Do IRAs make sense if you are in a 10 or 15% tax bracket?

Question

My understanding is that the advantage to an IRA is that you don't pay taxes on capital gains. However, if you are in the 10 or 15% tax brackets, you don't pay capital gains taxes anyway. In that case, are there any advantages to using an IRA anyway? The disadvantage is that you're penalized for early withdrawals.

The tax rate for capital gains is applied based on your income when you withdraw, right? If so, you're not making any money during retirement, so if you take it out when you're 60 and retired, you wouldn't have to pay capital gains taxes. So when do IRAs ever make sense?

Answer 1

First you need to distinguish between short-term and long-term capital gains. In an IRA you can use investment strategies that incur short-term capital gains without being taxed as ordinary income.

As mentioned in a comment above, with a Roth IRA, you can invest now at your low income tax rates and withdraw all gains without incurring any taxes at retirement time.

You can also pull out your contributions penalty free before retirement age (59 1/2) if you've had the account for more than 5 years. You only pay taxes and penalties on the earnings. You can also make withdrawals for education expenses and you have one lifetime exclusion of $10,000 for a down-payment on a house.

Answer 2

One reason is that you can trade in the IRA without incurring incremental taxes along the way. This may be especially important if you intend to shift your portfolio allocation as you approach retirement. For instance, gradually selling stocks and buying bonds can incur taxes if you do it in a taxable account (if you do it while you have other income and thus may face capital gains taxes). Also, if you have mutual funds in a taxable account, they may distribute capital gains to you that you'll owe taxes on, but holding the funds in an IRA will shield you from that.

There are also some other side benefits to IRAs because they are considered to "not count" for certain purposes when determining what you're worth. For instance, if you go bankrupt, you could be forced to sell assets in taxable accounts to pay your creditors, whereas IRAs are protected in many cases. Likewise, if you try to get financial aid to pay for college for your kids, money in an IRA won't be counted among your assets in determining your aid eligibility, potentially giving your kids access to more aid money.

Finally, an especially prominent benefit is, paradoxically, the early withdrawal penalty. For many people, part of the purpose of an IRA is to "lock away" their money and prevent themselves from accessing it until retirement. Early withdrawal penalties provide a concrete consequence that psychologically deters them from raiding their retirement savings willy-nilly.