Straight Index Fund vs IRA + Index Fund

Question

I am about to open a traditional IRA and put my money in an Index Fund (to be decided). Which has the advantage that taxes are deferred until withdrawal. It also seems that I have the advantage of being able immediately/tax-free re-invest my dividends. If I skip the IRA and place my money in the Index Fund, I would of course have to pay capital gains on earnings.

My question is what is cheaper in the long term. I have no intent of withdrawing the money. I am having a bit of trouble balancing the net gain given, paying taxes as on capital gains, thus affecting the principal (or at least my cash) versus not paying any tax until withdrawal. Are there any good charts/calculators for this?

My hunch is that an IRA where my money is in an Index Fund is better long term than an Index Fund alone if I'm just wanting to save up money for retirement. Of which, I could at a fixed/desired rate pull the needed amount of money I want (control the tax bracket) when/as I need it.

It also seems that a Roth IRA and Traditional IRA come out to be the same due the fact that the tax multiplier is just multiplied through at a different point. i.e. P * Tax * (Interest) ^ years = (P * (Interest) ^ years) * Tax

Thanks, forgive me if my terminology/understanding is incorrect.

Answer 1

You're misunderstanding the concept of retirement savings.

IRA distributions are taxed, in their entirety, as ordinary income. If you withdraw before the retirement age, additional 10% penalty is added.

Investment income has preferential treatment - long term capital gains and qualified dividends are taxed at lower rates than ordinary income.

However, IRA contributions are tax deductible. I.e.: you don't pay taxes on the amounts contributed to the IRA when you earned the money, only when you withdraw. In the mean time, the money is growing, tax free, based on your investments. Anything inside the IRA is tax free, including dividends, distributions (from funds to your IRA, not from IRA to you), capital gains, etc.

This is very powerful, when taking into account the compounding effect of reinvesting your dividends/sale proceeds without taking a chunk out for taxes. Consider you make an investment in a fund that appreciated 100% in half a year. You cash out to reinvest in something less volatile to lock the gains. In a regular account - you pay taxes when you sell, based on your brackets. In the IRA you reinvest all of your sale proceeds. That would be ~25-35% more of the gains to reinvest and continue working for you!

However, if you decide to withdraw - you pay ordinary rate taxes on the whole amount. If you would invest in a single fund for 30 years in a regular account - you'd pay 20% capital gains tax (on the appreciation, not the dividends). In the IRA, if you invest in the same fund for the same period - you'll pay your ordinary income rates. However, the benefit of reinvesting dividends tax-free softens the blow somewhat, but that's much harder to quantify.

Bottom line: if you want to plan for retirement - plan for retirement. Otherwise - IRA is not an investment vehicle.

Also consider Roth IRA/conversions. Roth IRA has the benefit of tax free distributions at retirement. If your current tax bracket is at 20%, for example, contributing $5K to Roth IRA instead of a traditional will cost you $1K of taxes now, but will save you all the taxes during the retirement (for the distributions from the Roth IRA). It may be very much worth your while, especially if you can contribute directly to Roth IRA (there are some income limitations and phaseouts). You can withdraw contributions (but not earnings) from Roth IRA - something you cannot do with a traditional IRA.