23

I still don't get what is good about IRAs. For example, in a traditional IRA when you deposit you won't have to pay tax but when you withdraw you still have to pay taxes. So you only benefit if you are in lower tax bracket when you withdraw, and can even get screwed if you are in a higher tax bracket. Is it just banking on you being in a lower tax bracket when you withdraw?

What makes IRA better than putting in a brokerage account to buy index funds etc.? Also is there any statistics on which one usually comes out ahead traditional or roth IRA?

13
  • 18
    The lower tax bracket is expected (or at least, the goal). Mortgage? Paid off. Kids' college tuition? Done. Retirement savings? Done. One you start withdrawing from the IRA, you shouldn't need to match your pre-retirement income, only your post-retirement expenses.
    – chepner
    Jul 21 at 13:17
  • 11
    Lack of taxation in an IRA enables IRA assets to compound at a faster rate. Couple that with the likelihood of a lower tax bracket after retirement and you're way ahead with the IRA. Jul 21 at 13:30
  • 11
    Ignoring a rational reason, you can always look at this way; If it wasn't (generally) beneficial from a tax perspective, the government wouldn't limit the amount you can contribute each year
    – TCooper
    Jul 21 at 20:18
  • 3
    @alephzero The tax benefit of traditional IRAs and 401Ks comes each year. It's not really much of a gamble when you've already filed your taxes and already received the benefit. Your argument might be more applicable to Roth which depend much more on tax laws not changing around them.
    – JimmyJames
    Jul 22 at 14:25
  • 3
    @alephzero That's an extremely pessimistic point of view. Obviously you're entitled to your own opinions... but I at least have some faith in society. The government, as much as its a "big bad entity" (and I'm all for small government) is still just people, and they all have the desire to be re-elected - which they won't be if they shaft everyone on their retirements.
    – TCooper
    Jul 22 at 15:10

11 Answers 11

34

For the reasons you cite may prefer the Roth IRA where you pay tax on the money contributed now, but future withdrawals are tax free.

However there is a benefit to pretax plans such as traditional IRAs.

Assume Tim and Ron are in a the 25% tax bracket and each will dedicate 1K per year to retirement savings. Tim does a traditional IRA, Ron a Roth. Because of taxes Tim contributes the full 1K, but Ron only 750.

After 30 years you end up with something like this:

Tim has $170,568 Ron has $127,460

Tim's balance is far more attractive but taxable. If Tim withdrew his funds in full in one year, then he would probably end up with less than Ron as he would be in a pretty high tax bracket.

However Tim has options. He could withdraw the money in amounts such that he owes almost nothing in taxes. In that case he could be much better off than Ron.

So what will the tax laws be in 30 years as compared to where they are now? It is a tough guess. One thing is certain: If you experience a low income year, it would be a good idea to convert some pretax retirement savings to Roth. It will often result in little income tax and reduce your liablity in the future.

7
  • 1
    Good answer with a good example!
    – Hilmar
    Jul 21 at 11:50
  • 8
    I don't think the question was about traditional vs. Roth, but rather what is the point of IRAs at all. It's important to mention that ordinary investments incur taxes on interest, dividends, and capital gains that do not apply to IRAs.
    – nanoman
    Jul 21 at 14:37
  • 5
    I think you've missed the primary point of either other is that you do not pay taxes on any growth. The 401k is taxed when you take it out. The ROTH is taxed when you put it in. But between there, both are untouched by the taxman. A normal investment account will have to deal with taxes, which will likely take down the gains. Oh... And @nanoman already made this point. Jul 21 at 22:19
  • 3
    @Chris incorrect. Withdrawals from Roth are completely tax free both the gains and original investment. Withdrawals from IRA/401K etc... are completely taxed including the original investment and gains.
    – Pete B.
    Jul 22 at 19:49
  • 1
    @jamesqf: the same 10% penalty plus normal tax applies to withdrawals before 59.5 from Roth of the earnings i.e. beyond the initial contributions (plus taxed conversions after 5 years), and for an account decently invested as little as 10 years earnings should be at least half of the balance. And (for both) there are exceptions to the penalty for special cases like 'first-time' homebuyer, excess medical expense, higher education, natural disaster, and reservist called to active duty, but I agree these generally aren't whims. Jul 23 at 11:01
17

So you only benefit if you are in lower tax bracket when you withdraw

With a traditional IRA, you benefit the most if you are in a lower tax bracket when you withdraw, but you still benefit some if you are in the same or even a slightly higher tax bracket.

You are implicitly comparing to a non-IRA alternative, which I will take to be an ordinary taxable investment account.

Suppose you are currently in the 25% tax bracket and have a spare $3,000 to invest this year (after all your expenses including income taxes). If you simply do a taxable investment, you can put in $3,000. But if you qualify for a deductible IRA contribution, you can put in $4,000. Why? The tax deduction will put $1,000 back in your pocket and you'll only be out $3,000.

Now, let's say the underlying investments have grown 10x when you withdraw. With the taxable investment, you have $30,000 minus the effect of taxes paid along the way on interest and dividends, minus capital gains taxes from selling at a profit. So in the end, less than $30,000 to spend. With the traditional IRA, you have a $40,000 balance taxed at 25%, so you have fully $30,000 to spend. (No additional taxes on interest, dividends, or capital gains.)

So there is an advantage to the IRA even if you remain in the same bracket. A change in bracket will modify this, but you start out ahead.

Another way to see this is the well-known equivalence between a traditional IRA and a Roth IRA under the assumption of staying in the same bracket. A Roth IRA has a clear and simple advantage over a taxable account: No taxes on interest, dividends, or capital gains. In the above example, you could simply contribute $3,000 to a Roth IRA and end up with fully $30,000 to spend, regardless of your tax bracket upon withdrawal.

A traditional IRA is basically a Roth IRA plus a side bet on your tax bracket in retirement, with the breakeven point being your current bracket.

6
  • Except that taxes on capital gains are at a considerably lower rate than salary or IRA distributions. The IRA locks you into paying tax on capital gains and dividends at the salary rate, even if they are qualified for a lower capital gains rate. Jul 21 at 22:56
  • 6
    @Harper-ReinstateMonica No, not really. When you take into account the tax deduction for contributions, a traditional IRA (with no change in tax bracket) is equivalent to a Roth IRA, where there is no tax on growth at all. This is reflected in my answer where I show that the traditional IRA ends up with a full $30k available after tax. In a taxable account, even if the capital gains taxes are low, they come out of the $30k.
    – nanoman
    Jul 21 at 23:36
  • good point, I missed something there. That said, Trad is not equivalent to a Roth except mathematically. Real world, the Trad's "tax on distribution" combines extremely badly with dramatically increasing end of life living expenses. Aides, skilled nursing etc. Jul 22 at 1:03
  • @Harper - Reinstate Monica: That's assuming that you a) have such expenses; and b) have them immediately after you retire. Most of us will probably be able to go along for years, taking out either the Minimum Requred Distribution or however much would keep us in the lower tax brackets. Some things are just luck and/or good planning, as when you have a high income (perhaps because you're still working) despite having to take those MRDs.
    – jamesqf
    Jul 23 at 18:57
  • @jamesqf b) is flat wrong and a) assumes euthanasia. What happens when your partner gets Alzheimers and you break a hip? Medicare doesn't cover the 24x7 care you now need. Now you're munching through your 401K at twice your original salary! That's senior life... I don't think you're ready for it lol. Jul 23 at 19:19
11

Any trades made within an IRA are not subject to being taxed for that given year.

If you wanted to be a high-risk trader then you could trades stocks till your eyes bleed and not be subject to taxes on your gains. This of course assumes that you're actually making trades in your favor instead of losing money like most people =)

1
  • 4
    Agreed. See similar but not duplicate question money.stackexchange.com/questions/141243/… and my answer: "Retirement accounts have the major advantage that changing one's investments within the account (over the coming decades) does not incur capital gains tax along the way. This is a separate, underappreciated benefit from the famous benefits of retirement accounts such as pre-tax contributions or no-tax withdrawal in retirement." Jul 21 at 22:08
6

Lots of good answers pointing out the financial advantages, but I don't see any mention that retirement accounts can also provide you with some protection in the event of a bankruptcy or lawsuit. While not ironclad protection in either event, they're definitely not as exposed as a brokerage account would be.

https://www.fool.com/retirement/what-happens-financial-accounts-in-bankruptcy.aspx https://www.investopedia.com/ask/answers/090915/can-my-ira-be-taken-lawsuit.asp

5

My question is basically what makes IRA better than putting in a brokerage account to buy index fund etc.

You put money in a regular brokerage account with after-tax dollars. When you sell something within a brokerage account, you may pay taxes on your gains every year1.

If you were to take the same after-tax dollars and put them into a Roth IRA instead of a regular brokerage account, you don't have to pay any tax on your gains, ever, as long as you wait to withdraw the gains until you are 59.5 years old. In an emergency you may withdraw up to the amount of your contributions (not the gains) before age 59.5 without any penalty2. This is why putting money into a Roth IRA is far better than putting money into a brokerage account. Note you are limited to only contributing $6-7K per year into an IRA, so beyond that you would use a regular brokerage account.

A second option, is a Traditional IRA instead of a Roth IRA. The advantage of a Traditional IRA over a brokerage account is that it is tax deductible in the year you make the contribution, which, as you point out is simply deferring those taxes until you reach age 59.5. Many people assume they will be in a lower tax bracket at retirement than today, and if they are correct, a Traditional IRA is a good choice for them. Another benefit of the Traditional IRA over a brokerage account is that you don't have to pay any taxes until you make withdrawals from the IRA, versus potentially each year you sell something and realize taxable gains in a brokerage account.

Additional details provided by dave_thomspons_085:

1 In a brokerage account, in addition to realized gains, you pay tax each year on dividends or interest (even if you reinvest them, or the residue of them). You avoid this yearly tax within a Traditional IRA (and of course a Roth IRA which does not have any tax).

2 In a Roth, there are some exceptions to what you can withdraw and when without penalty. For example, initial contributions and conversions that have 'aged' 5 years, and for some emergencies approved in the Code you can even withdraw earnings without penalty

2
  • 1
    For taxable, in addition to realized gains, you pay tax each year on dividends or interest (even if you reinvest them, or the residue of them). Although reduced rates apply to long-term gains and qualified dividends. Also for Roth you can withdraw early without 10% penalty initial contributions and conversions that have 'aged' 5 years; for some emergencies approved in the Code you can even withdraw earnings without penalty. Jul 23 at 10:59
  • @dave_thompson_085 great addition, thanks. I've incorporated your comment into the answer. (Feel free to edit if I didn't quite capture it.)
    – TTT
    Jul 23 at 14:08
3

When your income is low, then contributions into a Roth IRA or Roth 401(k) make a lot of sense. When my kids were in school and not making much money, then paying their 0% tax to put money in the Roth makes perfect sense.

At somebody is at the end of their career when they are in a high tax bracket then the traditional plan makes the most sense. Someplace in the middle they will switch. they may even go some years with contributions to both.

Most people will have money in both traditional and Roth retirement accounts.

3

You are deferring taxation part of your income until a time that you choose to have it taxed.

That choice is a critical component of retirement tax planning. With careful planning, it is possible to never pay taxes on deposits or earnings in an IRA.

For example, as long as you keep your IRA withdrawal (and any other income) during retirement below the standard deduction (or your other combined deductions) you can withdraw it without ever paying taxes on it. You have (almost) complete control of when and how much you withdraw in any given year. (Subject to minimum withdrawal requirements)

In fact, if well-planned withdrawals may be used to put a person in the correct income bracket to qualify for income tax credits.

1

Roths grow tax-free

To make the clearest (simplest) case for IRA, let's consider the ROTH IRA. This was developed to answer some problems with traditional IRAs. Comparing "Roth IRA" to "normal investments" will illustrate the situation very well.

Ron earns $5000 and puts it in a Roth IRA. Norma earns $5000 and puts it in a brokerage account. Both of them are investing money they already paid taxes on, which makes this comparison easy.

Both buy the same index fund. Over 40 years, their $5000 grows averaging 8% a year, to $110,000. They sell their index funds.

Norma fills out Schedule D, listing a "Cost Basis" of $5000, "Sale Price" of $110,000, and "Proceeds" of $105,000. Unfortunately in the ensuing 40 years, capital gains tax rates aren't so great, and Norma pays 25% State and Federal tax, or $26,250, on the gains.

So, Norma collects $83,750.

Ron collects $110,000 in proceeds. That's it. End of story.

Now do you understand the value of a Roth?

Except it's worse than that.

Because neither of them sits in the same index fund for 40 years. They buy and sell, "rebalance" their portfolios, so on average any given asset gets exchanged for another every 5 years. That means that Norma gets pinched for capital gains taxes EIGHT TIMES, diluting Norma's profits further.

Ron does the same asset swaps, but does not pay any capital gains tax because the assets are inside an IRA.

Traditional IRAs enjoy the same benefit... kinda.

With a traditional IRA, you are not taxed when you contribute the money, but you are taxed when you withdraw it. Since you weren't taxed "on the way in", you can contribute more.

So for instance, if Ron and Norma above were in a 30% combined tax bracket, they had to earn $7142 in order to have $5000 after taxes to contribute to their Roth and brokerage accounts, respectively.

How about Trish, who doesn't pay tax on the $7142 and contributes it to a Traditional IRA (ignoring contribution limits; say Trish uses a 401(K) which works the same way). What happens to Trish?

Again assuming 8% average growth, Trish is at $155,000 after 40 years. Since it's a Traditional IRA, Trish must pay 30% normal income tax "coming out of it". This is a worse rate than Norma, but it starts with more money. So with $45,000 taxes paid, Trish is right back at the same $110,000 as Ron.

Trish does the same asset swaps, but does not pay any capital gains tax because the assets are inside an IRA.

With mathematics alone, Traditional is equivalent to Roth

However, there are very significant non-math complications that make Traditional IRAs an inferior choice.

Somewhere in another answer here I have an extensive list. But the first and biggest problem relates to tax brackets. The general concept is you're supposed to be able to withdraw a Traditional IRA funds at a lower tax bracket, because you're supposed to be making less money per year when you're retired. And also assuming tax brackets aren't raised, either by government action or by the creep of inflation.

The idea is you're supposed to withdraw IRA funds evenly from age 59-1/2 to end of life. Easy as pie, right? All you need to do is know your death date. Because, you see, the whole plan falls apart if necessities oblige you to withdraw a great deal more money in certain years. That drives you into a high tax bracket in those years, and generally speaking, you get creamed on taxes.

And unfortunately, that is life in retirement these days. At least you or your partner is very likely to have a slow, lingering endlife with lots of care needed that isn't paid by Medicare. So a traditional IRA leaves you two bad options:

  • Withdraw at a faster rate than is ideal, and thus, pay more taxes than are ideal.
  • Be driven into very high tax brackets in years when medical crises necessitate large withdrawals.

By contrast, a Roth has no "coming out" taxes, so it's very friendly to the "withdrawal spike/surge" scenarios.

2
  • OTOH if you put all of your money in ROTH, you are wasting the lower bands (including the tax free band) during your retirement years. It seems to me that a mixture of traditional and roth (and possiblly some "roth conversions") is likely to be more of an optimum. Jul 31 at 3:47
  • This is an interesting exception to the general rule of keeping money in the Roth IRA as long as possible. Jul 31 at 5:09
0

In principal at least, the fact that you can defer the taxes means that you can afford to put more towards retirement in the first place. Obviously, getting the benefit of that depends on you taking steps to make sure that you're actually doing that - if you just save whatever amount you would have saved anyway the benefit of that disappears. Personally, I make it a practice to put most of my tax refund towards savings and investments rather than spending it for that exact reason.

A second issue is taxes before you retire. If you're investing outside of a tax-sheltered account, you have to pay taxes on any dividends or realized gains; on the other hand, if you're investing in a tax-sheltered account, you don't have to pay yet. This means that the money can grow a little faster than it would otherwise.

You are, of course, perfectly correct that you still have to pay taxes when you take the money out of a traditional IRA. That is not the case for Roth IRAs, though - you don't pay when you take money out. The advantage of that is that the money can grow considerably before you take it out. A $30,000 initial investment held for 30 years at 8% interest compounding annually will be worth $301,879.71 when it's taken out. Suppose that you're at a 25% tax rate; a Roth would mean that you'd have 0.75*30,000=22,500 to invest, which would result in $226,409.78 at the end. On the other hand, you'd have 0.75*301,879.71=226,409.78 at the end with a traditional IRA. While these sound equivalent, consider the following: if you needed $50,000 to live on, you'd have to withdraw 50000*1.25=62,5000 every year. So, at the end of each year with the Roth, you'd end up with:

enter image description here

On the other hand, with the traditional IRA, you'd have

enter image description here

Which results in the following for the Roth:

176409.78
140522.5624
101764.367392
59905.5167833601
14697.9581260289
-34126.2052238888

and for the traditional:

164409.78
115562.5624
62807.567392
5832.17278336005
-55701.2533939712

In other words, you'd run out of money during the sixth year for the Roth and in the fifth year for the traditional. Furthermore, in your last year before running out of money, you'd have only approximately $5,800 for the traditional but $14,700 for the Roth. (You're in a little bit of trouble either way, but you get the point).

Incidentally, here's a C# script if you'd like to run this calculation with other amounts of money:

void Main()
{
    // How much they want to have every year for after-tax expenses
    const double annualSalary = 50000;
    
    // Need to take out money every year for taxes
    // For the Roth, simply set this to 1; otherwise, it's (1 + tax bracket)
    const double taxMoney = 1.25;
    
    // How much the assets are worth right before retirement
    const double amountAtRetirement = 226409.78;
    
    // 8% interest per year
    const double annualInterestRate = 1.08;

    double a0 = amountAtRetirement - (taxMoney * annualSalary);
    
    Console.WriteLine(a0);
    
    for (int i = 1; i <= 10; i++) {
        a0 = (annualInterestRate * a0) - (taxMoney * annualSalary);
        Console.WriteLine(a0);
    }
}
0

What makes IRA better than putting in a brokerage account to buy index funds etc.?

In the brokerage account, you pay taxes before you put the money in AND after you take the money out. In a Roth IRA, you only have to pay taxes when you put it in.

[Update: Never having owned a traditional IRA, I'd always assumed the behavior was dual to that of a Roth IRA, which is apparently not the case. As @JeopardyTempest points in the comments, in a traditional IRA you're taxed on all distributions, not just on capital gains, so the only advantage to a traditional IRA versus a brokerage account would be the possibility of taking the money out while in a lower tax bracket after retirement. Seems like a pretty dicey "benefit," given the withdrawal penalties and the fact that taxes could theoretically be dramatically higher in the future.]

4
  • The money you put into a brokerage account has already been taxed, and the gains are taxed after whenever they are realized. It can take place even during a year you never sold any investments. Jul 23 at 10:02
  • 1
    Seems the whole amount is taxed once either way... for a regular brokerage account, the principal is taxed before investing, gains are taxed upon sale... for a regular IRA both the principal and gains are taxed upon withdrawal. Only with a Roth is it not fully taxed, only with a tax on the principal (before investing), but no tax on gains (though that's why there are instead limits to how much you can put in a Roth and early withdrawal penalties) Jul 23 at 11:58
  • @mhoran_psprep: Yes, I am simplifying and assuming the main way you realize gains is by selling and withdrawing the money. There are of course such things as interest, dividends, capital gains distributions, and so on. Jul 23 at 13:37
  • 1
    Investopedia looks to disagree: "When you withdraw the money, both the initial investment and the gains it earned are taxed at your income tax rate in the year you withdraw it.". Indeed the compounded nature results in less overall tax, but though I'm no expert, both still seem to be taxed once as a whole... it's just later taxing means you've built more money (hopefully at better than inflation) and so results in more overall. Jul 23 at 19:44
0

Something is often missing from the IRA conversation. This is what marginal rates look like in 2021.

enter image description here

While working, the IRA deposit comes off the top, e.g. while you are in the 22% bracket. Now. You save, and have $1M at retirement. You take out $40,000 per year. $12,500 is the standard deduction. $9,950 is taxed at 10%, $995 tax bill. The remaining $17,500 is taxed at 12%. $2106 tax bill for a total tax due of $3101 on that $40,000. But, you saved $8800 in taxes when you deposited it.

To say it in words - Your pre-tax savings, IRA, 401(k), etc, are saved at your marginal rate, off the top. But withdrawals pass through each bracket, starting at zero (the standard deduction), and passing through 10,12, etc.

$3101 tax on $40,000 is a 7.75% 'average' rate even though the last dollar coming out is taxed at 12%.

This is the clearest way I can describe the benefit of the IRA/401(k) pretax account.

Edit: To Dilip's point - Instead of taking just $40K early on, make it $60K. The extra $20K is taxed. $13,025 @ 12% ($1563) and $6975 @ 22% ($1535) for a total tax bill of $6199, an average rate of 10.3% vs the $13,200 saved as it was withheld pre-tax.

His comment also reminds me of the fact that I should have noted that one should use a Roth while earning money at a marginal 12%. Only when taxable income is in a higher marginal rate, save the extra (the earnings over $40,525 taxable) to the pretax side, if possible. This takes just a bit of attention, unless one's income is very unstable.

2
  • I don’t think your argument regarding withdrawals is quite correct. Traditional IRAs are subject to Required Minimum Distributions, and these RMDs are an increasing percentage of the (end-of-last-year) balance. In short, taking out $40k year after year from an initial balance of $1M is not going to work for long; the RMDs will kick in at age 72 and more will need to be pulled out to satisfy the RMD. Jul 24 at 2:51
  • Yes. Great point, see my updated answer. Jul 24 at 12:07

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

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