to put the money in a roth to take advantage of your current realtively low tax rate and contribute to the traditional IRA/401K later when your marginal tax rate is higher.

  • I think the question is actually much deeper than this. The OP says they would reinvest the upfront tax savings and earn interest on it. So it's not so simple. – WetlabStudent Jan 8 at 14:50

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